Industries

Industry context matters. Business models, risks, and value drivers vary widely across sectors. Mercer Capital applies rigorous valuation and financial analysis grounded in long-standing industry specialization, delivering independent conclusions informed by how businesses operate within their markets.

Business & Professional Services

This sector encompasses companies that build, deliver, and support essential infrastructure and supply chain activity.

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Construction & Building Materials

Mercer Capital provides valuation and related advisory services to companies in the construction and building materials industry.

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Transportation & Logistics

Mercer Capital provides valuation and related advisory services to transportation and logistics companies.

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Consumer

From car dealerships to food & beverage brands, hospitality groups, and multi-channel retailers, consumer industries must continually adapt to changing preferences and economic conditions.

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Animal Health

Mercer Capital provides valuation and advisory services to companies and practices in the animal health industry.

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Auto Dealerships

Mercer Capital provides valuation and advisory services to companies throughout the nation in the auto dealer industry.

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Food & Beverage

Mercer Capital provides food and beverage producers, distributors, and wholesalers with valuation and advisory services.

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Hospitality

Mercer Capital provides valuation and advisory services to the hospitality industry.

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Retail

Mercer Capital provides valuation and advisory services to companies in the retail industry.

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Energy & Power

From traditional oil & gas operations to emerging alternative and renewable platforms, Mercer Capital provides independent valuation and advisory services across the Energy sector.

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Oil & Gas

Mercer Capital provides oil & gas companies, oil & gas servicers, and mineral & royalty owners with corporate valuation, litigation support, transaction advisory, and other related services.

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Alternatives

Mercer Capital provides renewable energy companies, energy-transition technology firms, and alternative fuel producers with corporate valuation and other financial advisory services.

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Financial Services

Independent valuation and financial advisory services for financial institutions navigating complex transactions, reporting requirements, and strategic decisions

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Banks

Mercer Capital has provides banks, thrifts, and credit unions with corporate valuation, transaction advisory, litigation support, and financial reporting services.

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Credit Unions

Mercer Capital’s offers a broad range of services to Credit Unions, including M&A advisory and representation, fairness opinions, strategic planning, and stress testing services.

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Financial Technology

Mercer Capital provides FinTech companies, from start-ups to more mature companies, and their partners with valuation, financial advisory, and consulting services.

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Insurance

Mercer Capital provides valuation and advisory services to insurance agencies, brokerages, underwriters, insurtech companies, third-party administrators, and other service providers.

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Investment Management

Mercer Capital provides valuation, transaction, litigation, and related services to asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers.

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Financial Sponsors

Mercer Capital provides corporate valuation and financial advisory services to private equity firms and other financial sponsors to help our clients minimize risk and maximize value.

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Specialty Finance

Mercer Capital provides specialty finance companies with independent valuation, transaction advisory, litigation support, and related financial services.

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REITs & Real Estate Businesses

Mercer Capital provides REITs, real estate operating companies, developers, and property managers with independent valuation, transaction advisory, and litigation support services.

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Healthcare

Mercer Capital provides independent valuation and related advisory services to hospitals, medical device manufacturers, diagnostic technology firms, and other healthcare companies, supporting transactions, planning, financial reporting, and dispute matters

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Healthcare Facilities

Mercer Capital provides hospitals, clinics, ASCs, and other healthcare facilities with independent valuation, transaction advisory, litigation support, and related financial services.

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MedTech & Devices

Mercer Capital provides medical device manufacturers, diagnostic technology companies, and other medtech innovators with independent valuation and transaction advisory services.

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Industrials

Mercer Capital provides manufacturers, distributors, agribusiness operators, and heavy equipment dealers with independent valuation and transaction advisory services.

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Agribusiness

Mercer Capital supports producers, processors, distributors, and other agribusiness enterprises with independent valuation, litigation support, and transaction advisory services.

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Heavy Equipment Dealers

Mercer Capital provides heavy equipment dealers, rental operators, and related businesses with independent valuation, transaction advisory, and litigation support services.

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Distribution

Mercer Capital supports wholesale, industrial, and specialty distributors across a range of end markets with independent valuation, transaction advisory, litigation support, and related services.

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Manufacturing

Mercer Capital supports manufacturers of industrial components, consumer goods, and specialized products with independent valuation and transaction advisory services.

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Technology, Media, & Telecommunications

Mercer Capital supports professional sports organizations and related media, technology, and telecommunications companies with independent valuation and advisory services.

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Media & Entertainment

Mercer Capital supports traditional and digital media businesses and related businesses with independent valuation, transaction advisory, and litigation support services.

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Professional Sports

Mercer Capital is the leader in professional sports valuation. We have deep industry knowledge and experience and a deep bench of professionals ready to help.

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Technology

Mercer Capital provides software developers, SaaS platforms, AI solution providers, and IT services firms with independent valuation, transaction advisory, and litigation support services.

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Telecommunications

Mercer Capital provides wireless carriers, fiber & broadband providers, and telecommunication companies with independent valuation and transaction advisory services.

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Insights

Thought leadership that informs better decisions — articles, whitepapers, research, webinars, and more from the Mercer Capital team.

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What a Cold Snap Teaches Us About Cycles in RIA M&A

Seasonal Market Metaphors

While frigid temperatures disrupted travel and infrastructure across the country, the RIA M&A market has remained anything but frozen. Deal activity continues at historically strong levels, reminding firms that favorable conditions are best used to prepare for the inevitable shifts that come with market cycles.

Bank Watch: January 2026

Some “Slop” About 2025 Bank Stock Performance

Small-cap bank stocks delivered a so so 2025. Despite solid earnings growth, small-cap bank valuation multiples remain below long-term averages, reflecting a gap between bank performance metrics and investor sentiment. Large-cap banks continued to outperform small-caps, as well as the broader market, due to strong capital markets activity.

RIA M&A Update: Q4 2025

M&A activity in the RIA industry remained elevated through the end of 2025, capping a year defined by historically strong deal volume. While monthly deal counts in the fourth quarter moderated from the record-setting pace observed earlier in the year, overall activity remained well ahead of prior-year levels.

The Role of the Third Appraiser

After watching some controversial calls unfold this past weekend during the NFL playoffs, I couldn’t help but draw the correlation between throwing the challenge flag and looking for a third appraiser. Overtime in a playoff game, win or go home, the situation is as intense as it gets. Similarly, when a buy-sell agreement calls for a third appraiser, the stakes are high and it is fairly late in the game.

Defying the Cycle: Haynesville Production Strength in a Shifting Gas Market

Haynesville shale production defied broader market softness in 2025, leading major U.S. basins with double-digit year-over-year growth despite heightened volatility and sub-cycle drilling activity. Efficiency gains, DUC drawdowns, and Gulf Coast demand dynamics allowed operators to sustain output even as natural gas prices fluctuated sharply.

The State of Wealth Management Entering 2026

The wealth management industry delivered another year of growth in 2025, supported by favorable equity market performance amid periods of market volatility. Within the publicly traded RIA universe, outcomes varied across investment manager models and asset exposures.

December 2025 SAAR

The U.S. auto industry closed 2025 with modest sequential improvement, surpassing 16 million units for the first time since 2019. While volumes stabilized late in the year, continued year-over-year declines, rising incentives, and uneven inventory levels across brands highlight a market that is normalizing rather than accelerating. As the industry moves into 2026, disciplined inventory management and margin preservation will be critical drivers of dealer performance and franchise value.

Haynesville Shale M&A Update: 2025 in Review

Key TakeawaysHaynesville remains a strategic LNG-linked basin. 2025 transactions emphasized long-duration natural gas exposure and proximity to Gulf Coast export infrastructure, reinforcing the basin’s importance in meeting global LNG demand.International utilities drove much of the activity. Japanese power and gas companies pursued direct upstream ownership, signaling a shift from traditional offtake agreements toward greater control over U.S. gas supply.M&A was selective but meaningful in scale and intent. While overall deal volume was limited, announced transactions and reported negotiations reflected deliberate, long-term positioning rather than opportunistic shale consolidation.OverviewM&A activity in the Haynesville Shale during 2025 was marked by strategic, LNG-linked transactions and renewed international investor interest in U.S. natural gas assets. While investors remained selective relative to prior shale upcycles, transactions that did occur reflected a clear pattern: buyers focused on long-duration gas exposure, scale, and proximity to Gulf Coast export markets rather than short-term development upside.Producers and capital providers increasingly refocused efforts on the Haynesville basin during the year, including raising capital to acquire both operating assets and mineral positions. This renewed attention followed a period of subdued transaction activity and underscored the basin’s continued relevance within global natural gas portfolios.Although the Haynesville did not experience the breadth of consolidation seen in some oil-weighted plays, the size, counterparties, and strategic motivations behind 2025 transactions reinforced the basin’s role as a long-term supply source for LNG-linked demand.Announced Upstream TransactionsTokyo Gas (TG Natural Resources) / ChevronIn April 2025, Tokyo Gas Co., through its U.S. joint venture TG Natural Resources, entered into an agreement to acquire a 70% interest in Chevron’s East Texas natural gas assets for $525 million. The assets include significant Haynesville exposure and were acquired through a combination of cash consideration and capital commitments.The transaction was characterized as part of Tokyo Gas’s broader strategy to secure long-term U.S. natural gas supply and expand its upstream footprint. The deal reflects a growing trend among international utilities to obtain direct exposure to U.S. shale gas through ownership interests rather than relying solely on long-term offtake contracts or third-party supply arrangements.From an M&A perspective, the transaction highlights continued willingness among major operators to monetize non-core or minority positions while retaining operational involvement, and it underscores the Haynesville’s attractiveness to buyers with a long-term, strategic view of gas demand.JERA / Williams & GEP Haynesville IIIn October 2025, JERA Co., Japan’s largest power generator, announced an agreement to acquire Haynesville shale gas production assets from Williams Companies and GEP Haynesville II, a joint venture between GeoSouthern Energy and Blackstone. The transaction was valued at approximately $1.5 billion.This acquisition marked JERA’s first direct investment in U.S. shale gas production, representing a notable expansion of the company’s upstream exposure and reinforcing JERA’s interest in securing supply from regions with strong connectivity to U.S. LNG export infrastructure.This transaction further illustrates the appeal of the Haynesville to international buyers seeking stable, scalable gas assets and highlights the role of upstream M&A as a tool for portfolio diversification among global utilities and energy companies.Reported Negotiations (Not Announced)Mitsubishi / Aethon Energy ManagementIn June 2025, Reuters reported that Mitsubishi Corp. was in discussions to acquire Aethon Energy Management, a privately held operator with substantial Haynesville production and midstream assets. The potential transaction was reported to be valued at approximately $8 billion, though Reuters emphasized that talks were ongoing and that no deal had been finalized at the time.While the transaction was not announced during 2025, the reported discussions were notable for both their scale and the identity of the potential buyer. Aethon has long been viewed as one of the largest private platforms in the Haynesville, and any transaction involving the company would represent a significant consolidation event within the basin.The reported talks underscored the depth of international interest in Haynesville-oriented platforms and highlighted the potential for large-scale transactions even in an otherwise measured M&A environment.ConclusionWhile overall deal volume remained selective, the transactions and reported negotiations in 2025 reflected sustained global interest in U.S. natural gas assets with long-term relevance. Collectively, the transactions and negotiations discussed above point to a Haynesville M&A landscape driven less by opportunistic consolidation and more by deliberate, long-term positioning. As global energy portfolios continue to evolve, the Haynesville basin remains a focal point for strategic investment, particularly for buyers seeking exposure tied to U.S. natural gas supply and LNG export linkages.

RIA Market Update: Q4 2025

Alternative asset managers faced a more challenging quarter, with declining prices and valuation compression driven by investor preference for traditional strategies in a higher-for-longer rate environment. Despite near-term headwinds, scale, recurring revenue models, and long-term growth fundamentals continued to underpin investor interest across the sector. We explore these trends further in our Q4 2025 Market Update.

Bank Watch: December 2025

Bank M&A in 2026 May Have a 1990s Vibe

Bank M&A activity in 2025 returned to a more normal pace, with announced deals rising to 176 and disclosed deal value jumping to $49 billion, supported by improved pricing, stronger bank valuations, and faster regulatory approvals. Large regional bank transactions, including Fifth Third–Comerica and Huntington’s acquisitions, signaled a more favorable and permissive environment that could resemble the consolidation wave of the late 1990s. Looking ahead to 2026, stable economic conditions, healthier bank profitability, and supportive equity markets suggest M&A activity could remain strong, though outcomes will depend on market performance and pricing discipline.

Medtech and Device Industry Newsletter - Q4 2025

Feature Article | Year in Review: Across MedTech, Discipline Is a Recurring Theme

PODCAST | Beyond the Lot: Understanding Dealership Valuations

with Kevin Timson and David Harkins

Mercer Capital Vice President David Harkins was recently featured on the podcast Beyond the Lot: Understanding Dealership Valuations, hosted by Kevin Timson, for a wide-ranging conversation on the factors that truly drive value in automotive dealerships. Drawing from his experience advising auto dealers nationwide, David discusses how elements such as brand strength, real estate, fixed operations, and local market dynamics influence dealership valuations.

Top 10 Oil & Gas Blog Posts of 2025

Year-end 2025 is quickly approaching so that means it’s time to take a look back at the year. Here are the top ten posts for the year measured by readership.

‘Twas the Blog Before Christmas

The Ghost of Trust

Each year, we close our blog with a holiday poem inspired by Clement Clarke Moore’s A Visit from St. Nicholas. This season, with markets at record highs but public trust in institutions on shakier ground, it seemed fitting to summon the ghost of J. P. Morgan himself. In “The Ghost of Trust,” Morgan visits on a December night in New York to remind us that even in an age of algorithms, skyscrapers, and artificial intelligence, the most important capital a firm can hold is integrity.

Trust Capabilities and the RIA Move Up-Market

A growing number of RIAs are positioning themselves up-market, targeting larger households, multi-generational families, and clients whose needs extend well beyond investment management. Ultra-high-net-worth clients often rely on trusts not just for estate planning but as central vehicles for governance, control, tax efficiency, and multi-generational wealth transfer. These structures must be administered accurately and consistently for years — often decades — after they are created.

Themes from Q3 2025 Earnings Calls

Third-quarter commentary from E&P and oilfield service companies highlighted a cautious near-term outlook paired with growing confidence in long-term demand. While operators remain in “maintenance mode,” structural growth themes—LNG, data centers, offshore development, and water midstream—continue to shape strategy. Despite softer activity, companies emphasized free cash flow, efficiency, and positioning for stronger demand later in the decade.

November 2025 SAAR

The November 2025 SAAR improved to 15.6M, yet industry volumes posted a second month of year-over-year declines amid tariff impacts and expiring EV incentives. After September’s tax-credit rush, BEV market share has fallen by more than half, signaling a sharp reset in EV sales momentum. Finally, despite likely topping 16M units for 2025, per-unit profitability is slipping, and dealer performance is increasingly dependent on brand-specific inventory discipline.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of December 4, 2025

Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis.

Five Ways RIAs Can Turn Good Years Into Lasting Momentum

How to Convert a Great Year Into Durable Success

Momentum for RIAs isn’t about riding strong markets, it’s about building systems that hold up when conditions tighten. As firms look toward 2025-26, the advantage will go to those that understand the true drivers of their growth, reinforce margins, and modernize ownership to support long-term strategy.

Bank Watch: November 2025

Top Three Questions for Potential Bank Acquirers

Community bank M&A accelerated in 2025, with deal volume, values, and pricing all rising amid a more favorable regulatory climate and continued economic expansion. If these trends continue, 2026 could offer attractive opportunities for banks exploring strategic options. Against this backdrop, acquirers should focus on strategic fit, realistic valuation, and the pro forma impact of any potential transaction.

Leftovers: RIA Themes from 2025 That Will Carry Into 2026

As firms sort through the “leftovers” of 2025, several themes are poised to carry meaningful weight into 2026. Margin discipline, improved client engagement, and rising operational maturity have strengthened the industry’s foundation. Strategic dealmaking, evolving succession plans, and measured progress with AI adoption continue to shape valuations and competitive dynamics. These lingering trends aren’t remnants—they’re the building blocks of a resilient, opportunity-rich year ahead for RIAs.

Earnouts That Actually Pay in RIA M&A

Earnouts can bridge valuation gaps in RIA M&A by tying part of the purchase price to post-close performance. This article explains the differences between retention and growth earnouts, key metric choices, and structural considerations that help create clear, predictable, and effective earnout frameworks for both buyers and sellers.

Just Released: Q3 2025 Oil & Gas Industry Newsletter

Region Focus: Appalachia

Overall, the Appalachian basin enters late-2025 on firmer footing than a year ago, characterized by stable production, recovering equity performance, and improving infrastructure fundamentals. Continued progress on export capacity and incremental LNG demand should provide a constructive backdrop for basin economics heading into 2026.

A Decade in Motion: How COVID Reshaped Valuations in the Transportation Industry

The last several years have been nothing short of transformative for the transportation and logistics industry. Shifts in global trade patterns, consumer behavior, capital markets, and cost structures have left an indelible mark on both the operating performance and valuation metrics of transportation companies. A review of enterprise value to EBITDA (EV/ EBITDA) multiples across key subsectors, truckload, less-than-truckload (LTL), air, marine, rail, and logistics, reveals three distinct eras: the calm before the storm (pre-COVID), the whiplash of the pandemic years, and the normalization that followed.

Transportation & Logistics Newsletter

Third Quarter 2025

How RIAs Should Use Their Excess Horsepower

Making Productive Use of Earnings

Investment management firms generate more earnings than they need. The real challenge isn’t making money—it’s deciding, intentionally and strategically, how best to use it.

Beyond the SAAR: What Really Drives Auto Dealership Value

Because the federal government has just reopened, the official data for the monthly light-vehicle SAAR (Seasonally Adjusted Annual Rate) is not yet available. In the meantime, we invite you to download and review our whitepaper, “Understand the Value of Your Auto Dealership.”

Oil vs. Gas: Diverging Valuations in the Energy Patch Persist

U.S. Upstream Producers Are Closing 2025 with Sharply Different Stories Depending on the Molecules They Sell

2025 continues some of the same valuation trends that I have written about earlier this year. As U.S. oil producers battle with middling prices, emerging breakeven cost issues, and shrinking Tier 1 acreage, gas investors are foreseeing growth and future profitability. Investors are rewarding future demand visibility over near-term cash generation, a rare reversal in a sector long dominated by oil.

Medtech and Device Industry Newsletter - Q3 2025

Feature Article | Caris Life Sciences: Precision Medicine Meets AI

What to Look for in an Acquisition Target for Your RIA

This week we’re flipping the script on last week’s post, "What to Look for in a Buyer for Your RIA," to analyze transactions from the buy-side perspective. This post focuses on the key attributes that RIA acquirers should look for in a target that should make the transaction successful, value-accretive, and enduring.

The Evolving Economics of Oilfield Water

From Breakevens to Data Centers

The oilfield water sector continues to mature as one of the more strategically significant and rapidly changing segments of the energy value chain. At the recent 7th Annual Oilfield Water Industry Update, executives and analysts from across the industry discussed how water management is no longer a secondary operational consideration but a primary driver of production economics, infrastructure planning, and even cross-industry innovation.

2025 Year in Review: Across MedTech, Discipline Is a Recurring Theme

Last month, the medtech team at Mercer Capital attended the 2025 Musculoskeletal New Ventures Conference, where discussions among founders, venture investors, strategic acquirers, and advisors converged on a consistent message: activity in the industry is increasingly shaped by discipline around clinical differentiation, capital efficiency, and strategic coherence. Innovation continues across the ecosystem, though expectations around execution, funding, and exit visibility have tightened. For early-stage companies, investors described an environment that supports new ventures, albeit with a greater emphasis on efficient capital deployment. Successful companies are pursuing leaner development strategies with earlier clinical or regulatory wins, rather than broad, capital-intensive pipelines. Incremental innovation, particularly in mature segments such as orthopedics, has been attractive when paired with platform scalability or data-enabled (AI) differentiation. Management quality and adaptability remain critical at this stage. In contrast, as other observers have also noted, venture capital has favored select growth-stage and later-stage deals. Investments flowed into companies able to articulate coherent clinical and commercial strategies aligned with the priorities of large, strategic buyers. Clear narratives around end-market adoption, strategic fit, and integration potential have tended to lead to higher valuations across observed transactions. Among large, established medtech companies, portfolio optimization was an ongoing effort. For public companies, exposure to higher-growth segments has increasingly supported better valuation multiples and relative equity performance. In response, strategic acquirers such as Stryker, Boston Scientific, Medtronic, and Johnson & Johnson have tuned their portfolios through targeted acquisitions, divestitures, and capital redeployment. For example, Stryker’s acquisition of Inari Medical reflects the appeal of the high-growth interventional markets with strong clinical differentiation, while its divestment of the spine business demonstrates an effort to exit slower-growth or less strategically differentiated segments. Similarly, Johnson & Johnson’s acquisitions of Shockwave Medical and V-Wave in 2024 augmented a cardiovascular platform focused on markets with long-term growth potential, while the announced separation of its DePuy Synthes orthopedics business signals a broader effort to simplify and sharpen strategic focus within its portfolio. Overall healthcare IPO activity in 2025 was broadly in line with 2024 levels, with issuance concentrated among higher-quality medtech and life sciences companies rather than reflecting a broad-based market reopening. Offerings such as Caris Life Sciences, which combined scale, revenue growth, and a differentiated data-driven platform, were relatively well received, suggesting that the IPO window remains available but is selective. Across various company stages and transactions, 2025 activity in medtech reflected a consistent emphasis on disciplined, capital-efficient growth. Whether among early-stage investments prioritizing focused development, later-stage companies articulating clear strategic fit, or large strategics actively reshaping portfolios, the common thread has been the pursuit of durable clinical differentiation and well-defined paths to scale or exit.

What to Look for in a Buyer for Your RIA

For many RIA founders, the decision to sell is one of the most significant milestones in their professional lives. A sale represents not only the opportunity to unlock financial value but also the responsibility to ensure that clients, employees, and the firm’s legacy are well cared for in the next chapter. The growing number of active acquirers in the RIA space means that founders have choices—but more options can also make the decision more complex.

Now Available: Mercer Capital’s 2025 Energy Purchase Price Allocation Study

The 2025 Energy Purchase Price Allocation Study provides a detailed analysis and overview of valuation and accounting trends in these sub-sectors of the energy space. This study also enables key users and preparers of financial statements to better understand the asset mix, valuation methods, and useful life trends in the energy space as they pertain to business combinations under ASC 805 and GAAP fair value standards under ASC 820. We utilized transactions that reported their purchase allocation data in calendar year 2024 and not reported in previous annual filings.

STUDY | Mercer Capital’s Energy Purchase Price Allocation Study

This study researches and observes publicly available purchase price allocation data from companies primarily contained in one of the four sub-sectors of the energy industry: (i) exploration & production; (ii) oilfield services; (iii) midstream; and (iv) downstream. This study is unlike any other in terms of energy industry specificity and depth.The Energy Purchase Price Allocation Study provides a detailed analysis and overview of valuation and accounting trends in these sub-sectors of the energy space. This study also enables key users and preparers of financial statements to better understand the asset mix, valuation methods, and useful life trends in the energy space as they pertain to business combinations under ASC 805 and GAAP fair value standards under ASC 820. We utilized transactions that reported their purchase allocation data in calendar year 2024 and not reported in previous annual filings.This study is a useful tool for management teams, investors, auditors, and even insurance underwriters as market participants grapple with ever-increasing market complexity. It provides data and analytics for readers seeking to understand undergirding economics and deal rationale for individual transactions. The study also assists in risk assessment and underwriting of assets involved in these sectors. Further, it helps readers to better comprehend financial statement impacts of business combinations.

Whitepaper: How to Value Your Exploration and Production Company

For this week’s post, we’re highlighting our whitepaper, How to Value Your Exploration and Production Company. The piece provides a comprehensive overview of the key factors that drive value in the upstream oil and gas sector, offering readers a clear framework for understanding how operational performance, reserve economics, and commodity pricing influence company worth. It also explores core energy valuation methodologies—including cash flow analysis, reserve-based approaches, and market benchmarking—to help executives, investors, and advisors navigate the complexities of assessing value in a constantly evolving energy market.

Understanding Reinsurance for Auto Dealers (Part II)

Valuation and Planning Considerations

In this post, we discuss the valuation implications of reinsurance on auto group corporate planning and ownership estate planning options, and contrast them to core dealership operations as well as the real estate owned by the auto group.

Schwab's SAN Shift Demands RIA Organic Growth and Dashboard Vigilance

From Autobahn to Blind Curve

Schwab’s announcement that they’re halving client referrals to RIAs through the SAN program threatens an industry that was already struggling with organic growth. Dependable, sustainable growth requires building a marketing strategy that isn’t dependent on outside factors like ambitious custodians, and a tracking system to know how that marketing strategy is performing. Keeping an eye on your metrics will help keep you on the road to lasting value.

Appalachian Basin Finds Its Footing

The economics of oil and gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Haynesville, and Appalachian plays. The cost of producing oil and gas depends on the geological makeup of the reserve, the depth of the reserve, and the cost to transport production to market. These factors drive meaningful differences in costs across regions. This quarter, we take a closer look at the Appalachian.

RIA M&A Update: Q3 2025

RIA M&A activity rebounded sharply in 2025, with record deal volume in the first half of the year. Through September, 209 transactions were completed—up from 156 in 2024—driven by private equity involvement, lower borrowing costs, and ongoing consolidation trends. While total transacted AUM declined, serial acquirers and aggregators continued to dominate deal flow. For RIAs, shifting rate dynamics, valuation trends, and evolving buyer profiles highlight the importance of strategic planning—whether pursuing growth, transitioning ownership, or exploring a sale.

5 Things to Know About Selling Your Business to Private Equity

We recently read a fantastic post on the Altair Advisers' blog, "Words on Wealth," by Jason M. Laurie, Managing Director and Chief Investment Officer. The post addresses five things that founders wish someone had told them before selling their businesses to private equity firms. We thank Jason for allowing us to share the post with our readers.

Alternative Asset Managers Stumble in 2025 Following Half a Decade of Outperformance

After several years of industry-leading performance, alternative asset managers have begun to lose momentum in 2025. Despite strong fundamentals, these firms have underperformed broader markets amid higher-for-longer interest rates and shifting investor preferences toward liquidity. While short-term valuations have softened, the long-term case for alternatives remains intact, supported by their structural advantages and ability to navigate volatility.

Appalachian Basin M&A Update: October 2024 to September 2025

A Quiet Consolidation Phase

Over the October 2024 through September 2025 timeframe, merger and acquisition activity in the Appalachian Basin (Marcellus / Utica / associated plays) has been relatively muted, reflecting constrained upstream deal flow across the U.S. At the same time, selective bolt-ons, midstream consolidations, and creative capital structures have surfaced where synergies and niche value remain. In this post, we examine the notable transactions and thematic drivers emerging from this period.

Upstream Valuation Through a Lender’s Lens

What Credit Analysts See

Credit analysis offers a different lens on upstream performance—one centered on sustainability rather than growth alone. Scale and production mix drive efficiency and resilience, while cost structure and netbacks expose the true quality of assets. Reserve life and replacement efficiency underpin long-term viability, and strong liquidity, hedging, and leverage discipline ultimately determine access to capital and enterprise value.

Understanding Reinsurance for Auto Dealers (Part I)

What It Is and Why It Matters

In the first post of this series, we introduce the basics of reinsurance in the context of auto dealerships and explore both the pros and cons of establishing a reinsurance company.

RIA Market Update: Q3 2025

RIAs delivered mixed results in Q3 2025, with larger asset managers leading the sector at an 11% quarterly gain, outpacing the S&P 500’s 8% return. Smaller managers rose modestly, while alternative managers continued to lag after a stretch of strong growth in 2023 and early 2024.

October 2025 | The New Frontier of Consumer Credit: Banks vs. Fintechs

Bank Watch: October 2025

Evaluating the Buyer’s Shares and The New Frontier of Consumer Credit: Banks vs. Fintechs

Bank M&A activity has surged in 2025, with roughly 175 transactions expected by year-end. For selling shareholders, deal consideration often includes the buyer’s stock—raising important questions about the investment merits of those shares. Understanding liquidity, profitability, valuation, and capital management is critical, yet often overlooked. Mercer Capital outlines key factors boards should consider when evaluating a buyer’s shares and highlights why “value” deserves as much attention as “price.”

The UHNW Institute’s "Wealthesaurus"

The post introduces The UHNW Institute’s Wealthesaurus—a glossary of terms central to family wealth and enterprise conversations. For investment managers, this resource provides a valuable framework for understanding how families think about sustainability, reporting, liquidity, and governance, all of which influence investment decisions.

Hart Energy’s A&D Strategies and Opportunities Conference Recap

At Hart Energy’s 2025 A&D Strategies and Opportunities Conference in Dallas, two central themes emerged: the maturation of Tier 1 U.S. shale inventory and diverging dynamics between private and public players in dealmaking. The conference highlighted the evolving dynamics of the U.S. upstream oil and gas market. With Tier 1 shale assets maturing, private and public participants are behaving differently, and deal strategies have become more selective.

Private Equity’s Growing Influence on RIA Dealmaking and Valuation Multiples

Examining the trends fueling PE’s dominance, the valuation multiples shaping transactions, and strategic considerations for RIA owners navigating this transformative landscape

August 2025 SAAR

In August 2025, the U.S. auto industry slowed as the SAAR of 16.1 million units represented a 2.9% decrease from the prior month. However, the trend of year-over-year increases continued, as eleven of the past twelve months have beat the prior year, with a 6.2% increase from August 2024. The August 2025 performance is particularly impressive given the inflated baseline from the previous year's CDK software outage that shifted sales into July and August 2024.

The One Big Beautiful Bill Act: Implications for U.S. Oil & Gas Valuations

The OBBB represents a significant shift in the U.S. oil and gas industry and is a key component of the Trump Administration’s agenda for U.S. energy dominance. The BBB represents a significant shift in how public lands are managed and how our government supports energy development.

Is There a Scarcity Value for Independent Trust Companies?

Supply/Demand Dynamics in Trust Company M&A

The scarcity of independent trust companies in today’s market underscores a compelling opportunity for RIAs seeking to enhance their service offerings and secure long-term growth and for trust companies that are considering an external sale.

An Overview of Senior Care / Long-Term Care as of Q2 2025

While the senior care industry faces a variety of challenges, including staffing shortages, regulatory pressures, and rising costs, there are also numerous opportunities for growth.

Dental Service Organizations

By 2028, an estimated 16% of specialized practices will be affiliated with DSOs. These specialized practices have even higher margins than general practices and have been receiving more referrals each year, making them particularly attractive to PE firms.

Ambulatory Surgery Centers

The popularity of ASCs among patients and insurers has propelled the value of the ASC market in the United States. Currently, the market is valued at $46 billion and is expected to reach $66 billion by 2033.

Ten Takes from Ten Years of RIA Valuation Insights

After 500 Blog Posts, We Still Have More to Say

In the late spring of 2015, we started talking about creating a blog to explore what we were seeing regarding valuation and advisory projects in the RIA space. The big question was not whether we could start it, but whether we could keep it going. When we got back from lunch, I pulled up a Word doc and Brooks and I started brainstorming topics. In a few minutes, we had several dozen ideas, so it was pretty clear we had enough to say. Ten years later, we still haven’t run out of ideas.

Bank Watch: September 2025

2025 Core Deposit Intangibles Update

Core deposit intangible (CDI) values have remained relatively stable in 2025. As deposit mix, rate outlook, and funding pressures continue to evolve, understanding the unique drivers of your institution’s deposit base is critical. In our latest analysis, Mercer Capital examines recent trends in CDI values, deposit premiums, and what they may signal for banks moving forward.

Themes from Q2 2025 Earnings Calls

In this week's post, we cover what auto retailer executives had to say during the Q2 2025 earnings calls. We noted three major themes from last quarter’s calls: tariffs, acquisitions, and fixed operations.

The Growing Appeal of Independent Trust Companies

Within the broader investment management industry, independent trust companies are carving out a significant niche, capturing the attention of high-net-worth clients and investment management professionals alike.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of August 26, 2025

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of June 11, 2025

Themes from Q2 2025 Earnings Calls

Disciplined Capital Allocation Meets International Opportunity Amid Domestic Uncertainty

The second quarter of 2025 brought no shortage of talking points across both oilfield services (“OFS”) providers and exploration and production (“E&P”) companies. Management teams faced questions on market softness, capital discipline, and whether the long-awaited offshore and international upcycle has truly taken hold. Some leaned into shareholder returns and consolidation, others stressed patience in a choppy pricing environment, and nearly all pointed to selective opportunities abroad as a counterweight to domestic headwinds.

Building Valuable RIAs

Navigating Margins, Compensation, and Long-Term Growth

When assessing your firm’s margins, it’s important to consider the context of the firm’s ownership and compensation structure and also the tradeoffs associated with margins that are too high or too low.

July 2025 SAAR

The July 2025 SAAR came in at 16.4 million units, up 7.1% from last month and up 3.7% from July 2024. It is important to note that this modest year-over-year gain requires a bit more context due to irregularly high sales this time last year. The June 2024 CDK software outage shifted sales into July and August 2024, making July 2025’s year-over-year performance even more impressive.

Why E&P Companies Need a Quality of Earnings Analysis

The purpose of a QofE analysis is to translate historical reported (GAAP) earnings into a relevant picture of earnings and cash flow that is useful in developing credible forward-looking estimates.

Enhancing RIA Value Through Family Office Services

Being Ambitious Without Becoming Delusional

In the ever-evolving wealth management sector, we see RIAs exploring ways to bolster their competitive edge, long-term sustainability, margin, and valuation. An increasingly common strategy involves integrating family office services.

Change in Republicans’ Thinking Shifts Policy Support in Renewables

While the battle continues for the hearts and minds of Americans over the debate between fossil fuels and renewables, the current Trump administration appears to be responsive to this shift by setting priorities for the development of fossil fuels.

Just Released: Q2 2025 Oil & Gas Industry Newsletter

Regional Focus: Permian Despite a late-period decline in rig counts, Permian production continued upward over the latest year. However, geopolitical forces and international trade matters pushed oil prices lower, resulting in the Permian producer stock prices being battered since June 2024, particularly in the first quarter and early second quarter of 2025.

You Can’t Spell RIA Without AI

The Impact of Artificial Intelligence on the RIA Industry

This post explores the multifaceted impact of AI on the RIA industry, drawing on trends observed in Q2 2025 and beyond, while providing actionable insights for firms looking to adapt.

RIA M&A Isn’t the Only Way

Internal Transactions Still Work

Internal transactions don’t generate headlines, and prospective buyers (next-gen management) likely aren’t beating your door down to close a deal. While they may be less conspicuous, internal transactions are a viable avenue for succession planning and one that many RIAs accomplish successfully.

BankWatch: August 2025

2025 Mid-Year Market Update

Bank stocks have staged a strong recovery in 2025, with the Nasdaq Bank Index up 16.2% year-to-date and larger banks leading gains amid a “flight to quality.” Net interest margins continue to improve for most institutions, supported by a stable rate environment and expectations of further Fed cuts. M&A activity is also on the rise, with deal volume already surpassing 2024 levels by mid-year. In this month's Bank Watch newsletter, we discuss these market trends, net interest margin expansion, and what shifting interest rates could mean for bank performance and M&A activity going forward.

Blue (Sky) Is in the Eye of the Beholder – Part 2

Ongoing Earnings and Other Valuation Considerations

In this post, we discuss our perspective on how dealership earnings are evaluated, adjusted, and normalized, based on our experience and discussions with dealmakers in the space.

Buy, Sell, Plan: The Business of Advisor Succession

Matt Crow on Dimensional Fund Advisors "Managing Your Practice" Podcast

Matt Crow had the pleasure of joining Aaron Hasler, Managing Partner at Skyview, and Catherine Williams, head of practice management at Dimensional Fund Advisors, for a discussion about the financial strategies involved in succession planning. We covered financing options, common roadblocks, generational dynamics, and much more.

Permian Producer Stocks Pummeled

Despite a late-period decline in rig counts, Permian production continued upward over the latest year. However, geopolitical forces and international trade matters pushed oil prices lower, resulting in the Permian producer stock prices being battered since June 2024, particularly in the first quarter and early second quarter of 2025.

RIA M&A Update: Q2 2025

M&A activity in the RIA industry, which had been trailing 2023 levels for much of 2024, experienced a surge in the first half of 2025. A spike in January set a new record for monthly deal volume, exceeding the high watermark previously set in October of 2024.

Royalty Consolidation Accelerates Amid Broader E&P M&A Wave

The mineral and royalty sector remains active beneath the surface of headline E&P consolidation. Public mineral aggregators are executing both asset-level and corporate-scale transactions, using a disciplined mix of equity, credit, and structured consideration.

June 2025 SAAR

The June 2025 SAAR came in at 15.3 million units, down 1.7% from last month but up 2.3% from June 2024. When looking at the year-over-year comparison, it is important to consider that June 2024 sales were impacted by the CDK software outage. As such, the year-over-year change in the SAAR presents the June 2025 performance in a better light than it would be without the impact of the 2024 CDK event.

Independent Trust Company Trends in 2025

One of the most frequently overlooked sectors in the wealth management industry may be its first cousin, the independent trust industry. While many still associate trust administration with banks, which account for more than 75% of the space, the growing prominence of independent trust companies is capturing the attention of many participants in the investment management community.

Understanding the EV/Production Multiple

Multiples such as EV/Production can provide context for market pricing in the form of a range. Relying solely on a single market multiple as an indication of value can be limiting, especially when valuing a privately held company.

Private Equity and Family Business

A Complicated Relationship

If private equity and family business had a relationship status on social media, it would undoubtedly be “It’s Complicated.”

RIA Market Update: Q2 2025

RIAs generally outperformed the S&P in Q2 2025, with smaller asset managers returning over 13%, and alternative asset managers facing another quarter of underperformance after a year of strong growth. Year-over-year, alternative investment managers saw the strongest AUM growth, while traditional managers proved better at converting this growth to earnings.

Bank Watch: July 2025

From Disruption to Deposits: What Circle’s Rise Signals for Banks

As Stablecoins move from the fringes of finance to the center of regulatory and market attention, banks face a familiar but evolving challenge to their deposit base. Nearly 50 years after the introduction of the cash management account, Circle’s IPO and the passage of the GENIUS Act may mark a new inflection point. With investor enthusiasm high and policymakers signaling support, traditional institutions will need to evaluate how, and how quickly, they respond to the rise of tokenized money.

Value Focus: Insurance Industry | Third Quarter 2025

Insurance sector lagging as valuations ease and M&A slows

Portfolio Valuation: Private Equity and Credit

Fall 2025

The recent Paramount-Rith Capital transaction highlights a growing challenge in private markets—valuations that fail to reflect market reality. As continuation funds become more common, conflicts arise when general partners act as both buyer and seller. Independent fairness opinions have become essential, ensuring transparency, validating valuations, and reinforcing fiduciary duties. In an environment of deep NAV discounts, these opinions are not formalities—they are vital checks that uphold integrity and trust in private market governance.

March 2000 vs. June 2024: How Different Is It?

We at Mercer Capital do not know which way markets will go in the coming quarters and years, but we can speculate. Mercer Capital does know bank valuation and transaction advisory.

Navigating Valuation Challenges in the Great Wealth Transfer

Over the next two decades, an estimated $68 trillion is expected to transfer from Baby Boomers and Gen X to Millennials and Gen Z in what has been dubbed the “Great Wealth Transfer.” For RIAs and trust companies, this transition presents both opportunities and challenges that directly impact firm valuations.

Overview of Auto Finance in 2025

Origination, Delinquency, and Portfolio Trends

Experian releases a “State of the Automotive Finance Market” webinar every quarter. The information in the most recently released webinar outlines origination, portfolio balances, and delinquency trends observed in the first quarter of 2025. We discuss in this post.

Viper-Sitio Transaction Signals Strategic Shift in U.S. Royalty Landscape

The Viper-Sitio merger represents a notable shift in strategy within a traditionally fragmented sector. It signals a move toward greater scale, operational leverage, and investor confidence in the royalty business model.

Succession Conundrums: Why Sell to Insiders for Less?

(Because It May End Up Making You More)

A frequent question among RIA owners is whether internal buyers, such as employees or partners, pay less for their equity stakes compared to external buyers, and if so, why pursue internal succession?

Capital Shifts and LNG Lifts

Takeaways from the 2025 Hart Energy Capital Conference

The energy industry is at a critical point, where producers must not only meet the ever-growing global energy demand resulting from population growth, industrialization, and the increasing electrification of uses, but also adapt to ever-changing environmental regulations and shifting societal expectations related to sustainable practices.

May 2025 SAAR

The May 2025 SAAR came in at 15.6 million units, down 9.3% from the previous month and representing a 1.1% decline from May 2024.

Don’t Punt on Succession Planning, Even if You Plan to Sell Externally

While external sales can be a viable exit option, we caution against viewing them as a substitute for a robust succession planning process. Having a viable succession plan in place is not just a fallback option; it’s a cornerstone of a successful external sale.

Upstream Natural Gas Valuations: A Big Year

Cash flows are seen to pick up significantly in the future for upstream natural gas producers.

Webinar Replay: Succession Planning for RIAs

Transition with Confidence

In this webinar, Matthew R. Crow, CFA, ASA and Brooks K. Hamner, CFA, ASA guide you through the critical steps of succession planning, ensuring your firm's legacy thrives while maximizing its value. They discuss different ownership models and their implications, key considerations for maximizing firm value during a transition, and practical tools and steps to start planning for a successful transition today.

June 2025 | Fairness Opinions: Evaluating a Buyer’s Shares from the Seller’s Perspective

Bank Watch: June 2025

Fairness Opinions: Evaluating a Buyer’s Shares from the Seller’s Perspective - 2025 Update

While bank M&A activity has been steady in 2025, boards evaluating offers should look beyond headline prices to scrutinize the real value of consideration—especially when deals are paid in acquirer stock. A high stock price can make a transaction look attractive, but it also masks risks tied to dilution, liquidity, and the buyer’s future performance. Fairness opinions, detailed due diligence, and a clear-eyed assessment of the acquirer’s shares are essential to protect selling shareholders from unpleasant surprises once the deal closes.

Issue No. 15 | Updated Metrics for Mid-Year 2025

Feature Articles: Q2 2025 Earnings Calls and 2025 Auto Industry Tariff Update

Should You Choose an Industry or Valuation Expert?

Blue (Sky) Is in the Eye of the Beholder – Part 1

Perspectives on Auto Dealership Blue Sky Multiples and Valuations

On a recent client engagement, I was asked the question, “Why are Haig and Kerrigan’s multiples so far apart?” I’ve never really viewed them that way, as the blue sky multiples published in their quarterly newsletters tend to cluster reasonably close together.

Succession Planning and Its Impact on RIA Valuations

For the investment management industry, succession planning is not just a strategic necessity—it’s an important driver of firm value.

Whitepaper: Succession Planning for Investment Management Firms

Read our updated whitepaper.

Oilfield Services Companies and How To Value Them

Managing Your RIA’s Priorities

The Owner Strategy Triangle

Sometimes we come across an idea that is so good we’re jealous of the person or persons who developed it. The Owner Strategy Triangle is one such idea.

April 2025 SAAR

The April 2025 SAAR came in at 17.3 million units, down 3.1% from last month but up 7.8% from April 2024. Even with a slight month-over-month decline from the short-term peak of last month’s SAAR, April 2025 still saw the second-highest SAAR since April 2021. This highlights the strong demand in the current market as consumers are motivated to purchase a vehicle before potential tariff-related price increases.

Oilfield Services Update for 2025

In this post, we focus on the Oilfield Services (OFS) industry. In particular, we cover changes related to the recent recovery in activity level, the influences of technological advances, the push for energy independence, and expectations going forward.

Just Released: Q1 2025 Oil & Gas Industry Newsletter

Regional Focus: Eagle Ford

The Impact of Market Volatility on RIA Valuations

An Illustrative Example of the Dangers of Formula Pricing in a Buy-Sell Agreement

In this post, we show an illustrative example of how the market volatility we’ve endured so far this year could impact the formula pricing valuation of a $1 billion AUM RIA that has 70% of its clients’ assets in the S&P 500 and 30% in a diversified bond fund.

Estate Planning for Auto Dealers

For this week’s edition of Auto Dealer Valuation Insights, we revisit a timely article on estate planning for auto dealerships.

Bank Watch: May 2025

Dividends and Shareholder Returns | A Ten-Year Lookback

With investors favoring dividend-paying funds amid equity market volatility, we examined the role of dividends in bank shareholder returns over the past decade. While dividends made up a significant portion of total returns, especially in a middling decade for bank stocks, our analysis shows they are not the sole driver. Long-term shareholder value is still rooted in growing earnings and book value—even in uncertain times.

Uncertainty Rules the Day

Oil Markets Bewildered as World Trade Patterns Shift

Oil markets and energy companies are wrestling with understanding changes in domestic and international energy markets. As company outlooks become cloudier, uncertainty is on the rise. This has been developing for several weeks now, with some early indications showing that executives and investors don’t quite know how to respond yet.

Market Volatility and the Enduring Value of Wealth Management

Following a comparatively placid first quarter, this month hasn’t been kind to anyone working in investment management. Y

RIA M&A Update: Q1 2025

M&A activity in the RIA industry, which had been trailing 2023 levels for much of 2024, experienced a surge in January. This spike set a new record for monthly deal volume, exceeding the high watermark set in October 2024. Q1 2025 was a record-setting quarter for deal volume. Fidelity’s March 2025 Wealth Management M&A Transaction Report listed 72 deals through March, which exceeds the 70 deals executed during the same period in 2023, the next highest Q1 on record.

Eagle Ford Production Edges Downward Again on Reduced Drilling

The economics of oil & gas production vary by region. Mercer Capital focuses on trends in several plays including the Eagle Ford, Permian, Haynesville, and Marcellus and Utica. This quarter we take a closer look at the Eagle Ford.

April 2025 Auto Industry Tariff Update

Where Do We Stand and What Does That Mean for My Dealership?

The U.S. automotive industry has been navigating an increasingly uncertain landscape since the 2024 presidential election. Given how deeply globalized the industry is, automotive manufacturing often involves complex supply chains where parts and materials may cross borders multiple times before a vehicle reaches the end consumer.

Asset Managers Underperform the S&P

Tariff Meltdown Presents Opportunity

Amid stabilizing interest rates and inflation, the asset management industry (and the stock market as a whole) experienced moderate growth over the past year.

Where Have All the Eagle Ford Deals Gone?

Over the past 12 months, deal activity in the Eagle Ford remained stagnant, with only two pure Eagle Ford Shale deals closing compared to two transactions closed in the prior 12-month period, according to Shale Experts.

RIA Market Update: Q1 2025

RIAs underperformed the S&P in Q1 2025, with alternative asset managers declining almost 20% after a year of outperformance. Year-over-year, traditional investment managers saw the strongest AUM growth, while alternative managers proved better at converting this growth to revenue. We explore further in our Q1 2025 Market Update.

Challenges for U.S. Drilling Amid Tariff Uncertainties

Natural gas producers have continued to reduce costs and refrain from increasing production despite strong fourth-quarter earnings that surpassed consensus expectations.

March 2025 SAAR

The March 2025 SAAR came in at 17.8 million units, up a staggering 11.0% from last month and 13.3% from March 2024. March 2025 saw the highest SAAR since April 2021, reflecting not only the recent trend of strong consumer demand but also the additional demand generated by consumers motivated to purchase a vehicle to avoid potential tariff-related price increases.

April 2025 | Mortgage Banking’s Next Chapter

Bank Watch: April 2025

Mortgage Banking’s Next Chapter: Is a Recovery Taking Root?

After years of booming mortgage profits driven by ultra-low rates, the industry has faced a prolonged slump amid stubbornly high mortgage rates and weakened housing demand. Despite rate cuts by the Fed, affordability remains strained, and mortgage volumes lag forecasts. However, transaction volume is expected to pick up despite high rates while home prices remain flattish, which should serve to boost mortgage originations. Major moves by Rocket Companies, including acquisitions of Redfin and Mr. Cooper, hint that the worst may be over and a recovery in mortgage banking could be taking shape.

Second Quarter 2025 | Segment Focus: Building Materials

Concrete prices grew at a steady rate over the past year, lumber prices experienced a significant drop in Q2 2025, and steel prices soared in the second quarter due to industry effects from tariffs. The Trump Administration’s “Liberation Day” tariffs took effect early in the quarter, leading to an immediate sell-off in the market. However, major indexes recovered quickly. Trade policy is in a state of limbo as the administration continues to negotiate terms with trading partners.

Healthcare Facilities Q2 2025

Segment Focus: Senior Care / Long-Term Care

Senior care is a large and growing industry in the United States. Growth is primarily predicated on demographic shifts, with an aging population likely to need both general and specialized living assistance.

Value Focus: Insurance Industry | Second Quarter 2025

Mixed results for insurance stocks in the second quarter of 2025

Medtech and Device Industry Newsletter - Q2 2025

EXECUTIVE SUMMARYThis quarterly update includes a broad outlook that divides the healthcare industry into four sectors:Biotechnology & Life SciencesMedical DevicesHealthcare TechnologyLarge, Diversified Healthcare CompaniesWe include a review of market performance, valuation multiple trends, operating metrics, and other market data. This issue also includes a review of M&A and IPO activity

E&P Third Quarter 2025

Region Focus: Appalachia

Appalachia // The Appalachian basin enters late-2025 on firmer footing than a year ago, characterized by stable production, recovering equity performance, and improving infrastructure fundamentals

E&P Second Quarter 2025

Region Focus: Permian

Permian // The Permian basin continues to serve as the centerpiece of the U.S. shale revolution.

Transportation & Logistics Newsletter

Second Quarter 2025

The second quarter’s tariff news started on April 2nd, when President Trump announced the levels of the previously proposed “reciprocal” tariffs. All imports would be subject to a base tariff of 10%, and various countries would have additional tariffs levels, ostensibly based on the trade deficit with each respective country. The European Union, South Korea, and Taiwan would be subject to tariffs of 20%, 25%, and 32%, respectively. Two days later, China would face a total tariff of over 50%. China announced a retaliatory 34% tariff on U.S. imports. The 10% baseline tariffs were scheduled to go into effect on April 5th, and the reciprocal tariffs were going to be effective as of April 9th.

Webinar Replay: Understanding RIA Valuations

A Guide for Today's Market

In our latest webinar, Brooks K. Hamner, CFA, ASA and Zachary C. Milam, CFA explore the critical elements shaping RIA valuations in today's market. They discuss the key factors influencing RIA valuations, the latest industry trends, methodologies for valuing RIAs, and best practices to maximize firm value.

Key Components in a Typical Oil & Gas Lease

When negotiating and drafting oil and gas leases, understanding the basic framework that governs these agreements is essential. While there is no true “standard” lease, the primary areas and considerations of an oil and gas lease are discussed in this post.

What Drives RIA Value – Growth or Margin?

More of Both Is Best, but the Tradeoff Is Measurable

We regularly get asked how to optimize the value of an RIA. The answer is easier spread than done. Starting with the obvious, value is a function of cash flow, risk, and growth.

U.S. LNG in 2025

The Future is Bright, Though with Potential Headwinds

Expectations for the LNG industry in 2025 were modestly positive before the November 2024 U.S. elections but are notably more robust with the transition from the decidedly pro-green/renewable, anti-carbon energy Biden administration to the decidedly pro-American energy dominance Trump administration. However, as always true of domestic commodity markets subject to international market influences, the outlook for the U.S. LNG industry in 2025 is tempered by a number of potential domestic, international, and geopolitical pressures that could hamper actual results relative to expectations.

Q4 2024 Earnings Calls

Auto Industry Volumes and Per-Unit Profitability Continue to Normalize

Themes for this seasons' earnings calls were 1: Volume growth and GPU normalization in the new vehicle market, Technician expansion and strong profitability in Parts and Service, and Policy uncertainty in the U.S. surrounding tariffs and EVs

5 Takeaways from Dimensional Fund Advisors’ Deals & Succession Conference

The 2025 Dimensional Fund Advisors’ Deals and Succession conference was held at Dimensional’s offices in Charlotte, North Carolina. The event focused on the current M&A environment and best practices for internal succession planning and ownership expansion.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of March 12, 2025

The 2025 Tariff Surge: Timeline and Industry Impact - Part II

In the Q1 2025 Transportation Industry newsletter, we discussed the impact of the newly levied tariffs on the transportation sector. We focused on the main targets of the original tariffs (Canada, China, and Mexico) and the proposed removal of the De Minimis exemptions. These actions led to an increase in imports due to companies rushing to acquire inventory prior to the start of the tariffs, and speculation that inflation would be on the rise shortly after. Since Q1, the ever-evolving tariff landscape has created new implications for importers and exporters alike.

The 2025 Tariff Surge: Timeline and Industry Impact

In the Q1 newsletter, we discussed the impact of the newly levied tariffs on the transportation sector. We focused on the main targets of the original tariffs (Canada, China, and Mexico) and the proposed removal of the De Minimis exemptions. These actions led to an increase in imports due to companies rushing to acquire inventory prior to the start of the tariffs, and speculation that inflation would be on the rise shortly after. Since Q1, the ever-evolving tariff landscape has created new implications for importers and exporters alike.

How to Understand Your Mineral Interests

Because of the popularity of this post, we revisit it this week. Originally published in 2019, this post is as a guide for mineral owners who are seeking to learn more about what they own.

Succession Planning Options for RIAs

Succession planning has been an area of increasing focus in the RIA industry, particularly given what many are calling a looming succession crisis. The industry’s demographics suggest that increased attention to succession planning is well warranted: a majority of RIAs are still led by their founders, and only about a quarter of them have non-founding shareholders. While there is growing recognition of the importance of succession planning, it often lags far behind other strategic initiatives with more immediate benefits like new client and staff growth1. In the long run, however, firms with a well-developed succession plan have a distinct competitive advantage over those without. Fortunately, many viable options exist for RIA principals looking to solve succession planning issues. In this post, we review several of the more common options.Internal transition to the next generation of firm leadership. Internal transitions of ownership are the most common type of transaction for investment management firms and for good reason. Many RIA owners prefer working for themselves, and their clients prefer working with an independent advisor.Internal transitions allow RIAs to maintain independence over the long term and provide clients with a sense of continuity and comfort that their advisor’s interests are economically aligned. A gradual transition of responsibilities and ownership to the next generation is usually one of the best ways to align your employees’ interests and grow the firm to everyone’s benefit. While this option typically requires the most preparation and patience, it allows the founding shareholders to handpick their successors and future leadership.Debt financing. Debt financing has become a readily available option for RIAs in recent years as the number of specialty lenders focusing on the sector has increased. External debt financing is often used to finance internal transactions as an alternative to seller financing. Such arrangements avoid introducing a new outside equity partner and can work well when the scope of succession issues to solve is limited to financing the transaction.There are potential drawbacks, however. For example, debt financing for RIAs typically requires a personal guarantee, which many borrowers oppose. Borrowers are also more exposed to their own business by levering up to purchase an equity stake.Sale to a consolidator or roll-up firm. RIA consolidators have emerged, promising a means for ownership transition, back-office efficiencies, and best practices coaching. The consolidator model has been gaining traction in the industry in recent years. Most well-known RIA consolidators have grown their AUM at double-digit growth rates over the last five years, and acquisitions by consolidators represent an increasing portion of overall deal volume in the sector.For RIA principals looking for an exit plan, a sale to a consolidator typically provides the selling partners with substantial liquidity at closing, an ongoing interest in the firm’s economics, and a mechanism to transfer the sellers’ continued interest to the next generation of management. There’s a wide spectrum of consolidator models, and they can vary significantly in terms of their effect on the day-to-day operations of the acquired RIA. RIA owners considering selling to a consolidator should think carefully about which aspects of their business they feel strongly about and how those aspects of the business will change after the deal closes.Sale to a private equity firm. Drawn to the industry’s typically high margins, low capital expenditure needs, and recurring revenue model, private equity managers have sharpened their focus on investment management firms in recent years. Private equity can be used to buy out a retiring partner, but it is not typically a permanent solution. While PE firms provide upfront cash, remaining principals must sacrifice most of their control and potentially some of their ownership at closing.Minority financial investment. Minority financial investments can provide existing ownership with liquidity while allowing remaining shareholders to maintain control and an ongoing interest in the firm’s Minority investors typically do not intrude on the firm’s operations as much as other equity options, but they will seek deal terms that adequately protect their interest in future cash flows.Sale to a strategic buyer. A strategic buyer is likely another RIA, but it could be any other financial institution hoping to realize certain efficiencies after the deal. On paper, this scenario often makes the most economic sense, but it does not afford the selling principals much control over what happens to their employees, clients, or the company’s identity.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.1 See https://content.schwab.com/web/retail/public/about-schwab/2024-Charles-Schwab-RIA-Benchmarking-Study.pdf

February 2025 SAAR

The February 2025 SAAR came in at 16.0 million units, up 3.2% from last month and 2.1% from February 2024. While February typically records one of the lowest sales volumes each year, this month's SAAR exceeded the average of the last five Februarys (approximately 15.3 million units). February 2025 performance reflected strength in consumer demand, primarily driven by improved inventory and incentive spending.

BankWatch: March 2025

Profitability, Growth and Valuation

After a strong 2H24, community and regional bank stocks are down 5% in Q1 2025 and are down about 15% from late November when bank stocks peaked in a run that started mid-year. Valuations for individual stocks, a sector such as banking and the overall market will ebb and flow with a variety of factors, but ultimately earnings and earnings growth are the mother’s milk of investing. One asset manager years ago provided a useful framework to think about profitability, growth, and valuation as a framework for stock selection.

Themes from Q4 2024 Earnings Calls

Upstream (E&P) and Oilfield Service (“OFS”) Companies

Companies are evaluating the trade-offs between optimizing existing assets and pursuing mergers and acquisitions. Capital allocation remains a focal point, with an emphasis on debt reduction and shareholder returns. Additionally, firms are positioning themselves to navigate evolving market conditions, ready to capitalize on emerging opportunities. This analysis offers valuable insight into the strategies industry leaders are employing for the future.

Specter of Stagflation Threatens RIAs

Time to Stop and Consider a Trifecta of Possible Headwinds for Investment Managers

Stagflation is a term coined by British politician Ian Macleod in the 1960s to describe an economic period that simultaneously exhibits high inflation, stagnant economic growth, and elevated unemployment. It’s too early to tell if the current focus on tariffs and government austerity, layered on top of private sector weakness, will lead to stagflation in the U.S. But it’s starting to be discussed, and it isn’t too early to consider what it might mean to the RIA sector.

Asset Retirement Obligations in Oil & Gas

Their Impact on Valuation & Transactions

An asset retirement obligation (ARO) in oil and gas refers to the legal or regulatory requirement for a company to dismantle, remove, and restore a site once an asset (such as an oil well, offshore platform, or pipeline) reaches the end of its useful life. These obligations arise due to environmental laws and lease agreements requiring companies to clean up and restore the land or seabed. Typical costs include plugging and abandonment, reclamation, and remediation.

Nissan’s Search for a Merger Partner

If you own or manage a Nissan dealership, you likely have questions about what the company’s next steps mean for your business. Many of these questions are prudent, as Nissan’s ongoing search for strategic partnerships could still have significant implications for dealers down the line. Below are the key factors that could shape the future for Nissan dealers.

RIA Valuations and How to Maximize Yours

This episode of the The Buyer’s Boardroom podcast discusses RIA valuation methods, misconceptions surrounding rule-of thumb measures, key value drivers, and the pros and cons associated with internal versus external sales of your business.

The Oil & Gas Industry is Pumped Up

NAPE 2025 Recap

Mercer Capital’s Bryce Erickson and Andy Frew insights from the NAPE (North American Prospect Expo) summit on February 5th and 6th, 2025 in Houston, Texas.

Unpacking the Relative Success of Victory Capital

Victory Capital is a relative newcomer to the small list of publicly traded asset managers. Since its IPO, it has quietly outperformed many publicly traded peers by employing an acquisition-driven growth strategy that has delivered impressive shareholder returns. In this post, we take a closer look at the factors driving Victory’s success.

The Uinta Basin Resurgence

The Uinta Basin has gained renewed relevance due to advancements in fracking and horizontal drilling and is increasing in significance as oil and gas companies are priced out of the Permian. While transportation challenges remain due to the unique properties of the basin's waxy crude oil, the region's potential is attracting significant attention, especially as companies seek acreage outside the increasingly competitive and expensive Permian Basin. With renewed investment and interest from both public and private operators, the Uinta Basin is poised to play a growing role in U.S. oil production.

Who Should Own Your RIA?

The Best Ownership Model Is One That Supports the Business Model

Aside from the initial startup years, when fledgling RIAs struggle to achieve profitability, the most difficult period that most firms endure is the transition from the founding generation of leadership to G2. For those that make the transition, getting from the second generation to the third, and so forth, is comparatively easy. Much of this difficulty relates to a contemporaneous transition of ownership — not just the identities of the owners but also the structure of the ownership.

January 2025 SAAR

The January 2025 SAAR came in at 15.6 million units, down 7.5% from last month and up 3.8% from January 2024. January is typically one of the lowest months of sales volume each year, but as seasonal adjustments usually account for this, it is notable that this month’s SAAR dipped to the lowest point since January 2024. It is also worth mentioning that this month’s SAAR exceeded the average of the last five Januarys (approximately 15.4 million units).

February 2025 | A Cautiously Optimistic Outlook for Bank M&A

Bank Watch: February 2025

A Cautiously Optimistic Outlook for Bank M&A: AOBA 2025 Recap

The 2025 Acquire or Be Acquired (AOBA) Conference in Phoenix reflected a renewed sense of optimism for the banking industry. With small-cap banks rebounding in late 2024 and earnings growth on the horizon, the outlook for M&A is improving. Increased capital market activity, pent-up demand from buyers and sellers, and a shifting regulatory environment all signal a potential acceleration in bank deals this year.Read our full breakdown of AOBA’s key themes and insights in this month’s BankWatch.

The Latest in Natural Gas Valuations

Continued Optimism for Global Demand Buoys Multiples

The world is getting more direct access to LNG than ever before. Natural gas is becoming more globally portable. Going forward, it will help stabilize regional prices and market volatilities, which, in turn, will help U.S. producers that have more gas than the U.S. needs. Investors are optimistic that as more global portability of gas becomes available, more opportunities await to maximize potential in U.S. gas plays.

What Does the RIA Valuation Process Entail?

For this week’s post, "What Does the RIA Valuation Process Entail?," we’ll channel our inner Nick Saban and focus on the process.

Just Released: Q4 2024 Oil & Gas Industry Newsletter

Regional Focus: Bakken, DJ Basin, Woodford Shale, Uinta, and the SCOOP/STACK

Mercer Capital’s Value Focus: Exploration & Production newsletter provides an overview of the industry through supply and demand analysis, commodity pricing, and public market performance. In addition, this quarterly issue focuses on the Bakken, DJ Basin, and Woodford Shale, along with the Uinta Basin and the SCOOP/STACK.

New Update: Understand the Value of Your Auto Dealership

If you own an interest in an auto dealership, we encourage you to take a look. While the value of your dealership may not be top of mind today, chances are one day it will be.

Personal Goodwill: Implications for RIAs

Goodwill and the distinction between personal and enterprise goodwill can have important economic consequences in RIA transactions and disputes.

2025 U.S. Oil Outlook

Don’t Count On A "Drill Baby Drill" Mentality

The November election brought optimism to many oil producers who felt hamstrung by the Biden Administration’s policies. Even Biden’s ban on offshore drilling is expected to be challenged or changed when Trump is sworn in. However, administrations can only do so much when it comes to global supply and demand dynamics. In fact, they can usually do little in the big picture; and the big picture is that there is probably going to be more supply coming online in 2025 than demand to meet it. Therefore, U.S. upstream producers are not planning on blowing their budget on aggressive drilling plans, no matter what Trump says, especially considering the lukewarm pricing environment that the market foresees. In addition, the U.S.’ shale dominance may be headed towards inevitable decline. There’s a lot to consider, so let us jump in.

Reviewing 2024 RIA Performance: Wealth Management

The wealth management industry experienced remarkable growth in 2024, driven by robust market performance, inflation cooling, and shifts in monetary policy. Contrary to earlier concerns of economic instability, the year delivered substantial growth across the RIA sector, signaling resilience and adaptability in an ever-changing financial landscape.

Examining Bakken, DJ Basin, and Woodford Shale Production and Activity

The economics of oil & gas production vary by region. Mercer Capital regularly covers trends in the Eagle Ford, Permian, and Appalachian plays. The cost of producing oil and gas depends on the geological makeup of the reserve, its depth, and the cost of transporting raw crude to market. These factors lead to varying production costs across regions. This quarter, we depart from our regular coverage and take a closer look at the Bakken, DJ Basin, and Woodford Shale.

RIA M&A Update: Q4 2024

M&A activity in the RIA industry, which had been trailing 2023 levels for much of 2024, experienced a dramatic surge in October. This spike set a new record for monthly deal volume and brought year-to-date transaction figures through November in line with 2023’s pace.

December 2024 SAAR

The December 2024 SAAR came in at 16.8 million units, just slightly higher than last month and up 4.2% from December 2023. Notably, this month’s SAAR outpaced the last three Decembers and was the highest monthly SAAR since May 2021 (17.0 million units).

Shining Some Light on Four Overshadowed Oil and Gas Plays

Uinta Basin, Bakken Shale, DJ Basin, and SCOOP/STACK

The Mercer Capital Oil and Gas industry team covers merger and acquisition activity as well as provides an economic profile for four primary oil and gas plays: Permian Basin, Eagle Ford Shale, Haynesville Shale, and Marcellus & Utica Shale. This week's blog offers economic and M&A snapshots into four more plays: Uinta Basin, Bakken Shale, DJ Basin, and SCOOP/STACK.

RIA Market Update: Q4 2024

RIAs continued to outperform the S&P in Q4 2024, with alternative asset managers boasting an impressive 60% price gain year-over-year. In 2024, traditional investment managers saw the strongest AUM growth, while alternative managers proved better at converting this growth to revenue. We explore further in our Q4 2024 Market Update.Download update

Bank Watch: January 2025

2024 Recap: Bank Stock Performance

After the turbulence caused by rising interest rates and regional bank failures, 2024 marked a turning point for community and regional bank stocks. The S&P Small Cap Bank Index surged 23% in the second half of the year, buoyed by optimism around net interest margins and a friendlier regulatory environment. However, challenges remain for smaller banks in 2025, such as weak loan growth and higher-for-longer short-term interest rates that may limit NIM expansion. Meanwhile, larger banks look poised to benefit from rising capital markets activity. While the outlook for bank earnings in 2025 is positive, this should be viewed in the context of a richly valued stock market where index fund and ETF outflows pose a threat to bank stock performance. We look back on 2024 performance and consider factors that may influence bank stock performance in 2025.

First Quarter 2025 | Segment Focus: Residential Construction

Growth in residential and non-residential building sectors has slowed, with Value Put-in-Place up 2.8% and 2.9% Y-o-Y, respectively, on a seasonally adjusted annual basis. Residential building sentiment has slowed, as the NAHB Housing Market and Remodeling Market Indices have fallen 23.5% and 4.6% Y-o-Y as of Q1 2025. The presence of a new presidential administration and policy will have a significant impact on the industry.

Healthcare Facilities Q1 2025

Segment Focus: Dental Service Organizations (DSOs)

Over the past decade, Private Equity (PE) funds have scaled their platform and add-on expansions in healthcare, deploying over $1 trillion worth of capital. In 2021 alone, the sector saw over $200 billion in acquisitions.

Value Focus: Insurance Industry | First Quarter 2025

Insurance Stocks Proved Resilient During a Volatile First Quarter 2025

Medtech and Device Industry Newsletter - Q1 2025

This quarterly update includes a broad outlook that divides the healthcare industry into four sectors: Biotechnology & Life Sciences, Medical Devices, Healthcare Technology, Large, Diversified Healthcare Companies

E&P First Quarter 2025

Region Focus: Eagle Ford

Eagle Ford // Despite a notable rig count decline, Eagle Ford production generally remained about flat over the twelve months ended March 2025.

Bank M&A 2024 — Off the Bottom

In our year ago M&A epistle, we speculated that activity would improve and that a related theme could be equity recap transactions. The prediction was hardly heroic because M&A activity in 2023 represented a multi-decade low, while low public market multiples for a small subset of banks with high CRE exposure signaled investor expectations that an equity infusion was possible.

Anatomy of Volatility: Evolent (EVH)

A few notes on EVH price volatility in recent quarters – we remain observers and may report further notable developments.

Trends in MedTech Valuation Step-Up Multiples 2024

The medtech industry followed the overall venture runup in 2020 and 2021 and was not immune to the drop in funding in 2022 and 2023.

What Is the Makeup of the Car Parc?

Data from Q3 2024

Each quarter, Experian releases an Automotive Market Trends report. This report includes vehicle registration data from each state's Department of Motor Vehicles, vehicle manufacturers, and captive finance companies. This week, we summarize the data from the Q3 2024 report and add insights for our dealership audience.Vehicles in OperationThe makeup of vehicles in operation ("VIO") in the U.S. and Canada can be a leading indicator of what to expect from automotive sales over the medium term. For example, VIO can inform industry-wide estimates of what models are currently the most popular to own, how many of those models should be manufactured, and, inevitably, how many should be marketed and sold. These estimates can be made based on changes in VIO, the average age of VIO, and what vehicle segments and brands make up VIO.Changes in Total VIO over the Past YearAs of Q3 2024, VIO in the United States and Canada was 341.9 million. This includes light vehicles (cars, pickup trucks, SUVs, etc.) as well as medium and heavy-duty vehicles (large vans, delivery trucks, RVs, etc.) and power sports vehicles (motorcycles, snowmobiles, etc.). While tracking total VIO can be a valuable insight from a macroeconomic perspective, light vehicle totals are the most relevant to our auto dealer clients.In the U.S. and Canada, light duty vehicles in operation were 292.1 million on September 30, 2024, a positive difference of 3.6 million units or 1.2% higher than the same figure in Q3 2023. In fact, light-duty VIO has increased by 3.6 million units for two years in a row. These two consecutive, identical increases may have happened by chance but certainly highlight a longer-term trend of expansion in the car parc due to increased manufacturing activity post-COVID and fewer retirements due to longer-lasting vehicles. A segment of consumers being financially stretched also contributes to an increasing age of VIO. The specific components of light vehicle VIO change over the last twelve months are 15.6 million new vehicle registrations minus 12.0 million vehicles taken out of operation. See the chart below for a visualization of the change in VIO over the last year. New vehicle registrations were up 5.3% to 4.0 million during the third quarter of 2024, while used vehicle registrations were up 2.0% to 10.1 million. These positive growth rates over the third quarter tell the story of the past two years for the auto dealer industry: new vehicle inventories have been recovered for some time now after the pandemic and ensuing disruption from the chip shortage in 2020-2022 when registrations of both new and used vehicles fell before changing course and normalizing over the last two years. As one might expect, used vehicle transactions do not directly affect VIO. These types of transactions do not add new vehicles to the car parc but rather represent existing vehicles changing hands. Over the past year, approximately 38.9 million used vehicles changed owners. When you combine the retirement of used vehicles and used vehicle changing-of-hands transactions, 17.4% of the total car parc was involved in a used vehicle transaction or retirement over the past year. VIO by Model YearOver the past decade, drivers have been holding on to their vehicles for longer, partially due to improved longevity in modern vehicles and, at times during the pandemic, due to market conditions like availability and pricing of new and used vehicles. Factors are also at play, such as persistently high transaction prices for new vehicles and consumer worries over the shift to electric vehicles.The average age of a vehicle on the road hit 12.6 years in May 2024, according to Business Insider, which is up from 2023's average and marks the seventh year in a row that the average age of vehicles on the road has increased. In the context of an aging car parc, most of the country's VIO is still newer than 20 years old. As of Q3 2024, 83.9% of total VIO was less than 20, and 93.1% were less than 25 years old.According to the Automotive Market Trends report, there is an aftermarket "sweet spot" for the age of used vehicles, namely six to twelve years. This sweet spot is close to when most vehicles age out of general manufacturer warranties for repairs. As of Q3 2024, 36.2% of total VIO were within the used vehicle sweet spot (model years 2013 – 2019). This proportion is 0.4 percentage points higher than last year and 5.3 percentage points higher than the same time in 2020 when the pandemic was in full swing. Going forward, Experian expects the sweet spot to continue growing until 2026. It is not a coincidence that the sweet spot is expected to stop growing six years after 2020, as pandemic-affected manufacturers released fewer vehicles during the pandemic years than before.From the perspective of auto dealers, the ever-increasing average age of VIO is a double-edged sword. On one hand, a higher average age is likely to increase the volume of parts and service departments nationwide. Parts and service margins are among the most favorable of a dealership's profit centers, and dealers should look forward to increased work. On the other hand, a higher average age means consumers are purchasing vehicles less frequently, which could put slight pressure on selling departments.VIO by Vehicle Source, Type, and SegmentLooking at the makeup of VIO by domestic vs import, 58% of light-duty VIO were import models, and 42% were domestic models during Q3 2024. This represents a notable change from 52% import / 48% domestic just one year ago and emphasizes struggles by domestic manufacturers in recent years. Domestic automakers have lost market share to imports due to consumer perceptions of better reliability, technology, and fuel efficiency from foreign brands. Furthermore, challenges like a slower adaptation to trends such as electric vehicles have further hindered competitiveness between domestic and import brands.Splitting light-duty VIO by type, SUVs/Crossovers (56.7% of total light-duty VIO), passenger cars (20.8%), and light trucks (22.5%) all contribute to light-duty VIO. SUVs and crossovers have exploded over the last few years, making up a larger share of light-duty VIO each period. These vehicles have gained market share from cars due to their versatility, higher seating position, and increased cargo space, which appeals to families and consumers with active lifestyles. The improved fuel efficiency of these models in recent years has made them more practical, while their perceived safety has also drawn consumers away from traditional sedans.These broad vehicle types can be divided into around 20 more specific vehicle segments. The full-size pickup truck segment is the most popular in the United States, representing 16.4% of total VIO. Full-size pickup trucks are followed by midsize cars (13.0%), midsize crossovers (12.7%), and compact cars (8.1%). In recent years, midsize cars have lost some of their share to crossovers and compact cars. Looking at trucks specifically, as of Q3 2024, the Ford F-150 (3.7% of total VIO) and the Chevrolet Silverado 1500 (2.7%) were the two most popular models on the road.VIO by ManufacturerVIO by manufacturer is another way that the car parc can be analyzed. See the chart below for a look at VIO by manufacturer market share. General Motors, Ford, and Toyota are the most popular manufacturers in this cross-sectional data snapshot. VIO by manufacturer data represents what vehicles are currently on the road and includes vehicles of all ages, not just new vehicles. This data does not reflect consumer satisfaction or current sales trends but typically lags because it is more long-term focused. Therefore, this data is best viewed as a rearview mirror rather than a windshield for the industry, though it gives an eye into parts and service departments today. Going forward, we expect these proportions to slowly shift towards prevailing sales trends. GM and Ford continue to lead the way, representing 20.5% and 15.7% of total VIO, respectively. However, these two domestic manufacturers have slowly lost market share to import brands in recent years. The best example is Toyota, which has gained over the last couple of years but still lags behind Ford and GM. Perhaps we may see Toyota jump Ford and approach GM in total VIO soon. Kia is another notable mover on this list over the last year, as it gained two percentage points and jumped one spot from tenth to ninth. In some ways, this data reflects what we've seen with auto dealership values. For example, Toyota has outperformed, as seen in the graph above, which has translated to higher dealership values as reflected in Blue Sky multiples. About UsMercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

'Twas the Blog Before Christmas

Are Difficult Partner Discounts Applicable to RIAs?

A few months ago, I attended a business appraisal conference in Portland, Oregon, where I learned about a case involving a “Difficult Partner Discount.” Since we’re often hired when business owners can’t agree on price, we’re well aware of partnership disputes, but I’m pretty confident I’ve never directly applied a “Difficult Partner Discount” to the value of a business or interest therein. That doesn’t mean that partner disputes and departures can’t significantly impair the value of a company, which we address in this post.

Top 10 Oil & Gas Blog Posts of 2024

Year-end 2024 is quickly approaching so that means it's time to take a look back at the year. Here are the top ten posts for the year measured by readership. Click on any of the post titles to revisit the post.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of December 3, 2024

November 2024 SAAR

The November 2024 SAAR came in at 16.5 million units, which is 1.5% higher than last month and 6.2% higher than November 2023. Of note, November 2024 had one more selling day than November 2023.

The Four Types of RIAs

And What It Means for Practice Management

There are 15,000 or so RIAs in the US. No two are identical, of course, but broadly speaking, firms that seek to serve the same types of clients tend to end up with similar-looking business models, whether intentionally or through some form of convergent evolution. A firm’s structure—its org chart, compensation model, advisory team model, internal processes, marketing, technology, and so on—tends to reflect the types of clients the firm seeks to serve and, relatedly, the value proposition it offers to those clients. The result is that firms tend to cluster around a handful of distinct models, and identifying what those models are and how they differ can be a useful exercise both in analyzing a particular firm and in thinking about practice management issues.Back in 2021, Ashish Nanda and Das Narayandas—both economists and professors specializing in professional services and client management strategies—published an article in the Harvard Business Review titled What Professional Services Firms Must Do To Thrive. In that article, the authors introduced a framework for thinking about professional services firms based on the type of service they provide to clients. While the framework is generally from the perspective of professional services, we’ve found it to be a particularly useful tool for thinking about asset and wealth management firms.The framework categorizes firms into four buckets based on where they fall along a spectrum of the complexity of services provided. At one end of the spectrum are Commodity Practices—firms that offer undifferentiated services that solve simple problems. Next are Procedural Practices—those firms that offer clients the ability to tackle larger problems that are complicated primarily by larger scope and multiple moving parts. Next are Gray Hair Practices—firms that bring experience and institutional knowledge to solve even more complex problems. At the other end are Rocket Science Practices—firms that solve unique, difficult, and high-stakes problems for sophisticated clients. Firms are defined along this spectrum not by their own self-perceptions but by the selling proposition that brings clients to the firm. If clients select a particular firm because it’s the lowest-cost provider, that’s likely a commodity practice. At the other end of the spectrum, if clients choose a particular firm because they think it’s best suited to solve a particularly difficult and novel problem, that firm is likely best classified as a rocket science practice. What does this look like for RIAs? To illustrate, it’s helpful to look at the profiles of firms that fall in each category. Many firms may have elements that place them into multiple categories, but generally, firms lean most heavily into a single or perhaps two categories at most. For wealth management firms, we think most practices straddle the Procedural and Gray Hair categories.Commodity RIAs. Includes firms that use scale and automation to deliver low-cost, standardized investment services. Firms with algorithm-driven portfolio management strategies and mass-market advisory firms would likely fall into this category.Procedural RIAs. Includes firms with services that involve complex but well-defined processes. For RIAs, this could be offering comprehensive financial planning that follows structured steps. The administratively heavy nature of independent trust companies would also generally place them in this category.Gray Hair RIAs. This category includes RIAs that provide more sophisticated advice to more sophisticated clients than procedural practices, relying heavily on the experience and expertise of their advisors. Firms that predominantly serve ultra-high-net-worth clients, families with multi-generational wealth, or those that offer complex estate planning strategies generally fall into this category.Rocket Science RIAs. Asset managers that utilize complex or novel investment strategies would fall into this category—think those that have developed proprietary, quantitative trading strategies or those that utilize complex, derivative-based hedging strategies or certain alternative investment strategies. This framework has implications for the profit drivers of a business and the resources required to succeed. The farther a firm is towards the commodity end of the spectrum, the more important efficiency and systems for delivery become because these are necessary to deliver while remaining profitable. For RIAs, this typically means that such firms have org charts that are wider at the bottom, lower compensation levels on average, and low margins that are offset by scale and the ability to more easily leverage and grow the business. The farther a firm is toward the Rocket Science end of the spectrum, the more important knowledge management, experience, and analytical expertise become to the firm’s success. For RIAs, this typically manifests in a higher ratio of senior staff to junior staff, higher average compensation levels, higher margins, and less leverage. Such practices are inherently more difficult to scale because they rely more on individual expertise than company-wide systems to deliver their value proposition. Depending on where your practice falls on the spectrum, the type of talent you hire will be different, the way you structure client service teams will be different, the internal systems and processes you develop will be different, the way you market services will be different, and the way you invest in technology will be different.Successful Practices Are Clear About Where They Fall on the SpectrumWhile “commodity” and “rocket science” may elicit different knee-jerk responses in the professional services world, it’s important to note that one type of practice is not categorically better than any other. Success can be found through each of the routes above, and we’ve seen examples from each. But it’s essential to have a clear vision of the type of practice you’re seeking to run. Thinking about the type of practice you’re running is a valuable exercise for identifying the areas you want to lean into and the areas you want to avoid, as it has implications for the resources required for success.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, RIAs, trust companies, broker-dealers, PE firms, and alternative managers.

December 2024 | Bank M&A 2024: Off the Bottom

Bank Watch: December 2024

In this issue: Bank M&A 2024 — Off the Bottom

November 2024 | Moo Deng’s Post-Election Outlook for the Banking Industry

Bank Watch: November 2024

In this issue: Moo Deng’s Post-Election Outlook for the Banking Industry

Moo Deng’s Post-Election Outlook for the Banking Industry

BankWatch was swept up in the viral sensation of Moo Deng, a baby pygmy hippo. What would the Oracle of the Khao Kheow Open Zoo expect for the next four years?

Recap or Rescue?

CI Financial Has One Kind of Leverage, ADIA Has Another

Mubadala Capital is an asset management arm of the Abu Dhabi sovereign wealth fund and has offered to acquire CI Financial for C$32 per share, about a 33% premium to where the stock (CIX.TO) closed last Friday. CI Financial encompasses a Canadian asset, wealth, and custody platform and a U.S. wealth management platform. Including debt, the offer values CI at C$12.1 billion, of which consideration for equity totals C$4.7 billion (US$3.4 billion).

Themes from Q3 2024 Energy Earnings Calls

Upstream (E&P) and Oilfield Service (“OFS”) Companies

The earnings calls from the third quarter focused on technological efficiency, optimized capital allocation, and expectations for natural gas demand in the long term.

Whitepaper Release: Purchase Price Allocations for RIAs

Inventory Management Strategies for Franchised Auto Dealers

While dealers cannot control their allocation from OEMs, they can and should respond with the most appropriate sales strategy for the inventory they receive. There are two main approaches available to dealers: maximize price or volume. The key is balancing these strategies to optimize both sales and profitability. We discuss the pros and cons of each below.

WHITEPAPER | Purchase Price Allocations for RIAs

Is There a Ticking Time Bomb Lurking in Your Buy-Sell Agreement?

Buy-sell agreements don’t matter until they do. When written well and understood by all the parties, buy-sell agreements can minimize headaches when a company hits one of life’s inevitable potholes. But far too many are written poorly and/or misunderstood. Directors are always eager to discuss best practices for buy-sell agreements. In this week's post, Travis Harms, President of Mercer Capital, talks to our founder and author of four books on buy-sell agreements, Chris Mercer, and asks, “Is there a ticking time bomb lurking in your business?”

How Will Trump’s Second Term Affect the RIA Industry?

Now that the dust has finally settled on the 2024 election, we can turn our attention to its expected impact on the investment management industry.

Port Strikes, Supply Chains, and a Looming Deadline

In October 2024, the International Longshoremen Association (ILA) initiated a strike throughout the Eastern and Gulf Coast ports after negotiations surrounding a new contract stalled with the United States Maritime Alliance (USMX). This strike comes just two years after similar negotiations stalled on the West coast between the USMX and Internal Long shore and Warehouse Union (ILWU) in 2022 which led to decreased traffic and volume for about a year. Many ships were rerouted to other ports across the country during this time, removing volume from the West coast ports.

Organic Growth and RIA Valuations

Organic growth is a key metric for the RIA industry, but it’s also one that’s easy for many firms to ignore. Why is that? We think part of the answer lies in the prevailing revenue model of the industry, where fees are assessed against the market value of client assets.

October 2024 SAAR

The October 2024 SAAR came in at 16.0 million units, 1.7% higher than last month and 3.7% higher than October 2023. A strong October 2024 SAAR was accompanied by increased inventories and incentive spending levels industry wide, which put pressure on transaction prices and dealership profits.

National Association of Royalty Owners (NARO) National Convention

This year’s National Association of Royalty Owners (NARO) National Convention was held in Houston and Mercer Capital’s Bryce Erickson, ASA, MRICS and David Smith, CFA, ASA had the privilege of attending. NARO has represented the interests of oil and gas royalty owners for over 40 years, seeking to support, advocate and educate for the empowerment of mineral and royalty owners.

D CEO's 2024 Energy Awards

This year, Mercer Capital had the privilege to sponsor and attend the 2024 D CEO Energy Awards, an event that celebrates the energy sector and honors leadership and companies from across the value chain that impact the Dallas-Fort Worth metroplex.

Component Analysis of RIA Returns

A Method to Examine Valuation, Risk Management, and Return Optimization

If you ask most people to name an entrepreneur who made their mark in cars, they would probably name Henry Ford or Elon Musk. A third and equally compelling story is that of Bernie Ecclestone, the former chief executive of Formula One Group. Ecclestone grew a fairly obscure and marginally sustainable auto racing series into one of the world’s largest and most widely followed sports, with billions of viewers. Even more remarkable is that Ecclestone didn’t “acquire” his ownership in F1 from anybody—he created it.Ecclestone started his career after World War II as a parts dealer, mechanic, and sometimes racecar driver. In the early 1970s, he cobbled together enough money to buy an F1 team (a much cheaper endeavor then). With the perspective of a team owner, Ecclestone realized that the teams needed to band together to collectively negotiate better deals with track owners and television, and formed the Formula One Constructors Association and later the Formula One Promotions and Administration.Eventually, Ecclestone negotiated the Concorde Agreement, yoking together the teams and associations affiliated with F1 to set the terms by which teams compete in races. He then wrapped all of this up in Formula One Group, effectively his holding company. By the late 1990s, Ecclestone had, piece by piece, constructed an enterprise that controlled Formula One racing, and he controlled that enterprise. It made F1 what it is today, and it made him a billionaire.The Sum Is a Function of Its PartsBernie Ecclestone’s assemblage of F1 from various parts that became greater as a whole is a useful reminder that businesses can be viewed not just as a monolithic enterprise but also as an assemblage of individual functions with their own performance attributes, risks, and opportunities. Like a racecar, the whole may be greater than the sum of its parts, but examination of the parts yields valuable information about the whole.This sort of component analysis can be a helpful way to analyze RIAs. Broadly speaking, RIAs exist to manage money, but that business's profitability (and value) over time hinges on 1) servicing existing clients and 2) attracting new clients. Those two functions are usually not thought of independently of each other. An example P&L for a $5 billion AUM firm might look something like this: For purposes of this discussion, it doesn’t matter what flavor of RIA this is (wealth or asset manager, individual or institutional, MFO or OCIO, etc.). In aggregate, our “Generic” RIA has $5 billion in AUM, generates revenue off a blended fee schedule of 65 basis points, spends a bit over half of that on labor, between 15% and 20% on non-labor expenses, and ultimately generates an EBITDA margin of just over 30%.Existing Business on a Stand-Alone BasisThe value of an RIA is a function of recurring revenue. Investment management engenders long-term relationships between firms and their clients, and the persistence of those relationships provides an almost bond-like series of predictable returns. If you take the Generic RIA we’ve set up as an example and look at the revenue from the existing book of business and the cost of servicing that revenue, you get a stand-alone P&L that looks something like this: Returns from the existing book of business can generally be characterized as more plentiful than returns from new business. In an era of growing fee pressure, existing business usually pays more (basis points) than new business. Labor costs remain significant to service existing business but are lower than the cost of acquiring new clients. Even if we charge for an appropriate amount of occupancy and other G&A, the existing book of business, in isolation, generates a profit margin more than 25% higher than that of the aggregate enterprise. It shouldn’t be surprising that existing business is usually the most profitable business.Performance Metric for Existing BusinessThe golden opportunity for RIAs is the higher and more predictable margins associated with existing relationships. The biggest threat to that opportunity is, of course, client attrition. Mitigating attrition requires spending on client service, and from that relationship, you can glean a valuable performance metric.If you’re looking for a useful KPI to help manage your business, think about the tradeoff between the incremental margin generated by servicing existing clients and the net AUM attrition (client withdrawals and terminations net of market returns and client contributions). Theoretically, more spending on servicing existing clients should stem attrition. Optimizing the margin/retention equation will build value in your firm.(RIA) Growth at a Reasonable PriceThe worst-kept secret in the RIA industry is that most firms struggle to generate organic growth. This is often explained in terms of the industry's maturation, the aging advisor base, and the lack of service differentiation. Arithmetically, though, it’s easy to show that growing an RIA is, if you look at it in isolation, very expensive. Assume our Generic RIA shows net AUM growth of 5% per year, absent market activity. That’s $250 million and probably at a somewhat lower fee schedule than legacy clients pay. Attracting new business doesn’t need much of the client service, compliance, administrative, and G&A costs that servicing existing clients requires, but it does require expensive sales and marketing. The cost of attracting new business in any given year usually exceeds the marginal benefit of that new business in the first year and sometimes in the first several years.Growth is expensive, but it isn’t optionalGrowth is expensive, but it isn’t optional. Growth provides opportunities for staff development, which reduces talent attrition and augments shareholder returns. Growth provides a portion of an investor’s required return and supports the narrative that the firm’s business model is viable and sustainable. For these reasons, among others, the RIA community is racing to find multiple arbitrage opportunities to generate growth that isn’t happening organically.Performance Metric for New BusinessWhat is a reasonable cost for growth? As shown above, efforts to deliver new AUM to manage often cost more, initially, than the revenue generated by new business. In our example case, the total expense for new revenue is nearly three times the amount of new business. Put another way, it will take three years for the new business to pay for the investment to generate it. After the payback period, new business becomes accretive to profitability as it becomes part of that existing book, with more predictable revenue and bigger margins.The payback period for new business is a useful way to think about a firm’s investment in generating new business. If the payback period is too long, an RIA may not have an effective marketing plan. If payback is too quick, the firm may be under-exploiting an excellent opportunity. Optimizing the payback period is a function of the growth and investment tolerance of the ownership, and the margin on existing business. If building a larger book is particularly valuable, you’ll have more margin to invest in building more business.Unfortunately, the opposite is also true. Poor margins on existing business won’t provide the cash flow needed to build the business.Volatility and ValuationSegmenting an RIA into component returns also offers opportunities to think about risk and value to the RIA. The steady returns of existing business, in which market gains and client additions may be more than enough to offset withdrawals and attrition, suggest a bond-like return. Mapping returns from new business can show everything from moderate variability (in the case of mass-affluent wealth management) to very lumpy (in the case of institutional platforms like an OCIO) and should be thought of through the lens of probability distribution.Think about risk and value to the RIAAs such, the cost of capital for the existing book of business is necessarily much lower than it would be for new business. How much lower is a function of fact patterns specific to the RIA and some market-informed judgment? Fortunately, a close look at historical investment flows should reveal a pattern for what to expect in terms of net AUM changes from an existing book of business. Applying a lower than firm-wide discount rate offers clues as to the value of the existing book on a stand-alone basis, as well as the proportion of overall firm value.It’s also interesting to think about the value of growth by modeling the internal rate of return for investment in new business.In this case, we’ve assumed that the EBITDA margin for new business in our Generic RIA would be around 60% and modeled the IRR to receive that return for ten years following the marketing expenditure to land the business. (A more thorough analysis would look at the likely attrition rate on new business and model some residual cash flow at the end of the projection period into perpetuity. For the sake of not putting any more numbers on your screen than necessary, a finite ten-year projection is a good guess.) If the investment amount is higher, or the marginal EBITDA return is a lower percentage of new fees, the IRR compresses. If returns are better or the cost to generate them lower, the IRR will improve. One would want an IRR at a good premium to the firm’s aggregate cost of capital to make marketing for new business worthwhile. Optimizing the investment in new business would likely be a tradeoff between the highest aggregate level of new business (more is more) and the IRR of the effort (more is more).Component Analysis of RiskComponent return analysis is also useful to model the risk attributes of an investment management firm. Certain risks affect the existing base of business differently than new business.Certain risks affect the existing base of business differently than new business.For RIAs in businesses facing legislative action, such as attempts to restrict institutional ownership of rental housing, component analysis helps isolate the stroke-of-the-pen risk that would limit opportunities to raise new funds or make new investments to the “new business” side of the equation, leaving the value of servicing existing relationships intact.Other sorts of exogenous shocks, like severe market corrections, may negatively impact existing client relationships but simultaneously increase opportunities for new relationships. This ties well with our thesis that existing business models are like a bond, where risk is asymmetric to the downside, and new business models more like an option, where volatility is accretive to value.In Closing…There’s much more to say about component return analysis, but we don’t offer it as a substitute for keeping your eyes on the big picture. As brilliant as Bernie Ecclestone was in creating his dominant position in F1, he also became a bigger target and was eventually dethroned and lost his position at Formula One Group. He may have focused a bit too much on the upside when he neglected to pay all of his taxes and, consequently, had to face the downside of incarceration.If you’re curious about how to examine your RIA using component analysis, give us a call, and we will think through the exercise with you. You might be surprised by what you learn.

October 2024 | Fed Rate Cut(s) – Now What?

Bank Watch: October 2024

In This Issue: Fed Rate Cut(s) – Now What?

Fed Rate Cut(s) – Now What?

Rate cycles are predictable in one sense: a period of falling rates tends to follow a period of rising rates. The opposite is true, too.

Now Available: Mercer Capital’s 2024 Energy Purchase Price Allocation Study

Mercer Capital is pleased to announce the release of the 2024 Energy Purchase Price Allocation Study.This study researches and observes publicly available purchase price allocation data from companies primarily contained in one of the four sub-sectors of the energy industry: (i) exploration & production; (ii) oilfield services; (iii) midstream; and (iv) downstream. This study is unlike any other in terms of energy industry specificity and depth.The 2024 Energy Purchase Price Allocation Study provides a detailed analysis and overview of valuation and accounting trends in these sub-sectors of the energy space. This study also enables key users and preparers of financial statements to better understand the asset mix, valuation methods, and useful life trends in the energy space as they pertain to business combinations under ASC 805 and GAAP fair value standards under ASC 820. We utilized transactions that reported their purchase allocation data in calendar year 2023 and not reported in previous annual filings.This study is a useful tool for management teams, investors, auditors, and even insurance underwriters as market participants grapple with ever-increasing market complexity. It provides data and analytics for readers seeking to understand undergirding economics and deal rationale for individual transactions. The study also assists in risk assessment and underwriting of assets involved in these sectors. Further, it helps readers to better comprehend financial statement impacts of business combinations.DOWNLOAD THE STUDY

RIA Aggregator Investments Trick or Treat

Are Longer Holding Periods a Viable PE Strategy or Just an Extend-and-Pretend Tactic?

Halloween is the ultimate extend-and-pretend film series. From the original 1978 Halloween to 2022’s Halloween Ends, moviegoers estimate that Michael Myers apparently died eight times but somehow appeared in all thirteen films over the series’ 44-year history. The cynical (but likely accurate) rationale for this inconsistency is that the studios recognize that it makes the most economic sense to extend the Halloween saga after each movie and pretend Michael didn’t die in the last one. Private equity firms with investments in RIA aggregators appear to be facing a similar (though less haunting) predicament. A recent CityWire article noted that private equity firms are extending their holding periods for RIA aggregator firms to take advantage of the industry’s higher margins and long-term growth prospects. This stalling tactic shouldn’t spook their LPs since the RIA sector is renowned for its recurring revenue, above-average margins, and demonstrated ability to grow cash flows over an extended period of time. Not many industries have businesses that can sustain The Rule of 40, which posits that venture investors prefer to invest in businesses in which the profit margin plus the growth rate adds up to at least 40%. The investment management industry is a notable exception since it typically boasts EBITDA margins in the 20% to 30% range and annualized growth in revenue on the order of 10% to 15%. It’s like candy corn with a lasting sugar high to prospective investors. So what’s so scary about paying +15x EBITDA for these businesses? If we use the EBITDA single-period income capitalization method to build up an applicable EBITDA multiple for RIA aggregators based on their current cost of capital and expected long-term growth rates, that math probably looks something like this: This analysis suggests that an RIA aggregator’s cost of capital and growth profile support a 15x EBITDA multiple. There’s also market evidence to affirm these valuations — Goldman is estimated to have paid ~18x EBITDA for RIA aggregator United Capital, and PE firm Clayton, Dubilier & Rice purchased Focus Financial for ~13x EBITDA last year. Market evidence supports extending holding periods for these types of investments rather than flipping them to the next investor. PE firm GTCR purchased a 25% stake in RIA acquisitive Captrust Financial Advisors in 2020, which valued Captrust at $1.25 billion before Carlyle bought another minority stake in the business, valuing the firm at just over $3.7 billion three years later. An extended holding period for an RIA aggregator investment at a 15x EBITDA entry multiple appears very reasonable for the PE firms backing these businesses. What about the multiple that these aggregator firms are paying for their underlying RIAs? That math looks a bit different since these investment management firms tend to be much smaller, riskier, and have little or no access to (cheaper) debt financing: When we do see RIA transactions in the +15x EBITDA space, much of the total deal value is typically paid in the form of an earnout or contingent consideration payment based on the target firm’s future financial performance, usually 1-5 years out from the initial down payment. These multiples are often calculated based on the total deal value (including contingent consideration) divided by trailing twelve-month EBITDA prior to closing, even though the earnout portion is unknown at that point, and the time value of money is not factored into the calculation. Paying north of 20x EBITDA for these businesses with no buyer protection in the form of earnout payments could be more horrifying than a hayride with Michael Myers on his ninth life. We’re here to help (with the former).About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, RIAs, trust companies, broker-dealers, PE firms, and alternative managers.

2024 NADC Fall Conference Update

Key Takeaways for Auto Dealers

We provide a few takeaways from sessions we attended at this year’s conference. We believe the topics we cover are especially important for auto dealer counsel and their clients during the remainder of the year and beyond.

Alternative Asset Managers Outperform as RIA Sector Gains Momentum

Alternative asset managers fared particularly well during favorable market conditions for the RIA sector. Over the past year, both alternative asset managers and large RIAs (with assets under management, or AUM, exceeding $250 billion) outperformed the S&P 500, achieving gains of 64.6% and 37.7%, respectively.

"Hayne" in There, Haynesville!

The Haynesville/Bossier Shale was discovered in 2008 in East Texas and Western Louisiana. As a play, it differs from other reserves. The reservoirs are highly pressured and deeper than most other reservoirs. The average hydrocarbon reservoir in Haynesville is almost 12,000 feet deep, far exceeding the average depth of 6,000 feet (per the most recently available data from the EIA). This extra depth can make drilling activities more expensive. This is not just because of the additional pipe length. Temperatures at such great depths can be extremely high, so the equipment to drill wells must be able to withstand particularly high temperatures. Such equipment typically costs more than standard drilling equipment. Additionally, Haynesville is saturated with smaller independent operators compared to plays like the Eagle Ford and the Permian over the last decade. The greater share of independent operators can lead to relatively higher average drilling costs from smaller average contract sizes.Source: Family Tree Oil & Gas CorporationDespite these challenges, Haynesville has a number of advantages over other basins. While the equipment required to complete projects is more expensive, Haynesville is located extremely close to the Gulf of Mexico and its LNG export terminals, especially compared with the Marcellus in Appalachia. While the Marcellus may have cheaper operating costs at the well level because it is not as deep as the Haynesville, the long transportation distance required for its reserves to be exported eats away at its natural price advantage. The Permian is relatively close to export terminals and has cheaper operation costs, but the gas there has faced transmission problems.TransactionsHaynesville has seen unsteady transaction activity over the last ten years. The chart below shows that M&A has been sporadic, with most activity in the last five years occurring in 2021 and additional smaller closings in 2Q 2022 and 3Q 2023. M&A activity in 2024 has been relatively limited per Shale Experts, likely because of the harsh operating conditions for gas-forward plays.The most notable Haynesville transaction in the Shale Experts data occurred in the second quarter of 2018 when B.P. America Production Company (a subsidiary of B.P.) acquired the assets of Petrohawk Energy Corporation, (at the time) a wholly owned subsidiary of BHP Billiton Petroleum (North America) Inc. The total value of the transaction was $10 billion. Notably, the Petrohawk assets included were not just in Haynesville but also in the Eagle Ford and the Permian Basins. As such, it is not strictly comparable with the other transactions shown in the chart. A specific breakout of the value per basin is unavailable, but the transaction’s press release did include the information summarized in the table below the chart. Data per Shale Experts Notably excluded from the Shale Experts data is Chesapeake Energy’s acquisition of Southwestern Energy in January 2024 (which we have written about previously). The resulting entity, known as Expand Energy, involves a total consideration of $7.4 billion. Through the deal, Chesapeake acquired 7.9 bcf/d from Southwestern’s assets in the Appalachian and Haynesville. In recent news, word has spread that Chevron Corporation (CVX) is discussing selling its Haynesville assets with Tokyo Gas. Chevron’s portfolio includes 72 thousand acres of undeveloped land. In the same publication, the author speculates that the potential transaction could be worth up to $1 billion. Tokyo Gas’s interest in the Haynesville assets may be related to Japan’s reliance on imported fossil fuels. Before its conversations with Chevron, Tokyo Gas had also completed an acquisition of Rockcliff Energy for $2.7 billion. As of the writing of this post, the Rockcliff assets contribute as much as 1.3 bcf of gas per day to Tokyo Gas.ActivityIn the last twelve months, Shale Experts shows that there have been 232 total deals completed in Haynesville. These completions have been heavily concentrated among a few operators, as shown above. The top eight operators have a total of 216 completions, representing 93% of all completed deals since the start of 3Q 2023. The chart below shows that transactions have been trending downward since the second quarter of 2023. [caption id="" align="alignnone" width="1072"]Data per Shale Experts[/caption] Since it is overwhelmingly a gas-focused basin, Haynesville producers have been hit hard by declining natural gas prices. As of February 2024, S&P estimated that the average breakeven price for efficient operators in the Haynesville Shale was $2.67/MMBtu. For less efficient operators, wellhead clearing prices are well above $3.00/MMbtu. For context, the most recent natural gas weekly update from the EIA places the Henry Hub spot price at $2.42/MMbtu. At current prices, there simply is no incentive for new completions in Haynesville despite its large reserves and convenient geography. The Biden Administration’s pause on new LNG export approvals has had a brutal impact on the Haynesville Shale. Companies have hesitated to commit to new projects without the certainty of being able to export LNG. As of the writing of this post, the pause is still in place. In the longer term, things look much more positive. There are already indications that LNG demand is rising faster than previously expected. Shale operators across the board are looking to lower their capital expenditures without negatively impacting production, and the data shows that they have been very successful in the Haynesville Basin. Over the twelve months leading up to September 2024, rig counts decreased by 15.4% YoY, while production only decreased by 10.1% over the same period (for additional detail, see Mercer Capital’s 3Q 2024 E&P Newsletter). If this trend continues, the decreased clearing price for natural gas operators in Haynesville will cause operations in that area to be economical once again. In December 2023, Hart Energy published a report predicting that U.S. LNG capacity will increase from 13 Bcf/d in 2024 to 25 Bcf/d by 2030. Per Hart Energy, Haynesville will be a critical provider of this additional capacity, as the Haynesville is expected to provide 13Bcf/d of that additional demand, making it the dominant provider of a massively ballooning market. One can see the gap between short-term and long-term expectations by comparing the production numbers above with the changes in capacity shown in the graph below (courtesy of Enverus Intelligence). While current production is low, companies are making significant investments in expanding their LNG export capacity. Naturally, a large portion of these exports will be occurring in the Haynesville Basin. But put simply, there are good times ahead. Mercer Capital has assisted many clients with various valuation needs in the oil and gas industry in North America and globally. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate, and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.Additional Sources:Assorted data from Shale ExpertsAssorted data from the U.S. Energy Information Administration“Haynesville/Bossier Shale Information & Statistics”“Haynesville Region Drilling Productivity Report”

Fairness Opinions: Evaluating a Buyer's Shares from the Seller's Perspective

Strong performance of U.S. equity markets in 2024 combined with narrowing credit spreads in the high yield bond, leverage loan and private credit markets are powerful stimulants for M&A activity. According to the Boston Consulting Group, U.S. M&A activity based upon deal values rose 21% though September 30 compared to the same period in 2023 after Fed rate hikes during 2022 and 1H23 weighed on deal activity.Deal activity measured by the number of announced deals is less compelling as deal activity has been dominated by a number of large transactions in the energy, technology and consumer sectors.While large company M&A may continue, the broadening rally in the equity markets (Russell 2000 +13% YTD through October 16; S&P 400 Midcap Index +14%) suggests that deal activity by “strategic” buyers may increase. If so, deals where publicly-traded acquirers issue shares to the target will increase, too, because M&A activity and multiples have a propensity to increase as the buyers’ shares trend higher.It is important for sellers to keep in mind that negotiations with acquirers where the consideration will consist of the buyer’s common shares are about the exchange ratio rather than price, which is the product of the exchange ratio and buyer’s share price.When sellers are solely focused on price, it is easier all else equal for strategic acquirers to ink a deal when their shares trade at a high multiple. However, high multiple stocks represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be obvious even when the buyer’s shares are actively traded.Our experience is that some if not most members of a board weighing an acquisition proposal do not have the background to thoroughly evaluate the buyer’s shares. Even when financial advisors are involved, there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to, “value.”A fairness opinion is more than a three- or four-page letter that opines as to fairness of the consideration from a financial point of a contemplated transaction. The opinion should be backed by a robust analysis of all of the relevant factors considered in rendering the opinion, including an evaluation of the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future, but rather to evaluate the investment merits of the shares before and after a transaction is consummated.Key questions to ask about the buyer’s shares include the following:Liquidity of the Shares.What is the capacity to sell the shares issued in the merger? SEC registration and NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently. OTC traded shares should be heavily scrutinized, especially if the acquirer is not an SEC registrant. Generally, the higher the institutional ownership, the better the liquidity. Also, liquidity may improve with an acquisition if the number of shares outstanding and shareholders increase sufficiently.Profitability and Revenue Trends. The analysis should consider the buyer’s historical growth and projected growth in revenues, EBITDA and net income as well as trends and comparisons with peers of profitability ratios.Reported vs Core Earnings. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated (preferably over the last five years and last five quarters) with particular sensitivity to a preponderance of adjustments that increase core earnings.Pro Forma Impact. The analysis should consider the impact of a proposed transaction on the pro forma balance sheet, income statement and capital structure in addition to dilution or accretion in EBITDA per share, earnings per share and tangible book value per share both from the seller’s and buyer’s perspective.Shareholder Dividends. Sellers should not be overly swayed by the pick-up in dividends from swapping into the buyer’s shares; however, multiple studies have demonstrated that a sizable portion of an investor’s return comes from dividends over long periods of time. Sellers should examine the sustainability of current dividends and the prospect for increases (or decreases). Also, if the dividend yield is notably above the peer average, the seller should ask why? Is it payout related, or are the shares depressed?Share Repurchases. Does the acquirer allocate some portion of cash flow for repurchases? If not, why not assuming adequate cash flow to do so?Capex Requirements. An analysis of capex requirements should focus on whether the business plan will necessitate a step-up in spending vs history and if so implications for shareholder distributions.Capital Stack.Sellers should have a full understanding of the buyer’s capital structure and the amount of cash flow that must be dedicated to debt service before considering capex and shareholder distributions.Revenue Concentrations. Does the buyer have any revenue or supplier concentrations? If so, what would be the impact if lost and how is the concentration reflected in the buyer’s current valuation.Ability to Raise Cash to Close.What is the source of funds for the buyer to fund the cash portion of consideration? If the buyer has to go to market to issue equity and/or debt, what is the contingency plan if unfavorable market conditions preclude floating an issue?Consensus Analyst Estimates.If the buyer is publicly traded and has analyst coverage, consideration should be given to Street expectations vs. what the diligence process determines. If Street expectations are too high, then the shares may be vulnerable once investors reassess their earnings and growth expectations.Valuation. Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles.Share Performance.Sellers should understand the source of the buyer’s shares performance over several multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Strategic Position. Assuming an acquisition is material for the buyer, directors of the selling board should consider the strategic position of the buyer, asking such questions about the attractiveness of the pro forma company to other acquirers?Contingent Liabilities. Contingent liabilities are a standard item on the due diligence punch list for a buyer. Sellers should evaluate contingent liabilities too.The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential and risk profile. We at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over three decades of business.

Vulcan Materials’ Acquisition of U.S. Concrete

As participants in and observers of mergers and acquisitions, the 2021 acquisition of U.S. Concrete, Inc. (“U.S. Concrete”) by Vulcan Materials Company (“Vulcan Materials”) (NYSE: VMC) is a terrific opportunity to study the valuation nuances of the construction and building materials industry. In this article, we look at the fairness opinions delivered by Evercore and BNP Paribas rendered to the U.S. Concrete board regarding the transaction and provide some observations on the methodologies utilized by these two investment banks.

September 2024 SAAR

The September 2024 SAAR came in at 15.8 million units, 3.3% higher than last month and in line with September 2023. At their September meeting, the Federal Reserve cut benchmark interest rates by 50 basis points and highlighted a slight rise in unemployment. This won’t directly or dramatically impact the industry, but we do expect to see the effects of this rate cut (and likely forthcoming cuts) within the industry over the next couple of months and into 2025.

Just Released: 3Q24 Exploration & Production Newsletter

RIA M&A Update: Q3 2024

Following a year where deal volume in the RIA industry nearly matched the all-time high of 2022, RIA M&A activity has cooled in 2024. Fidelity’s September 2024 Wealth Management M&A Transaction Report listed 155 deals through September 2024, down 11% from the 174 deals executed during the same period in 2023.

RIA Market Update: Q3 2024

RIAs outperformed the S&P in the third quarter of 2024, with alternative asset managers experiencing the strongest returns amid multiple expansion. All groups examined experienced growth in AUM and revenue year-over-year. We explore further in our Q3 2024 Market Update.Download Update

Should Appalachian Natural Gas Producers’ Stock Price Resiliency Be Surprising?

In a year where natural gas prices have spent almost the entire year under $3.00 per mcf, including a few months under $2.00, the stock prices of publicly traded Appalachian gas producers have remained remarkably stable. In fact, Antero Resources’ price is up this year and Range Resources is basically flat for the year so far. Others such as EQT and Coterra Energy are down only marginally. This could come across as surprising. Appalachia has some disadvantages to other US gas producing basins, such as takeaway capacity, logistics, and longer distances to major LNG production facilities. However, since 2022 the stock market has held steady for these companies; of which this confidence has outlasted commodity price and earnings declines over the past two years.

One Strike and We’re Out?

The ILA Strike and It’s Implications on Industry Data

At the beginning of October, we attended the Memphis World Trade Club’s annual Memphis Logistics Summit. In conjunction with the New Orleans Port Night, the Memphis Logistics Summit gathers players from a wide cross section of the transportation industry to discuss the industry, current events, and new technology. The Summit began on October 2nd and the schedule was filled with excellent panels and speakers. The space between sessions was filled, of course, with discussions of the ILA strike and how it was impacting different aspects of the transportation world.

Fourth Quarter 2024 | Segment Focus: Non-Residential Construction

Both the residential and non-residential building sectors have enjoyed strong years thus far, with Value Put-inPlace up 5.7% and 3.6% Y-o-Y, respectively, on a seasonally adjusted annual basis. Non-residential construction has experienced strong tailwinds from elevated growth in corporate profits, though this has slowed during the fourth quarter of 2024.

Healthcare Facilities Q4 2024

Segment Focus: Ambulatory Surgery Centers

Ambulatory Surgery Centers (ASCs) have seen a significant increase in popularity during the past few years. Currently in the United States, there are 11,555 active centers, representing a 3% year over year increase.

Value Focus: Insurance Industry | Fourth Quarter 2024

2024: A great year for Brokers, P&C, and Insurtech; Insurance IPOs win big

Medtech and Device Industry Newsletter - Q4 2024

Feature Article | Trends in MedTech Valuation Step-Up MultiplesEXECUTIVE SUMMARYThis quarterly update includes a broad outlook that divides the healthcare industry into four sectors:Biotechnology & Life SciencesMedical DevicesHealthcare TechnologyLarge, Diversified Healthcare CompaniesWe include a review of market performance, valuation multiple trends, operating metrics, and other market data. This issue also includes a review of M&A and IPO activity

E&P Fourth Quarter 2024

Bakken, DJ Basin, and Woodford Shale

Bakken, DJ Basin, and Woodford Shale // As a supplement to our usual regional coverage, this quarter we take a closer look at the Bakken, DJ Basin, and Woodford Shale. On an oil equivalent basis, the DJ Basin ended the review period 2% below production levels from a year earlier, while the Bakken ended at nearly 5% lower. Only the Woodford Shale ended the review period at a level above its November 2023 production, though at a negligible 0.1% higher.

Transportation & Logistics Newsletter

Fourth Quarter 2024

Striking the Right Balance Between Margins and Compensation

New Book: "Buy-Sell Agreements: Valuation Handbook for Attorneys"

We are excited to share the release of our latest book Buy-Sell Agreements: Valuation Handbook for Attorneys authored by Z. Christopher Mercer, FASA, CFA, ASA and published by the American Bar Association. This week, we share an excerpt from the book that discusses what you can expect to find in the full copy. Whether you are an attorney who advises clients on their buy-sell agreements or are a party to a buy-sell agreement, you will find important information in this book.

2024 Core Deposit Intangibles Update

Although deal activity has been slow, we have seen a marginal uptick in core deposit intangible values relative to this time last year.

Navigating Challenges in Appalachian Production

The economics of oil & gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Haynesville, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of the reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. This quarter, we take a closer look at the Marcellus and Utica shales.

Five Ideas to Turn Your RIA’s Success Into Momentum

Understanding why you’ve been successful is important to sustaining your success.

Where Is the Auto Dealer Industry in the Cycle?

For years, it’s been a question of when, not if, things would normalize. The more difficult follow-up question has been, “Where will earnings and margins normalize?”

Does This Presidential Election Matter to the RIA Industry?

For some reason, we get this question every four years or so, and it’s come up quite a bit in recent weeks. We have to step back and think about what either candidate’s election would mean for the broader financial services industry, taxes, and stock market returns

Observing the Negotiations of the Chesapeake - Southwestern Merger

A Marcellus and Utica Shale M&A Update

M&A activity among upstream participants in the Marcellus and Utica Shales has been sparse in recent years, with Shale Experts reporting only one transaction since November 2022. In a departure from our typical analysis and discussion of recent deals in the upstream oil and gas industry, this week’s Energy Valuation Insights blog takes a break from deal multiples and observes the negotiations of the $7.4 billion merger between Chesapeake Energy Corp. (“Chesapeake”) and Southwestern Energy Co. (“Southwestern”), a significant player in the Marcellus Shale.

August 2024 SAAR

The August 2024 SAAR came in at 15.1 million units, notably 4.5% lower than last month. In fact, this month’s SAAR is even lower than June, which was negatively impacted by the CDK cybersecurity attack. We believe consumers are likely finally feeling the pain of a softer labor market, as indicated by the July 2024 Jobs Report from the Bureau of Labor Statistics.

Are Retirement Plans an Underappreciated Growth Opportunity for RIAs?

Beyond deepening relationships with existing clients, offering DC services opens doors to developing connections with SMB business owners (often HNW individuals) and HNW plan participants. The connections formed through defined contribution services can create a valuable pipeline to mine for new HNW advisory clients.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of September 3, 2024

Bank Watch: September 2024

2024 Core Deposit Intangibles Update

Funding Your RIA’s Buy-Sell with Life Insurance Just Got Much Harder

SCOTUS Compels Closely-Held Business Owners to Review a Potential Problem in Their Ownership Agreement

When is something worth more than it’s supposed to be worth? If it’s a vintage sports car, it might be that a restoration shop has modified the original car to make it more visually appealing, faster, and more useful than new. If it’s a decedent’s interest in an RIA, it’s because life insurance benefits paid upon the death of the shareholder are now included in the value of the business.

Equity Capital Raises

The banking zeitgeist is evolving: 2023 was about a liquidity crisis that claimed three banks who were members of the S&P 500; 2024 is shaping up as the year of capital raises by a handful of regionals to deal with the aftermath of the Fed’s ultra-low-rate environment.

2024 Mid-Year Market Update

After a period of underperformance due to earnings pressure from rising rates and falling margins, banks rallied strongly during the reporting of 2Q24 earnings.

Themes from Q2 2024 Energy Earnings Calls

Upstream (E&P) and Oilfield Service (“OFS”) Companies

In our prior earnings call post, Themes from Q1 2024 Energy Earnings Calls, we touched on how the Upstream (“E&P”) and Oilfield Services (“OFS”) segments emphasized their dividend and share buyback programs and the industry’s response to depressed natural gas prices. This week, we explore the Q2 2024 earnings calls of Upstream and OFS companies, highlighting the significance of this quarter’s themes across the entire sector.

Q2 2024 Earnings Calls

Here is what auto retailer executives had to say during the Q2 2024 earnings calls.

Valuing Asset Managers

Understanding the value of an asset management business requires some appreciation for what is simple and what is complex.On one level, a business with almost no balance sheet, a recurring revenue stream, and an expense base that mainly consists of personnel costs could not be more straightforward. At the same time, investment management firms exist in a narrow space between client allocations and the capital markets. They depend on revenue streams that rarely carry contractual obligations and valuable staff members who often are not subject to employment agreements. In essence, RIAs may be both highly profitable and prospectively ephemeral. Balancing the risks and opportunities of a particular investment management firm is fundamental to developing a valuation.WHITEPAPERValuing Asset ManagersDownload

WHITEPAPER | Valuing Asset Managers

Unlocking Value in the Oil & Gas Industry

The oil and gas industry is constantly changing, with a lot of moving parts and financial complexities. Accurate valuation of assets within this sector is critical for making informed strategic decisions. At Mercer Capital, we have cultivated a deep understanding of the oil and gas industry through decades of experience. To share our knowledge and insights, we have produced three complimentary whitepapers for our blog readers.How to Value Your Exploration & Production CompanyThe valuation of exploration and production (E&P) companies is a complex process influenced by a multitude of factors, including price volatility, technology, regulation, and different drilling economies depending on the play. Our updated whitepaper provides insights into the financial considerations and key valuation methodologies for E&P companies. By understanding the drivers of value, companies can optimize their strategic direction and financial performance. Download hereUnderstanding Oilfield Services Companies & How to Value ThemThe oilfield services (OFS) industry is characterized by its cyclical nature. The unpredictable cyclicality of the OFS industry requires careful consideration of many industry-wide and company-specific factors in developing a reasonable forecast of future operating results. Our whitepaper describes the key drivers and indicators of the OFS industry, as well as the key valuation methodologies of an OFS company. By understanding the key factors that impact the value of OFS companies, industry participants can make informed decisions about mergers, acquisitions, and capital allocation. Download hereHow to Value an Oil & Gas Royalty InterestA lack of knowledge regarding the worth of a royalty interest could be very costly. This can manifest itself in a number of ways. A shrewd buyer may offer a bid far below the interest’s fair market value; opportunities for successful liquidity may be missed; or estate planning could be incorrectly implemented based on misunderstandings about value. Understanding how royalty interests are properly appraised will ensure that you maximize the value of your royalty, whenever and however you decide to transfer it. Download hereConclusionAt Mercer Capital, we are committed to providing valuable insights and resources to the oil and gas industry. Our whitepapers on E&P companies, OFS companies, and valuing royalty interests offer a comprehensive understanding of the valuation complexities within this sector. We hope you find them helpful.

Handling RIA Ownership Disputes

When RIA owners can’t agree on the appropriate price for a shareholder buyout, we’re often jointly retained to value the departing member’s interest in the business pursuant to a buy-sell agreement. Whether we’ve been court-appointed or mutually chosen by the parties to do the project, we’ve done enough of these over the years to learn that the process matters as much as the outcome.

What Does the Valuation Process Entail for an Oil and Gas Royalty Interest?

A lack of knowledge regarding the worth of a royalty interest could be very costly. This can manifest itself in a number of ways. A shrewd buyer may offer a bid far below the interest’s fair market value; opportunities for successful liquidity may be missed; or estate planning could be incorrectly implemented based on misunderstandings about value. Understanding how royalty interests are properly appraised will ensure that you maximize the value of your royalty, whenever and however you decide to transfer it.

July 2024 SAAR

The July 2024 SAAR came in at 15.8 million units, a 4.2% increase from last month and roughly flat with July 2023 (-0.8%). While the month-over-month increase was expected based on the CDK cyber-attack that hit the auto dealer industry in late June, we find it notable that results were still below last year.

Build, Buy, or Outsource

RIAs Need Trust Capabilities, but How?

There’s a growing demand for expanding the suite of services to include trust administration, either by bringing those services in-house and making it a one-stop shop for clients or by seamlessly outsourcing. For RIAs that can figure it out, there are opportunities for higher growth and retention at the margin relative to a field of competitors that lack robust trust capabilities.

What Does the Valuation Process Entail for an E&P Company?

RIA Value Is a Function of Liquidity

Is the Investment Management Industry Missing Part of Its Capital Stack?

The value of any asset is determined by the market in which it trades. The most significant component of that market as it relates to value is the relative access to liquidity of market participants.

August 2024 | 2024 Mid-Year Market Update & Equity Capital Raises

Bank Watch: August 2024

In this issue: 2024 Mid-Year Market Update & Equity Capital Raises

Economic Pressure on Commercial Real Estate Sector

CRE has long been a hot topic of conversation and CRE regulatory guidance to address elevated concentrations of CRE loans and help institutions manage risk accordingly was released all the way back in 2006.

Will Rate Cuts Improve RIA Multiples?

Naturally, we’re interested in how expected rate cuts will affect the investment management industry’s transaction multiples. Many industry observers believe anticipated rate cuts will have little or no impact on the sector since most RIAs don’t have any debt on their balance sheets. While it’s true that most investment management firms do not employ leverage in their capital structure, lower interest rates will nonetheless impact their cost of equity and, consequently, their valuations. We can illustrate this by way of a common decomposition of the most prevalent valuation metric in the RIA space — the EBITDA multiple.

Personal Goodwill in the Auto Industry

This post discusses important concepts of personal goodwill in divorce litigation engagements. The discussion relates directly to several divorce litigation cases involving owners of automobile dealerships. These real-life examples display the depth of analysis that is critical to identifying the presence of personal goodwill and then estimating or allocating the associated value with the personal goodwill. The issues discussed here pertain specifically to considerations utilized in auto dealer valuations, but the overall concepts can be applied to most service-based industries.It is important that the appraiser understands the industry and performs a thorough analysis of all relevant industry factors. It is also essential to determine how each state treats personal goodwill. Some states consider personal goodwill a separate asset, and some do not make a specific distinction for it and include it in the marital assets.

Premiums for Inventory Scale

In the last year, M&A activity in the upstream area of the oil and gas industry has increasingly become top-heavy, characterized by several headline deals. While the broader North American E&P deal count has been shrinking since 2022, a handful of major acquisitions in the last year have led to a spike in upstream M&A spending.

What’s “Play”-ing in the DJ Basin?

An Introduction to the Denver-Julesburg Basin

The Denver-Julesburg (“DJ”) Basin is a vast and geologically complex basin marked by sedimentary layering, tectonic shifts, and hydrocarbon generation. Encompassing an area of approximately 20,000 square miles, it stretches across regions of Colorado, Wyoming, Nebraska, and Kansas. Notable within the basin are various fields and geological formations, including the Wattenberg Field, Niobrara, Codell, Greenhorn, Adena Field, Hereford area, and the Redtail Field area.

Independent Trust Company Trends

One of the most frequently ignored sectors in the wealth management industry may be its first cousin, the independent trust industry. While many still associate trust administration with banks, which account for more than 75% of the space, the growing prominence of independent trust companies is capturing the attention of many participants in the investment management community. In this post, we examine current trends impacting independent trust companies.

RIA M&A Update: Q2 2024

Following a year where deal volume in the RIA industry nearly matched the all-time high of 2022, RIA M&A activity has cooled in 2024. Fidelity’s May 2024 Wealth Management M&A Transaction Report (most recent available data) listed 86 deals through May 2024, down 17% from the 103 deals executed during the same period in 2023.

June 2024 SAAR

The June 2024 SAAR came in at 15.3 million, a 4.0% drop from last month and a 4.8% drop from June 2023. According to Wards Intelligence, the CDK cyberattack caused a 50,000-unit deficit during June 2024; however, second-quarter sales were still relatively flat (-0.4%) from the second quarter of 2023 as only 11 of 91 days were impacted in the quarter.

Just Released | 2Q24 Exploration & Production Newsletter

Region Focus: Permian

Private Equity Investors Learn What Family Shareholders Have Always Known

Family shareholders bear the risk of illiquidity. So what can family businesses and family shareholders do to manage the burden of illiquidity? Five things come to mind:

RIA Market Update: Q2 2024

RIAs underperformed in the second quarter of 2024, with even the largest asset managers facing a decline in stock price in spite of a stronger asset base on which to collect revenue. Despite the price drop, all groups examined experienced growth in fundamentals year-over-year. We explore further in our Q2 2024 Market Update.

July 2024 | Economic Pressure on Commercial Real Estate Sector

Bank Watch: July 2024

In this issue: Economic Pressure on Commercial Real Estate Sector

Third Quarter 2024 | Segment Focus: Roads, Bridges, and Highways

Both the residential and non-residential building sectors have enjoyed strong years thus far, with Value Put-inPlace up 4.9% and 5.6% Y-o-Y, respectively, on a seasonally adjusted annual basis. The median sales price of houses sold has further moderated in 2024. Elevated rates and commodity input prices have proved to be strong headwinds for industry activities.

Value Focus: Insurance Industry | Second Quarter 2024

Insurtech leads all sectors in Q2-2024; Market shows strong appetite for insurance IPOs

Value Focus: Insurance Industry | Third Quarter 2024

All four insurance sub-sectors tracked by Mercer Capital outperformed the S&P 500 in the third quarter of 2024.

Medtech and Device Industry Newsletter - Q3 2024

E&P Third Quarter 2024

Appalachian Basin

Appalachian Basin // Appalachian production declined over the last twelve months due to reduced drilling activity, driven by low natural gas prices and high storage inventory.

Transportation & Logistics Newsletter

Third Quarter 2024

The Latest on CDK Global Cybersecurity

Risks Come into Focus after Lurking in the Shadows

As frequent auto conference attendees and sponsors, we discuss trends in the industry with other service providers. In an increasingly digital world, we’ve noted an increase in service providers catering to cybersecurity in a variety of ways. While no dealer gets excited about spending thousands of dollars to mitigate risks rather than grow profits, the CDK Global cyberattack may be a watershed moment for the industry.

New SEC Analysis of Form ADV Data

Insights on RIA Consolidation Trends

A new report published by the SEC reveals that there were approximately 15,400 individual SEC-registered investment advisory firms in 2023, up from about 10,800 in 2013. Deal activity (measured as a percentage of total RIAs) rose from about 0.3% to 1.6% over this time—a dramatic increase, yet not enough to offset new RIA formation. Several factors have contributed to the increase in the number of RIA firms.

Acquisition Premiums Return to the Oil Patch

The shale industry is showing signs of maturity. Some acquisition trends appear to be burgeoning, such as acquisition premiums, more debt, and looser hedging requirements. These portend higher values and perhaps more of an emphasis on longer-term drilling inventory as opposed to nearer-term production metrics. Let us take a quick look at them.

Permian Production Growth Stands Alone

The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Permian, Eagle Ford, Haynesville, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, the depth of the reserve, and the cost of transporting the raw crude to market. We can observe different costs in different regions depending on these factors. In this post, we take a closer look at the Permian.

Ken Fisher’s Deal Is Remarkable Because It Isn’t Remarkable

With a proven track record of organic growth like Fisher, 15 times EBITDA seems reasonable, if not cheap. It suggests that Fisher means it when he says he remained in control, and that this wasn’t a minority deal that offered the financial partner many features of control — as we often see happen.

2024 State of Auto Finance

Origination, Delinquency, and Portfolio Trends

In this year’s "2024 State of Auto Finance," we review these themes and lay out new developments and changes in auto finance since this time last year.

Whitepaper Release: Assessing Earnings Quality in the Investment Management Industry

A thorough QofE analysis plays an important role in evaluating the performance of RIAs. It transcends traditional financial assessments, providing a view of a company’s sustainable earning power by adjusting for nonrecurring items and discretionary expenses and analyzing revenue and cost structures.

WHITEPAPER | Assessing Earnings Quality in the Investment Management Industry

Earnings are a crucial reference point in determining transaction prices negotiated by buyers and sellers of RIA firms. However, reported earnings, even when audited and presented in accordance with Generally Accepted Accounting Principles (GAAP), have limitations. GAAP earnings are backward-looking, reflecting how a business has performed under specific rules in the past. While these historical earnings have their uses, buyers in the RIA industry focus more on the future—what’s visible through the windshield, not the rearview mirror.In this whitepaper, we illustrate how buyers and sellers benefit from a quality of earnings report that extracts a company’s sustainable earning power from the thicket of historical GAAP earnings. We review the most common earnings adjustments applied in QofE analyses and review the role of working capital and capital expenditures as the links between EBITDA and cash flow available to buyers.

May 2024 SAAR

The May 2024 SAAR was just shy of the 16 million mark, coming in at 15.9 million units, generally flat from last month (+0.8%) and reflecting year-over-year growth of 2.5%. Throughout the pandemic years, the auto industry was defined by volatility and uncertainty as inventory levels plummeted and transaction prices skyrocketed. In the first half of 2024, however, we have seen more stability in the SAAR as inventory levels rise and transaction prices moderate.

Large Acquisitions Dominate the Permian M&A Landscape

Transaction activity in the Permian Basin declined over the past 12 months, with the transaction count decreasing 53% to nine deals, a decline from the 19 deals that occurred over the prior 12-month period. This level is also well below the 21 deals that occurred in the 12-month period ended mid-June 2022 and the 27 transactions that closed during the same time period in 2021.

Portfolio Valuation: Private Equity and Credit

Summer 2024

Perhaps it is back to an alternate future as the Dodgers defeated the Yankees in the World Series after losing to the Yankees in 1977, 1978, and 1996.

Mid-Year 2024 Review of the Auto Dealer Industry by Metrics

Tray Tables Up?

In this post, we discuss several key metrics we have tracked in this space over the last several years: new vehicle profitability, the supply of new vehicles, average trade-in equity values of used vehicles, fleet sales, and vehicle miles traveled.

Why Haven’t Higher Interest Rates and Inflation Derailed RIA Dealmaking Activity?

Last year, many RIA industry participants expected a similar cessation to dealmaking in the sector following the adverse impact of higher interest rates and inflation on investment managers’ AUM balances and profitability in 2022. Fortunately for the industry’s bankers, these economic headwinds haven’t derailed the sector’s M&A momentum. Fidelity recently reported 227 deals last year involving RIA sellers with $100 million or more in assets under management, only a 1% decline from 2022 levels.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of June 3, 2024

June 2024 | March 2000 vs. June 2024: How Different Is It?

Bank Watch: June 2024

In this issue: March 2000 vs. June 2024: How Different Is It?

Issue No. 13 | Data as of Mid-Year 2024

Feature Articles: Mid-Year 2024 Review of the Auto Dealer Industry by Metrics and Q2 2024 Earnings Calls

Selling Your RIA? Five Ways to Bridge the Valuation Gap

Before parties to an RIA transaction can close, they must first agree on a price. Narrowing that bid/ask spread is tricky, which is often why negotiations between prospective buyers and sellers fail. Buyers and sellers naturally have different perspectives that lead to different opinions on value: Where a seller sees a strong management team, a buyer sees key person risk. “Long-term client relationships” in the eyes of a seller translates to “aging client base” in the eyes of a buyer. When a seller touts a strong growth trajectory, the buyer wonders if that will continue.

What Is the Market Approach and How Is It Utilized for Auto Dealer Valuations?

The market approach enables analysts to determine a value indication by comparing the subject auto dealership to other similar dealerships. These comparable dealerships could be similar in size, geographic location, or, most importantly, franchise.

Is It Time to Eat the Golden Goose?

Even if all the other boxes are checked, is selling the bank’s insurance agency that took 20 years to build the right long-term move? Maybe. Is it shortsighted to sell off the golden goose agency in the name of “balance sheet repositioning”? Maybe not. Every situation and every transaction is unique.

Formula Pricing Gone Wrong

What Happens If Your Buy-Sell Agreement Prices Your Firm Too High or Too Low?

Hard to imagine today, but just one year ago, some of the largest prices paid for new cars relative to MSRP were for an EV. The Porsche Taycan, a six-figure ride in any configuration, was commonly selling for 20-25% above sticker. What a difference a year makes. Today, EVs are shunned by many (certainly the press), and Porsche is rushing out a new version of the Taycan for 2025 to address flagging sales. For those who paid premium prices to Zuffenhausen a year ago, the depreciation they’ll experience if they try to trade that year-old Taycan today would be breathtaking. Life’s a gas!Pricing MattersThe backbone of our business at Mercer Capital is valuation, so we have a self-interested bias against formula prices in buy-sell agreements. An independent valuation is, by far, the best way to manage the settlement of transactions between shareholders. Doing so annually has the added benefit of managing everyone’s expectations.Simple is not always betterI’ll concede that annual valuations can be excessive for smaller firms with a few shareholders and transactions that seldom occur. Formula pricing offers a degree of certainty and grounds expectations in what is usually a pretty simple equation. Simple is not always better, however.More often than not, the formula prices we encounter do more harm than good. The simplicity of formula pricing equations means they don’t consider important factors like debt, non-recurring items, loss of key staff or large customers, market conditions, or offers to purchase. Formulas can ground expectations but may set expectations unrealistically low or high, provide a false sense of security, and encourage partner behaviors that do not support the business model.The Object of Transaction PricingIn part, buy-sell agreements offer a mechanism to settle transactions between shareholders when some event forces a transaction. Often the event is many years, if not decades, after the signing of the agreement. Nobody expects to be thrown out of their firm, get divorced, or die — even though we know the former two happen often and, in the case of the latter, happens to everyone. Even retirement is hard to foresee when a firm is in its nascency and crafting a shareholder agreement to handle issues that seem so far off that even the inevitable is irrelevant.Signers to a buy-sell rarely foresee the consequencesAs such, the signers to a buy-sell rarely foresee the consequences of what they’re signing. Many of these consequences involve valuation.If you ask them, most people say they want the pricing mechanism in their shareholder agreement to treat everyone fairly. “Fair” is the first word in Fair Market Value, a standard of value established by the Treasury Department in Revenue Ruling 59-60 and reiterated and expounded upon in professional literature throughout the valuation community.Fair Market Value, generally, is a standard of pricing that considers the usual motivations of typical buyers and sellers, described as hypothetical parties, to distinguish them from the very specific and particular persons involved in a subject matter. The parties to a fair market value transaction are assumed to be funded, informed, and reasonable. Fair market value further assumes an orderly (not forced) transaction, and settlement is on a cash equivalent basis.Most people want something akin to fair market value pricing in a buy-sell agreement, but formulas usually only achieve this by coincidence. Most formulas will either price an interest too high or too low. This creates “winners” and “losers,” depending on who gets the better side of the transaction.When the Formula Price Is Too HighWe often see formula pricing in buy-sell agreements set at what could be called optimistic levels. I suppose this is because these agreements are usually written when firms are first established, too new to evaluate the stabilized economics of the business model when compensation patterns are observable, fee schedules are settled, and margins become regular.Formula pricing commonly relies on rules of thumbFormula pricing commonly relies on rules of thumb that don’t represent the particular economic characteristics of a given RIA’s business model. An example of this would be the old myth that investment management firms were worth 2% of AUM.The 2% rule dates back to the days before wealth management and asset management were well delineated, and money managers commonly earned a realized effective rate of 100 basis points on assets under management. At those fees, a billion-dollar shop could produce pre-tax margins between 25% and 35%. At those margins, 2% of AUM implied a value of 6x to 8x pre-tax net income. At the time, that pricing was reasonable. RIAs were not considered an established money management platform (broker-dealers were still the dominant force), and consolidation activity was minimal. Industry insiders recognized that RIA clients were stickier than those of most professional services firms, so 6x to 8x pre-tax net income was a premium to a more typical 4x-5x for other owner-operator professions.Today, of course, consolidation activity is rampant, and multiples are generally higher. But fees have taken a hit, and not every firm earns a “normal” margin. If realized fees are 60 basis points and margins are 15%, a formula that values the RIA at 2% of AUM looks pretty expensive.There is a very human tendency to get too comfortable with large numbers. Owners like big valuations, even when they aren’t real. And until an event occurs that requires a transaction, people rarely question a robust, if unrealistic, valuation. It’s a game of mental gamma, where everyone hopes imaginary pricing pulls on value like a large block of out-of-the-money call options. It feels good but doesn’t get tested until a triggering event invokes the buy-sell agreement. Then something happens. If a 25% partner in this “Now” RIA passes away unexpectedly, and the buy-sell agreement specifies purchase at 2% of AUM, the transaction price is $5 million. We’re going to posit, for purposes of this post, that the actual fair market value of this interest is 8x-10x pre-tax, the midpoint of which is 9x. At 9x pre-tax, the 25% stake has an implied value of about $2 million. If the RIA is required to purchase the interest pursuant to the formula, they will be paying over 60% of the value of the firm for a 25% stake. The estate “wins,” and everyone else loses. What are the implications of an internal transaction at 22x pre-tax? Let’s assume the buy-sell agreement states the RIA can finance the purchase of the decedent’s interest at SOFR plus 200 basis points (about 7.3% today) over ten years. The annual payment would be nearly $725 thousand, or 80% of pre-tax (a proxy for distributable cash flow). For a decade, 80% of distributions will be claimed by a 25% ownership interest.80% of distributions will be claimed by a 25% ownership interestWe’ve seen this happen, but there are reasons the formula pricing might not hold. Usually, a buy-sell gives the other partners and/or the firm the option to purchase at the formula price but doesn’t require it. In this case, the option is entirely out of the money. In that case, the firm might decide to punt on the option and pay the estate their pro rata portion of distributions ($225K per year, or about $500K less than financing at the formula price). The estate is left as an outside minority owner in a closely held business. If the estate isn’t satisfied with this, the executor will have to negotiate — from a very weak position — with the other partners. In effect, this nullifies the buy-sell agreement.When the Formula Price Is Too LowBuy-sell formulas that undervalue interests are no better than those that overvalue interests. There is no “conservative” or “aggressive” in valuation, only reasonable and unreasonable. If, in the scenario listed above, the formula price specified that the firm was to be valued based on book value, the outcome would be no more favorable.RIAs usually don’t have much balance sheet value. Our valuations in the space rarely employ an asset approach. We consider whether the balance sheet has a normal level of working capital to finance ongoing operations or if it has a material amount of non-operating assets. Beyond that, the balance sheet is rarely more than some cash, leasehold improvements, and short-term payables. Book value for a firm like the one discussed above might be no more than $250K.At book value, that formula would price the decedent’s interest at $62,500 — unreasonable for a stake that was earning over three times that much in annual distributions. The transaction would be highly accretive to the remaining partners, who would share in the distribution stream they got for next to nothing. But the specter of what would happen to their beneficiaries in the event of their deaths would dampen any sense of having won.If this buy-sell formula also applies in the event of retirement or withdrawal from the firm, who would ever leave? It would be very difficult to execute ownership succession for partners who are giving up their distributions in exchange for so little compensation. Of course, without succession, the firm eventually wears out — a circumstance in which book value might be a reasonable measure.What’s Your Aspiration?Ask yourself whether or not you think the pricing of a forced transaction should create “winners” and “losers.” There are legitimate reasons for wanting a somewhat below-market price for transactions because it benefits the ongoing firm and continuing partners. Above-market pricing just creates a race for the exit. But if your formula price is too high and transaction execution is optional, an informed buyer will pass, and you’ll be negotiating as if there were no agreement. Hardly a good solution.If this has prompted you to think about your formula pricing and you’d like to talk specifics to us in confidence, reach out. We work with hundreds of investment management firms like yours to defuse time bombs and create reasonable resolutions. Don’t let your ownership issues disrupt your operations.

Hybrid Vehicles and the Goldilocks Principle

EVs Get the Headlines While Consumers Are Getting Hybrids

In this week's post, we touch on recent developments with electric vehicles and how they are leading to a surge in demand for hybrids.

Themes from Q1 2024 Energy Earnings Calls

Upstream (E&P) and Oilfield Service (“OFS”) Companies

In our prior earnings call post, Themes from Q4 2023 Energy Earnings Calls, we touched on the global focus that both the Upstream and OFS segments had focused on and the persistent drive to optimize efficiency in well operations and services with technological advancements, durable inventory, and more. This week, we explore the Q1 2024 earnings calls of upstream and OFS companies, highlighting the appearance of this quarter’s themes across the entire sector.

Are Toxic Cultures the Silent Killers of the Asset Management Industry?

Paul Black, CEO of WCM Investment Management, a $67 billion asset manager headquartered in Laguna Beach, California, provides great insights on the impact of culture on the viability of a money management firm.

Oilfield Water Industry Update, Trends, and the Future

The oilfield water industry (OFW, or midstream water) continues to grow in importance within the general upstream energy industry. So much so that while historically considered part of the Oilfield Services Industry (OFS), midstream water is now considered its own industry within the upstream space, separate from the more general OFS. In this week’s Energy Valuation Insights blog, we explore the current status, trends, and expectations for the future of midstream water.

April 2024 SAAR

The April 2024 SAAR was 15.7 million units, reflecting generally flat month-over-month (+1.1%) and year-over-year (+0.4%) growth. Over the last several months, we have seen more stability in the SAAR than we have seen since the pandemic. This stability will likely give confidence to dealers and consumers alike after years of volatility and uncertainty in transaction prices and vehicle availability. Inventory levels, increased incentive spending, average transaction prices, and per-unit dealer profits will all be discussed later in this post.

SilverBow’s Shareholder Brawl

It is an election year, and the battle is on. SilverBow Resources, a publicly traded oil and gas company operating in South Texas’ Eagle Ford shale, is wrapped up in a big conflict with some of its own shareholders. Kimmeridge Energy Management, both a large shareholder and a rival operator in the Eagle Ford, has proposed a merger (which it, at least temporarily, withdrew last month), and now is proposing several new board members in a proxy battle. The primary question centers on the direction of SilverBow’s value enhancement strategy. However, it appears this strategy hinges, in part, on its debt position, and dividend policy. Management has one idea on how this should go; Kimmeridge clearly has another.This clash has arisen from a myriad of circumstances, but it could reasonably be condensed down to two dynamics: leveraged acquisitions in the past few years and the drop in gas prices from their highs in 2022. Since 2021 SilverBow has made several acquisitions. These acquisitions, highlighted by its purchase of Sundance Energy in 2022 and most recently Chesapeake’s Eagle Ford portfolio in the second half of 2023, can be broadly characterized by three things: (i) mostly oil and liquids production driven (a change from their more historically gas heavy portfolio), (ii) purchased at opportunistic prices (SilverBow’s blended acquisition price to flowing barrel metric was approximately $25,000 for its eight deals since the second half of 2021 compared to other publicly traded oil and liquids tilted Eagle Ford producers such as Magnolia and SM Energy who both trade for over $40,000 per flowing barrel), and (iii) mostly funded with debt.The good news for SilverBow is that oil and natural gas liquids tend to be higher-margin products than gas right now, and SilverBow’s EBITDA margin was relatively high (79%) to show for it. By contrast, Comstock Resources, a pure-play gas producer in the Haynesville Shale, has had its margin battered by low gas prices in 2023. Through these acquisitions, SilverBow has shifted its production mix significantly and it creates optionality to drill for oil and liquids during periods of low gas prices. Although SilverBow is still producing relatively more gas than its Eagle Ford peers such as SM Energy, Magnolia, or EOG it is now much more liquids-driven than in recent years. In addition, funding with debt is usually cheaper than equity, so it offers a leveraged return opportunity for shareholders. However, the trade-off is that too much debt can be risky. SilverBow used to be Swift Energy but filed bankruptcy in 2015 and restructured after the collapse of oil prices, so it has a history of too much debt in the capital structure at the wrong time. This is worrisome to investors and it can tamp down on equity value. Equity markets for the upstream sector have frowned on heavy debt loads for several years now in the wake of bankruptcies after 2014.How Much Debt Is Too Much Debt?What defines a heavy debt load? It depends. The ratio of debt to EBITDA is cited often in the industry. These days at or below a 1.0x ratio is what companies frequently aim for, SilverBow included. However, there is not a definitive answer to the question. From a capital structure perspective, SilverBow has a higher debt-to-equity market capitalization percentage than the companies listed below that have varying similarities to SilverBow: Kimmeridge has criticized SilverBow for taking on this much debt and offered to inject cash to pay it down in its now-abandoned merger proposal. Management has countered with its position that the value and optionality it received in its acquisitions will allow the company to reap high margins and cash flow to accelerate debt repayment and eventually get to that 1.0x debt ratio by the end of 2025. Kimmeridge seems to believe that if SilverBow de-levers more quickly, then the stock price will rise more quickly. This is logical, but that would require selling equity or assets or both.Dividends MatterDividends have been a big trend in the oil and gas industry. Investors have pined for oil and gas companies to pay dividends for many years now. Growth and reinvestment have been curtailed in favor of direct shareholder returns in the form of stock buybacks and more importantly, dividends. SilverBow does not pay a dividend. Most publicly traded peers do. Companies that pay a dividend tend to have higher multiples as well. Kimmeridge has pointed this out and also proposed a dividend in their merger proposal. However, adding a dividend is not a guarantee of a value boost. Comstock Resources suspended its dividend early in 2024, and its stock has gone up significantly since then. However, it is also a gas producer only, which has hamstrung it in a cash burn position so far in 2024. SilverBow’s shift towards liquids has buoyed its cash flow.Value Now Or Value Later?The market has shown skepticism from a valuation standpoint of SilverBow’s acquisition appetite over the past few years. As such its valuation metrics lag almost everyone in this group in a meaningful way:It is notable that although SilverBow is increasingly liquids-driven and has excellent margins, its valuation multiples still lag this group. Even Vital Energy, which also has a lot of debt and doesn’t pay a dividend either, has superior metrics. If SilverBow lowers risk by de-levering to industry norms, the equity value may be rewarded. But when? It may be over a year before that happens. A lot can happen between now and then. Kimmeridge does not want to wait. It wants policy changes now. Management has pointed to strong cash flow and results above expectations so far in 2024 as proof that its strategy is working. Management is skeptical of Kimmeridge’s intentions. They believe Kimmeridge’s end game is to force a dilutive transaction with Kimmeridge Texas Gas. Both sides want a higher stock price. Which one presents the better path to get there remains to be seen and will come down to what the shareholders decide.Originally appeared on Forbes.com.

One Dealer Is Not Like the Other

Independent Dealers Industry Segment Highlight

This week, we highlight the auto dealer market: independent dealers.

Internal Transactions Are Still an Option for RIAs

With a constant stream of headlines about M&A and near-daily inquiries from prospective acquirers, it’s easy for RIA owners to get the impression that external transactions are the norm.

The Inside “SCOOP”

The SCOOP/STACK is a significant oil and gas play found in the Anadarko Basin of Oklahoma. The “SCOOP” part of the name refers to “South Central Oklahoma Oil Province,” and “STACK” is an abbreviated geographic description: the Sooner Trend oil field, the Anadarko basin, and the Canadian and Kingfisher counties.

Should You Accept Rollover Equity?

Road to Riches or “Worst Idea Ever”

Rollover equity is neither inherently good nor bad. It makes pricing a deal a little more challenging, and it requires sellers (i.e., investors in the rollover equity) to do considerable due diligence on prospective buyers — not something we see everyone doing. Like choosing a car to leave one’s wedding, sometimes the option that looks attractive ahead of time can ultimately lead to some discomfort. If someone offers you their equity in exchange for yours, give us a call. Make sure you don’t opt for the “worst idea ever.”

May 2024 | Is It Time to Eat the Golden Goose?

Bank Watch: May 2024

In this issue: Is It Time to Eat the Golden Goose?

Now Could Be a Great Time for Bank Investors to Consider Estate Planning

It may be an opportune time for bank investors to consider estate planning opportunities. Rising inflation has been top of mind for business owners and bankers (and everyone for that matter) over the last few years.While inflation has decelerated from its peak, business owners, bankers, and investors are adjusting to the new higher for longer interest rate environment.Higher inflation and interest rates have affected every business with few exceptions. All else equal, higher interest rates will negatively affect business value as higher discount rates are used to bring future cash flows to the present. In some industries though, inflation-driven increases in earnings or revenue growth expectations have offset (or even outweighed) the negative impact of higher interest rates.However, not all industries have been immune to pressure from higher interest rates and inflation on the value of their shares. Banking is one of several industries that have underperformed broader market indices as investors remain skeptical of the “new normal” and impact of the rate environment on banks’ cost of funds and net interest margins.As shown in the following tables, small and mid cap public bank stocks have underperformed broad market indices, and valuation multiples (as measured by P/E and P/TBV) remain below long-term historical averages.While it remains uncertain when the interest rate easing cycle will begin, the easing cycle will likely also have divergent outcomes for different industries. At this point between cycles and with bank valuation multiples below long-term averages, it is important to consider the potential opportunity to favorably transfer business value to future generations.A second reason to consider estate planning transactions in the current environment is issues on the tax and policy front.The Tax Cuts and Jobs Act enacted in December 2017 doubled the basic exclusion amounts individuals could give away without paying estate taxes. The sunsetting of this provision on December 31, 2025 and the potential for lower exclusion amounts thereafter and higher estate taxes, makes considering transfers all the more important.The combination of lower bank stock valuations combined with sunsetting favorable estate tax provisions make 2024 a worthwhile year for bank investors to consider estate planning strategies.Many strategies will require a current valuation of your bank, and our professionals are here to help.Originally appeared in the April 2024 issue of Bank Watch.

The Beginning of a Bakken Behemoth

Chord Energy and Enerplus

In a significant development for the energy industry, on February 21, 2024, Chord Energy Corporation and Enerplus Corporation announced a definitive agreement to merge. This strategic combination aims to create a powerhouse in the Williston Basin, leveraging their complementary strengths and operational expertise.

What to Look for in a Quality of Earnings Provider for RIA Transactions

A Quality of Earnings (or QofE) analysis is an essential component of transaction diligence for both buyers and sellers. Optimizing your transaction diligence requires assembling the right team. In this post, we discuss five things RIA buyers and sellers should look for when evaluating potential QofE providers.

What Is the Income Approach and How Is It Utilized for Auto Dealer Valuations?

The income approach is based on capitalizing future expected cash flows using estimates of risk and growth specific to the subject dealership. This analysis is incredibly important for auto dealerships due to the expected future cash flows of most dealerships being the primary driver of value.

Market Resilience: Asset Managers Thrive Amidst Economic Volatility in 2023

Despite persistent inflation, elevated interest rates, and heightened geopolitical tensions, the asset management industry and the stock market as a whole saw a resurgence during 2023. Our index of publicly traded asset management firms generally tracked the movement in the broader market, with stock prices for smaller asset managers (AUM under $250 billion) up 30.3% and large asset managers (AUM over $250 billion) up 22.0% over the year ended March 31, 2024, while the broader market (S&P 500) was up 29.9%.Fund FlowsWhile market movement is often the dominant contributor to AUM changes over a particular period, it’s a variable that’s largely outside a manager’s control. On the other hand, organic growth can be influenced by the quality of a firm’s marketing and distribution efforts and can be a real differentiator between asset management firms over longer periods.Many asset managers have struggled with organic growth in recent years, partly due to rising fee sensitivity and the influence of passively managed investment products. This year proved no different, with our index of publicly traded asset/wealth management companies seeing $103 billion in aggregate net outflows, compared to aggregate net outflows of $62 billion in 2022.As expected, considering the performance of the stock and bond markets over the past year, market movement was the primary driver of the change in AUM, accounting for $551 billion additional AUM for the index during 2023. During the challenging market conditions of 2022, the index saw an aggregate $922 billion decrease in AUM due to market movement.Click here to expand the image aboveOutflows from Active Funds AccelerateWhile asset managers saw net outflows over the past twelve months, there were significant variances between active and passively managed funds. Fund flow data from Morningstar (table below) shows that total outflows across active funds for the year ended March 31, 2024, were approximately $377 billion. The aggregate outflows over the past year were most severe for U.S. equity, allocation, and international equity, with these asset classes shedding a combined $427 billion in assets. All categories of actively managed funds except alternative investments, taxable bonds, alternatives, and nontraditional equities saw net outflows over the past year.On the other hand, passively managed funds continued to outpace active funds in terms of net new assets over the past twelve months. The Morningstar data shows that total inflows across passively managed funds for the year ended March 31, 2024, were approximately $621 billion, with all asset classes except commodities and miscellaneous assets reporting positive net inflows.Click here to expand the image aboveAs you can see from the following chart, there has been a trend over the past ten years of investors moving from active to passive funds, and this trend accelerated with the market downturn in 2022. The relative underperformance of active managers, when compared to their benchmarks over the past ten years, has driven investors to low-fee passive funds. This trend will likely continue to pose a challenge for many types of active asset managers in attracting new assets.Click here to expand the image aboveOutlookThe outlook for asset managers depends on several factors. Investor demand for a particular manager’s asset class, recent relative performance, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets.With inflation starting the year higher than expected, it remains to be seen if the Fed will be able to implement the rate cuts that many investors expect to come during 2024. With the prospect of interest rates remaining higher for longer, persistent inflation, and geopolitical tensions, there is much uncertainty in the market heading into 2024. Despite these challenges, the industry enters 2024 with higher starting AUM levels, offering a potential boost to revenues and earnings. Navigating these uncertain times requires a proactive approach to capitalize on emerging opportunities and mitigate risks effectively.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.

Just Released | 1Q24 Exploration & Production Newsletter

Region Focus: Eagle Ford

2024 NADC Conference Key Takeaways

In this post, we provide a brief list of takeaways from a few of the sessions we attended at this year’s conference. We believe the topics we cover are especially important for auto dealer counsel and their clients to watch during the remainder of the year and beyond.

RIA M&A Update: Q1 2024

Following a year where deal volume in the RIA industry nearly matched the all-time high of 2022, RIA M&A activity cooled in the first quarter of 2024. Fidelity’s March 2024 Wealth Management M&A Transaction Report listed 50 deals through March 2024, down 29% from the 70 deals executed during the same period in 2023. RIA deal activity experienced a greater decline than the broader M&A market. The number of M&A transactions for all industries (excluding the RIA industry) decreased 9% year-over-year through the first quarter of 2024 (per Bloomberg), compared to a decline of 29% in the RIA industry. Despite the decline in the total number of deals, there was a significant uptick in total transacted AUM during 2024. Total transacted AUM through March 2024 was $139.2 billion—a 63% increase from the same period in 2023. The average AUM per transaction during the first quarter of 2024 was $2.8 billion, a 128% increase over the prior year. The increase in deal size has been an encouraging sign, given the rise in the cost of capital over the past two years. The growth in deal size resulted from the completion of several large transactions during the first quarter of 2024, coupled with the overall increase in AUM levels due to market performance. Per Echelon’s RIA M&A Deal Report, “This elevated number of larger transactions, in light of buyers facing a higher cost of capital and economic uncertainty, demonstrates buyer resilience and likely indicates that $1BN+ deal activity will increase to 2021 levels or higher once macroeconomic headwinds, namely higher interest rates subside.” Another contributor to the increase in deal size has been RIAs partnering with private equity firms. According to Fidelity’s March 2024 Wealth Management M&A Transaction Report, private equity backing was involved in 88% of the transactions in March. Per Echelon’s RIA M&A Deal Report, “Another driver of deal size was the heightened creativity in deal structures, adopted by private equity firms seeking to get deals across the finish line in the face of higher borrowing costs. Structured minority investments, with features such as paid-in-kind and preferred distribution rights, have become more popular in the largest transactions, especially those involving sellers with more than $10 billion in assets.”Noteworthy transactions backed by private equity include Caprock’s acquisition of Grey Street Capital, Mariner Wealth Advisor’s purchase of Fourth Street Performance Partners, and Hightower’s acquisition of Capital Management Group of New York.The prevalence of serial acquirers and aggregators has continued in the RIA M&A market. In recent years, the professionalization of the buyer market and the entrance of outside capital have driven demand and increased competition for deals. Serial acquirers and aggregators have increasingly contributed to deal volume, supported by dedicated deal teams and access to capital. Such firms accounted for approximately 70% of transactions during the first quarter of 2024. Mercer Advisors, Miracle Mile Advisors, and Allworth Financial completed multiple deals during the fourth quarter.Deal activity has also been supported by the supply side of the M&A equation, as the impetus to sell is often based on more than market timing. Sellers are often looking to solve succession issues, improve quality of life, and access organic growth strategies. Such deal rationales are not sensitive to the market environment and will likely continue to fuel the M&A pipeline even during market downturns.What Does This Mean for Your RIA?For RIAs planning to grow through strategic acquisitions: Pricing for RIAs has trended upwards in recent years, leaving you more exposed to underperformance. Structural developments in the industry and the proliferation of capital availability and acquirer models will likely continue to support higher multiples than the industry has seen. That said, a long-term investment horizon is the greatest hedge against valuation risks. Short-term volatility aside, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth than their broker-dealer counterparts and other diversified financial institutions.For RIAs considering internal transactions: We’re often engaged to address valuation issues in internal transaction scenarios, where valuation considerations are top of mind. Internal transactions don’t occur in a vacuum, and the same factors driving consolidation and M&A activity have influenced valuations in internal transactions as well. As valuations have increased, financing in internal transactions has become a crucial secondary consideration where buyers (usually next-gen management) lack the ability or willingness to purchase a substantial portion of the business outright. As the RIA industry has grown, so too has the number of external capital providers who will finance internal transactions. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and, in some instances, may still be the best option). Still, an increasing amount of bank financing and other external capital options can provide selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs.If you are an RIA considering selling: Whatever the market conditions are when you go to sell, it is essential to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. As the RIA industry has grown, a broad spectrum of buyer profiles has emerged to accommodate different seller motivations and allow for varying levels of autonomy post-transaction. A strategic buyer will likely be interested in acquiring a controlling position in your firm and integrating a significant portion of the business to create scale. At the other end of the spectrum, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Given the wide range of buyer models out there, picking the right buyer type to align with your goals and motivations is a critical decision that can significantly impact personal and career satisfaction after the transaction closes.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.

March 2024 SAAR

The March 2024 SAAR was 15.5 million units, a 1.3% decrease from last month and a 3.7% increase compared to this time last year. The year-over-year sales improvement, along with declining transaction prices and generally flat inventory levels, may indicate that the industry is reverting to pre-pandemic trends.

Oil & Gas Roadblocks: Prices, Production, and People Holding Sway

There are always going to be barriers to success in an industry. Barriers to entry, barriers to growth, barriers to profitability, and barriers to progress can lurk to name a few. The upstream industry has its share. For gas, its own oversupply and low prices are an issue. For oil, capital constraints are reining in investment. Both commodities also thirst for quality labor to fuel growth and longer-term underlying optimism, but that workforce does not exist right now and may take a while to develop.

RIA Market Update: Q1 2024

With Valuations Up, Investor Interest Moves to Alts and Big-Name Managers

Share prices for most publicly traded asset and wealth management firms trended upward with the broader market during the first quarter of 2024. Alternative asset managers continued to outperform the market and other RIAs, ending the quarter up about 12.6%. On a year-over-year basis, all sectors of RIAs experienced growth as the markets rebounded from the 2022 slump. RIAs directly benefit from improving market conditions as they result in a stronger asset base on which to collect fees.Performance by SectorThe market uptick in Q1 translated to increased share prices for most public RIAs. Prices for alternative investment managers experienced a stronger increase than the S&P 500, increasing by 12.6% compared to the S&P’s 10.6%. Both larger RIAs (AUM over $250 billion) and smaller RIAs (AUM under $250 billion) lagged the S&P 500, seeing price increases of 4.3% and 10.3%, respectively, during the quarter.Pricing TrendsThe median Enterprise Value to LTM EBITDA multiples for public RIAs increased modestly during Q1. Smaller RIAs had the strongest increase at 5.4% during the quarter. Alternative asset managers saw a 2.4% increase and larger RIAs saw an increase of 0.3%. After trending downwards for the first three quarters of 2023, multiples began to increase during the fourth quarter of 2023 and into the first quarter of 2024.Growth TrendsOn a year-over-year basis, all sectors of RIAs experienced growth in AUM as the markets rebounded from the 2022 slump. The largest increase came from larger RIAs, which had a median increase in AUM of 13.3% over the past year. The second largest increase in AUM came from smaller RIAs which had a median increase in AUM of 10.8%. This was followed by alternative asset managers, which had a 7.7% increase in AUM over the past year. Revenue growth lagged AUM growth for all groups, reflecting lower effective realized fee levels. Both the larger (>$250B AUM) and smaller (<$250B AUM) groups of traditional asset managers reported negative EBITDA growth.Growth in AUM for the smaller RIA group ranged between 4.6% (Westwood Holdings Group) and 22.1% (Wisdom Tree). For the Larger RIA group, AUM growth was between 3.4% (Affiliated Managers Group) and 16.6% (Janus Henderson Group).Most RIAs experienced organic AUM outflows during the twelve months ending March 31, 2024. These organic outflows were offset by market growth, which led to a net AUM increase for all RIAs we measured.For the smaller RIA group, revenue growth ranged from negative 6.5% (Diamond Hill) to 21.0% (Westwood Holdings). Revenue growth for larger RIAs was between negative 8.1% (Affiliated Managers Group) to 7.1% (Federated Hermes).For the smaller RIA group, EBITDA growth ranged from negative 36.1% (Diamond Hill) to 48.1% (WisdomTree). EBITDA growth for larger RIAs was between negative 25.8% (Invesco) to 7.6% (Federated Hermes).

5 Reasons Upstream Sellers Need a Quality of Earnings Report

Apart from a number of headline deals, M&A activity was sidelined for much of 2022 and 2023. But needing to replenish a depleting asset base with quality mineral acreage, stabilizing interest rates, and pent-up M&A demand are expected to compel buyers and sellers to renew their efforts in 2024 and beyond.As deal activity recovers, sellers need to be prepared to present their value proposition in a compelling manner. For many sellers, an independent Quality of Earnings (“QofE”) analysis and report are vital to advancing and defending their asset’s value in the marketplace. And it can be critical to the ensuing due diligence processes buyers apply to targets.The scope of a QofE engagement can be tailored to the needs of the seller. Functionally, a QofE provider examines and assesses the relevant historical and prospective performance of a business. The process can encompass both the financial and operational attributes of the business model.In this article, we review five reasons sellers benefit from a QofE report when responding to an acquisition offer or preparing to take their businesses or assets to market.1. Maximize value by revealing adjusted and future sustainable profitability.Sellers should leave no stone unturned when it comes to identifying the maximum achievable cash flow and profitability of their assets. Every dollar affirmed brings value to sellers at the market multiple. Few investments yield as handsomely and as quickly as a thorough QofE report. A lack of preparation or confused responses to a buyer’s due diligence will assuredly compromise the outcome of a transaction. The QofE process includes examining the relevant historical period (say two or three years) to adjust for discretionary and non-recurring income and expense events, as well as depicting the future (pro forma) financial potential from the perspective of likely buyers. The QofE process addresses the questions of why, when, and how future cash flow can benefit sellers and buyers. Sellers need this vital information for clear decision-making, fostering transparency, and instilling trust and credibility with their prospective buyers.2. Promote command and control of transaction negotiations and deal terms.Sellers who understand their objective historical performance and future prospects are better prepared to communicate and achieve their expectations during the transaction process. A robust QofE analysis can filter out bottom-dwelling opportunists while establishing the readiness of the seller to engage in efficient, meaningful negotiations on pricing and terms with qualified buyers. After core pricing is determined, other features of the transaction, such as working capital, assumption of asset retirement obligations, thresholds for contingent consideration, and other important deal parameters, are established. These seemingly lower-priority details can have a meaningful effect on closing cash and escrow requirements. The QofE process assists sellers and their advisors in building the high road and keeping the deal within its guardrails.3. Cover the bases for board members, owners, and the advisory team and optimize their ability to contribute to the best outcome.The financial and fiduciary risk of being underinformed in the transaction process is difficult to overcome and can have real consequences. Businesses can be lovingly nurtured with operating excellence, sometimes over generations of ownership, only to suffer from a lack of preparation, underperformance from stakeholders who lack transactional expertise, and underrepresentation when it most matters. The QofE process is like training camp for athletes — it measures in realistic terms what the numbers and the key metrics are and helps sellers amplify strengths and mitigate weaknesses. Without proper preparation, sellers can falter when countering an offer, placing the optimal outcome at risk. In short, a QofE report helps position the seller’s board members, managers, and external advisors to achieve the best outcome for shareholders.4. Financial statements and tax returns are insufficient for sophisticated buyers.Time and timing matter. A QofE report improves the efficiency of the transaction process for buyers and sellers. It provides a transparent platform for defining and addressing significant reporting and compliance issues. There is no better way to build a data set for all advisors and prospective buyers than the process of a properly administered QofE engagement. This can be particularly important for sellers whose level of financial reporting has been lacking, changing, outmoded due to growth, or contains intricacies that are easily misunderstood.For sellers content to work their own deals with their neighbors and friendly rivals, a QofE engagement can provide some of the disciplines and organization typically delivered by a side-side representative. While we hesitate to promote a DIY process in this increasingly complicated world, a QofE process can touch on many of the points that are required to negotiate a deal. Sellers who are busy running their businesses rarely have the turnkey skills to conduct an optimum exit process. A QofE engagement can be a powerful supporting tool.5. In one form or another, buyers are going to conduct a QofE process – what about sellers?Buyers are remarkably efficient at finding cracks in the financial facades of targets. Most QofE work is performed as part of the buy-side due diligence process and is often used by buyers to adjust their offering price (post-LOI) and design their terms. It is also used to facilitate their financing and satisfy the scrutiny of underlying financial and strategic investors. In the increasing arms race of the transaction environment, sellers need to equip themselves with a counteroffensive tool to stake their claim and defend their ground. If a buyer’s LOI is “non-binding” and subject to change upon the completion of due diligence, sellers need to equip themselves with information to advance and hold their position.ConclusionThe stakes are high in the transaction arena. Whether embarking on a sale process or responding to an unsolicited inquiry, sellers have precious few opportunities to set the tone. A QofE process equips sellers with the confidence of understanding their own position while engaging the buy-side with awareness and transparency that promotes a more efficient negotiating process and the best opportunity for a favorable outcome. If you are considering a sale, give one of our senior professionals a call to discuss how our QofE team can help maximize your results.

Just Released: Year-End 2023 Auto Dealer Industry Newsletter

We are pleased to release our latest edition of Value Focus: Auto Dealer Industry Newsletter. The newsletter features industry data from year-end 2023. Additionally, this issue includes two timely articles: "Q4 2023 Earnings Calls" and "No Soup for You: Lessons from Seinfeld on Customer Lifetime Value and Brand Loyalty in the Auto Industry."

April 2024 | Now Could Be a Great Time for Bank Investors to Consider Estate Planning

Bank Watch: April 2024

In this issue: Now Could Be a Great Time for Bank Investors to Consider Estate Planning

Second Quarter 2024 | Segment Focus: Building Materials

Residential construction has seen a Q-o-Q increase of 3.6% in value put in place on a seasonally adjusted annual rate basis. The median sales price of houses sold has continued to stabilize following sharp increases in 2021 and 2022. Elevated rates and commodity input prices have proved to be strong headwinds for industry activities.

E&P Second Quarter 2024

Permian

Permian // Permian production growth over the past year was a positive outlier among the four basins covered in our analysis, with Eagle Ford, Appalachia, and Haynesville all posting production declines (albeit Appalachia’s decline being insignificant at 0.3%).

Transportation & Logistics Newsletter

Second Quarter 2024

The level of domestic industrial production directly impacts demand for transportation services.

The Benefits of a Quality of Earnings Analysis for E&P Companies

For buyers and sellers, the stakes in a transaction are high. A QofE analysis is an essential step in getting the transaction right.

Revenue Share Transactions: Considerations for RIAs

As outside capital for RIAs has become increasingly available, so too has the opportunity set for RIAs interested in pursuing minority transactions. One of the structures that’s emerged for minority transactions is that of the revenue share.

Public Auto Dealer Profiles: Group 1 Automotive

We talk a lot about the differences between most privately held and publicly traded auto dealers. Scale, diversification, and access to capital make the business models different, even if store and unit-level economics remain similar. Public auto dealers provide insight into how the market prices their earnings, the environment for M&A, and trends in the industry.

2024: Five Trends to Watch in the Medical Device Industry

Medical Devices OverviewThe medical device manufacturing industry produces equipment designed to diagnose and treat patients within global healthcare systems.Medical devices range from simple tongue depressors and bandages to complex programmable pacemakers and sophisticated imaging systems.Major product categories include surgical implants and instruments, medical supplies, electro-medical equipment, in-vitro diagnostic equipment and reagents, irradiation apparatuses, and dental goods.The following outlines five structural factors and trends that influence demand and supply of medical devices and related procedures.1. DemographicsThe aging population, driven by declining fertility rates and increasing life expectancy, represents a major demand driver for medical devices.The U.S. elderly population (persons aged 65 and above) totaled 60 million in 2023 (18% of the population).The U.S. Census Bureau estimates that the elderly will number 92.7 million by 2065, representing more than 25% of the total population.U.S. Population Distribution by Age GroupThe elderly account for nearly one third of total.Personal healthcare spending for the population segment was approximately $22,000 per person in 2020, 5.5 times the spending per child (about $4,000) and more than double the spending per working-age person (about $9,000).U.S. Population Distribution by AgeU.S. Healthcare Expenditure by AgeSource: U.S. Census Bureau, Centers for Medicare and Medicaid Services, Office of the Actuary, National Health Statistics GroupAccording to United Nations projections, the global elderly population will rise from approximately 808 million (10% of world population) in 2022 to 2.0 billion (19.4% of world population) in 2065.Europe’s elderly made up 20% of the total population in 2022, and the proportion is projected to reach 31% by 2065, making it the world’s oldest region.Latin American and the Caribbean is currently one of the youngest regions in the world, with its elderly at 9% of the total population in 2022, but this region is expected to undergo drastic transformations over the next several decades, with the elderly population expected to expand to 25% of the total population by 2065.North America has an above-average elderly population as of 2022 (17%) and is projected to expand to 27% by 2065.World Population 65 and Over (% of Total)Click here to expand the image above2. Healthcare Spending and the Legislative Landscape in the U.S.Demographic shifts underlie the expected growth in total U.S. healthcare expenditure from $4.4 trillion in 2022 to $7.2 trillion in 2031, an average annual growth rate of 5.5%.This projected average annual growth rate is slightly higher than the observed rate of 5.1% between 2013 and 2021, suggesting some acceleration in expected spending. Projected growth in annual spending for Medicare (7.5%) and Medicaid (5.0%) is expected to contribute substantially to the increase in national health expenditure over the coming decade.Growth in national healthcare spending, after significant growth in 2020 of 10.2%, slowed to 2.7% in 2021. Healthcare spending as a percentage of GDP is expected to increase from 18.3% in 2021 to 19.6% by 2031.Since inception, Medicare has accounted for an increasing proportion of total U.S. healthcare expenditures.Medicare currently provides healthcare benefits for an estimated 65 million elderly and disabled people, constituting approximately 10% of the federal budget in 2021.Spending growth is expected to average 7.8% from 2025 to 2031.The program represents the largest portion of total healthcare costs, constituting 21% of total health spending in 2021 and 10% of the federal budget.Medicare accounts for 26% of spending on hospital care, 26% of physician and clinical services, and 32% of retail prescription drugs sales.U.S. Healthcare Consumption Payor Mix and as % of GDPAverage Spending Growth Rates, Medicare and Private Health InsuranceDue to the growing influence of Medicare in aggregate healthcare consumption, legislative developments can have a potentially outsized effect on the demand and pricing for medical products and services. Medicare spending totaled $944.3 billion in 2022 and is expected to reach $1.8 trillion by 2031.The Inflation Reduction Act (“IRA”) was signed into law on August 16, 2022 by the Biden administration.Among other items, the IRA aims to lower prescription drug costs and improve access to prescription drugs for Medicare enrollees.Two healthcare spending-related items in the IRA include out-of-pocket caps for insulin products (capped at $35 for each monthly subscription under Part D and Part B) and a $2,000 out-of-pocket annual spending cap for drugs under Medicare Part D.These provisions could have significant effects on the growth rates for out-of-pocket spending for prescription drugs, which are projected to decline by 5.9% and 4.2% in 2024 and 2025, respectively.3. Third-Party Coverage and ReimbursementThe primary customers of medical device companies are physicians (and/or product approval committees at their hospitals), who select the appropriate equipment for consumers (patients).In most developed economies, the consumers themselves are one step (or more) removed from interactions with manufacturers, and, therefore, pricing of medical devices.Device manufacturers ultimately receive payments from insurers, who usually reimburse healthcare providers for routine procedures (rather than for specific components like the devices used).Accordingly, medical device purchasing decisions tend to be largely disconnected from price. Third-party payors (both private and government programs) are keen to reevaluate their payment policies to constrain rising healthcare costs.Hospitals are the largest market for medical devices.Lower reimbursement growth will likely persuade hospitals to scrutinize medical purchases by adopting 1) higher standards to evaluate the benefits of new procedures and devices, and 2) a more disciplined price bargaining stance.The transition of the healthcare delivery paradigm from fee-for-service (FFS) to value models is expected to lead to fewer hospital admissions and procedures, given the focus on cost-cutting and efficiency.In 2015, the Department of Health and Human Services (HHS) announced goals to have 85% and 90% of all Medicare payments tied to quality or value by 2016 and 2018, respectively, and 30% and 50% of total Medicare payments tied to alternative payment models (APM) by the end of 2016 and 2018, respectively.A report issued by the Health Care Payment Learning & Action Network (LAN), a public-private partnership launched in March 2015 by HHS, found that 48.9% of (traditional) Medicare payments were tied to Category 3 and 4 APMs in 2022, compared to 40% in 2021 and 35.8% in 2018.In 2020, CMS released guidance for states on how to advance value-based care across their healthcare systems, emphasizing Medicaid populations, and to share pathways for adoption of such approaches.CMS states that value-based care advances health equity by putting focus on health outcomes of every person, encouraging health providers to screen for social needs, requiring health professionals to monitor and track outcomes across populations, and engaging with providers who have historically worked in underserved communities. Ultimately, lower reimbursement rates and reduced procedure volume will likely limit pricing gains for medical devices and equipment.The medical device industry faces similar reimbursement issues globally, as the EU and other jurisdictions face similar increasing healthcare costs.A number of countries have instituted price ceilings on certain medical procedures, which could deflate the reimbursement rates of third-party payors, forcing down product prices.Industry participants are required to report manufacturing costs, and medical device reimbursement rates are set potentially below those figures in certain major markets like Germany, France, Japan, Taiwan, Korea, China, and Brazil.Whether third-party payors consider certain devices medically reasonable or necessary for operations presents a hurdle that device makers and manufacturers must overcome in bringing their devices to market.4. Competitive Factors and Regulatory RegimeHistorically, much of the growth of medical technology companies has been predicated on continual product innovations that make devices easier for doctors to use and improve health outcomes for the patients.Successful product development usually requires significant R&D outlays and a measure of luck.If viable, new devices can elevate average selling prices, market penetration, and market share.Government regulations curb competition in two ways to foster an environment where firms may realize an acceptable level of returns on their R&D investments.First, firms that are first to the market with a new product can benefit from patents and intellectual property protection giving them a competitive advantage for a finite period.Second, regulations govern medical device design and development, preclinical and clinical testing, premarket clearance or approval, registration and listing, manufacturing, labeling, storage, advertising and promotions, sales and distribution, export and import, and post market surveillance.Regulatory Overview in the U.S.In the U.S., the FDA generally oversees the implementation of the second set of regulations.Some relatively simple devices deemed to pose low risk are exempt from the FDA’s clearance requirement and can be marketed in the U.S. without prior authorization.For the remaining devices, commercial distribution requires marketing authorization from the FDA, which comes in primarily two flavors.The premarket notification (“510(k) clearance”) process requires the manufacturer to demonstrate that a device is “substantially equivalent” to an existing device (“predicate device”) that is legally marketed in the U.S.The 510(k) clearance process may occasionally require clinical data and generally takes between 90 days and one year for completion.In November 2018, the FDA announced plans to change elements of the 510(k) clearance process.Specifically, the FDA plan includes measures to encourage device manufacturers to use predicate devices that have been on the market for no more than 10 years.In early 2019, the FDA announced an alternative 510(k) program to allow medical devices an easier approval process for manufacturers of certain “well-understood device types” to demonstrate substantial equivalence through objective safety and performance criteria. In February 2020, the FDA launched its voluntary pilot program: electronic Submission Template and Resource (eSTAR) as an interactive submission template that may be used by the medical device submitters to prepare certain pre-market submissions for a device.Starting in October 2023, all 510(k) submissions were required to be submitted using eSTAR unless exempted.The premarket approval (“PMA”) process is more stringent, time-consuming, and expensive.A PMA application must be supported by valid scientific evidence, which typically entails collection of extensive technical, preclinical, clinical, and manufacturing data.Once the PMA is submitted and found to be complete, the FDA begins an in-depth review, which is required by statute to take no longer than 180 days.However, the process typically takes significantly longer and may require several years to complete.Pursuant to the Medical Device User Fee Modernization Act (MDUFA), the FDA collects user fees for the review of devices for marketing clearance or approval.The current iteration of the Medical Device User Fee Act (MDUFA V) came into effect in October 2022.Under MDUFA V, the FDA is authorized to collect $1.8 billion in user fee revenue for the five-year cycle, an increase from the approximately $1 billion in user fees under MDUFA IV, between 2017 and 2022.A significant change from MDUFA IV to MDUFA V relates to performance goals for De Novo Classification requests (requests for novel medical devices for which general controls alone provide reasonable assurance of safety and effectiveness for the intended use). There has also been updated PMA guidance, with the FDA conducting substantive reviews within 90 calendar days for all original PMAs, panel-track supplements, and 180-day supplements.Regulatory Overview Outside the U.S.The European Union (EU), along with countries such as Japan, Canada, and Australia all operate strict regulatory regimes similar to that of the FDA, and international consensus is moving towards more stringent regulations.Stricter regulations for new devices may slow release dates and may negatively affect companies within the industry.Medical device manufacturers face a single regulatory body across the European Union: Regulation (EU 2017/745), also known as the European Union Medical Device Regulation (EU MDR).The regulation was published in 2017, replacing the medical device directives regulation that was in place since the 1990s.The requirements of the MDR became applicable to all medical devices sold in the EU as of May 26, 2021.The EU is the second largest market for medical devices in the world with approximately €150 billion in sales in 2022, only behind the United States. The EU MDR has introduced stricter requirements for medical device manufacturers, including increased clinical evidence and post-market surveillance. Consequently, there is an increased risk for longer approval processes and delays in manufacturing of these devices.5. Emerging Global MarketsEmerging economies are claiming a growing share of global healthcare consumption, including medical devices and related procedures, owing to relative economic prosperity, growing medical awareness, and increasing (and increasingly aging) populations.According to the WHO, middle income countries, such as China, Turkey, and Peru, among others, are rapidly converging towards outsized levels of spending as their income scales.When countries grow richer, the demand for health care increases along with people’s expectation for government-financed healthcare.Upper-middle income countries accounted for 16.6% of total global healthcare spending in 2021, up from 8.2% in 2000.As global health expenditure continues to increase, sales to countries outside the U.S. represent a potential avenue for growth for domestic medical device companies.According to the World Bank, all regions (except Sub-Saharan Africa and South Asia) have seen an increase in healthcare spending as a percentage of total output over the last two decades.World Health Expenditure as a % of GDPGlobal medical device sales are estimated to increase 5.9% annually from 2023 to 2030, reaching nearly $800 billion according to data from Fortune Business Insights.While the Americas are projected to remain the world’s largest medical device market, the Asia Pacific market is expected to expand at a relatively quicker pace over the next several years.SummaryDemographic shifts underlie the long-term market opportunity for medical device manufacturers.While efforts to control costs on the part of the government insurer in the U.S. may limit future pricing growth for incumbent products, a growing global market provides domestic device manufacturers with an opportunity to broaden and diversify their geographic revenue base.Developing new products and procedures is risky and usually more resource intensive compared to some other growth sectors of the economy.However, barriers to entry in the form of existing regulations provide a measure of relief from competition, especially for newly developed products.Post-Script – 2024 OutlookThe medical device industry looked to have put the effects of COVID-19 behind by 2023.A large number of elective procedures were deferred in the early part of the pandemic and a measure of catch-up in procedure volumes was reported in subsequent periods.Back to focusing on the longer-term demographic and other trends?Well, maybe not quite so fast.It was always likely that the pandemic-induced disruptions would linger just a bit longer, creating some uncertainty around consumers’ needs and preferences.But the industry awakened to a different type of potential disruption in mid-2023.Would GLP-1 drugs alter long-term demographic trends by reducing massive obesity rates?And would the industry face widespread lower demand for bariatric surgery devices, glucose monitors, cardiovascular devices, orthopedic implants and other equiptment?A mid-year swoon in medtech stock prices was attributed, at least by some, to the wonder drugs.As 2023 came to a close, however, many appear to have reversed course from that early response.We may or may not get more clarity on the longer-term effects of these treatments in 2024 but, surely, they will also bring opportunities to go along with potential challenges for device makers.Taking a broader view, some trends from recent periods will likely persist in 2024.Companies will continue to focus on profitability and profitable growth in a (relatively) higher-interest rate environment.Some observers suggest that an expected but measured decline in rates over 2024 (if it materializes) may not do much for medtech stock prices, further underscoring the need to shore up margins.On the flip side, since the period of rapid interest rate increases appears to be behind us, transaction volume should pick up from the low levels of the past two years.Finally, innovation, as always, will continue to be part of the conversation as novel treatments that serve unmet needs will help to unlock new markets.2024 Outlook reading list:What To Expect From Medtech In 2024 (McKinsey & Company)5 Medtech Trends To Watch In 2024 (MedtechDive)2024 Outlook For Life Sciences: GenAI, Drug Prices, Economy Likely To Influence Strategy (Deloitte)

NYCB Incurs Heavy Dilution in Its $1.0 Billion Capital Raise

The other significant industry news from the first quarter was the $1.05 billion equity investment in New York Community Bank (NYSE: NYCB) by an investor group led by former Secretary of the Treasury Steve Mnuchin. The investment was necessary to boost loss absorbing capital and to shore up confidence to stem a possible deposit run after its share price collapsed during February following a surprise fourth quarter loss that was later revised higher for a $2.4 billion goodwill write-off.The initially reported 4Q23 loss of $252 million was not catastrophic, especially considering the company reported net income of $2.4 billion excluding the goodwill write-off as a result of the bargain gain from the purchase of the failed Signature Bank; however, the fourth quarter loss that arose from a $538 million provision for loan losses highlighted investor concerns about NYCB’s sizable exposure to NYC rent-controlled apartments and offices.The figure on the right presents our proforma analysis of the transaction and its impact on the consolidated company (NYCB), the parent company in which the group invested, and wholly owned Flagstar Bank, N.A. The adage that capital is exorbitantly expensive if available at all when it must be raised comes to mind here with NYCB.Source: Mercer Capital, NYCB SEC filings, and S&P Global Market IntelligenceWe note the following:The investor group paid $1.05 billion for 525 million common share equivalents consisting of 59.8 million common shares for $2.00 per share and $930 million of Series B and C preferred stock with a 13% dividend that is convertible into 465 million common shares at $2.00 per share.Tangible book value per share (“TBVPS”) declined by about one-third from $10.03 per share as of year-end 2023 to $6.65 per share on a proforma basis.Inclusive of 315 million seven-year warrants with a $2.50 per share strike price, diluted proforma TBVPS is ~$5.80 per share.The 525 million common shares represent ~40% of the 1.25 billion proforma shares while dilution to existing shareholders exceeds 50% inclusive of the warrants.The capital injection boosted the Company’s consolidated leverage ratio by ~80bps to 8.6% and total risk-based capital ratio by ~120bps to 13.0%.NYCB will generate ~$1.4 billion of pretax, pre-provision operating income in 2024 and 2025 based upon consensus analyst estimates that will supplement the new capital to absorb loan losses.Given NYCB’s shares are trading around 50% to 60% of proforma TBVPS, investors are questioning the magnitude of loan losses to be recognized; whether more capital will be required; and long-term earning power.Our additional thoughts on the transaction can be found HERE, and a link to NYCB’s investor deck announcing the transaction can be found HERE.If we can assist your board with a capital raise or other significant transaction, please call us.Originally appeared in the March 2024 issue of Bank Watch.

Capital One Financial Corporation to Acquire Discover Financial Services

The four major credit card networks are American Express, Discover, Mastercard, and Visa.In 2023, Discover had only 2.1% of the total market share in the U.S. based on the value of transactions, compared to Visa’s 61.1% market share and Mastercard’s 25.4% market share.1 Prior to its acquisition of Discover, Capital One partnered with both Visa and Mastercard for issuing their credit cards.So, why would Capital One pay $35.3 billion to acquire Discover’s 2.1% market share?Discover Financial Services operates as both a credit card issuer and credit card network.By owning its own credit card network, Discover is not partnered with any payment processors (Visa, Mastercard, etc.) and avoids “swipe fees” that payment processors collect. Therefore, one of Capital One’s primary objectives in acquiring Discover is to move its credit and debit cards onto Discover’s network over time and reduce its purchase volume on the Visa and Mastercard networks.The two companies entered into a definitive agreement on February 19, 2024, in which Capital One Financial Corporation agreed to acquire Discover Financial Services in an all-stock transaction valued at $35.3 billion.The deal represents a 26.6% premium to Discover’s closing price of $110.49 (2/26/24) as Discover shareholders will receive 1.0192 Capital One shares for each Discover share.More details on the transaction as well as the companies’ financials as of fiscal 2023 are displayed on the right.Summary of Transaction AnalysisFinancial ComparisonPreparing for the FutureAs technology continues to advance, both traditional, tech-heavy banks and Fintech companies have increased competition in the global payments industry.If the acquisition is approved, Capital One will surpass JPMorgan as the largest credit card company based on loan volume and become the third largest company based on purchase volume. With increased volume and market share, Capital One would be better prepared to compete against these other banks and Fintech companies. Richard Fairbank, the CEO of Capital One, strives to deal directly with merchants by owning his own payments network. This rare asset allows Capital One to create a closed loop between consumers and merchants, which better positions the company to deal with increasing threats from buy-now, pay-later companies (Affirm, Afterpay, Klarna, etc.).Both Capital One and Discover customers may have a lot to look forward to in the future should the deal be approved.Capital One intends to move 25 million cardholders onto the Discover network by 2027 and offer more attractive rewards for both debit and credit cardholders. The proposed merger would expand both issuers’ physical presence, and Discover customers would gain access to physical bank locations.Capital One will also leverage its international presence to increase accessibility and convenience for Discover cardholders on an international scale.In terms of credit and debit rewards, the increased competition in the industry is expected to drive companies to bolster their rewards program to seem more attractive to consumers.Regulatory HurdlesThe proposed deal between Capital One and Discover is expected to close by the end of 2024 or the beginning of 2025. However, the completion of the deal could depend on the results of the presidential election. Senators Elizabeth Warren and Josh Hawley have both expressed interest in blocking the deal as they believe the deal will create a “juggernaut” in the industry and lead to the extortion of American consumers. The Biden administration is more likely to block the deal or implement limitations and requirements in order for it to be executed.On the other hand, the proposed deal could stop legislation that threatens credit card rewards. Congress is considering new legislation known as the Credit Card Competition Act (CCCA).The purpose of this legislation is to reduce the swipe fees paid by merchants by enabling access to a wider range of payment networks. If the legislation is approved, credit card networks and issuers would face reduced transaction fees causing issuers to potentially reduce the wide range of rewards offered. However, the primary objective of the CCCA could be accomplished through the proposed merger, as routing Capital One’s purchase volume through Discover’s payment network would create a more viable competitor to the Visa/Mastercard duopoly.ConclusionMercer Capital has roughly 40 years of experience in assessing mergers, the investment merits of the buyer’s shares, and providing valuations of financial institutions. If you are considering acquisition opportunities or have questions regarding the valuation of your financial institution, please contact us. 1 Statista.com; Market share of Visa, Mastercard, American Express, Discover as general purpose card brands in the United States from 2007 to 2023, based on value of transactionsOriginally appeared in the March 2024 issue of Bank Watch.

Potential Impact of Baltimore Bridge Collapse on the Logistics Industry

It’s been hard to miss the news footage and video of the cargo ship Dali colliding with the Francis Scott Key Bridge across the Chesapeake Bay. The bridge collapse – as sudden as it is surprising – is another landmark in what has been a series of tumultuous years in the logistics industry. We recently wrote about global impacts on the supply chain, particularly East Coast ports, and this is another reminder about how unpredictable events can have a wide reach.The Port of BaltimoreThe Port of Baltimore is in the top twenty ports by volume in the United States and is the 5th largest port for foreign trade on the East Coast. TheWashington Postestimates that the port handled over 50 million tons of foreign cargo with value in excess of $80 billion during 2023. The port is the 2nd largest exporter of coal from the U.S. (though still a relatively small player on a global scale) and is the largest port for imports of automobiles, sugar, and gypsum. Baltimore is also equipped to handle Neo Panamax ships passing through the Panama Canal.Sharing the fortunes of several other East Coast ports of the last several years, the Port of Baltimore posted several records in 2023, including for the largest number of TEUs handled (1.1 million) and general cargo tons (11.7 million). Baltimore posts these growth records despite the overall decline in imports to the U.S. during 2022.Potential Short-Term and Long-Term ImpactShort term impacts will include delays of cargo already in transit for East Coast ports, whether originally bound for Baltimore or not. Just as we saw chokepoints on the West Coast lead to a redistribution of cargo among ports, the loss of the Baltimore port for the foreseeable future will cause ripple effects throughout the industry.Source: The Washington Post Other East Coast ports will likely take up the bulk of cargo previously destined for Baltimore. In particular, soybean shipments are expected to transfer to Norfolk, Savannah, and Charleston, while containers are expected to be processed in either Philadelphia or Norfolk. In any case, the truck routes and rail cars that previously serviced Baltimore will need to be recentered on other ports. However, this will be somewhat mitigated by global events that were already impacting East Coast ports—namely, the ongoing drought limiting capacity through the Panama Canal and the Houthi rocket attacks in the Red Sea, both of which had diverted some cargo away from East Coast ports prior to the bridge collapse. An additional concern is the International Longshoreman’s Association contract, which covers port workers from Texas through the Northeast. The contract is set to expire in September 2024. Talks stalled in early 2023 before resuming again in February 2024. The West Coast freight bottleneck that dominated transportation headlines in 2022 was brought on by labor disputes combined with a drastic increase in demand for shipping services due to COVID-fueled shopping. Conversely, the national freight market has been soft through 2023 and demand is not expected to rapidly escalate as it did a few years ago. This should limit long-term bottlenecks and chokepoints from forming on the East Coast.ConclusionMercer Capital’s Transportation & Logistics team constantly watches the transportation industry and global events and economic factors that can impact the overall industry, the supply chain, or various aspects of transportation.Mercer Capital provides business valuation and financial advisory services, and our transportation and logistics team helps trucking companies, brokerages, freight forwarders, and other supply chain operators to understand the value of their business. Contact a member of the Mercer Capital transportation and logistics team today to learn more about the value of your logistics company.

News Update: How the Collapse of the Baltimore Bridge Might Impact the Auto Supply Chain

By now, most of us have seen the harrowing images of cargo ship Dali wrecking into the Francis Scott Key Bridge in the Port of Baltimore in the early morning hours on Tuesday. Besides the tragedy of lives lost, the disruption for Baltimore commuters, and the time needed for recovery and rebuilding of the bridge, the catastrophe will have a major impact on the global supply chain and will also impact the auto supply chain. But how?

Eagle Ford Production Edges Down on Sharply Reduced Drilling

The economics of oil & gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Haynesville, and Marcellus and Utica plays. This quarter we take a closer look at Eagle Ford.

An Ontological Approach to Investment Management

Review of “Winning at Active Management” by William W. Priest et al.

When we started writing about investment management in 2007, my colleagues and I went looking for materials on practice management and, in general, found nothing. There was next to nothing out there about structuring and running an RIA. During our search, we missed the 2016 publication of “Winning at Active Management: The Essential Roles of Culture, Philosophy, and Technology” by Bill Priest and his colleagues at Epoch Investment Partners.

It’s Not About the Mangos: Focus on People

What We've Been Reading

With school in the home stretch and summer just around the corner, I wanted to share some insights I learned from reading “It’s Not About the Mangos” by Kent Coleman.

Eagle Ford M&A Update

Transaction Activity Plummets Over the Past 4 Quarters

Over the past twelve months, deal activity in the Eagle Ford has fallen off a cliff, with only two deals closing compared to 13 transactions closed in the prior twelve-month period. Significant volumes of wet gas, NGLs, and rich condensate combined with the proximity to the Port of Corpus Christi fueled deal momentum in the twelve months ended February 28, 2023. So why did this momentum come to a screeching halt during the remainder of 2023 and into the first two months of 2024?According to a report from Deloitte, M&A activity declined as E&P companies committed themselves to capital discipline. Free cash flows were diverted away from investing, acquiring for growth, and increasing market share toward paying dividends and share buybacks. The old drivers of M&A activity seem to have been replaced by new drivers.Recent Transactions in the Eagle FordDuring the twelve months ended February 29, 2024, Silverbow Resources purchased 42,000 acres from Chesapeake Energy for $700 million, while Crescent Energy purchased 75,000 acres from Mesquite Energy for $600 million. The total deal value of the two deals, $1.3 billion, equals the median deal value of the 13 deals for the twelve months ended February 28, 2023. A table detailing these two transactions is shown below.Click here to expand the image aboveChesapeake’s sale to Silverbow Resources is an extension of Chesapeake’s sell-off during the twelve months ended February 28, 2023 (see table below), during which Chesapeake sold a combined 549,000 acres over two deals. On the flip side, Silverbow Resources has continued its buying binge by purchasing assets from Chesapeake, adding to the four purchases it made during the twelve months ended February 28, 2023 (see table below). Silverbow Resources spent $547 million on these four purchases, adding 76,000 acres to its portfolio at $7,197/acre.Click here to expand the image aboveRock, Returns, and Runway: Why Chesapeake is a SellerChesapeake announced the sale of its remaining Eagle Ford shale assets to Silverbow Resources on August 14, 2023. The sale of these assets affirmed Chesapeake’s commitment to the Marcellus and Haynesville shales, noting that the Eagle Ford was no longer core to its strategy. Further, Chesapeake’s activist investor Kimmeridge Energy Management, had urged a shift toward solely natural gas production. The Marcellus and Haynesville shales are both natural gas-rich formations. We note that the shift out of the Eagle Ford shale preceded Chesapeake’s merger with Southwestern Energy, which was announced on January 11, 2024. As Chesapeake’s CEO Nick Dell'Osso noted, the divestiture of the remaining Eagle Ford assets allows Chesapeake “to focus our capital and team on the premium rock, returns, and runway” of its assets within the Marcellus and Haynesville shales.Scale, Capital Efficiency, and Commodity Exposure: Why Silverbow Is BuyingWhile Chesapeake has completely exited the Eagle Ford, Silverbow Resources is the other side of the coin. The acquisition of the Chesapeake assets has propelled the company into the largest public pure-play Eagle Ford operator.Silverbow Resources CEO Sean Woolverton noted “We are excited to close the Chesapeake transaction, which materially increases our scale in South Texas…Our differentiated growth and acquisition strategy has positioned us with … a portfolio of locations across a single, geographically advantaged basin. The acquired Chesapeake assets further enhance our optionality to continue allocating capital to our highest return projects and will immediately compete for capital.”ConclusionM&A activity in the Eagle Ford has plummeted over the last twelve months, with only two deals announced, one of which portrays two very different attitudes towards the Eagle Ford. However, according to Enverus Intelligence Research, the Eagle Ford shale is one of a few areas that can expect an uptick in M&A activity in 2024 as the list of attractive targets in the Permian Basin has dwindled due to heavy M&A activity in that play in 2023. Enverus also notes that “The core of the Eagle Ford is the gift that keeps giving for operators with the best acreage.” Despite denser development, recoveries remain high in these core areas of the Eagle Ford.Mercer Capital has assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space. We can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate, and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Q4 2023 Earnings Calls

New Vehicle Resilience, Lightly Used Inventory Scarcity, and Disappointing EV Sales

After reviewing earnings calls from executives of the six publicly traded auto dealers, the market for new vehicles appears resilient. Improved inventory balances and wider availability of models have relieved pressure from the new vehicle market. As a result, transaction prices have been falling, and consumers have been able to find the models they are looking for with more success. Meanwhile, used vehicle availability has been mixed, with lightly used models falling short. However, the demand for electric vehicles has been disappointing, and capital allocation decisions have become more complicated in the current environment.

How EBITDA Margins Affect Revenue Multiples

Whenever someone asks me what their RIA is worth as a multiple of revenue, I respond by asking about their firm’s EBITDA margin. My response is largely driven by the math behind the enterprise value (EV) to revenue ratio.

Employee Alignment Is Essential in Wealth Management

Employee alignment is important for most companies, but in asset and wealth management, it’s essential.

February 2024 SAAR

The February 2024 SAAR was 15.8 million units, a 6.0% increase from last month and a 6.3% increase compared to this time last year. February 2024’s year-over-year sales improvement and consistently improving inventory levels may indicate that the industry is reverting to its pre-pandemic ways. As nationwide inventory balances continue to expand, incentive spending from auto manufacturers has followed in tandem as OEMs and retailers compete to draw in buyers. Check out our recent blog for a deep dive into Customer Lifetime Value and the importance of getting buyers in the door for both dealers and manufacturers.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of March 4, 2024

Worldwide Impacts on Marine Shipping – Q4 2023

We discussed reshoring and nearshoring trends a bit in the last Value Focus Transportation and Logistics newsletter.There’s been some developments on that front, especially as it relates to the ongoing battle between East Coast and West Coast ports.As we mentioned last time, a variety of pandemic-related and regulatory issues resulted in long delays at California ports, the traditional import location for the majority of goods from East Asia.Many carriers shifted their import handling to East Coast ports – with the port of Savannah being one of the biggest winners.Georgia has posted three straight record–setting years for exports. A study by Cushman Wakefield that ran through October 2023 shows that volumes at East Gulf Ports exceeded West Coast volumes for the majority of 2022 and 2023.However, early results indicate the West Coast ports grew faster than East Coast ports in November and December 2023, and there are a couple of reasons behind that.(click here to expand the image above)The El Niño weather event has hit the Panama Canal hard.Under normal conditions, between 36 and 38 ships per day will make the transit.Due to the worst droughtPanama has experienced in over 70 years, the Canal Authority began reducing the number of ships passing through on a daily basis in July 2023.In February 2024, the Canal Authority reduced the total number of ships to 18 per day.Meanwhile, approaching from the other direction has been made harder by attacks on vessels in the Red Sea.About one-fifth of freight reaching East Cost ports travels through the Red Sea and the Suez Canal.Shippers continuing to use the Suez canal route will face higher insurance charges, while shippers opting to go around the Cape of Good Hope can expect to add at least a week to transit times.More recently, the first fully sunk ship from the conflict also disrupted underwater data cables.So far, analysts have had mixed opinions on the overall impact that will arise from the Houthi attacks.Between Red Sea disruptions and climate issues in Latin America the impact of worldwide current events on marine logistics cannot be ignored.

Capital Budgeting for Team Building

Tools for Long-Term Greedy Practice Management

This week, news that Apple was canceling what was known as its “Apple Car” project after a decade of work and billions invested puts a spotlight on the troubles facing EV development. As little as one year ago, EVs seemed inevitable, as several automakers declared they would abandon internal combustion engines (ICEs) within the next decade and dedicate their entire fleets to battery propulsion. A decade from now, we’ll know whether media hype over EVs pushed the industry too far ahead of their buyers, whether media hype turned willing EV buyers against battery-powered cars, or some combination of the two.

An Estate Planning Primer

Why Auto Dealers Need to Start Thinking About Estate Planning Again

One thing we’ve hardly written about in this space is estate planning, in part because dealerships have experienced record performance. However, as record profits have receded towards more normalized levels, and with the significant cliff looming at the end of 2025, it’s time for auto dealers to revisit their estate planning.

Themes from Q4 2023 Energy Earnings Calls

Upstream (E&P) and Oilfield Service (“OFS”) Companies

This week, we delve into the Q4 2023 earnings calls of upstream and OFS companies, underscoring the consistent emergence of these themes across the entire sector.

March 2024 | Capital One Financial Corporation to Acquire Discover Financial Services

Bank Watch: March 2024

In this issue: Capital One Financial Corporation to Acquire Discover Financial Services and NYCB Incurs Heavy Dilution in Its $1.0 Billion Capital Raise

Themes From the 2024 Acquire or Be Acquired Conference

For those who haven’t been to Bank Director’s Acquire or Be Acquired conference (AOBA) before, it is a two-and-a-half-day conference in the desert (Phoenix) that typically includes great weather, golf at the end, and has broadened over the years to focus on a combination of M&A, growth, and FinTech strategies.Cautious OptimismWhile the 2024 version of AOBA included a number of discussions around headwinds facing the sector, there was optimism for 2024 when compared to 2023.For example, the banking audience was asked during the conference: How do you feel about 2024 compared to your experience in 2023?~90% responded that they felt more optimistic about 2024 when compared to 2023. Additionally, several sessions noted that optimism exists for an uptick in deal activity in the second half of 2024.Traditional Bank M&A Tailwinds and HeadwindsWhile the turbulence and potential headwinds for bank M&A that slowed deal activity in 2023 continue to persist at the outset of 2024, traditional bank M&A remained a much discussed topic at the 2024 AOBA conference. Discussions focused on the nuts and bolts of M&A from valuation to due diligence to structuring and ultimately to integration. While certain themes change and evolve, the strategy to achieve greater scale and growth through M&A and to enhance efficiency and profitability that create value over the long run, persist. The challenging M&A landscape could present an opportunity for acquirers with the balance sheet and capacity to engage in a transaction, and the silver lining for those acquirers may be less competition for sellers as some buyers focus internally during the challenging operating environment.Balance Sheets in FocusThere were definitely more sessions this year discussing balance sheets. A number of sessions noted that one key to dealmaking in the current environment was managing the balance sheet, and several discussed the impact of fair value marks on sellers and pro forma combined balance sheets and the impact on deal activity. For acquirers, a strong balance sheet and capital level can position their institution to be able to take advantage of the current deal environment. For sellers, having a balance sheet that is less impacted from the fair value marks to loans and bonds and with more valuable deposits enhances their attractiveness to potential acquirers.In one session, my colleagues Jeff Davis and Andy Gibbs discussed the impact of taking a loss today on low-coupon bonds that are worth less than the current market price versus holding the bonds to maturity on the value of a bank’s equity. They also reviewed an intermediate strategy referred to as the installment method.Deposits, Deposits, DepositsConsistent with discussions around the balance sheet, the interest rate environment, and impact on the banking industry & M&A, discussions about deposits came up often.These discussions covered strategies to retain business or consumer deposits, the attractiveness of core deposits for acquirers in the current environment, how to grow deposits organically (some of the largest banks are even turning back the clock and building branches again), trends in core deposit intangible valuations, and how to provide your customers with the technology and digital banking solutions to onboard and retain deposits more efficiently. One question discussed in several sessions that will be interesting to see the answer to in 2024 was: Has the cost of funds peaked?Technology Brings OpportunitiesOver the last few years, technology has been an increasing topic discussed during sessions of AOBA. Technology topics discussed included leveraging payments to enhance retail and small business banking, using software and/or digital banking to more efficiently make loans and/or open deposit accounts and best practice for developing and managing risk of FinTech partnerships. Even AI, the market’s favorite topic of 2024, was discussed. A consensus on how best to leverage AI in banking has not yet emerged in my view but topics discussed included leveraging AI to enhance loan growth or efficiency of common tasks in the back office. Traditional M&A has historically focused on the potential diversification benefits of combining loan portfolios, deposit portfolios, and geographic footprints but increasingly the tech stacks of buyers and sellers are being compared to see what diversification benefits exist and what the cost may be to combine the tech stack after closing.Technology Also Brings Potential RisksOne challenging aspect of technology for banks was how best to balance the potential benefits of technology with the risks inherent in them, particularly new technologies and FinTech partnerships. Tech-forward banks and their valuations were also discussed. As we have noted in the past, this tech-forward bank group has seen increased volatility in market performance than their peers as the market digests some of the tech-oriented business models (such as banking-as-a-service) and weighs the potential for higher growth and profitability against the potential risk of these business models and regulatory scrutiny.Non-Traditional DealsSimilar to traditional bank deals, bank acquisitions in non-traditional areas like specialty finance, insurance, and asset management have been modest and challenging given the difficult operating environment, higher cost of debt, and opportunity cost of excess liquidity. However, there were some discussions around best practices and lessons learned from specialty finance transactions and that additional opportunities may emerge as non-bank lenders also deal with the challenging funding and interest rate environment. Additionally, Truist recently announced the sale of its insurance business to book a gain, focus on core banking, and enhance capital. The announced bank acquisitions by credit unions and private investors also illustrate that non-traditional deals remain a part of a bank’s strategic playbook.ConclusionWe look forward to discussing these issues with clients in 2024 and monitoring how they evolve within the banking industry over the next year. As always, Mercer Capital is available to discuss these trends as they relate to your financial institution, so feel free to call or email.Originally appeared in the February 2024 issue of Bank Watch.

No Soup for You

Lessons from Seinfeld on Customer Lifetime Value and Brand Loyalty in the Auto Industry

Like the price elasticity of automobiles, especially high-end automobiles, OEMs and auto dealers must confront the challenges of brand loyalty and customer retention. In this week’s post, we discuss customer lifetime value ("CLV") and cost of customer acquisition ("CAC") and offer tips to auto dealers to achieve greater customer retention.

Texas Statewide Rule 8 Overhaul

What's in Store for Texas Oilfield Waste Disposal Operators?

In October 2023, the Railroad Commission of Texas (the "RRC," or the "Commission") announced that for the first time in nearly 40 years, 16 Texas Administrative Code (TAC) §3.8 (relating to Water Protection), also known as Statewide Rule 8 ("Rule 8"), would undergo a significant overhaul. We discuss that in this post.

Will RIAs Be Subject to Anti-Money Laundering Rules?

Last week, the U.S. Treasury’s Financial Crimes Enforcement Network (“FinCEN”) proposed a rule to require investment advisors to comply with Bank Secrecy Act requirements, including implementing anti-money laundering (“AML”) controls and filing suspicious activity reports to FinCEN. The agency has attempted to bring investment advisors under Bank Secrecy Act provisions twice in the past, most recently in 2015. Unlike prior attempts, however, this proposal does not hold investment advisors accountable for identifying their clients. Still, the agency is contemplating a separate joint proposal with the SEC outlining future customer ID requirements for investment advisors.

Non-Operating Working Interests in Oil & Gas: Part II

Markets and Valuation Characteristics of Non-Op Working Interests

As we continue our discussion on non-op working interests from Part I of this series, we turn to how the markets and valuation parameters are structured.

Reconciling Real-World RIA Transactions with Fair Market Value

The value of asset and wealth management firms depends very much on context. In the valuation community, we refer to the context in which the firm is being valued as the “standard of value.” A standard of value imagines and abstracts the circumstances giving rise to a particular transaction. It is intended to control the identity of the buyer and the seller, the motivation and reasoning of the transaction, and the manner in which the transaction is executed.

How a Quality of Earnings Analysis Benefits Auto Dealership Buyers

As our readers know, the auto dealer transaction space has been white hot for the last several years. What else could impact transactions in 2024? After sitting on the sidelines for much of 2022 and 2023, the prospect of Fed rate cuts may lure even more buyers back onto the field in 2024. And if deal activity continues to be hot, due diligence will be as critical to buyers as ever. For many buyers, a quality of earnings (“QofE”) report is a cornerstone of their broader diligence efforts.

RIA M&A: What Can Possibly Go Wrong?

A Very Incomplete List of What Not to Do in Transactions

As business combinations go, it’s hard to imagine a better press release: Ferrari, the most storied and most successful name in Formula One racing history and the only team to compete in every world championship ever held, boasting a top 16 Constructors’ Championships and 15 Drivers’ Championships……signs Lewis Hamilton, the most recognizable and winningest driver in Formula One, tied with Michael Schumacher for the most Drivers’ Championships, who serves as a global ambassador for Formula One, built McLaren’s reputation and cemented Mercedes’s, and was knighted by Queen Elizabeth.Ferrari brings unparalleled intellectual property and commitment to racing, capital from a robust market valuation, and a history of being on top. Hamilton brings unparalleled driving skills, a following among not just fans but also mechanics and builders, and a history of being on top.What Could Possibly Go Wrong?I’ll get back to the Ferrari/Hamilton deal later. In the RIA community, nothing gets people’s blood flowing like a transaction. Big mergers are fantastic, but even deals involving a few hundred million of AUM are widely reported. For all the hype, making M&A successful requires minding Ps and Qs, and is as much, if not more, about attention to detail and being realistic as it is about sweeping vision and uplifting pronouncements.I’ve written in the past about the perils of focusing on the volume of press releases instead of the volume of earnings. Today, I thought it would be worthwhile to discuss what can go wrong in an RIA deal and how to protect yourself from it.Here’s a partial list of mistakes we’ve seen (some from buyers, some from sellers) in no particular order.Failing to Get an Independent Quality of Earnings AssessmentA Quality of Earnings assessment is like a SWOT analysis of your financial statements, looking at all of the risks and opportunities inherent in your revenue, expenses, and earnings.Is this a seller issue or a buyer issue? Both.The Quality of Earnings analysis is designed to show you how a buyer would look at youIf you are a seller, a Q of E assessment can alert you to issues that will be exhumed during due diligence and held against you by the buyer in negotiations. If you have real opportunities for earnings enhancement, it will help you get paid for those opportunities. The Quality of Earnings analysis is designed to show you how a buyer would look at you so you’re realistic about what you bring to the table and ready to negotiate the best deal for you. Whatever you do, don’t hire the Q of E firm that does regular work for the buyer — they have an inherent conflict of interest, and they will find things that the buyer can use against you in the due diligence process to whittle down the offer price to help create a “gain on purchase” (to buy you for less than you’re worth).If you are a buyer, a Q of E analysis is a deep dive into a range of qualitative and quantitative issues that protect you from simply trusting seller representations. If the seller presents you with their own Q of E, get that analysis in its native format (usually Excel) and hire someone to review and critique it. It’s not unusual to see adjustments to reported results that are realistic. Others might just be possible. Others might be fantasy.Failing to Meet with Multiple Generations of LeadershipIf a selling firm has two owners of retirement age and a half dozen senior managers below them in their forties and fifties, who will ultimately be tasked with making the transaction successful? I know this sounds obvious, but we’ve seen multiple deals in which the buyer didn’t meet with anyone other than the owner selling the firm so they can retire in the foreseeable future.On signing day, the buyer is introduced to the staff, who are presented with employment agreements. This may be a tough announcement if the next-gen was expecting to buy out their owners and take over themselves. And if their existing employment agreements aren’t pretty good, this could be the scene in which the proverbial assets get on the elevator, go home, and don’t come back. Yes, this has happened.Whether you are a buyer or a seller, it’s important to involve all the relevant stakeholders in preparing for a transaction to ensure continuity of operations after closing. It’s not always easy, but it’s always necessary.Misunderstanding the Economics of the Transaction StructurePop quiz: if deal consideration is five times EBITDA in cash, five times EBITDA in rollover equity, and five times EBITDA in earnout payments, what is the deal multiple? If you guessed 15 times EBITDA, you’d make a typical trade journalist, but you would also, very likely, be wrong.Cash consideration is easy enough to understand, but precious few RIA deals are “cash for keys.”Rollover equity is complicated because it’s based on the relative value of the buyer’s equity. Buyers naturally want accretive transactions in which they are picking up more dollars of earnings per share than they make themselves. But if the deal is accretive to the buyer, it’s symmetrically dilutive to the seller. And if the acquiring firm sells one day for a lower multiple than it was valued at the date of your transaction, it will be even more dilutive. We are always surprised when RIA acquirers boast about the high multiples at which they are valued (by firms they hire to value them…); savvy sellers will know those high valuations work against them.As for contingent consideration, the question revolves around how realistic the earnout targets are and whether those payments will be made in cash or stock. And then there’s the time value of money. Our advice is to be realistic about risk adjusting contingent payments and then discount them. It doesn’t take much to turn a 5x EBITDA headline earnout into 3x on an economic basis.So, what’s our hypothetical five-plus-five-plus-five deal worth? Probably less than 15 times EBITDA.Unrealistic Compensation ExpectationsCompensation can be highly idiosyncratic, especially for founder partners. You might only “pay” yourself $100 thousand per year because you get distributions on 40% of your firm’s earnings. That’s fine as an independent enterprise, but a buyer isn’t going to pay a multiple for your compensation just because you characterize it as earnings.Occasionally, you’ll meet an unsophisticated buyer who is willing to pay a multiple on what would be part of a normal compensation package. This never ends well. A selling partner with eight figures in sale proceeds usually won’t exert himself or herself at the same level for comparatively de minimis pay.Conversely, don’t leave money on the table. If you are a selling partner and take out more in wages than it would reasonably take to replace you, make that adjustment and get paid a multiple on the difference.Consider what a realistic, market-based compensation package is for the partnersIn any event, prior to going to market, consider what a realistic, market-based compensation package is for the partners. That may increase or decrease earnings, but it will probably bend the margin toward something a buyer would consider “normal” or at least sustainable. Negotiating deal pricing over partner compensation is unnecessary. Pick a reasonable balance between returns to capital and returns to labor, and craft your transaction accordingly.Viewing a Merger as a SaleIn a typical RIA transaction, the “seller” is making a bigger investment in their “acquirer” than the other way around. Why? Because, outside of the initial cash consideration, the seller is accepting rollover equity and earnout payments in exchange for their company.Rollover equity is essentially an investment in the acquirer, with what might be an indefinite holding period and an uncertain ultimate liquidity event. Earnout payments, also known as contingent consideration, mean the selling principals are actually going to be partners with the acquirer in their firm until such time as those earnout payments are, well, earned (or not).Also, remember that the scale of economics between seller and buyer is disproportionate. The seller is handing over their life’s work, often in exchange for a small percentage of the acquirer’s enterprise. The deal’s success matters to everyone, but it matters far more to the seller.Not Considering Post-Transaction RealityThis one could be titled “Viewing a Sale as a Merger.”For sellers, it’s important to remember that selling your firm, even part of it, is giving up control. There is no such thing as a no-touch acquirer.There are ways to minimize the invasiveness of a new owner with revenue-sharing arrangements and employment agreements. But we’ve seen supposed financial buyers taking minority stakes who find clauses in their agreement that allow them to exert as much pressure as they think they need after the ink dries. The subsidiary leadership’s only leverage is that they generate the revenue and can leave.For buyers, remember that you are hiring entrepreneurs, and entrepreneurs are often that way because they don’t want (can’t live with) a boss. The great irony of the consolidation movement in the RIA space is that the RIA space formed in the first place because ambitious people at wirehouse firms and bank trust departments decided they could do better if they left the mothership and headed out on their own. Consolidation negates much of that spirit, but to the extent it involves second and third-generation leadership at RIAs, those folks may be more accustomed to having a boss and will be more adaptable to working for a parent organization.Press Releases Don’t Build BusinessesGetting back to the dream combination of Ferrari/Hamilton: What could possibly go wrong? Lots.Ferrari hasn’t won a Constructors’ Championship in sixteen years. Not since before the GFC. Translated to our world, that’s a lot of negative alpha. Enzo Ferrari sold road cars to fund his racing ambitions; now, his company is public, a global branding house that races to sell cars, media, and lifestyle accoutrements. If you’ve seen the excellent movie Ford versus Ferrari, you know that Ford tried to buy Ferrari in the 1960s. Today, Ferrari’s buyer would more likely be LVMH.Hamilton. Is. Old. At 225 miles per hour, age isn’t just a number. This is my unvarnished opinion and the subject of much debate in the F1 community, but Lewis Hamilton turned 39 last month, and his last Drivers’ Championship was four years ago. In the past fifty years, only one driver as old as Hamilton has managed to win the F1 season. Even if he’s the greatest F1 driver in history, Hamilton’s instincts, eyesight, reaction time, and nerves are off-peak in a ridiculously competitive field.So, a little due diligence suggests that pairing an also-ran team with an aging icon won’t produce many podiums. But it will garner millions, if not billions, of dollars of free publicity for both Ferrari and Hamilton. If that is their actual ambition, the deal will be wildly successful. For RIAs, unfortunately, press releases don’t build firms.

January 2024 SAAR

The January 2024 SAAR was 15.0 million units, down 6.9% from last month and roughly flat (down 0.7%) compared to this time last year. Following 17 consecutive months of year-over-year improvements, the January 2024 SAAR ended the streak with a slight decline. Since January is generally a low-sales month, a decline in the SAAR itself does not necessarily dampen expectations for the remainder of 2024.

Just Released | 4Q23 Exploration & Production Newsletter

Regional Focus: Haynesville Shale

Will Finfluencers Replace Financial Advisors?

We think finfluencers are more likely to be a marketing opportunity than a competitive threat to financial advisors seeking business from younger investors. FAs that stress their value proposition and key points of differentiation will usually win the clients they want over their conflicted competitors. If that fails, they can always partner with one, but we highly recommend they read CFAI’s report before doing so.

Non-Operating Working Interests in Oil & Gas: Part I

Characteristics of Non-Op Working Interests, the Risks, and the Benefits

The economics between an operating interest and a non-op interest can sometimes differ significantly in certain circumstances.

Understanding the Asset Approach

What Is It and How Is It Used for Auto Dealer Valuations?

Everyone in the auto dealer industry has likely heard of Blue Sky values. Under the market approach, valuation professionals add the indicated Blue Sky value to the dealership’s tangible net asset value. This is where the asset approach comes into play.

February 2024 | Themes from AOBA and Pay vs. Performance: What’s New in Year 2

Bank Watch: February 2024

In this issue: Themes From the 2024 Acquire or Be Acquired Conference and Pay vs. Performance: What’s New in Year 2

The Tangled Path to Banking’s Garden of Earthly Delights

Hieronymus Bosch, The Garden of Earthly Delights, 1490-1510, Museo del Prado, Madrid.One of BankWatch’s favorite artists is the Dutch painter Hieronymus Bosch (1450-1516). His work is both enigmatic and fantastical, with bizarre human/animal hybrid forms and other monstrous creations of Bosch’s fecund imagination. Indicating its lasting relevance and, in a sense, modernity, centuries later Bosch’s work served as inspiration when the Surrealist movement sought to depict dreamlike scenes formed from the depths of their unconscious mind. One triptych, The Garden of Earthly Delights, depicts a utopian scene in the middle panel adjacent to a hellscape in the right panel.It serves as an apt metaphor for the banking industry’s stomach churning volatility in 2023.As in the hellscape panel on the right side of the triptych, the banking industry sunk to the depths of despair beginning in March 2023, tormented by bank failures and deposit runs.From year-end 2022 to the nadir in May 2023, the Nasdaq Bank Index sunk 34%. Bank stocks rebounded during the summer but remained under pressure through the fall as the ten year Treasury rate briefly exceeded 5%.Finally, more dovish comments from Chairman Powell lifted sentiments, causing the Nasdaq Bank index to appreciate by 12% in November 2023 and 15% in December 2023.While we have not returned to a banking utopia, the greener pastures in which Bosch’s hybrid forms graze in the triptych’s middle panel seem more representative of industry conditions at year-end 2023.2023 PerformanceFor 2023, the Nasdaq Bank Index and the KBWNasdaq Regional Bank Index depreciated by 7% and 4%, respectively (see Figure 1 ). This marks the second year of negative performance for bank stock indices. Between year-end 2021 and 2023—covering the entire period of rising rates—the Nasdaq Bank and Regional Bank indices decreased by 24% and 13%, respectively (see Figure 2).After losing 19% in 2022, the S&P recovered in 2023 with 24% appreciation, meaning that the S&P 500 at year-end 2023 returned to a level virtually identical to year-end 2021. Struggling with earnings pressure, banks lost favor with growth minded investors, thereby underperforming the broader market.Figure 1 :: Index Performance (12/31/22 - 12/31/23)Figure 2 :: Index Performance (12/31/21 - 12/31/23)Figure 3 stratifies the 328 banks and thrifts traded on the NYSE and Nasdaq by asset size. Banks in the three strata between $1 billion and $100 billion performed similarly, with the median bank’s stock price falling by about 5% in 2023. Between 30% to 40% of banks reported share price appreciation over year-end 2022. The largest banks outperformed in 2023, as several banks like J.P. Morgan Chase (NYSE: JPM) “over-earned” their long-term return on equity target. JPM and other money center banks were boosted by low-cost deposits flowing from smaller banks in the wake of the failures of SVB, Signature Bank, and First Republic Bank.JPM also recorded a bargain purchase gain from the acquisition of First Republic Bank as did First Citizens BancShares (NYSE: FCNCA) and New York Community (NYSE: NYCB), the winning bidders for SVB and Signature Bank.Figure 3Figure 4 replicates the analysis for the period between year-end 2021 and year-end 2023. Not all banks have struggled through this rising rate environment, as 28% of banks reported share price appreciation over the two-year period. Nevertheless, the largest number of banks have experienced a 10% to 20% decline in their share prices.Figure 4Catalysts for (Under)PerformanceChanges in the net interest margin have the greatest effect on profitability and share price performance in the current environment, given limited credit issues. Figure 5 includes publicly traded banks with assets between $1 billion and $10 billion, sorted into quartiles based on their NIM change between the fourth quarter of 2022 and the third quarter of 2023.Figure 5The first quartile, including banks with the most severe NIM pressure, experienced a median stock price change of negative 14% in 2023. Meanwhile, banks in the fourth quartile—with the least NIM pressure or even NIM expansion—eked out a positive 2% change in stock price.This relationship holds true if we consider the entire rising rate period between the first quarter of 2022 and the third quarter of 2023 (see Figure 6). Over this period, approximately one-half of the banks reported a higher NIM; however, the market provided a meager reward with share prices for banks in the fourth quartile appreciating by a median of 4%. This reflects the market’s focus on the more recent trend in the margin—generally downward for most banks—rather than a historical anchor in a low rate environment. Meanwhile, the banks in the first quartile that were most exposed to rising rates suffered a median -24% change in their stock prices.Figure 6Valuation ImplicationsFigure 7 illustrates the earnings pressure resulting from tighter NIMs.For 2023, analysts’ EPS estimates indicate a median EPS decline of 15% for publicly traded banks with assets between $1 and $15 billion, with 73% of the banks in the analysis expected to face lower year-over-year earnings in 2023. These estimates are based upon recent data. Measured from January 2023, the reduction in earnings estimates is much more severe, meaning analysts cut estimates as the year progressed.Figure 7The outlook is only marginally better in 2024, as the median decline in EPS is 8%. Analysts generally expect NIMs to stabilize, or at least decline at a more modest rate, in the first half of 2024, followed by some expansion in the second half of 2024. The NIM stabilization in the latter half of 2024 leads to earnings growth in 2025 for most banks, with a median EPS growth rate of 10%. However, only 28% of banks in our analysis are projected to have higher EPS in 2025 than in 2022.With the share price recovery in late 2023, publicly traded banks with assets between $1 and $15 billion reported a median price/one year forward earnings multiple of 11.5x and a price/tangible book value multiple of 1.26x. As indicated in Figure 8, these multiples are in-line with the range over the last five years. Therefore, the catalyst for further share price appreciation likely will be earnings improvement rather than P/E multiple expansion.Figure 8ConclusionThe worst has passed for banks, with slowing deposit attrition and stabilizing NIMs, unless credit performs materially worse than expected.However, conditions likely are not ripe for rapid earnings growth. First, NIMs likely will recover more slowly than they contracted due to volume of assets repricing years into the future. Second, many banks are reporting slowing loan growth, as higher rates have gradually eroded loan demand. Third, if loan demand exists, marginal funding remains difficult to obtain at a favorable cost of funds.For many publicly traded banks, returning to the garden of earthly delights remains a ways off.Orginally appeared in the January 2024 issue of Bank Watch.

Quality of Earnings Analysis for RIAs

As we’ve often highlighted on this blog, transaction activity in the RIA space has increased dramatically over the last decade. Alongside this increase in deal activity, there have been significant developments in the supporting infrastructure for M&A. Many large consolidators now have dedicated outreach and deal teams and standardized due diligence processes. This professionalization of the buyer market combined with more recent headwinds to deal activity have led to increasing scrutiny of target earnings.

Vroom in the Tomb and Used Vehicle Gloom

What Does the Collapse of Vroom Say for Auto Dealers?

Vroom and other used-only dealerships are more squeezed because they aren’t tied to a franchise. They can only sell used vehicles whose prices have been more volatile, and they don’t have access to captive financing from their OEMs. In short, we don’t think traditional franchise dealers will be stung by the forces that took down Vroom. However, we believe Vroom shouldn’t be ignored as it can provide valuable insights. Its S-1 highlighted e-commerce penetration in the industry sits at just under 1%, compared to about 16% for total retail.

2024 Oil and Gas Outlook

A Year Of Divergence

When it comes to the oil and natural gas upstream markets, it appears each commodity and their producers are heading to different places in 2024. We can see it through market sentiment, prices, production, and corporate actions such as mergers.

Navigating the Shifting Tides

Trends Shaping the RIA Industry in 2023 and Beyond

As the financial landscape continues to evolve, the RIA industry experienced a notable shift in 2023, diverging from the challenges faced in the preceding year. Despite predictions going into 2023 that persistent inflation and elevated interest rates would lead to an economic downturn, no recession came to pass, and all sectors of the RIA industry experienced growth as markets rebounded from the 2022 slump.

2024 Automotive Trends

A Look Back to Look Forward

Following the auto industry rollercoaster of the past two and a half years, perhaps 2024 will be a return to the times before the pandemic. If not, this could be our new normal. Margins and profitability have already declined in the latter half of 2023. The buying process for vehicles has forever changed, offering online and omnichannel options to the traditional in-person experience at the dealership. While inventory supply from the OEMs continues to improve, will it level off, or will it also climb back to pre-pandemic levels in 2024?

The Chesapeake and Southwestern Merger

Reshaping U.S. Natural Gas

On January 11th, 2024, Chesapeake Energy Corporation and Southwestern Energy Company announced that they would be merging, with the resulting (currently unnamed) company becoming the largest natural gas producer in the country.

The Remarkable Resilience of RIA M&A Activity

RIA M&A activity has demonstrated remarkable resilience, defying initial expectations of a slowdown amid challenging macroeconomic conditions. As the economy entered 2023 facing high inflation, rising interest rates, and tight labor markets, many anticipated a decline in M&A activity. However, Fidelity’s November 2023 Wealth Management M&A Transaction Report listed 210 deals through November 2023, up 3% from the 203 deals executed during the same period in 2022. Notably, there was a significant uptick in total transacted AUM during 2023. Total transacted AUM through November 2023 was $336.6 billion—a 25% increase from the same period in 2022.

December 2023 SAAR

The December 2023 SAAR was 15.8 million units, up 3.2% from last month and up 16.8% compared to this time last year. After only two months of single-digit year-over-year improvements, the December SAAR returned to double-digit year-over-year growth. The December SAAR marks a strong finish to 2023, with growth in line with the double-digit percent increases seen from March to September. The December SAAR extended the streak of consecutive year-over-year improvements to 17 months.

Haynesville DUCs Buoy Production Despite Rig Count Decline

The economics of oil & gas production vary by region. This quarter, we take a closer look at the Haynesville shale.

RIAs Finish 2023 with a Q4 Rally

Investor Interest Moves to Alts and Big-Name Managers

Share prices for most publicly traded asset and wealth management firms trended upward with the broader market during Q4 2023. For the second quarter in a row, alternative asset managers outperformed the market and other RIAs, ending the quarter up about 21% compared to 11% for the S&P 500. On a year-over-year basis, all sectors of RIAs experienced growth as the markets rebounded from the 2022 slump. RIAs directly benefit from improving market conditions as they result in a stronger asset base on which to collect fees.

What Is the Car Parc Makeup?

Data from Q3 2023

Initiating Coverage of the Haynesville Shale

We’re starting 2024 with coverage of the Haynesville shale. The Haynesville shale is one of the top natural gas plays in the U.S., particularly when factoring in its geographic location, pipeline and infrastructure capacity, and deliverability of gas to the Gulf Coast industrial complex and liquified natural gas (LNG) export facilities.

The Baltimore Bridge Collapse, One Month Later

Q1 2024

It’s been about a month since cargo ship Dali collided with the Francis Scott Key Bridge in the waters of the Chesapeake Bay. We wrote about the collapse when it occurred and wanted to revisit the topic. The bridge collapse represents another event in a string of global impacts on the supply chain and is another reminder about how unpredictable events can have a wide reach.

January 2024 | The Tangled Path to Banking’s Garden of Earthly Delights

Bank Watch: January 2024

In this issue: The Tangled Path to Banking’s Garden of Earthly Delights

Value Focus: Insurance Industry | First Quarter 2024

Brokers and P&C underwriters outperformed the broad market and other insurance sectors in Q1-2024

Medtech and Device Industry Newsletter - Q1 2024

FEATURE ARTICLE | Five Trends to Watch in the Medical Device IndustryEXECUTIVE SUMMARYThis quarterly update includes a broad outlook that divides the healthcare industry into four sectors:Biotechnology & Life SciencesMedical DevicesHealthcare TechnologyLarge, Diversified Healthcare CompaniesWe include a review of market performance, valuation multiple trends, operating metrics, and other market data. This issue also includes a review of M&A and IPO activity

E&P First Quarter 2024

Eagle Ford

Eagle Ford // Despite significant rig-count declines, Eagle Ford production declined only modestly over the twelve months ended March 2024, aided by a significant number of DUCs going into production.

Transportation & Logistics Newsletter

First Quarter 2024

Bank M&A 2023

Subdued But Potentially Explosive

‘Twas the Blog Before Christmas...

2023 Mercer Capital Auto Dealer Holiday Poem

Enjoy our year-end poem.

Top 10 Energy Valuation Insights Blog Posts of 2023

Auto Dealer Insights: Best of 2023

We are about to put a bow on 2023! Our weekly posts follow the auto industry closely to keep up with market trends and gain insight into the private dealership market. We hope you have enjoyed our content in 2023, and we look forward to connecting further in 2024! Below, we have recapped four of our popular topics.Auto Industry Trends to Monitor in 2023Early in the year, we wrote a post discussing a potpourri of trends to monitor in 2023, coming off specific statistics from 2022. We discussed new vehicle pricing, used vehicle pricing, electric vehicles, connected cars, and SAAR predictions for 2023. As we close out 2023, we revisit some of these topics and predictions in hindsight.The average transaction price for new vehicles continued to rise in early 2023 before flattening out and eventually declining. As of the most recent data, the average transaction price of new vehicles stood at $45,332 in November, representing a decline ranging from 1.5-2%, depending on the source. Consistent with those trends, incentives on new vehicles have steadily risen and now comprise approximately 4.5-5%, depending on the source. Finally, the percentage of new vehicles selling above MSRP is 21.4%, compared to nearly 37.1% from this time last year, according to JD Power/LMC. All of these trends indicate that we are shifting from a seller’s market to a buyer’s market for automobile consumers.Average transaction prices for used vehicles also followed suit, posting a figure of $29,985 for November, a decline of approximately 2.9% from November 2022.Avid readers are familiar with our monthly SAAR reports. With a strong December, which is typically the strongest selling month of the year, the annual SAAR is expected to land somewhere in the area of 15.6 million units. As a point of reference, predictions for 2023 ranged from 14.1 to 15 million from industry experts such as Edmunds, Cox Automotive, NADA, and Toyota North America. After underperforming expectations in 2022, predictions were reigned in, and the rebound materialized in 2023, outstripping expectations.EV PotpourriAccording to Automotive News, EVs continued to increase market share, with estimates ranging from approximately 7% at the beginning of the year based on the total number of new vehicle registrations to 8.6% in June. This post discussed the different charging levels, various requirements automakers have for their dealers, and the expanding presence of charging stations at retailers and restaurants.Later in the year, we discussed the recent development of EV affordability, as well as a view of consumer demand measured by days’ supply of EV inventory versus all vehicles. EVs continue to be more expensive than their internal combustion engine (ICE) counterparts, with average transaction prices of $55,436 and $41,630 for new and used EVs, respectively. Only five of the twenty new EV models to be introduced in 2024 will be offered at prices below the average transaction price for all new vehicles.While production of EVs has increased, the amount of EV inventory on dealers is beginning to mount, perhaps reflecting a softening interest in these models. For all OEMs other than Chevrolet and Cadillac, the days’ supply of inventory for EVs is far more than the days’ supply of all new vehicle inventory. Stated simply, EV inventory is sitting on dealers’ lots for extended periods compared to ICE vehicles.Ford recently announced it is scaling back its $3.5 billion Michigan battery plant as EV demand has declined and labor costs have increased.United Auto Workers StrikeThe increase seen in labor costs is due to the UAW strike, which began on September 15th and ended on November 20th, when new deals were ratified. Our October 6th post chronicled the strike in real time, including insights into why the union was striking, the key players in negotiations, and how this strike differed from previous ones. Historically, the UAW only targeted one OEM at a time during a strike. But as this was the first simultaneous strike against the Big 3, it enabled the UAW to use concessions by one OEM as negotiation leverage with the others. Possibly learning from the recent supply chain constraints, the strikes also targeted specific factories that produce the most popular and profitable vehicles, allowing the UAW to inflict maximum economic pain while limiting the interim losses of its striking members.The new contract gave union workers an immediate pay increase of 11%, and union members will get a total pay increase of 25% throughout the 4½-year deal. The new contracts also reinstated cost-of-living adjustments, let workers reach top wages in three years instead of eight, and protected their right to strike over plant closures.For comparison sake, we noted reports that the UAW was seeking: As expected, the UAW gained some valuable concessions but also didn’t get everything they were seeking. Floorplan Interest Income FadingIn the post-COVID and supply chain-constrained boom, auto dealers enjoyed an unlikely profit center: floorplan interest. Floorplan loans are provided to dealers by banks, specialty lenders, and vehicle manufacturers. Interest accrued on these loans is called floorplan interest, and in the time between when the vehicle is acquired by the dealer and sold to a consumer, the dealer must pay floorplan interest expense to the lender. The longer the vehicle sits on the lot, the longer interest accrues.When dealers started selling vehicles as soon as they arrived at the dealership, floorplan credits exceeded floorplan interest expense. Normally a cost of doing business, low interest rates coupled with depressed inventories meant the sales-volume-based credits many dealers receive from their OEM exceeded the financing cost of holding vehicles on the lot.As we noted in our post this year, this began to fade in 2023 as inventories recovered and rates remained elevated. With no end in sight, they continued to rise as many Fed watchers anticipated a “higher for longer” interest rate environment.

7 Considerations for Your RIA's Buy-Sell Agreement

If you haven’t looked at your RIA’s buy-sell agreement in a while, we recommend dusting it off and reading it in conjunction with the discussion in this post.

Worldwide Impacts on Marine Shipping

Q4 2023

We discussed reshoring and nearshoring trends a bit in the last newsletter. There’s been some developments on that front, especially as it relates to the ongoing battle between East Coast and West Coast ports.

Assessing an RIA’s Quality of Earnings

Don’t Pay a Premium for a Project

A thorough quality of earnings assessment can go a long way to understanding why a given firm is profitable and how likely it is to remain so after a transaction.

Remembering Charlie Munger

His Investment Wisdom and Legacy

Mr. Buffet took this one step further – “I will confidently wager that no computer will ever replicate Charlie.” Unfortunately, he was probably right.

November 2023 SAAR

The November 2023 SAAR was 15.3 million units, down 0.7% from last month but up 7.4% compared to this time last year. As demonstrated by a second consecutive single-digit year-over-year improvement, the industry continues to grow slower than the double-digit percent increases seen from March to September.

Munger Games: Charlie Munger’s Legacy

And His Common Sense Approach to Business and Investing

This week, we step aside from our usual musings on valuation trends in the RIA industry to honor the late Berkshire Hathaway Vice Chairman with our thoughts on some of his famous quotes (that might be relevant to you and your clients).

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of November 17, 2023

Bank Watch: December 2023

In this issue: Bank M&A 2023—Subdued But Potentially Explosive

Issue No. 12 | Data as of Year-End 2023

Featured Articles: No Soup for You: Customer Lifetime Value and Brand Loyalty in the Auto Industry and Q4 2023 Earnings Calls

Return to Status Quo or a New Normal?

Auto Leasing Trend Update

Consumers are typically faced with two options when considering their next vehicle transaction at the dealership: buying an automobile or leasing one.

It’s Getting Real(ized)

Rising rates have driven unrealized losses in bank bond portfolios, prompting some banks to restructure securities to boost yields, margins, and long-term earnings despite near-term capital impacts.

Key Takeaways for Auto Dealers from the 2023 AICPA Dealership Conference

Last month, we attended the 2023 AICPA Dealership conference and in this post present key takeaways from two sessions that are of interest to our blog readers: “Driving Success in Auto Retail” and “The Electrification of Auto Retail.”Key Takeaways: "Driving Success in Auto Retail " Session This session was presented in the form of a conversation between Alan Haig of Haig Partners and Daryl Kenningham, CEO of Group 1 Automotive. Group 1 Automotive owns approximately 205 auto dealerships in the United States and the United Kingdom and boasts approximately $16 billion in annual revenues. They specifically own 150 auto dealerships in the United States, with headquarters and a high concentration of dealerships in the Houston, Texas market. (For information on other publicly traded auto dealers, see our ongoing blog series featuring profiles on Asbury Automotive Group, Auto Nation, Sonic Automotive, and Lithia Motors.)Here are the key takeaways for our readers.The Service Experience for Tesla Consumers May Not Be OptimalWhile Tesla consumers have loved the direct sales model buying experience, they have not enjoyed the service experience. As we’ve discussed, franchised auto dealers have implemented elements of the direct sales model through digital/online platforms. Unlike Tesla, franchised auto dealers have physical locations near their customer bases and are more equipped to provide ongoing service for the life of their vehicles.There Is a Used Car ShortageWith more focus on the shortage of new vehicles produced in the last three years caused by the pandemic and microchip shortage, the shortage of used vehicles hasn’t been as widely discussed. Fewer new vehicles sold leads to fewer trade-ins, which leads to fewer used vehicles for sale. Mr. Kenningham estimated that 8 million fewer used cars are available in the system even though approximately 40 million used vehicles trade hands annually. Also contributing to the system’s shortage of used vehicles are consumers maintaining their current vehicles longer, fewer new units available, as well as affordability issues.There Is a Technician ShortageGroup 1 and other auto groups have countered the lack of skilled technicians in the workforce by gradually raising labor rates. While this strategy has been effective, it has led to costlier repairs on average and, eventually, a ceiling on these increased rates. Mr. Kenningham estimated that an empty service bay would cost the company $17,000 in gross profit each month.It Is Hard to Retain a Service Department CustomerMr. Kenningham estimated that Group 1 and other franchised auto dealers only retain approximately 2/3 of service customers from new vehicles they sell directly. The Service Department is one of the higher margin segments in the auto dealership business model; therefore, it’s important for dealers to try to retain more ongoing service work for their current customers. While oil changes and tire rotations are not very profitable to auto dealers, they provide frequent/additional opportunities for the auto dealer to service the customer.Younger Customers Are Not Loyal CustomersYounger customers are more inclined to seek out the purchase of a new automobile on a digital platform because of the comfort of making material purchases in that format. However, younger customers tend to be less loyal in the long run, so auto dealers must strike a balance in their sales offering methods to the customers.The 3 Things Dealers Should Focus OnConsistent with these trends and observations, Mr. Kenningham listed three things that auto dealers should focus on in the future:Invest in technology,Invest in customers, andDrive scale into all elements of your business model.Key Takeaways: "The Electrification of Auto Retail – 2023 Update" SessionThis presentation by Capital Automotive provided a snapshot of the current landscape for the electric vehicle (EV) market as well as a comparison of industry conditions and headwinds in 2021 versus 2023. Specifically, the headwinds in 2021 were cost parity to traditional internal combustion engine (ICE) vehicles, consumer adoption/demand, and the charging network. These headwinds primarily still exist in today’s environment.Affordability and Value Retention Are a Question MarkThe following graph from information provided by Cox Automotive details the average new and used price trends from battery electric vehicles (BEVs): Source: Cox AutomotiveClick here to expand the image aboveIn September 2023, the average transaction price for a new BEV totaled $55,436 compared to the $47,899 average transaction price for all new vehicles (Cox Automotive). For used vehicles, the average transaction price for BEVs was $41,630 compared to $28,935 for all used vehicles (Edmunds).In addition to higher transaction prices, the six BEV models in the following graph are projected to lose 25%-42% of their value five years after purchase. This may seem like a high percentage, but for comparison, Capital Automotive noted that an iPhone 11 lost ~75% of its value five years after purchase. Sources: AAA, AppleClick here to expand the image aboveFinally, Capital Automotive provided two other views of the affordability of BEVs/EVs. The first data point examined the cost of ownership of an F150 Platinum Truck (ICE) versus an F150 Lightning (BEV) comparing the cost of fuel, average insurance premiums, fees & taxes, interest financing, repairs & maintenance, and depreciation. The BEV (F150 Lightning) was 21% more expensive to own (by ~$4,000) than the ICE (F150 Platinum Truck) even though the BEV had lower fuel and repairs & maintenance costs.The second data point offered by Capital Automotive related to the cost of 2024 BEV models. According to Car & Driver, CNET, Kelly Blue Book, and U.S. News, 20 new BEV models are being introduced to the market in 2024. Only five of those models (Cadillac Celestiq, Chevy Equinox EV, Fiat 500e, Honda Prologue, and Volvo EX30) will be offered at prices below the average transaction price for all new vehicles.Consumer Demand Has Grown But ...Based on the statistics of U.S. new light vehicle sales, the EV unit’s share of the market is 8.6% as of June 2023, according to Automotive News. While this figure remains a small percentage of the overall market, it has grown from a meager 0.1% in just six and a half years.Another way to view consumer demand is in inventory levels, as seen in the graph below presented by Capital Automotive. Source: Axios, CarEdge, Seeking AlphaClick here to expand the image aboveOther than Chevrolet and Cadillac, EVs’ average days’ supply and inventory levels are higher than traditional ICE vehicles for all other manufacturers listed above. Dealers have plenty of EV inventory on their lots, but the pricier EV models are not selling as quickly and are beginning to pile up.The states with the fastest EV adopters are mostly in the west and northwest (California, Washington, Oregon, Nevada, Arizona, and Colorado). The states with the slowest EV adopters represent more of the country's rural areas (Wyoming, Iowa, Arkansas, Mississippi, South Dakota, North Dakota, and West Virginia).Charging Infrastructure Is Not SufficientThe specific needs of EVs, such as charging levels and requirements and infrastructure investments, are well-known in the industry. Additional challenges have been presented by fires caused by the combustion of lithium batteries in EVs in apartment buildings, airport parking garages, and cargo ships. According to a 2023 Electrical Safety Foundation Survey, 50% of homes in the United States do not have electrical systems capable of the continuous load required for EV charging, and 54% of all homes would require an electrical panel upgrade to facilitate EV charging.ConclusionThe recent AICPA Dealerships conference provided a great forum to discuss current trends in the auto dealer industry and predictions for the future. It’s also informative to hear how individual dealerships are confronting their own unique challenges. All of these trends/factors will continue to impact the operations of dealerships and, ultimately, their profitability and valuation.Mercer Capital provides business valuation and financial advisory services, and our auto team assists dealers, their partners, and family members to understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your auto dealership.

Evaluating Your Firm’s Margin

In the investment management world, evaluating a firm’s margin isn’t as simple as “more is better.” For RIAs, margin reflects efficiency, but it also reflects the firm’s tradeoffs with compensation. Investment management is a talent business, and striking the right balance between margin and employee compensation that allows the firm to attract, retain, and incentivize talent is critical to an RIA’s success.

Themes from Q3 Energy Earnings Calls-Part 2: Oilfield Service Companies

Themes from Q3 2023 Energy Earnings Calls

Part 2: Oilfield Service (“OFS”) Companies

In our most recent earnings call blog post, Themes from Q3 2023 Earnings Calls, Part 1 Upstream, prevalent themes from E&P companies included discussions about consolidation in the industry, a focus on efficiency of operations, and strong production volumes throughout 2023. This week, we focus on the key takeaways from OFS operators’ Q3 2023 earnings call.

Themes from Q3 2023 Energy Earnings Calls

Part 1: Upstream

In Themes from Q2 2023 Energy Earnings Calls, we noted E&P operators’ search for ways to maintain production levels, expectations for low crude oil inventories, and decreased activity in the Haynesville shale region. This week, we focus on the key takeaways from Upstream Q3 2023 earnings calls.

Speed, Velocity, and Momentum

The Best Measure of RIA Success

Market performance gives you speed. Employee performance gives you velocity. Practice management gives you momentum. If you want to be successful, focus on building momentum.

October 2023 SAAR

The October 2023 SAAR was 15.5 million units, down 1.2% from last month but up 5.6% compared to this time last year. As we predicted in last month’s SAAR blog, this month officially marks the end of a seven-month streak of consecutive double-digit year-over-year improvements in the SAAR. While we do expect to see double-digit improvements pop up over the next few months, the end of this streak is a reminder that the industry has been on the path to recovery for some time now and is slowing down to a more normalized, sustainable level.

Newly Released: Auto Dealer Video Series

In each episode of the 12-part series, you'll find practical advice, expert insights, and real-world examples created especially for any auto dealer looking to navigate the complexities of valuations and succession planning successfully. We hope you enjoy!

D CEO's 2023 Energy Awards

This past week, Mercer Capital was a part of D CEO’s 2023 Energy Awards—a fantastic event that celebrates the energy industry, transactions, and individuals that impact the Dallas Fort Worth Metroplex. Major players such as Energy Transfer Partners, Exxon, and Denbury were honored or noted. However, broader reaches of the industry were also recognized, such as private equity and royalty companies.

Can Active Management Survive a Bear Market?

Moving forward, we expect some active managers to improve their competitive positioning but aren’t ignoring what the market is telling us about the outlook for these businesses – it’s probably going to get worse before it gets better.

Bank Watch: November 2023

In this issue: It’s Getting Real(ized)

Specialty Finance M&A

Acquiring a specialty finance company comes with a unique set of hurdles, different than acquiring a bank.

Consolidation in the RIA Industry?

A Look at Record-Pace RIA Acquisition

Time will tell if the RIA industry sees the same level of consolidation as we’ve seen in the banking industry. But at least in the near term, the number of RIA firms appears poised to continue growing as the supply of new firms more than offsets a significant level of M&A activity.

Just Released | 3Q23 Exploration & Production Newsletter

Third Quarter 2023 | Regional Focus: Appalachian Basin

Mercer Capital’s Value Focus: Exploration & Production newsletter provides an overview of the industry through supply and demand analysis, commodity pricing, and public market performance. In addition, each issue of this quarterly newsletter focuses on a region, including Eagle Ford, Permian, Bakken, and Appalachia, examining general economic and industry trends. Appalachian production fared well over the last year, particularly considering the sharp decline in the Henry Hub price. Despite the Henry Hub decline, the Appalachian rig count decline was less than that of two of the three oil-rich basins presented, largely due to Appalachia’s higher production declines, which require a higher rig count to maintain production levels.Exploration & ProductionThird Quarter 2023Region Focus: Appalachian BasinDownload Newsletter

Dealership Working Capital

A Cautionary Tale Against Rigid Comparisons

Opportunities for Ownership Succession in the Beer Wholesaler Industry

For those wholesalers contemplating succession, now is the time to act.

Energy Values Take Hits….And Keep Moving Forward

The famous philosopher Rocky Balboa once said: “It ain’t about how hard you can hit. It’s about how hard you can get hit and keep moving forward.”Amid mixed signals, Middle East conflict, rising inflation, rising interest rates, political and regulatory headwinds, and other factors the oil and gas industry continues to perform and cycle upwards. For the year to date, the S&P Oil and Gas Exploration & Production Select Industry Index has gone up over 7%. For the past three years, the index has had an annualized return of over 48%. TheS&P 500 has only a 7% annualized return itself over the past three years. It’s a marked change from the decade-long dry spell the industry had, particularly in 2014 and 2015. In a time where numerous things could dampen demand, prices, profits, and valuations the industry continues an upward trend. In addition, some defensive posturing that the industry has taken in recent years may pay off in ways that were not immediately obvious. Capital discipline, low debt, and improved technology have helped set the stage for the current conditions which should allow oil and gas producers to keep moving forward.Capital Discipline & DeleveragingOil prices have continued to be relatively strong for nearly two years now, rarely dropping below $70, sometimes topping $100, and averaging closer to $80. This is a far cry from the years and years of $50 oil (or less). More on that later. However, amid that strength of sustained higher commodity prices and the corresponding profitable drilling locations, rig counts have dropped year over year according to Baker HughesBHI0.0%. My Forbes colleague David Blackmon wrote about this a few weeks ago. The urge to drill with every available resource remains constrained, which is not how operators behaved in past cycles. The focus on returns and value creation appears to have overruled growth, and in addition, some of this may be coming from the continually rising costs to drill and complete wells according to the latest Dallas Fed Energy Survey, alongside a tight labor market. Additionally, technology continues to incrementally improve and increase efficiency of recovery at the well level, which helps productivity per rig.Another form of capital discipline has been the continual deleveraging trend. I have written on this before, but not in this interest rate environment. As the cost of debt capital goes up, the industry’s deleveraging will have another silver lining: directing more operating profits to shareholders instead of bankers. Operating decisions at many companies will be less immune to upward interest rate pressures or refinancing risks. On top of that – bankers often require companies to hedge large portions of their production to ensure downside protection for their debt. However, the trade-off companies make is that they also often give away some (or a lot) of upside commodity price potential. This is less of a problem when debt loads are low. Lastly, on this front, bankers are not the only capital source that has been reticent to supply new money to the industry. Equity investors have desired to do more harvesting than planting in the oil and gas sector, thus there has been less capital available to aggressively pursue drilling plans.Higher Forecasts For Commodity PricesThat’s not to say that drilling plans do not look good right now. They do. Not only are oil prices above $80 now, but the tail of the futures curve suggests prices above $60 as far out as 2029. Fed Energy Survey participants agree — prices should be buoyant into the intermediate future. This is arguably more important to management teams as they marshal resources for long-term projects. Dan Pickering of Pickering Energy Partners thinks oil will be around $80 in 2027 and that the upcycle will be continuing. Part of this is fueled by prior and continuing investments in oil and gas pipelines in the past several years and LNG infrastructure. The cheaper access to markets has helped to manage constrained or stranded supply (particularly gas). At the same time, the conceptual rationale for pricing is particularly circular. Constrained capital discipline will slow supply growth to match demand and vice versa, but there are other factors as well – more global ones on the supply-demand seesaw.Global ProductionThe global market is a little more unstable, but events more recent in Israel and in the Russian/Ukrainian war have had more muted effects on the global supply of oil than otherwise might be thought. While European sanctions on Russian gas appear to have been effective, Russian oil has found its way to other markets. This has helped to limit price shocks. (Side question: what might happen if Venezuela remounted its petroleum horse again?)However, as the shale revolution matures and Tier 1 drilling locations shrink, it will get harder to maintain and grow supply compared to demand. Now this could balance out in future years as demographics age and world population potentially slows and shifts. Nonetheless, one factor that could change the equation back to a more aggressive drilling posture is that oil will probably peak again in the next 20 years. As such, exploration will come back into the conversation as fields mature and declines increase. Even the Biden Administration relented on some offshore drilling leases, albeit minimally.What this means for energy valuations is that the upswing over the past few years does not appear to be peaking anytime soon. While there will be winners (most likely larger operators) and losers (most likely smaller operators), the sector’s overall value continues to move forward.Originally appeared on Forbes.com.

Just Released: Mid-Year 2023 Auto Dealer Industry Newsletter

We are pleased to release our latest edition of Value Focus: Auto Dealer Industry Newsletter.

Alt Managers Race Ahead

A Resurgent Year for Investment Management Firms

Alternative asset managers fared particularly well during favorable market conditions for the RIA sector. Over the past year, all categories of RIAs have experienced growth as the market has rebounded from its Q3 2022 trough. Alternative asset managers and RIA aggregators both outperformed the S&P 500 with gains of 44% and 28% over the past year. However, traditional asset managers trailed the S&P 500 with gains of 13%. RIAs have directly benefited from improved market conditions, which have boosted assets under management ("AUM").

RIA M&A Update: 3Q 2023

Although inflation has begun to subside and the stock market has rallied after a turbulent start to 2023, elevated interest rates and macroeconomic uncertainty have contributed to a leveling off of deal volume so far in 2023.

Now Available: Mercer Capital's 2023 Energy Purchase Price Allocation Study

The 2023 Energy Purchase Price Allocation Study provides a detailed analysis and overview of valuation and accounting trends in these sub-sectors of the energy space. This study also enables key users and preparers of financial statements to better understand the asset mix, valuation methods, and useful life trends in the energy space as they pertain to business combinations under ASC 805 and GAAP fair value standards under ASC 820. We utilized transactions that closed and reported their purchase allocation data in calendar year 2022.

September 2023 SAAR

The September 2023 SAAR was 15.7 million units, up 2.1% from last month and up 14.9% compared to this time last year. This month’s data holds true to the ongoing trend of double-digit year-over-year improvements. Altogether, this month marks the fourteenth straight month of year-over-year improvements in the SAAR.

Q3 2023: Alts Take the Lead as Other RIAs Lose Traction

Market Uncertainty and Fee Compression Trends Lead Investors to Take an Alternative Approach to RIA Investing

Share prices for most publicly traded asset and wealth management firms trended in line with the steady decrease in the broader market during Q3 2023. Alternative asset managers were a notable exception to this trend, ending the quarter up about 10%.

Leading America Toward Energy Independence

Hart Energy LIVE’s America’s Natural Gas Conference 2023

Last week, I attended Hart Energy LIVE’s second annual America’s Natural Gas conference in Houston. The speaker roster included CEOs of companies operating in the Utica (Encino Energy) and Haynesville shales (Rockcliff Energy) and Green River basin (PureWest Energy), investment bankers, private equity investors, and consultants, among others. CO2 emissions reduction, demand for LNG exports despite inadequate transportation and storage infrastructure, and the energy transition were three of the more prevalent themes discussed. Below are a few highlights I would like to share with you.

United Auto Workers Strike

What It Means for Auto Dealers

Rising wages for automakers will ultimately raise MSRP, though as noted above, this was a likely outcome regardless of the strikes due to the larger share of profit realized by auto dealers in the past few years. A drawn-out strike would reduce vehicle availability, but with relatively higher Days’ Supply, domestic dealers can weather the storm if they can successfully steer consumers toward models that are in greater supply. If not, other brands stand to benefit from increased market share.

Coming Off the COVID Wave

Q3 2023

We’re sitting most of the way through 2023 at this point, and we are continuing to live in interesting times. The shipping frenzy brought on by the COVID-19 pandemic has run its course and the industry is returning to more normal levels. At the same time though, it is important to note that a decline from never-before-seen highs does not necessarily indicate a freight recession is underway. Many of the year-over-year data points will indicated large declines, but on a quarterly or monthly basis, the data is much more stable.

Bank Watch: October 2023

In this issue: Specialty Finance M&A

Medtech and Device Industry Newsletter - Q4 2023

E&P Fourth Quarter 2023

Haynesville

Haynesville // Haynesville production held-up reasonably well during the 2023 review period, particularly considering the sharp fall-off in the basin’s rig count.

Transportation & Logistics Newsletter

Fourth Quarter 2023

A variety of pandemic-related and regulatory issues resulted in long delays at California ports, the traditional import location for the majority of goods from East Asia. Many carriers shifted their import handling to East Coast ports – with the port of Savannah being one of the biggest winners.

A Shortcut for Tax Savings

Charitable Giving Prior to a Business Sale Yields Big Results

In this week's post, we offer a quick overview of the tax strategy that charitable RIA owners ought to keep in mind when selling their firm (and don't forget RIA clients' selling businesses as well!).

This Interest Rate Environment Done Got Old

This article covers some implications of a higher-for-longer rate environment.

Appalachian Production Marches on Despite Henry Hub Plunge

The economics of oil & gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. This quarter, we take a closer look at the Marcellus and Utica shales.

5 Takeaways from the Association of Trust Organizations' (ATO) 2023 Annual Meeting

Earlier this week, ATO held its annual meeting at the Ritz Carlton in New Orleans to discuss a variety of topics relevant to independent trust companies, including the impact of AI, M&A and financial performance trends, and best practices for evaluating prospects. As a sponsor of this year's conference, here are our main takeaways from the meeting:

Inside the Board Rooms of a $5.4 Billion Oil and Gas Merger

In a departure from our typical analysis and discussion of recent deals, this week’s Energy Valuation Insights blog takes a break from deal multiples and observes the negotiations of the $5.4 billion merger between Sitio Royalties Corp. (“Sitio”), a player in the Marcellus Shale, and Brigham Minerals, Inc. (“Brigham”).

What’s Driving RIA M&A?

We first wrote about borrowing costs for RIA consolidators late last year, shortly after the Fed’s aggressive hiking cycle led to an abrupt spike in interest rates for virtually all borrowers. Since then, borrowing costs for RIA acquirers have remained roughly flat but at a level significantly elevated from 18 months ago.

Do You Know How Much Your Dealership Is Worth?

Whitepaper: Understand the Value of Your Auto Dealership

August 2023 SAAR

The August 2023 SAAR was 15.0 million units, down 4.5% from last month but 13.6% higher than August 2022’s figure. This month’s data holds true to the ongoing trend of considerable year-over-year improvements that have remained strong throughout the year. In fact, this month marks the thirteenth straight month of year-over-year improvements in the SAAR.

Where Is RIA Dealmaking Headed?

Matt Crow Interviewed for Barron’s Advisor Podcast

Steve Sanduski sat down with Matt Crow to talk about the state of the RIA industry for Steve’s Barron’s Advisor Podcast. In the episode, Steve and Matt explore the main drivers of the recent M&A environment for RIAs, the pros and cons of consolidation, and when selling to a consolidator makes sense instead of pursuing internal succession.

What Can We Make of Goldman’s Brief Foray into the Mass Affluent Space?

It seems unlikely that Goldman Sachs intended to own United Capital’s mass affluent business for only four years after its $750 million purchase in 2019.

Themes from Q2 2023 Energy Earnings Calls-Part 2: Oilfield Service Companies

Themes from Q2 2023 Earnings Calls

Part 2: Oilfield Service (“OFS”) Companies

This week, we focus on the key takeaways from OFS operators’ Q2 2023 earnings call.

September 2023 | This Interest Rate Environment Done Got Old

Bank Watch: September 2023

In this issue: This Interest Rate Environment Done Got Old

2023 Core Deposit Intangibles Update

Although deal activity has been slow, we have seen an obvious uptick in core deposit intangible values relative to this time last year.

Q2 2023 Earnings Calls

Lower New Vehicle Supply Boost Fails to Lift Profits; Used Vehicle Prices Drop Amid High Demand

Reviewing earnings calls from executives of the six publicly traded auto dealers, new vehicle gross profit declined as inventory availability improved, though the decline in profitability was less than anticipated. While unit-level profitability is anticipated to continue to decline, there are signs of strength in consumer demand. Despite affordability issues, the market is anticipated to remain structurally above pre-pandemic levels.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of August 21, 2023

Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership.Due to a variety of corporate structures (including master limited partnerships and Up-Cs) and complex capital structures (including preferred equity and non-traded common units), mineral aggregator enterprise values pulled from databases are often missing meaningful components of value, leading to skewed valuation multiples.Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis.Mineral Aggregator Valuation Multiples StudyMarket Data as of August 21, 2023Download Study

Unpacking Your RIA’s Income Statement

Performance Measurement Is More than Profits and Losses

The goal of this exercise should be to view the financial performance of an RIA from a strategic perspective rather than the generic and mostly unhelpful lens of GAAP. Revenue for an investment management platform is not simply a “sales” number that stands on its own merits but a function of business model efficiency, value to the market, and business mix. GAAP wants to depict every cost on an RIA’s income statement as operating expenses, but industry participants know that compensation policy carries very different implications for the growth and returns of the company than the copier lease or occupancy costs.

Succession Planning: RIAs Have Options

Themes from Q2 2023 Earnings Calls

Part 1: Upstream

In Part 1: Upstream themes from Q1 2023 Earnings Calls, notable themes included a divide on whether dividends or buybacks are the best means to return capital to shareholders and management’s reactions to a decline in strip prices, as well as highlighting inventory in the favorable Permian and Eagle Ford plays. This week, we focus on the key takeaways from Upstream Q2 2023 earnings calls.

Driving Value: Key Components of an Auto Dealership Valuation

Like most business owners, auto dealers are likely always curious about what their dealership might be worth. While there are many times they may want to know, there are life events that make them need to know the value, such as a transaction (including buy-sell), litigation, divorce, wealth transfer, etc. While valuations tend to be performed infrequently around these events, dealers can evaluate their business and improve its value by understanding and consistently focusing on the value drivers of their auto dealership.

A Little Less Conversation, A Little More Compensation

Compensation Structures for Investment Management Firms Whitepaper

Attached is a whitepaper that we update periodically on the topic of compensation structures for RIAs.

Industry Expert vs. Valuation Expert: Which Should You Choose?

In the complex world of the oil & gas industry, a nuanced understanding of industry intricacies and valuation principles is vital. While it's common to find specialists in either industry knowledge or valuation methods, a complete solution requires a synergy of both these domains. In this article, we explore the unique benefits of both industry and valuation experts before delving into why a firm with expertise in both these areas is the best choice for oil & gas industry companies.The Case for an Industry ExpertChoosing an industry expert to value your oil & gas company has several distinct benefits that stem from a deep understanding of the sector's unique dynamics, trends, and complexities. Here's a breakdown of some of the key advantages.Long-Time Analysts of the Oil & Gas IndustryIndustry experts are veterans in analyzing the oil & gas sector, employing years of observation and insight to interpret trends and make accurate predictions. They have an intimate understanding of the factors affecting the oil & gas sector, including regulatory changes, technological advancements, market demand, geopolitical influences, and environmental considerations. Industry experts are often well-versed in current market trends, including supply and demand dynamics, price fluctuations, and competitor strategies.Understanding of Industry Concepts and TerminologyTheir grasp of specific oil & gas terminology and concepts ensures that the valuation process is more tailored and precise. They know what factors to consider and how these factors interplay within the context of the industry.Writing/Speaking about Industry TrendsWith a thorough knowledge of the industry's evolution, these experts can provide invaluable insights and analysis on emerging trends.Transaction ExperienceIndustry experts have hands-on experience in dealing with transactions within the oil & gas sector, including with upstream E&Ps, JVs, Partnerships, and LLCs.Advisory ServicesIndustry experts are often sought to provide advisory services and are attuned to the market as typical acquirers and divestors of assets, entities, and interests in the oil & gas industry.Enhanced CredibilityFinally, an industry expert's valuation may carry more weight with stakeholders and regulatory authorities due to their specialized knowledge and experience in the oil & gas field. It reflects a deep understanding of the unique attributes of the industry.The Case for a Valuation ExpertSelecting a valuation expert to assess your oil & gas company brings a distinct set of advantages rooted in their specialized training, adherence to recognized standards, and a focused approach to valuation. Here are the key benefits.Training, Professional Designations, and Valuation StandardsWith specialized training and professional certifications, valuation experts bring credibility and expertise to the valuation process, adding confidence for stakeholders, investors, and regulators. In addition, valuation experts are trained in internationally recognized standards and methodologies. This ensures that the valuation is consistent, transparent, and in compliance with legal and regulatory requirements.Objective PerspectiveValuation experts approach the market as hypothetical buyers and sellers, providing an unbiased and objective perspective. This helps in creating a fair and neutral valuation that can withstand scrutiny.Expertise in Valuing Minority InterestsValuation experts have specialized skills in valuing minority interests, ensuring a fair and comprehensive understanding of all ownership stakes within the company.Advising on Buy-Sell AgreementsValuation experts can provide critical insights into contractual agreements that dictate the buying and selling of ownership interests.Defense in Litigated MattersValuation experts have experience in defending their work in litigated matters. If the valuation were ever challenged in court, their expertise could be instrumental in upholding the assessment.Handle Recurring Tax and/or Valuation WorkValuation experts can handle regular tax and valuation work, providing consistency and continuity, and ensuring ongoing compliance with tax laws and regulations.Cross-Industry KnowledgeValuation experts often have experience across various industries, allowing them to bring a broader perspective to the valuation. They can apply lessons and insights from other sectors to the unique context of the oil & gas industry.Why You Need BothThe best solution for an oil & gas company is to employ a firm that combines the experience and insights of both an industry and valuation expert. While industry experts bring the contextual understanding and transaction experience, valuation experts provide the specialized valuation skills that ensure accuracy and compliance with legal standards.The Mercer Capital ExampleMercer Capital, organized according to industry specialization, stands as a prime example of a firm embracing both these crucial elements:Industry Specialization: Our energy team has an extensive specialty oil & gas background, experience, and training. We've worked with operating entities, assets, and joint ventures throughout all phases of commodity price cycles.Recognition: Writing and speaking regularly on industry topics through channels like Forbes.com & Hart Energy, Mercer Capital has gained a reputation as a thought leader.Expert Valuations: Our firm has provided expert valuation opinions to over 15,000 clients across the globe, upheld by court jurisdictions and regulatory bodies like the IRS & PCAOB.Leadership: Actively leading in the valuation profession, Mercer Capital offers training to other professionals within the valuation, accounting, and legal communities.Global Reach: Our international experience spans Europe, the Middle East, South America, and nearly every major domestic basin and play. Through a unique combination of industry expertise and valuation specialization, Mercer Capital offers a holistic approach that caters to the multifaceted needs of the oil & gas sector, positioning itself as a preferred partner in this dynamic industry. Contact one of our professionals to discuss your valuation issue in confidence.

July 2023 SAAR

The July 2023 SAAR was 15.7 million units, almost exactly in line with last month’s SAAR but 18.2% higher than July 2022’s figure. This month’s data holds true to the ongoing trend of considerable year-over-year improvements that have remained strong as the year goes on. In fact, this month is the twelfth straight month of year-over-year improvements in the SAAR, marking a full year of rising tides in auto sales volumes.

Value Focus | Exploration & Production

Second Quarter 2023 | Region Focus: Permian

Mercer Capital’s Value Focus: Exploration & Production newsletter provides an overview of the industry through supply and demand analysis, commodity pricing, and public market performance. In addition, each issue of this quarterly newsletter focuses on a region, including Eagle Ford, Permian, Bakken, and Appalachia, examining general economic and industry trends. In this quarter's newsletter we focus on the Permian. Production growth over the past year continued to run well in the Permian, ahead of growth in the Eagle Ford, Appalachian, and Bakken, as the Permian basin remains one of the most economic regions for U.S. energy production. With the decline in commodity prices over the past year, rig counts fell, with the most significant decline occurring in May. With E&P firms expecting continued cost increases through the remainder of 2023, the Permian’s existing cost advantage will contribute to its continued dominance over the major U.S. basins.Exploration & ProductionSecond Quarter 2023Region Focus: PermianDownload Newsletter

Toyota’s Steady State Battery

Breakthrough or Yet Another Long-Dated Production Target?

In early July, Financial Times reported Toyota’s solid-state battery breakthrough. According to Keiji Kaita, president of Toyota’s research and development center for carbon neutrality, the goal is to cut the size, weight, and cost of both liquid and solid-state batteries in half. In this post, we get into the details of this report, what auto dealers should know about solid-state batteries, and provide some context for realistic expectations. For consumers, we don’t recommend delaying your vehicle purchase by four years based on this news.

Compensation Structures for RIAs

Part II

A well-structured equity incentive plan is accretive to existing shareholders, not dilutive. Some of the more common equity-incentive plans are discussed in this post.

August 2023 | 2023 Core Deposit Intangibles Update

Bank Watch: August 2023

In this issue: 2023 Core Deposit Intangibles Update

Exxon’s Acquisition of Denbury

A Tale of Two Businesses, and Neither One Is Worth $4.9 Billion

ExxonMobil made waves in the energy M&A markets by announcing its acquisition of Denbury, Inc. Exxon paid somewhere between Denbury’s stock price and a slight premium depending on the timing and stock price fluctuations. In total, the headline value was around $4.9 billion, according to Exxon’s news release.However, while Denbury is an energy company on the whole, it is made up of two main segments that have very different economics. First, its carbon capture utilization and storage segment (CCUS). Second, its upstream enhanced oil recovery segment. These two businesses, in many ways, represent Denbury’s journey over the last several years that have one foot in the carbon future and one foot in the oily past. Neither of their business segments appears to be worth the $4.9 billion price tag. So what did Exxon buy exactly, and how might one value it?A quick look at some of the overall implied metrics related to the deal reveals some oddities compared to pure-play oil companies. As to CCUS transactions, there really have not been many to compare to, and certainly not at the scale that Denbury has achieved thus far. The table below was compiled based on figures from the announcement and Capital IQ data. Just looking at the implied values relating to upstream multiples, the flowing barrel metric jumps out as high compared to most operators, especially with an EBITDA margin below 55%. This implies a higher multiple than much larger global companies such as BP, ConocoPhillips, and Occidental Petroleum—which does not make intuitive sense. On the other side of the equation, the value per mile of pipeline appears relatively high at first glance. This is considering management’s recent earnings call comments about construction costs being between $2 to $4 million per mile, coupled with the fact that the pipelines are not fully utilized yet. There clearly is a mix of segment-made contributions that drive different elements of the overall transaction price.Denbury’s CCUS business represents the future of Denbury and embodies the key rationale for Exxon’s interest. Denbury has touted this segment, and most of its marketing, to investors centers on this aspect of its business. Its enthusiasm is apparent as its annual report spent almost all its focus on this area of the business. CCUS does represent a synergistic operational advantage for the company because Denbury has been one of the few upstream companies focusing on older, depleted fields that have lost what the industry calls “natural drive” and thus require incremental efforts to bring oil to the surface. Denbury’s solution to this challenge for a long time has been to inject its CO2 into the fields to create pressure and stimulate oil production.However, the business model for a standalone CCUS business model is still relatively nascent, requiring hundreds of millions of dollars of investment and years before it could potentially reach cash flow sustainability separate from oil production activities. There’s already much in place now with 1,300 miles of pipeline and ten onshore sequestration sites, which was attractive to Exxon. However, things like the growth of offtake agreements, Section 45Q tax incentives (which I wrote about last year), and carbon storage contracts are not expected to generate net positive income for Denbury until several years in the future. Nonetheless, this developmental potential and strategic location in the Gulf region have significantly contributed to Denbury’s stock price and Exxon’s interest. How much the CCUS is contributing to Denbury’s value is uncertain. But in an interesting article published a few days ago, Hart Energy interviewed Andrew Dittmar, a Director at Enverus, who estimated that (effectively) about 62% of Denbury’s value was based on their CCUS business. In the meantime, Denbury’s upstream enhanced oil recovery (EOR) business has been pulling the income statement’s performance along. Nearly all profits for Denbury are generated through this business line. However, compared to other public upstream companies, Denbury’s profitability is comparably lower, production is smaller, and production costs are higher. This is not a recipe for high comparative valuations, certainly not over $100 thousand per flowing barrel, which only the likes of Exxon and Chevron imply. (While we’re on the topic of segments, it is not a clean comparison either since Exxon and Chevron are two integrated companies with many segments that contribute to their values too). Denbury is primarily a regional oil producer with less than 50 thousand barrels per day of production and EBITDA margins lower than many public oil companies. To its credit, Denbury does have lower decline rates than other companies due to the maturity of the fields they produce from. However, the flip side is that it costs $35-$39 per barrel to produce. Those are expensive lease operating costs when many companies operate somewhere in the teens per barrel. All that said, Enverus’s estimate in their Hart Energy interview was that the EOR business contributed about 38% of Denbury’s value. So, if Enverus’s analysis is to be applied here, that would put an adjusted value on Denbury’s production at around $39,000 per barrel and an adjusted value per pipeline mile of around $2.3 million. Take a look at these “adjusted” figures:Under this scenario, Denbury’s upstream business would potentially be slotted in with public regional upstream producers with characteristics closer to: (i) under 200 thousand barrels per day of production and (ii) EBITDAX margins under 60%. Companies like Chord Energy (a Bakken-focused producer), Callon Petroleum (a smaller Permian operator), or maybe even Enerplus (another Bakken-focused producer) come to mind. Additionally, the value per mile of pipeline drifts down to the lower end of the construction estimate range, which also appears to be more realistic. Of course, this value depends on commodity expectations, regulatory stability, and execution of Denbury’s plan. Exxon appears to be optimistic about it. Whether or not Denbury’s shareholders will be remains to be seen.Originally appeared on Forbes.com.

Compensation Structures for RIAs

Part I

Compensation models are the subject of significant handwringing for RIA principals—and for good reason. Out of all the decisions RIA principals need to make, compensation programs often have the single biggest impact on an RIA’s P&L and the financial lives of its employees and shareholders. The effects of an RIA’s compensation model are far-reaching, determining not only how compensation is allocated amongst employees but also how a firm’s earnings are split between shareholders and employees, what financial incentives employees have to grow the business, and what financial incentives are available to attract new employees and retain existing employees.Compensation models at RIAs tend to be idiosyncratic, reflecting each firm’s business model, ownership, and culture. In an ideal world, these compensation programs evolve purposefully over time in response to changes in the firm’s size, profitability, labor market conditions, and a variety of other factors. However, inertia is a powerful force: we often encounter compensation programs that made sense in the past but haven’t adapted to serve the firm’s changing needs as the business has grown in scale and complexity.Effective compensation programs need to change with the times, and the times have certainly changed. The RIA industry has seen tremendous growth over the last decade. As a result, firms today face increasingly complex compensation decisions that affect a growing list of stakeholders: outside shareholders, multiple generations of management, retiring partners, new partners, possible minority investors, and so on. On top of that, financial and labor market conditions have evolved dramatically over the last eighteen months, leading many RIAs to scrutinize their compensation models more than ever before.Introduction to RIA Compensation ModelsIt’s important to note at the outset what compensation models do and don’t do. Compensation models determine how the firm’s earnings are allocated; they don’t (directly) determine the amount of earnings to be allocated. When it comes to determining who gets what, it’s a fixed-sum game. The objective of an effective compensation policy is to allocate returns in such a way as to increase this sum over time.Compensation for RIAs can be broken down into three basic components, each of which serves different functions with respect to incentivizing, attracting, and retaining employees:Base Salary / Benefits. This is what an employee receives every two weeks or so. It’s fixed in nature and is paid regardless of firm or employee performance over the short term. On its own, base salary provides little incentive for employees to grow the value of the business over time.Variable Compensation / Bonus. In theory, variable compensation can be tied to specific metrics that the firm chooses or may be allocated on a discretionary basis. The amount of variable compensation paid to employees varies as a function of the chosen metric(s) or management’s qualitative analysis of an employee’s Variable compensation is also called at-risk compensation because all or part of it can be forfeited if target thresholds are not met. Variable compensation is most often paid out on an annual basis.Equity Compensation. Equity incentives serve an important function by aligning the interests of employees with those of the company and its shareholders. While base salary and annual variable compensation serve as shorter-term incentives, equity incentives serve to motivate employees to grow the value of the business over a longer period and play an important role in increasing an employee’s ties to the firm and promoting retention.Variable CompensationIn this blog post, we focus our attention on the variable compensation component (we’ll address the others in subsequent posts).Variable compensation plays an important role in incentivizing employees over the relatively short term (1-3 years). The evidence suggests that such incentives work, too. According to Schwab’s 2022 RIA Compensation Report, firms using performance-based incentive pay saw 28% greater AUM growth, 34% greater net asset flows, and 31% greater client growth over five years than firms without performance-based incentives.What Do You Want to Incentivize?As the name suggests, variable compensation changes as a function of some selected metric, typically revenue, profitability, or some other firm-level metric or individual-level metric, depending on the specific aspects that management intends to incentivize. Additionally, a qualitative assessment of employee performance across various areas may factor into variable compensation.In our experience, variable compensation pools tied to firm profitability and allocated amongst employees based on a combination of individual responsibilities and performance provide an effective incentive for most firms to grow the value of the business over time. Such structures tend to work well because linking variable comp to profitability creates a durable compensation mechanism that scales with the business and aligns the financial and risk management objectives of shareholders and management. Variable comp linked to profitability also promotes a cohesive team, rather than the individual silos that can arise out of revenue-based variable comp, which further helps to build the value of the enterprise.In market downturns, compensation mechanisms that directly link employee pay to firm profitability have the additional benefit of helping to blunt the impact of market conditions on firm profitability. Consider the example below, which shows the impact of a 10% AUM increase and a 10% AUM decrease for a hypothetical firm under two comp programs, one in which all compensation is fixed and the other in which there is a variable bonus pool equal to 20% of pre-bonus profitability.Click here to expand the image aboveIn this example, both compensation programs result in $4 million in EBITDA and an EBITDA margin of 24.6% in the base case scenario. In the downside scenario, however, the fixed comp structure leads to a high degree of operating leverage, and as a result, a 10% drop in AUM leads to a decline in EBITDA of over 40% and a decline in the EBITDA margin to 16.2%. Under the variable comp structure, the variable bonus pool helps to blunt the impact of declining AUM. In this example, a 10% decline in AUM results in a 32.5% decrease in EBITDA and a decline in the EBITDA margin to 18.5% under the variable comp program. In the upside scenario, the increase in EBITDA is greater under the fixed comp structure than under the variable comp structure (an increase of 40.6% vs 32.5%).From a shareholder perspective, a variable compensation program such as the one described above effectively transfers some of the risk equity holders bear to the firm’s employees. In downside scenarios, some of the decline in profitability that would otherwise accrue to shareholders is absorbed by employees. Similarly, some of the increase in profitability is allocated to employees in upside scenarios. The logic of such a compensation program is that employees are incentivized to grow and protect the same metric the shareholders care about—the firm’s profitability.ConclusionInvestment management is a talent business, and structuring an effective compensation program that allows the firm to attract, retain, and incentivize talent is critical to an RIA’s success. In future posts, we’ll address additional compensation considerations, such as equity compensation options and allocation processes.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.

Mid-Year 2023 Review of the Auto Dealer Industry by Metrics

Cooling Statistics, But Perspective Is Key

As the summer winds down and we turn the calendar to August, the first half of 2023 is fully in the rearview mirror, and mid-year statistics for the auto industry have been released. How has the industry performed, and what do the metrics tell us about the direction the industry is headed for the remainder of 2023? In this post, we discuss several key metrics that we have tracked in this space over the last several years: new vehicle profitability, the supply of new vehicles, average trade-in equity values of used vehicles, the used-to-new vehicle retail unit sales ratio, fleet sales, and vehicle miles traveled.

Trending: The Independent Trust Company

One of the most frequently ignored sectors in the wealth management industry may be its first cousin, the independent trust industry. While many still associate trust administration with banks, which still control more than 75% of the space, the growing prominence of independent trust companies is capturing the attention of many participants in the investment management community. In this post, we examine current trends impacting independent trust companies.

Tax Planning for Auto Dealerships

Why Auto Dealers Might Not Pay “Market” Rent

RIA M&A Update: 2Q 2023

Permian Production Growth Holds

June 2023 SAAR

Direct-to-Consumer Sales—Gaining Traction or Losing Their Footing?

The June SAAR was 15.7 million units, up 4.0% from last month and up 20.2% from June 2022. This June marks the 11th straight month of year-over-year improvements in the SAAR, and the magnitude of the improvements has continued to grow. As we laid out in last month’s SAAR blog, inventory levels were still dismal a year ago. The SAAR reported three straight months below 13.3 million units during June, July, and August of 2022. Inventory started to improve in August, and sales followed suit in September, sending the industry on the path to recovery. With this context in mind, we expect to see significant year-over-year increases in the SAAR for at least the next two months.

Q2 2023: RIAs Finish Strong Following June’s Bull Market

Steady Interest Rates Calm Investor Nerves, Boosting RIA Performance

Share prices for publicly traded asset and wealth management firms remained relatively stagnant for most of the first two months of Q2, tracking a broader market that struggled to find direction. In late May, however, the S&P 500 kicked off a summer rally that saw the index enter bull market territory in early June before continuing to notch an 8.3% gain for the quarter. This market uplift propelled AUM balances higher, and share prices for most categories of publicly traded asset and wealth management firms followed suit.

Bank Watch : July 2023

Bank Impairment Testing

E&P Third Quarter 2023

Appalachian Basin

Appalachian Basin // Appalachian production fared well over the last year, particularly considering the sharp decline in the Henry Hub price.

Transportation & Logistics Newsletter

Third Quarter 2023

Dust Off That Buy-Sell Agreement!

An Outdated Contract Is Hazardous to Your Wealth

One of the most exciting things in the vintage car world is when a classic model is “discovered” in a barn or a forest, or a field, covered in mud or dust or worse. Special because they’re untouched for decades, usually in original condition, and often with very little wear from use, these so-called “barn-finds” can sell for extraordinary sums at auction.Forgotten and ignored buy-sell agreements are also exciting, but usually not in a good way. Buy-sells tend to favor the business’s needs and the ownership’s thinking at a particular time. Decades later, the business has changed, the owners’ perspectives have matured, and the agreement—instead of being helpful—becomes a source of contention.Few RIA owners review their buy-sell agreements until something unexpected happensOur consistent experience is that few RIA owners review their buy-sell agreements until something unexpected happens. The partners argue over the future of the business. Someone gets divorced. Someone gets in trouble with the SEC. Someone dies suddenly. At that point, the buy-sell agreement goes from being a forgotten afterthought to the only thing on everyone’s mind. And, unfortunately, that one thing may be subject to interpretation.The biggest problem we see in shareholder agreements: pricing mechanisms.If a buy-sell is triggered and a 25% shareholder is to be redeemed, what’s the transaction price?The worst situations we’ve seen involved fixed-price agreements. Second to that, we’ve seen lots of problems with formula pricing.I probably don’t have to tell you what we think of formula pricing. Formula pricing has the benefit of simplicity, but simple isn’t always better.Is the formula a multiple of trailing, current, or forward earnings? Are appropriate multiples reflective of long-term averages, current market pricing, good times, bad times? Is the formula intended to generate a change of control value? To a financial buyer or a strategic buyer? Rational buyer looking for ROI or irrational buyer making a land grab? Pricing reflective of highly synergistic deal terms (use our vendors, sell our products, adopt our brand) or on a stand-alone basis? Sale of actual equity interests or a hybrid instrument that asymmetrically shares upside but protects the buyer against downside?In one situation, the agreement called for pricing an interest based on “prevailing market value.” What does that mean? Prevailing market conditions might work something like this:RIA with reported EBITDA of $5 million and adjusted EBITDA of $7 million when the LOI was drafted and reported EBITDA of $6 million and adjusted EBITDA of $8 million at the time of closing. Assume the firm sells for upfront consideration of $40 million plus the potential to get an additional $20 million in earnout if profits grow by 25% over three years. Based on this scenario, what’s the multiple? Is it:5x (upfront consideration as a multiple of adjusted EBITDA at closing)?6x (total possible consideration as a multiple of hurdle EBITDA at the time the earnout is paid)?7x (upfront consideration as a multiple of reported EBITDA at closing)?5x (total possible consideration as a multiple of adjusted EBITDA at closing)?8x (upfront consideration as a multiple of reported EBITDA at negotiation)?9x (total possible consideration as a multiple of adjusted EBITDA at negotiation)?10x (total possible consideration as a multiple of reported EBITDA at closing)?12x (total possible consideration relative to reported EBITDA when negotiated)?When people whisper deal multiples, they use the highest number possibleNaturally, the seller wants to believe they sold for 12x, and the buyer wants to tell his capital providers he paid 5x. It does no good to ask parties what multiple was paid. We find that when people whisper deal multiples, they use the highest number possible—in most cases, the maximum transaction proceeds possible as compared to a trailing measure of reported earnings. This serves the needs of all parties to the transaction. The seller gets to brag about what he was paid—and we all value psychological rewards. The investment banker brags about what a good job she did—and she probably did do a good job. And the buyer gets a reputation for paying up, so the potential sellers will return his call. All of this is good for the deal industry but not especially revealing as to valuation.Absent some reliance on formula pricing or headline metrics, you can hire an appraiser (like us), but even that’s complicated. Do you pick a valuation specialist or an industry expert? Valuation folks characteristically rely on projection models that might be more expressive of intrinsic value than market. That’s not me engaging in professional self-loathing—it’s just reality. Then there are industry experts—usually investment bankers—whose perspective leans heavily on the best deal they’ve heard of recently with a highly-motivated and over-capitalized buyer and a pristine target company with strategic relevance.If you hire a valuation expert with ample amounts of relevant industry experience (like us), you should get a balanced approach to the pricing of your transaction. But even the best resources out there (like us) have to deal with pricing expectations set long before we are involved. A buyer who wants something akin to intrinsic value and a seller who wants the highest bid imaginable will have a hard time coming to terms with the result of any valuation exercise. That situation is more common than not.I’ll offer two closing pieces of advice on crafting the valuation mechanism in your buy-sell agreement:Get your RIA valued on some kind of regular basis. If you have a smaller firm, a valuation every few years may suffice. If you have a larger firm, you might need it more than once per year. What this process offers, more than anything, is to manage expectations. The psychological bid/ask spread I describe above is much more narrow when the parties to an agreement are accustomed to seeing particular numbers, methodologies, and metrics used to determine the value of their interest. This is the main function of regular valuations. Buy-sell valuations are five-figure Buy-sell disputes are seven-figure catastrophes.Don’t draft your pricing mechanism to intentionally privilege either the buyer or seller at the expense of the other. We’ve seen estate situations where the company was compelled to redeem a 25% stake for about 45% of the value of the business. The resulting dilution to the remaining shareholders put a significant strain on the business model, ownership transition, and sustainability of the company. We’ve seen shareholder squeeze-outs where a group of shareholders was entitled to kick out a partner for minimal consideration. There’s no virtue in democracy when two lions and one lamb vote on what’s for dinner. Regardless of what you think your RIA is worth, if you aren’t intimately familiar with the terms of your buy-sell agreement, you don’t know what your interest in your RIA will net you in a transaction. Pull your agreement out, dust it off, and read it. If it seems at all confusing as to how it will function when the buy-sell mechanism is triggered, the reality will be worse than you expect.

M&A in the Permian

Acquisition Growth Flat Ahead of Expected Surge

Transaction activity in the Permian Basin remained flat over the past 12 months. The transaction count decreased slightly to 19 deals, a decline of two from the 21 deals that occurred over the prior 12-month period.

Net Interest Margin Trends for Banks Versus Credit Unions

The change in the median NIM from 1Q22-1Q23 is greater for banks versus credit unions (31 basis point expansion vs. 25 basis point expansion).Yields on earning assets expanded to a greater degree for banks versus credit unions from 1Q22-1Q23, which likely reflects a greater proportion of fixed rate loans for credit unions versus banks.The median yield on loans increased 87 bps for banks from 1Q22-1Q23 in comparison to 61 bps for credit unions.Credit unions appear to be less sensitive (at least so far) to funding cost pressure.The median cost of earning assets for banks increased by 91 bps from 1Q22- 1Q23 in comparison to 70 bps for credit unions.The 1Q22-1Q23 change in the NIM components varies by asset size (that is larger banks/CUs generally have experienced larger upward adjustments to both asset yields and the cost of funds, relative to smaller banks/CUs).Over the course of 2022, the median NIM for banks expanded from 3.06% in 1Q22 to 3.59% in 4Q22, while the median NIM for credit unions expanded from 3.04% to 3.40%.The NIM advantage reported by banks began to dissipate in 1Q23 as banks faced more cost of funds pressure than CUs.Bank NIMs widened by 17 bps more than CU NIMs between 1Q22 and 4Q22. However, funding cost pressures in 1Q23 caused bank NIMs to tighten by 22 bps in 1Q23, while CU NIMs compressed by only 11 bps.The change in NIMs between 1Q22 and 1Q23 can be decomposed as follows:Source of data for tables: S&P Capital IQ Pro, Mercer Capital research. Includes credit unions and banks with assets > $500 Million as of 12/31/21Originally appeared in the June 2023 issue of Bank Watch.

Bank Impairment Testing

Bank stocks have underperformed in the broad market since the beginning of the year and many currently trade below book value, which begs the question, is goodwill impaired?

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of June 19, 2023

Overview of Auto Finance 2023

Origination, Delinquency, and Portfolio Trends

In this blog post, we review these themes and layout new developments and changes in the state of auto finance since this time last year.

4 Considerations for Your RIA’s Buy-Sell Agreement

If the parties to a shareholder’s agreement think the pricing mechanism in the agreement isn’t robust, then the ownership model at the firm is flawed. Flawed ownership models eventually disrupt operations, which works to the disservice of owners, employees, and clients.

Demise of the Sedan

Does Recent Data Suggest the Sedan Will Follow the Station Wagon and Minivan?

While recent data from the average age of cars, production of vehicle types by class, and fuel economy by vehicle type might suggest that light trucks/SUVs/crossovers will continue to overtake market share, I’m not ready to author the eulogy for the demise of the sedan/passenger car just yet. While it’s true that a proliferation of more light trucks/SUVs/crossovers on the roads means that taller/heavier vehicles might also shift the road-safety equation, there still could be momentum shifting the popularity back to sedans. While legislation helped fuel the growth and profitability of trucks, perhaps in the coming years, legislation or government mandates regarding electric vehicles will tilt the scales back towards the sedan or passenger car.

Purchase Price Allocations for Asset and Wealth Manager Transactions

There's been a great deal of interest in RIA acquisitions in recent years from a diverse group of buyers ranging from consolidators, other RIAs, banks, diversified financial services companies, and private equity. These acquirers have been drawn to RIA acquisitions due to the high margins, recurring revenue, low capital needs, and sticky client bases that RIAs often offer. Following these transactions, acquirers are generally required under accounting standards to perform what is known as a purchase price allocation, or PPA.

Lessons from the Oracle of Omaha

Can you guess who said the following? “[M]y long-time partner, and I have the job of managing the savings of a great number of individuals. We are grateful for their enduring trust, a relationship that often spans much of their adult lifetime. It is those dedicated savers that are forefront in my mind as I write this letter.”

ISO: Cheap Capital

All Models Are Wrong, Some Are Useful

In the post-ZIRP environment, many RIA models are hitting a wall of market resistance, opening up space for new ideas. Some of those ideas will look a lot like the same wine in more presentable bottles—some will genuinely be new.

May 2023 SAAR

The Road Ahead: SAAR Predictions for the Rest of 2023

The May 2023 SAAR was 15.1 million units, a decrease of 6.5% from last month but an increase of 19.6% from this time last year. Last month also marks the tenth straight month of year-over-year improvements in the SAAR, highlighting almost a full year of rising tides in national auto sales. On an unadjusted basis, May 2023’s sales were up 22.8% from this time last year and are much closer to pre-pandemic levels.

6 Events That Warrant a Business Valuation of an Auto Dealership

What common events would require a business valuation of an auto dealership?

June 2023 | Net Interest Margin Trends for Banks Versus Credit Unions

Bank Watch: June 2023

In this issue: Key Considerations in the Valuation of Banks and Bank Holding Companies and Net Interest Margin Trends for Banks Versus Credit Unions

Issue No. 11 | Data as of Mid-Year 2023

Freature Articles: Mid-Year 2023 Review of the Auto Dealer Industry by Metrics and Q2 2023 Earnings Calls

Merger Arbitrage and Valuation

We are sometimes asked to value common equity securities where the target (usually our client) has agreed to be acquired but the transaction has not yet closed.

Four To-Dos Before You Sell Your Investment Management Firm

Considerations for Every RIA Owner

Long before your eventual exit, you should begin planning for the day you will leave the business you built. There are many considerations for investment managers contemplating a sale, but we suggest you start with these four.

Themes from Q1 2023 Earnings Calls

Part 1: Upstream

Despite the strength of the Eagle Ford, attention and resources were increasingly directed towards the Permian Basin, where operators aimed to capitalize on improving well economics, flexibility in project scheduling, and cost savings to drive enhanced free cash flow.

The Devil in the Details

Diving into the CI US/Bain Transaction

On May 11, 2023 CI Financial announced a transaction through which it will sell a 20% interest (a convertible preferred stake) in its U.S. wealth management division (CI US) for $1.0 billion to a group of institutional investors led by Bain. The transaction offers a few takeaways for RIAs.

What Is the Value of My Auto Dealership?

It Depends on Who's Buying

In our Valentine’s Day-themed Levels of Value Blog Series, we discuss the theoretical considerations of the three distinct levels of value and how they apply to auto dealerships. In this post, we take a more practical approach to the discussion. When dealers ask themselves, “What is my auto dealership worth?” the answer is, “It depends on who’s buying.”

Is TXO's Strategy Paying Off?

The TXO Energy Partners IPO

As our colleague Bryce Erickson said in a recent post, uncertainty rules the day in the upstream world despite strong demand for oil and elevated commodity prices. The war in Ukraine has contributed to this, but there is no way of knowing when or if it will wind down. Interest rates continue to rise, and recession fears loom. We believe the recent initial public offering (IPO) of TXO Energy Partners LP offers an interesting case study of how investors are responding to these mixed signals. In the early 2010s, upstream IPOs were at a peak. In 2011, there were no fewer than 20 IPO announcements, and the average targeted capital raises for IPOs climbed to well over $550 million by 2013. Things went sour from there. Since 2015, there have only been 22 IPOs announced. Due in part to the pandemic, average IPO targets for upstream firms have sunk to $15 million. Despite the vital role of oil and gas in the US economy, the market for public equity in upstream firms can certainly be described as underweight due to few publicly available investments in the sector and, thus, fewer opportunities for investment. Despite this, 2022 featured more IPO announcements than any year since 2016. Soaring commodity prices are bringing back interest in upstream investments. Upstream managers are confronting investor uncertainty by strengthening their balance sheets, using their historically high revenue to continue ramping production, and making generous distributions to shareholders. Click here to expand the image aboveValuation ConsiderationsTXO Energy Partners LP, formerly MorningStar Partners LP, is an E&P firm that IPO’d on the New York Stock Exchange on January 26, 2023, under the ticker TXO. The Partnership is focused on plays in the Permian and San Juan Basins within Texas, New Mexico, and Colorado. TXO offered five million common shares with a target price of approximately $20 per share (which would raise about $100 million). The IPO also allowed underwriters to purchase another 750,000 common shares at the IPO price net of discounts and commissions.One of the most important factors when considering TXO’s fundamentals is its recent acquisitions. In late 2021, they purchased 24,052 leasehold acres, a CO2 plant in the Permian Basin, and additional CO2 assets in Colorado (these assets are referred to as the “Vacuum Properties”). Within just a month, they also acquired an additional 21,112 gross leasehold acres in the Permian (the “Andrew Parker Acquisition”). Finally, they increased their interest in the Vacuum Properties in August 2022. Every transaction involved proven producing wells.Further, these wells have an average decline rate of just 7% (compared to a 9% projected decline rate across all TXO’s assets). By making such acquisitions, TXO noticed a short-term impact on its income statement but has ultimately set itself up for reliable, comparatively non-risky cash flows. The table below summarizes TXO’s developed and undeveloped acreage as of December 31, 2022. One observation immediately jumps off the page: despite the recent Permian Basin acquisitions discussed above, TXO’s acreage is heavily weighted towards developed acreage in the San Juan Basin. Questions arise from this observation: Is TXO indicating a shift in priorities from the San Juan Basin to the Permian Basin? Will the company sell some of its San Juan Basin assets and use the proceeds to purchase more developed acreage in the Permian Basin after 2023? At the very least, the company’s focus is clearly on developed acreage rather than undeveloped acreage (see below for management’s immediate investment plans).In its S-1 statement, TXO reported PV-10 as of year-end 2021 of $986.6 million, compared to established firms like Diamondback Energy ($21.8 billion) and Black Stone Minerals ($972.1 million). A summary of TXO’s reserves per its most recent 10-K is shown below.Despite its comparatively small war chest of reserves (per the table above this paragraph showing the company’s reserve portfolio as of December 31, 2022), management has indicated that they anticipate most of their 2023 expenditures will go towards optimizing existing wells rather than continuing to make acquisitions to grow the wells in their portfolio.In the nine-month period ended September 30, 2022, revenues for TXO were $204.0 million, as opposed to $138.9 million for the same period in the prior year. TXO’s Vacuum and Andrews Parker acquisitions helped boost production volumes by almost 1,200 Mboe. Higher commodity prices also provided a significant boost, with realized prices for both oil and gas over 50% higher than in 2021. TXO reported net income of $14.6 million for the nine-month period ended September 30, 2022, compared to $25.2 million for the nine months ended September 30, 2021 ($0.58 per unit and $1.01 per unit for each respective year). The year-over-year decrease in net income was primarily attributable to higher production expenses in 2022 as well as transportation and tax expenses. On a year-over-year basis, production expenses climbed 105% as of September 30, 2022, while taxes and transportation expenses climbed 92%. Management stated that both items increased due to the two Vacuum and Andrews Parker property acquisitions. The higher production cost is a function of the acquired properties’ strong focus on oil production, which is typically more expensive on a Boe basis than natural gas production. The increase in taxes and transportation expenses was caused by rising commodity prices and changes in the Partnership’s production mix.In its S1, TXO portrays itself as holding a conservative balance sheet. Per Capital IQ, at the end of 4Q 2022, their largest liability was a credit facility with a balance of $113 million. Paying this debt down was the primary reason for their IPO. TXO has one of the smallest debt-to-capital ratios among its peers, as shown below. With less leverage, TXO is a comparatively less risky investment, all else being equal. This makes it particularly attractive to investors preparing for a potential downturn in the larger economy or upstream space.What is interesting about these financials is that despite tailwinds from commodity prices and growth from new acquisitions, YTD EPS shrank by 50%, yet TXO filed for an IPO anyway. Why? First, the EPS shrinkage is related to their acquisitions. Second, TXO’s stated strategy plays to the current desires of the market. As mentioned earlier, TXO is spending most of its money optimizing existing wells. Despite this, they still have plans to identify new opportunities. When describing how they are going to go about spending the portion of their capital dedicated to development, TXO stated that “over the next 24 months we anticipate that approximately half of our development activity will be focused on drilling new wells, virtually all of which we expect to be conventional, vertical wells.”Additionally, 97% of TXO’s current wells are conventional plays rather than more risky shale operations. By focusing on conventional plays, TXO can take advantage of slower production volume decline rates and earn steady cash flows to pay out dividends. The Partnership clearly had a distribution-focused plan in mind setting up their firm, as their Partnership Agreement specifies that every quarter it must pay out virtually all cash available for distributions. At one point, the S1 directly states that “our primary goal is to maximize investor returns through cash distributions and flat to low production and reserves growth over time.” At the time of this blog post, TXO has yet to make its first distribution since its IPO. How it sets its policy relative to other smaller upstream companies will be an interesting phenomenon to watch.The market does not currently seem to be valuing aggressive growth programs. Instead, investors are looking for companies like TXO with conservative balance sheets, large amounts of distributable cash, comparatively non-risky reserves, and steady, stable growth.All of this naturally begs the question of whether TXO’s strategy is paying off. Between TXO’s IPO date and May 4, the market price of the Standard and Poor’s Exploration & Production Select Industry Index has decreased by about 19%. On the other hand, TXO’s share price has only decreased by just under 2%.With such a high degree of uncertainty in the market, investors are bracing themselves for Murphy’s Law to take effect. They are seeking shelter in stable growth, safe balance sheets, and frequent dividend payments. TXO offered that, so investors have rewarded it.Mercer Capital has its finger on the pulse of the energy industry. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the E&P operators and mineral aggregators comprising the upstream space. For a more targeted energy sector analysis that meets your valuation needs, please contact a member of the Mercer Capital Oil & Gas Team.

Infrastructure Investment for EVs, Data Privacy, and Dealership Buy-Back Programs

2023 NADC Conference Update

The National Association of Dealer Counsel (NADC) annual member conference was last week in Amelia Island, Florida. My colleague, Scott Womack, and I were happy to attend. In this week's post, we provide a few takeaways from the conference for readers to keep an eye on during the remainder of the year. At the end of the post is further reading about other topics presented at the conference.

RIA Dealmaking in a Post-ZIRP Market

Terms Bridge Seller Expectations and Market Realities

Seller expectations are sticky, but buyers who overpay will be left holding the proverbial bag. So deal terms will continue to evolve to find a way to reward sellers when things go well and protect buyers when they don’t. Our only warning to sellers—and buyers—is to look carefully at the underlying value of a transaction and not just the headline price.

IRS Valuation Guidance

Mines, Oil and Gas Wells, & Other Natural Deposits

In this blog post, we discuss portions of Treasury Regulation 1.611 and its additional guidance when determining the fair market value of mineral properties.

Common Valuation Misconceptions about Your RIA

Old Rules of Thumb, Recent Headlines, and the Endowment Effect

The "endowment effect" refers to an emotional bias that causes individuals to value an object they own higher than its market value. We’ve probably all been guilty of this at various times in our life when it comes to property values or assets that have some sort of emotional or symbolic significance to us.

April 2023 SAAR

The April 2023 SAAR was 15.9 million units, up 7.2% from last month and 11.4% from April 2022. This month’s improvements are significant for the month and the year as they emphasize the story that the data has been telling for months: vehicle availability has been improving, leading to higher sales volumes and more consistency in the SAAR. In fact, the year-over-year improvement in April marks the ninth straight month that the SAAR improved from the year prior. On an unadjusted basis, total sales for April came in at 1.39 million units, an improvement of 9.4% from April 2022. See the chart below for a comparison of the last eight April’s unadjusted sales.

May 2023 | Merger Arbitrage and Valuation

Bank Watch: May 2023

In this issue: Merger Arbitrage and Valuation

RIA Margins: How Does Your Firm’s Margin Affect Its Value?

First Republic Bank & The Asymmetry of Banking

First Republic Bank’s first quarter 2023 earnings release said little, yet little needed to be said.

What Are Bank Stocks Telling Investors?

What was expected to be a prosaic first quarter was anything but that.

Value Focus | Exploration & Production

First Quarter 2023 | Region Focus: Eagle Ford

Mercer Capital’s Value Focus: Exploration & Production newsletter provides an overview of the industry through supply and demand analysis, commodity pricing, and public market performance. In addition, each issue of this quarterly newsletter focuses on a region, including Eagle Ford, Permian, Bakken, and Appalachia, examining general economic and industry trends. In this quarter’s newsletter, we focus on the Eagle Ford. Strong rig-count growth spurred an Eagle Ford production increase that was second only to the Permian.However, production improvement was offset by commodity price easing in the latter half of 2022 and early 2023, resulting in Eagle Ford comp group stock price declines over the last year.Despite those dynamics, interest in the Eagle Ford remains high, with Devon doubling its presence in the basin in late 2022 and SilverBow making significant acquisitions (SandPoint and Sundance) last year.Exploration & ProductionFirst Quarter 2023Region Focus: Eagle FordDownload Newsletter

Middle Men: Family-Owned Auto Dealerships

In this 5-minute video, originally recorded in May 2022 for Mercer Capital’s Family Business On-Demand Resource Center, Scott Womack addresses the topic of auto dealership valuation. He explains the economic and financial challenges that have affected the auto dealer industry and what drives the ultimate value of your dealership.

Challenging Year Ahead for Asset Managers

Asset Management Firms Struggle as Market Downturn and Fund Outflows Persist

Rising interest rates and inflation caused painful losses in the stock and bond markets in 2022, and market conditions have remained choppy so far in 2023. Moody’s lowered their December outlook for the global asset management industry from stable to negative in response to the current business and economic environment. Following the decline in AUM in 2022, lower starting AUM levels will likely weigh down industry-wide revenues and earnings in 2023.

Earnings Stability and Geopolitical Volatility

Two Foes Are Battling Once More

In the mire of much of the chaotic goings-on of the world energy markets over the past year, a lot of things have changed. A lot of other things have not gone according to predictions or plans. War in Ukraine remains. Interest rates have gone up. Recession questions haunt the market: are we close to one or already in one? Uncertainty has ruled the day.

EV Potpourri

Discussing Levels of Charging to OEM Requirements of Dealers

News of electric vehicles (EVs) has permeated headlines in the auto industry as much as record profitability, supply chain issues, and microchip shortages over the last three years. While environment-conscious mandates and industry projections have framed the narrative on the overall popularity and adoption of EVs, several recent metrics have emerged that measure the momentum of EV sales. According to CleanTechnica, monthly EV sales exceeded 7% of all new light-duty vehicle sales in the U.S. for the first time in September 2022. Experian reported registration data from January 2023 that 7.1% of all new light vehicle registrations were all-electric vehicles.

Toronto-Dominion Bank and First Horizon National Merger

FHN is a tough call for the merger arbitrage community: $25 per share of cash if the current deal closes; regulators reject the deal, causing FHN's shares to trade freely in a tough market for bank stocks; or the parties extend the merger agreement again, but does the price get renegotiated?

RIA M&A Update: 1Q 2023

RIA M&A activity has remained resilient through the first quarter of 2023, even as macro headwinds have emerged for the industry over the past year. Fidelity’s March 2023 Wealth Management M&A Transaction Report listed 68 deals through March 2023, up 19% from the 57 deals executed during the same period in 2022.

March 2023 SAAR

Is North American Auto Production Lagging Behind?

The March SAAR was 14.8 million units, down 1.2% from last month but up 9.3% compared to March 2022. Year-over-year improvements in the SAAR continue to persist as inventory is more available compared to this time last year. In fact, this month marks the eighth month in a row of year-over-year improvements in the SAAR and signals consistency in auto production and auto demand trends. On an unadjusted basis, industry-wide sales numbers tell the same story. March 2023’s sales significantly improved from last year but remain below the levels seen in 2016 through 2019.

Q1 2023: The Market Rallies, RIAs Stay Behind

The RIA industry saw a tumultuous first quarter, with most categories of publicly traded investment managers underperforming the S&P 500. Alternative asset managers, however, saw a last-minute rally during the final few days of the quarter, leading to this category outperforming the S&P during the period.

April 2023 | What Are Bank Stocks Telling Investors?

Bank Watch: April 2023

In this issue: What Are Bank Stocks Telling Investors? and First Republic Bank & The Asymmetry of Banking

E&P Second Quarter 2023

Permian

Permian // Permian production growth over the past year continued to run well ahead of growth in the Eagle Ford, Appalachian, and Bakken, as the Permian basin remains one of the most economic regions for U.S. energy production.

Transportation & Logistics Newsletter

Second Quarter 2023

The level of domestic industrial production directly impacts demand for transportation services.

Public Auto Dealer Profiles: Asbury Automotive Group

Corporate Finance in 30 Minutes

Updated Whitepaper

In this updated whitepaper, we distill the fundamental principles of corporate finance into an accessible and non-technical primer.

An RIA’s Independence Is Valuable

Selling Control Is Losing Control

It’s more than a little ironic that many RIAs get their start because the founders want freedom from the constraints of a large corporation, only to build a successful business that ultimately gets resorbed into another large corporation. There are workarounds, like minority partners, but even then, the devil is in the details. Measure twice, cut once.

“I’m Not Broke. I’m Just Not Liquid.”

Like the Katy leaving the station, the banking industry is embarking into the unknown after the failures of SVB and Signature.

Eagle Ford Activity and Production Grow, Despite Price Easing

The economics of oil & gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. This quarter we take a closer look at Eagle Ford.

Plan for the Unexpected

Succession Planning for Auto Dealers

Succession planning involves the transfer of value or leadership in a company or organization. For auto dealers, the dealership can represent a lifetime of efforts and relationships with key employees and customers. Hopefully, the dealership has also provided the owner wealth and income over the years. These factors make the discussion of succession more complicated for auto dealers because of the deep emotions tied to the legacy that they have created. So, let's discuss a few of the key factors involved in the succession planning process and why they are so critical.

Q4 2022 Earnings Calls

Executives Anticipate a Return to Normal

Reviewing earnings calls from executives of the six publicly traded auto dealers, the consensus is that volumes will increase approximately 10% to about 15 million in 2023, but gross profit per unit (“GPU”) will decline as supply constraints are alleviated. Nobody is anticipating that record-setting unit-level profitability will continue, though most expect, or are at least hopeful, that “normalized” levels will be higher than pre-pandemic.

Eagle Ford M&A

Transaction Activity Picks Over the Past 4 Quarters

Deal activity in the Eagle Ford has increased over the past 12 months, with 13 deals closed compared to 10 that closed in the prior year. What is fueling Eagle Ford's M&A momentum?

The Relationship Between AUM Multiples and RIA Performance

Rules of thumb based on a percentage of AUM are frequently cited in the RIA industry as a back-of-the-envelope way to quickly estimate a firm’s value. One reason for the prevalence of AUM multiples is purely practical—AUM for RIAs is a publicly available metric, and it’s often the only window into a firm’s financial performance available to third parties. Another reason for the popularity is simplicity—AUM can be compared across firms without regard to fee levels, margins, compensation structure, and the like.The simplicity of AUM multiples is also the greatest pitfall. AUM multiples condense a significant amount of information into a single metric. In our experience, they’re usually better thought of as an output rather than an input to valuation. To gain insight into what drives AUM multiples, we can (using a little bit of math) decompose AUM multiples like this: From a practical standpoint, a dollar of AUM is worth more when it generates more fees, and those fees are worth more when they yield higher returns (earnings) to capital providers (all else equal). Investors will pay more for an RIA’s AUM when there’s more cash flow behind it. To illustrate, consider the sensitivity table below, which shows the implied AUM multiple for a given EBITDA multiple (in this case, 9.0x) as a function of effective realized fees and EBITDA margin. For sensitivity purposes, we’ve shown a wide range of effective realized fees (55 to 95 bps) and EBITDA margins (10% to 50%) which will encompass most, but not all, firms. A firm at the middle of both ranges (75 bps effective realized fee level and 30% EBITDA margin) transacting at a 9.0x EBITDA multiple would imply a 2.0% AUM multiple—in line with an often cited “2.0% of AUM” rule of thumb. But the range in the table is wide. A firm at the low end of profitability and effective realized fees (10% margin with fees of 55 bps) transacting at the same EBITDA multiple would imply a multiple of AUM of 0.5%. In comparison, a firm at the high end of the range (50% EBITDA margin and fees of 95 bps) would imply a multiple of AUM of 4.3%—a nearly ninefold increase in the multiple. This reality is why we see such disparity in the AUM multiples paid for investment management firms. Firms vary significantly in terms of their asset class focus or allocation, fee levels charged, client base demographics, and operational efficiency. All of these variables (and more) impact how AUM translates into profitability and thus what investors are willing to pay for a dollar of AUM. If a firm has balance sheet items such as GP interests or has non-AUM-based business lines, AUM multiples can be further skewed. When assessing AUM multiples from transactions, it’s important to keep these caveats in mind. If you’re an RIA principal looking to improve the value of your assets under management, the levers to pull are the effective realized fee, EBITDA margin (profitability), and the EBITDA multiple. Since the EBITDA multiple is primarily a function of risk, growth, and market conditions that are largely outside your control, the path of least resistance is probably fee discipline and margin improvement. (Though we acknowledge the difficulties of enhancing your bottom line when markets and AUM are falling while inflation swells your compensation costs and overhead expenses.) The takeaway is to focus on what you CAN control: hiring practices, new business development, incentive compensation structure, operating efficiencies, fee discipline, and cost controls. As the last year has proven, you can’t always rely on a market tailwind to lift AUM and revenue. Developing new business in a cost-efficient manner will increase margins and profitability in almost any market environment. It will also improve your AUM multiple and value by extension.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of March 3, 2023

Preparing for the Unknown Unknowns

The Importance of Sell-Side Due Diligence

I do not think it’s fair to say Focus’s foray into the public space was a failure. Over the years, I’ve blogged that the IPO was richly priced (it was). I thought some of their disclosures on things like organic growth were less than helpful (they were not). I wondered if they were overleveraged (and I wasn’t the only one). I noted that they had lots of competition in the acquisition space (as time went on, they did). It’s absolutely true that most of the total return on Focus was earned on the initial day of trading and the speculation over going private.

February 2023 SAAR

The February SAAR was 14.9 million units, down 6.3% from last month but up 8.6% from February 2022. Year-over-year increases in the SAAR have been a theme throughout the last several months. In fact, February 2023 marks the seventh month in a row that the SAAR improved from the year prior. Looking ahead, we believe that it is likely that year-over-year improvements will continue for several more months as nationwide inventory balances continue to recover.

When a Buyer Offers You Stock

Fairness Considerations in Equity Financed Transactions

Stock consideration is rarely discussed in RIA transactions, but it is a common financing feature in other industries. We expect to see more stock-for-stock deals in RIAs. How can a seller decide whether or not to accept a suitor’s stock?

2022 Auto Dealer Industry Metrics Review

Has Profitability Peaked?

2022 marked another very successful year for auto dealers. Most of the metrics discussed in this post seem to have peaked at some point during 2022 and are shifting in the other direction. Does this signal that profitability has peaked? Will increasing volumes compensate for declining unit economics? Only time will tell.

Themes from Q4 2022 Earnings Calls

Part 2: Oilfield Service Companies

The common themes among E&P operators and mineral aggregators’ in the Q3 2022 upstream earning calls included expanding business segments internationally, long-term sustainable growth for OFS, and production growth plans. In our most recent blog post, Themes from Q4 2022 Earnings Calls, Part 1 Upstream, prevalent themes from E&P companies included dividend distribution, organic growth, and management optimism regardless of upcoming economic challenges. This week we focus on the key takeaways from oilfield service operators’ Q4 2022 earnings call.

March 2023 | I’m Not Broke. I’m Just Not Liquid

Bank Watch: March 2023

In this issue: “I’m Not Broke. I’m Just Not Liquid.”

Themes from Bank Director’s 2023 Acquire or Be Acquired Conference

The 2023 version of AOBA felt bigger than ever.

Themes from Q4 2022 Earnings Calls

Part 1: Upstream

The common themes among E&P operators and mineral aggregators' in the Q3 2022 upstream earning calls included continued share buybacks, growth in production levels, and inflation’s impact on limiting growth. This week we focus on the key takeaways from the Upstream Q4 2022 earnings calls.

The Relationship Between Revenue Multiples and EBITDA Margins

Revenue multiples are cited perhaps as much as any other valuation metric in the RIA industry. In this week’s post, we focus on their key drivers and ways to improve the value of your management fees.

LOV(E): Why Getting the Level of Value Right Is So Important to Auto Dealers

Part II

In this two-part series (the first post dropped on Valentine’s Day), we are covering a topic near and dear to the hearts of business valuation analysts. LOV – or the “Levels of Value” – refers to the idea that while “price” and “value” may be synonymous, they don’t quite mean the same thing. A nonmarketable minority interest level of value is very different from a strategic control interest level of value.

NAPE 2023: Europe’s Post-Russian Energy Strategy & A 2023 Merger Outlook

Earlier this month, the NAPE Expo in Houston, TX, was once again at the center of the oil and gas industry. Every February, NAPE’s Global Business Conference provides insight from multiple perspectives in the industry. This year it included, among other topics, discussions of energy policy around the globe. Additionally, TPH&Co. provided a review of 2022 and an outlook on the merger and acquisition market in 2023.

As Deal Momentum Slows, What’s Next for Wealth Management Consolidation?

Is the slowdown here to stay? What does this mean for the future of deal activity? Here are a few predictions for the year ahead.

LOV(E): What Are the “Levels of Value" and Why Does It Matter to Auto Dealers?

Part I

Shareholders are occasionally perplexed by the fact that their shares can have more than one value. This multiplicity of values is not a conjuring trick on the part of business valuation experts but simply reflects the economic fact that different markets, different investors, and different expectations necessarily lead to different values.

Mailbox Money: Mineral Rights & Other Alternative Assets

In this 5-minute video, originally recorded for Mercer Capital’s Family Business On-Demand Resource Center, Bryce Erickson addresses the topic of oil and gas mineral/royalty rights. He explains what they are and what they aren’t, the basic framework and investment processes, and key drivers and risks associated with value.Click here to watch the video (you will be redirected to www.familybusinessondemand.com) In addition to the video, we have included additional resources on this topic that might be helpful to you.The Family Business On Demand Resource Center is a one-stop shop for enterprising families and their advisors facing the financial challenges that are common to family businesses. While not specific to the oil and gas industry, there you’ll find a curated and organized diverse collection of resources from Mercer Capital’s family business professionals, including more 5-minute videos, articles, whitepapers, books, and research studies.The perspectives offered on the Family Business On Demand Resource Center are rooted in our experiences at Mercer Capital, working with hundreds of enterprising families in thousands of engagements over the past forty years. Our main focus is on the financial challenges faced by family businesses. There’s nothing else like it, and we hope you will visit the site. We plan to feature additional videos from our oil and gas industry team in the near future.

Investment Management Is a People Business

Who’s in the Driver’s Seat?

There is no conclusion to my ramble other than an admonition that investment management is a people business and that there are aspects to a people business that do not yield to financial modeling. It’s kind of frustrating for our team at Mercer Capital, but it also keeps work interesting.

January 2023 SAAR

The January 2022 SAAR was 15.7 million units, which is 18% higher than December 2022 and 4% higher than this time last year. This month’s data release revealed the fifth straight month of year-over-year improvements in the SAAR, supporting that inventory levels are actually recovering from the throws of persistent supply chain disruptions.

Understanding Oilfield Services Companies & How to Value Them

This whitepaper provides invaluable guidance in regard to these aspects of the OFS industry. If you haven’t already, take a look.

Whitepaper Release: Compensation Structures for Investment Management Firms

For this week’s post we’re introducing our whitepaper on compensation structures for investment management firms. Since roughly 75% of an investment management firm’s expenses are compensation costs, figuring out the right balance of salary, performance pay, and equity incentives is always front of mind for RIA principals. This whitepaper is designed to help you navigate the various compensation models to optimize firm growth and employee retention.

WHITEPAPER | Compensation Structures for Investment Management Firms

February 2023 | Themes 2023 Acquire or Be Acquired Conference and Pay vs. Performance

Bank Watch: February 2023

Themes from Bank Director’s 2023 Acquire or Be Acquired Conference

2022 Bank Stock Performance Recap

As in 2022, no doubt some newfound concerns will emerge in 2023 to drive bank stock performance.

Are You Ready for the Next Recession?

What 2023 Might Have in Store

This post offers a few practical steps business owners, directors, and their advisors can take to ensure their business continues to thrive.

Floorplan Interest Income Fading

Part 1: Rising Interest Rates and Increasing Inventories Are Anticipated to Remove the Unlikely Profit Center

Interest rates and inventory levels remain top of mind for auto dealers. Compared to last year, interest rates have significantly increased since the Federal Reserve began raising rates in March 2022. Inventories have also improved as the industry works through its supply chain issues. These shifts in economic trends are expected to have an impact on many aspects of auto dealer operations. In this week’s post, we talk about floorplan interest income and pose some important questions: What is floorplan interest expense, and what are floorplan credits? How have floorplan credits turned into an unlikely profit center for dealers? Can we expect this trend to continue amid changing conditions?

What Does the FTC’s Proposed Non-Compete Ban Mean for RIAs?

Earlier this month, the Federal Trade Commission (FTC) announced a proposed ban on non-compete agreements in employment contracts. If enacted, the proposed ban would prohibit a common provision of employment agreements that employers use to limit employees’ ability to compete.

Wealth Management in Turbulent Times

Navigating the Challenges Ahead

With the prospect of a potential recession in 2023, the worst may still be ahead. While facing uncertainty heading into 2023, it will be important for wealth management firms to have a strategy in place to navigate these challenges and capitalize on opportunities that may arise.

Auto Industry Trends to Monitor in 2023

An Automotive Potpourri

January is a month to review statistics from the prior year and to make predictions for the new year. The automobile industry is no different. In this post, we tackle a potpourri of trends to monitor in 2023, including new and used vehicle prices, electric vehicles, connected cars, and SAAR predictions.

Value Focus | Exploration & Production

Fourth Quarter 2022 | Region Focus: Appalachian Basin

In this quarter’s newsletter, we focus on the Appalachian. Notable topics include Russia-Ukraine War’s effect on the demand for LNG exports to Europe in the face of winter, tight valuations between major operators, flat production levels in the region despite a high commodity price environment, as well as increased M&A activity in 2022 highlighted by Sitio Royalties and Brigham Minerals merger — creating the largest public minerals owner.

Six Things to Consider When Working with a Business Appraiser

In this post, we discuss six things that attorneys or auto dealers should consider when selecting or working with a business appraiser.

RIA M&A Update: 4Q 2023

RIA M&A activity set new records in 2022, even as macro headwinds for the industry emerged throughout the year. Fidelity’s December 2022 Wealth Management M&A Transaction Report listed 229 deals through December 2022, up from 215 in 2021. However, deal volume was most significant in the first half of 2022 and began to cool in the second half of the year, particularly in the fourth quarter.

All in the Family Limited Partnership

In this week’s Energy Valuation Insights post, we share a recent piece from our Family Business Director blog on the topic of Family Limited Partnerships. While the post speaks directly to family-owned businesses, the content is applicable to many because the individual estate tax exemption reverts to $6 million in 2026 from its current level of $12 million. As a result, many estates are beginning to plan now.

December 2022 SAAR

The December SAAR was 13.3 million units, down 5.3% from last month but up 4.7% from this time last year. This month’s SAAR data is a bit concerning for the auto industry, as supply chain improvements do not seem to be translating to improvements in vehicle sales pace as quickly as the last couple months have indicated. Over the past month, it has seemed more and more likely that plummeting trade-in equity, persistently-high interest rates, and growing fears of an economic recession are keeping the sale of automobiles low, which could spell trouble for auto dealers that have thrived in a high-price environment over the past eighteen months.

Appalachian Gas Valuations: A Beautiful Future Emerges From An Ugly Past

Today’s solid earnings and strong balance sheets are a far cry from what they were then. Stock prices have risen alongside a fresh confidence that $4 and $5 gas prices will be sustainable for a while. Mercer Capital’s sector statistics tell the story.

The Eye of the Storm

RIAs Outperform the S&P 500 in Q4 2022

The value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with closely held RIAs should be made with caution. Many smaller publics are focused on active asset management, which has been particularly vulnerable to headwinds such as fee pressure and asset outflows to passive products. Many sectors of closely-held RIAs, particularly wealth managers and larger public asset managers, have been less impacted by these trends and have seen more resilient multiples as a result. In the case of wealth management firms, strong demand from aggregators has also helped to bolster pricing in recent years.

January 2023 | 2022 Bank Stock Performance Recap

Bank Watch: January 2023

In this issue: 2022 Bank Stock Performance Recap

E&P First Quarter 2023

Eagle Ford

Eagle Ford // Strong rig-count growth spurred an Eagle Ford production increase that was second only to the Permian.

Transportation & Logistics Newsletter

First Quarter 2023

Domestic industrial production directly impacts demand for transportation services.

Bank M&A 2022 — Turbulence

At this time last year, we thought bank M&A would be described as a second year of “gaining altitude” after 2020 was spent on the tarmac following the short, but deep recession in the spring of 2020. Our one caveat was that bank stocks would have to avoid a bear market following a strong performance in 2021 because bear markets are not conducive to bank M&A.The caveat was correct. Bear markets developed in both bank stocks and fixed income that included the most deeply inverted U.S. Treasury curve since the early 1980s. Among the data points:The NASDAQ Bank Index declined 19% through December 28;The Fed raised the Fed Funds target rate 425bps to 4.25% to 4.50%;The yield on the 10-year US Treasury rose 236bps to 3.88%; andCredit spreads widened, including 150bps of option adjusted spread (OAS) on the ICE BofA High Yield Index to 4.55% from 3.05%.The outlook for deal making in 2023 is challenged by significant interest rate marks (i.e., unrealized losses in fixed-rate assets), credit marks given a potential recession, soft real estate values, and the bear market for bank stocks that has depressed public market multiples. For larger deals, an additional headwind is the significant amount of time required to obtain regulatory approval.However, core deposits are more attractive for acquirers than in a typical year given rising loan-to-deposit ratios, the high cost of wholesale borrowings and an inability to sell bonds to generate liquidity given sizable unrealized losses. A rebound in bank stocks and even a modest rally in the bond market that lessens interest rate marks could be the catalysts for an acceleration of activity in 2023 provided any recession is shallow.A Recap of 2022As of December 28, 2022, there have been 167 announced bank and thrift deals compared to 216 in 2021 and 117 in 2020. During the halcyon pre-COVID years, about 270 transactions were announced each year during 2017-2019.As a percentage of charters, acquisition activity in 2022 accounted for 3.5% of the number of banks and thrifts as of January 1. Since 1990, the range is about 2% to 4%, although during 2014 to 2019 the number of banks absorbed each year exceeded 4% and topped 5% in 2019. As of September 30, there were 4,746 bank and thrift charters compared to 4,839 as of year-end 2021 and about 18,000 charters in 1985 when a ruling from the U.S. Supreme Court paved the way for national consolidation.Also notable was the lack of many large deals. Toronto-Dominion’s (NYSE: TD)pending $13.7 billion cash acquisition of First Horizon (NYSE: FHN) represents 61% of the $23 billion of announced acquisitions this year compared to $78 billion in 2021 when divestitures of U.S. operations by MUFG and BNP and several larger transactions inflated the aggregate value.Pricing—as measured by the average price/tangible book value (P/TBV) multiple—was unchanged compared to 2021. As always, color is required to explain the price/earnings (P/E) multiple based upon reported earnings.The median P/TBV multiple was 154% in 2022. As shown in Figure 1, the average transaction multiple since the Great Financial Crisis (GFC) peaked in 2018 at 174% then declined to 134% in 2020 due to the impact of the short but deep recession on economic activity and markets.The median P/E in 2022 eased slightly to 14.6x from 15.3x in 2021; however, buyers focus on pro forma earnings with fully phased-in expense saves that often are on the order of 7x to 8x unless there are unusual circumstances. Accretion in EPS is required by buyers to offset day one dilution to TBVPS and to recoup the increase in TBVPS that would be realized on a stand-alone basis as investors expect TBVPS payback periods not to exceed three years.Figure 1 :: 1990-2022 National Bank M&A MultiplesClick here to expand the image abovePublic Market Multiples vs Acquisition MultiplesFigure 2 compares the annual average P/TBV and P/E for banks that were acquired for $50 million to $250 million since 2000 with the average daily public market multiple each year for the SNL Small Cap Bank Index.1Among the takeaways are the following:Acquisition pricing prior to the GFC as measured by P/TBV multiples approximated 300% except for the recession years of 2001 and 2002 when the average multiples were 248% and 267%.Since 2014, average P/TBV multiples have been in the approximate range of 160% to 180% except for 2020.The reduction in both the public and acquisition P/TBV multiples since the GFC reflects a reduction in ROEs for the industry since the Fed adopted a zero-interest rate policy (ZIRP) other than 2017-2019 and 2022.Since pooling of interest accounting ended in 2001, the “pay-to-trade” multiple as measured by the average acquisition multiple relative to the average index multiple has remained in a relatively narrow range of roughly 0.9 to 1.15 other than during 2009 and 2010.P/E multiples based upon unadjusted LTM earnings have approximated or exceeded 20x prior to 2019 compared to 14-18x since then.Acquisition P/Es have tended to reflect a pay-to-trade multiple of 1.25 since the GFC but the pay-to-trade multiples are comfortably below 1.0x to the extent the pro forma earnings multiple is 7-8x, the result being EPS accretion for the buyer.Figure 2 :: 2000-2022 Acquisition Multiples vs Public Market MultiplesClick here to expand the image aboveFigure 3 :: 2000-2022 M&A TBV Multiples vs. Index TBV MultiplesClick here to expand the image abovePremium Trends SubduedInvestors often focus on what can be referred to as icing vs the cake in the form of acquisition premiums relative to public market prices. Investors tend to talk about acquisition premiums as an alpha generator, but long-term performance (or lack thereof) of the target is what drives shareholder returns.As shown in Figure 4, the average five-day premium for transactions announced in 2022 that exceeded $100 million in which the buyer and usually the seller were publicly traded was about 20%, a level that is comparable to recent years other than 2020. For buyers, the average reduction in price compared to five days prior to announcement was 2.5%. There are exceptions, of course, when investors question the pricing (actually, the exchange ratio), day one dilution to TBVPS and earn-back period. For instance, Provident Financial (NASDAQ: PFS) saw its shares drop 12.5% after it announced it would acquire Lakeland Bancorp (NASDAQ: LBAI) for $1.3 billion on September 27, 2022.Figure 4About Mercer CapitalM&A entails a lot of moving parts of which “price” is only one. It is especially important for would be sellers to have a level-headed assessment of the investment attributes of the acquirer’s shares to the extent merger consideration will include the buyer’s common shares. Mercer Capital has 40 years of experience in assessing mergers, the investment merits of the buyer’s shares and the like. Please call if we can help your board in 2023 assess a potential strategic transaction.

MedTech & Device - Industry Scan 2022

For this quarterly update, we bring together a couple of strands of our medtech and device industry practice.First, as long-term observers, public market developments in 2022 were interesting and perhaps marked an inflection point for the short to medium term.Second, in October, we attended a medtech industry conference, where we were able to gather a rich set of perspectives.The implications for some of the larger companies in the space are probably clear-cut.The downstream reverberations to private, development stage companies may be less straightforward.Nevertheless, since development stage companies are typically constrained by currently available funds and continually contemplating the next funding round, these developments are of critical importance.2022: A Brief ReviewA tumultuous year in the public markets is coming to a close.By the end of the third quarter 2022, the S&P 500 was down nearly 25%, marking a near-bottom for the year.The broader medtech and devices industry largely followed suit.On the brighter side, established large, diversified companies, while lagging their own previous benchmarks, outperformed the broader market.As a group, some biotech and life sciences companies (see next section) also seemed to fare relatively well.A closer look reveals that within the group some of the larger companies with more diversified revenue bases and, perhaps more importantly, profitable operations performed much better than smaller companies promising higher growth but deferred profits.Current profitability also appeared to differentiate better stock price performers among the medical device and healthcare technology companies.At the same time, negative sentiment was more apparent for wide swathes of these two groups compared to the broader industry.It is obvious in hindsight but over the course of 2022, as interest rates rose and remained high, markets seemed to prefer existing earnings and nearer-term cash flows over future (rosier) prospects.The shift towards more caution also manifested in other measures of market sentiment and activity.Wholesale downward revisions of earnings (growth) estimates have not occurred so far (this may yet come to pass), so much of the price decline reflects compressing valuation multiples.The pace of M&A transactions, which had gone from strength to strength during 2020 and 2021 despite myriad disruptions and distractions, decelerated significantly in 2022.By our measure, total transactions volume in the industry through the first three quarters of 2022 was roughly equal to that of just the fourth quarter of 2021.The number of IPOs also slowed to a trickle.Looking Ahead to 2023 and Beyond: A Few Notes for Development Stage CompaniesNo industry is an island but as we and others have pointed out, several long-term trends, demographic and otherwise, suggest a favorable overall outlook for the medtech and device space. Even against the seemingly dour recent market backdrop, a multitude of attendees at the medtech conference agreed on the relative merits of the industry compared to the broader economy and market. We work with a number of development stage medtech and device companies over the course of a typical year. From that perspective, we find the long-term trends interesting because of the structural emphasis on continual innovation that improve outcomes for patients and clinicians.A defining feature of medtech innovation funding is that it occurs over multiple tranches as the technologies and companies achieve various developmental milestones.In this context, some observations for development stage companies:An obvious first order effect of the recent public market developments over the past year is that development stage companies should expect generally lower valuations for funding rounds (at least) over the next couple of years.Lackluster exit activity, via either M&A or IPO, delays and/or reduces deployable capital for venture capital funds, which will make them more cautious in considering investment decisions.The sentiment shift towards more caution is shared by all investors, although the degrees will differ.Accordingly, in addition to valuation compression, some types of companies (for example, those at the pre-clinical stage) will find fundraising to be extremely difficult.As a corollary, investors are likely to prize clean clinical data. Companies focused on demonstrating good clinical outcomes will be better prepared for future funding rounds.Similarly, companies that can stretch their existing funds until they can achieve a good (clinical) milestone will be better rewarded in the next funding round.Commercial traction after hurdling regulatory approval remains an important structural consideration, especially for the non-corporate investors.Wrap-upBeyond the near-term market dynamics, a key conference takeaway for us was that the medtech funding eco-system is deep and diverse.We met and heard from traditional venture capital investors, corporate investors, and folks who operate in the continuum between them.The goals for the various investors differ to some degree, with some focused on financial attributes while others (like corporate VCs) include strategic considerations in the mix.Investors with broader goals and considerations are, to an extent, less sensitive to the prevailing market conditions and can afford to take a longer-term view.Even among these investors, financial terms and preferred deal structures vary considerably.For development stage companies contemplating fundraising efforts, a deep and diverse investor eco-system can provide plenty of optionality.In keeping with a recurring theme of this update, a note of caution – evaluating a potential funding round requires both an examination of the financial terms and an understanding of the structural features and their longer-term implications.Mercer Capital has broad experience in providing valuation services to medtech and device start-ups, larger public and private companies, and private equity and venture capital funds involved in the sector.Please contact us to discuss how we may be of help.For a more in-depth review of the industry, take a look at our most recent newsletter.

‘Twas the Blog Before Christmas…

2022 Mercer Capital Auto Dealer Holiday Poem

‘Twas the Night before Christmas, when all through the lot No vehicle was stirring, no customer ‘Bot All service lanes and lifts were empty and bare In hopes that the technicians soon would be there.Our analysts report yet another great year Despite a war in Ukraine and other big fears Record profits and operations in fixed Here we go again with allocations nixed.When most in the industry can boast of success Let’s tip our glasses in hopes ‘chips be in excess Now it’s time to ponder, look back and review To our past Blog topics that interested you.Is the industry shifting to directly sell? Will Ford follow Tesla, or only time will tell? The dealership model protected by state law; Turns out different than anyone foresaw?Many market disruptors appear on the scene How will they perform? and what does it all mean? From ride share to tall machines, ready to vend Will they be successful, or come to an end?EVs continue to dominate headlines By 2030 ICE vehicles may draw fines And will there be enough stations to charge Or will constraints on the power grid be too large.Cars are ever changing, some may even call smart Connecting infotainment and data by part Then there are vehicles and sports of power Gaining popularity hour by hour.Now Penske! Now Sonic! Auto Nation, Group 1! Gupta, Smoke, other researchers join in the fun To listen by quarter to each earnings call Will Q4 be the one where revenues fall?Each passing month reports production by the SAAR Wondering where have we been; where we currently are How it all translates to multiples so high Best to be explained by metric called Blue Sky.Then events bring industry and sport together Just as the calendar, ever changing weather From the recent World Cup to upcoming ‘Bowl Advertisers, teams will be ready to roll.Wishing you joyful season with merry and glee We will be blogging again in 2023 Mercer Auto Team will now fade out of sight Merry Christmas to all, and to all good night!

Appalachian Production Holds True Despite Market Disruptions

The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. This quarter we take a closer look at the Marcellus and Utica shales.Production and Activity LevelsEstimated Appalachian production (on a barrels of oil equivalent, or “boe” basis) decreased approximately 1% year-over-year through late December. Production in the Eagle Ford, Permian, and Bakken increased 16%, 11%, and 5% year-over-year. Despite a much-improved year-over-year commodity price environment, Appalachian production was fairly stable, largely due to high price volatility over the year, which left the markets uncertain as to where prices would be going forward. Rig counts continued to climb in all four basins over the last year. Growth rates in the Appalachian and Permian basins were more modest, while rates for the Bakken and Eagle Ford basins were notably higher. The Appalachian rig count rose 30% from 40 to 52 rigs. Among the oil-focused basins, the Eagle Ford led with a 71% increase from 42 to 72 rigs. The Bakken followed with a 56% increase (27 to 42 rigs), while the Permian had the lowest increase with a 24% increase (283 to 350 rigs). As is typical, Appalachian production has been relatively flat despite its rig count growth. That’s due to the basin’s higher production declines which necessitate a higher rig count to maintain production levels. Commodity Price VolatilityHenry Hub natural gas front-month futures prices have experienced significant volatility over the latest year. Prices began 2022 on a general upswing before rising sharply as the market reacted to Russia’s invasion of Ukraine in late February. As Russia subsequently began leveraging its natural gas supplies against Europe in retaliation of Europe’s response to the war in Ukraine, natural gas prices became notably more volatile. They rose from an early March low of $4.56 to an early June high of $9.29 — only to drop back to $5.39 in late June and then hit a 2022 high of $9.42 in late August. By mid-December, Henry Hub had declined, albeit with only lightly reduced volatility, to $5.79.Oil prices, as benchmarked by West Texas Intermediate (WTI) and Brent Crude (Brent), also began 2022 on a steady upward trend that took the WTI from $76/bbl to $88/bbl and the Brent from $79/bbl to $91/bbl, prior to the Russian invasion. As the reality of the Russian-Ukraine war took hold, the oil benchmarks showed a marked uptick in volatility that lasted into mid-May, with prices hitting highs of $120/bbl and $128/bbl, and lows of $93/bbl and $96/bbl. Since then, WTI and Brent prices have trended downward, exhibiting more typical volatility other than modest rallies in August and October. As of mid-December, WTI sat at $73/bbl and Brent at $78/bbl.Financial PerformanceThe Appalachian public comp group saw markedly strong stock price performance over the past year (through December 12th), led by Antero and EQT with price increases of 90% and 77% as of December 12th. The remaining members of the comp group showed more modest 1-year price increases of 12% to 38%. Prices peaked in early June for all members, except EQT, with year-to-date increases of 71% to 171%. EQT’s stock price peaked in mid-September at a year-to-date increase of 143%. Stock prices fell sharply beginning in mid-September but reversed direction immediately following the sabotage of the Nord Stream pipelines in the Baltic Sea that transport Russian natural gas to northern Europe.Antero and EQT led the way among this group for several reasons. For Antero, one reason appears to have been its lack of hedging for 2023, which has allowed it greater exposure to the uptick in gas prices and has allowed Antero to be aggressive in paying down debt. EQT, on the other hand, does have more near-term hedging ceilings to deal with. However, its strength is in its operational efficiencies, whereby their recent literature demonstrates breakeven operating expenses at $1.37 per mcf. This is among the lowest in the industry and allows them to accumulate cash flow.ConclusionAppalachian production held steady in 2022 despite historically high commodity price volatility driven by the Russian-Ukraine war, the sabotage of the Nord Stream pipelines, and rising LNG exports to Europe to stave-off potential winter heating shortages. The Q4 Appalachian rig count is at a level beyond that needed for production volume maintenance, so there would seem to be at least some potential for Henry Hub price reductions going into 2023. However, the demand for new natural gas supplies to Europe provides a countervailing wind to any potential downward movement in natural gas prices. In the end, the natural gas markets seem to be in the midst of a series of events that promise continued supply and demand shifts with no certainty as to where the market will go in 2023.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

‘Twas the Blog Before Christmas…

The 2022 Mercer Capital RIA Holiday Poem

It has become a tradition for the RIA team at Mercer Capital to end the blog year with a “unique” annual summary of industry events, riffing off Clement Clark Moore’s classic “A Visit from St. Nicholas.” We hope all of you in the investment management community are enjoying the holiday season and looking forward to the many opportunities of the new year. We look forward to hearing from you in 2023. For now, please enjoy the finest only holiday poem written about money management.Happy Holidays from Mercer Capital’s RIA Team!‘Twas the night before Christmas, when all through our firm, We looked back on a year that was filled with concern; The stockings were hung by the chimney with care, In hopes ’23 wouldn’t be such a bear.Our analysts diligenced, scratching their heads, O’re down-sloping yield curves that offered no spreads; And tech stocks deflated, and rates out of sight - Each glance at the Bloomberg made anxious with fright.When out in the hall there arose such a clatter, I set down my coffee to check on the matter; Away to the lobby I flew like a flash, As good bankers do when they fear for their cash.When what to my wondering eyes should appear, But the ghost of Paul Volcker, looking quite debonair; A phantom in grey flannel, the Fed superstar, Who floated in haze from his giant cigar.“Good sir!” I addressed this strange apparition “Is it you: the inflation-fighting magician?” “The same” said the ghost, “and I sense from your query, That interest-rate changes have made your life dreary.”I told him our clients, ‘cross the RIA spectrum, Had found this past year quite a pain in the rectum; Business down, costs up, was the theme of my story, A punch to the gut that was not transitory:“First they killed crypto, then housing, then bonds! Every asset we held faced a flock of black swans! I blame the Fed board for all of this rot, My life was all good, ‘til they changed the Dot Plot!”“Relax!” cried the ghost, “don’t show your stupidity, There is such a thing as too much liquidity; Preserving your wealth is no justification, For letting the world suffer global stagflation.“When I was named Chair, we were on the back foot, But we didn’t give markets an endless Fed put! Your stocks will recover, your bonds will be fine, As soon as Jay Powell makes inflation decline.”He said plenty more, as is such with his work, He answered my questions; then turned with a jerk. A heav’nly elevator appeared there before us, And he boarded to hymns of the central bank chorus.Adjusting his glasses, perched high on his nose, He gave me a nod just before the doors closed. But I heard him exclaim, as he rose out of sight – “Don’t fight what we do, and your bets will go right!”

November 2022 SAAR

The November 2022 SAAR was 14.1 million units, down 6.5% from last month but up 7.9% from November 2021. Compared to this time last year, vehicle availability has significantly improved, and there seems to be hope around the industry that the auto inventory crunch is in its final act. If true, this would be good news for auto dealers and consumers alike, as more units on dealer lots seem to be the first step in a “return to normal” for the industry. While it’s clear that a year-over-year improvement is present, a dip from last month’s SAAR figure may raise red flags for some of our readers. However, an additional selling weekend in October and a marginal uptick in sales due to natural disasters in the Gulf of Mexico were both tailwinds that supported a surprising improvement in the SAAR last month. Given this perspective, November 2022’s SAAR seems to return to the larger trend of improving conditions.On a full-year basis, this month’s SAAR moved the 2022 average from 13.76 million units at the end of last month to 13.79 million units, a relative drop in the bucket. Even if another improvement in the industry’s sales pace follows suit in December, it’s clear that a full-year SAAR of fewer than 14 million units is almost inevitable. Unadjusted sales trends on a relative basis are in line with the last several months. November 2022 unadjusted sales are noticeably better than November 2021 but remain depressed compared to November 2015 through 2020. It’s likely that the gap between the pre-pandemic sales pace and the current sales pace will continue to narrow in 2023, but the rate at which improvements are expected throughout the next year remains unclear. As we have learned over the past two and a half years, no one truly knows what to expect regarding geopolitical events and OEM decision-making that impact inventory availability and consumers’ demand for automobiles. Simply put, expectations for the next year of selling should be cautiously optimistic.InventoryAs we mentioned earlier in this blog, it’s clear that inventory conditions are improving. According to the NADA, inventory on the ground reached 1.65 million units in November, which is up 6.5% from last month and 57% from last year. We believe it’s likely that nationwide auto inventories will remain roughly flat through the end of 2022, with continuing marginal improvements expected throughout 2023. The industry’s inventory-to-sales ratio, a metric released with a one-month lag, actually fell in October 2022 due to a significant improvement in last month’s sales pace (as elevated sales outran inventory production over the month). Going forward, we believe that a return to the long-run average inventory-to-sales ratio of 2.41x is very unlikely in the near term or throughout 2023. Given how auto dealer profitability has thrived in the low-inventory environment, we find it increasingly likely that a fundamental shift in the industry has already occurred. What if auto dealers never return to the days of 2-3x monthly sales worth of inventory on the lot? The last two years have informed us that dealers can thrive in this environment, but only time will tell us how sustainable this success may or may not be, particularly considering how profits are split between dealers and OEMs.Transaction Prices, Monthly Payments, and Incentive SpendingAccording to J.D. Power, November 2022’s average transaction price is expected to reach $45,872, 3.1% higher than this time last year. While 3.1% doesn’t seem egregiously high in this period of high inflation, we’d note that this is in addition to much higher prices from two years ago with no signs of meaningful price declines. The only way to know if prices will contract will be to wait for a complete recovery of nationwide inventory levels and the satisfaction of any pent-up demand that may still be lingering in the industry.Alongside sticker prices, another affordability metric is the industry’s average monthly payment. In November 2022, the average monthly payment is expected to be $712, an increase of $48 from last year. A few factors determine the average monthly payment made by consumers: 1.) the transaction price, 2.) the agreed-upon interest rate, and 3.) the term of the loan.While we have already made it clear that transaction prices continue to increase, it is notable that interest rates continue to grow as well. The Federal Reserve raised the federal funds rate for the fourth consecutive time in November 2022, bringing the overnight lending rate to its highest point since 2008 and elevating all interest rates throughout the economy. According to Experian’s State of the Automotive Finance Market Q3 2022 Report, the average auto loan rate in Q3 2022 was 5.16% (compared to 4.09% last year and 4.23% in 2020). Term lengths on auto loans, the final piece of the monthly payment puzzle, typically range from 12 to 84 months. According to Experian’s report, the average term of auto loans originated in Q3 2022 was 69.73 months, trending toward the 72-month mark and largely in line with the past two years (69.51 in 2021 and 69.64 in 2020). According to Edmunds, the share of auto loans exceeding 73-month terms increased from 27% in October 2017 to 34% in October 2022.Average incentive spending per unit is expected to total $1,009 in November 2022, down 35% from this time last year. Despite being down year over year, this month marks the end of a six-month streak where average incentive spending per unit remained below $1,000. Perhaps OEMs are beginning to relent and offer more incentives as spending across the economy cools off.December 2022 OutlookMercer Capital’s outlook for the December 2022 SAAR is optimistic. Industry supply chain conditions are improving. However, sales volumes will likely continue to be closely tied to production volumes, although less so than a few months ago. High profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Consumer activity may begin to cool off as affordability becomes an issue for many prospective buyers, but at this point, we have to see it to believe it.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Shifting Gears to 2023: Six Trend Changes for RIAs

Don’t Let Your Clutch Slip!

As the RIA team at Mercer Capital looks back on 2022 and ahead to next year, we’ve noticed a few themes emerge in discussions with clients that we expect to hear more about in the new year. Don’t think of these as predictions but simply the current state of market behavior—the implications of which will soon be evident.1. Dynamic Markets Favor Providers of DiversificationAfter a decade when do-it-yourself investing in a narrow band of large-cap domestic stocks was all you needed to be successful, we see a dramatic shift to dynamic markets which require analysis and judgment. Time will tell if FAANG has gone the way of the Nifty-Fifty, Dot-Coms, and other can’t-lose equity fads. What we know is large-cap U.S. stocks are among the priciest investments available (crypto is another story), and the dollar is punching above its weight. Having lived through the worst year for 60/40 in anyone’s career memory, we now have good opportunities across a broad swath of investment classes. All of a sudden, diversification matters.We think this bodes well for those who traffic in diversification, whether it’s OCIOs, multi-family offices, wealth managers, independent trust companies, or managers in niche asset classes that play a unique role in portfolio strategies. Anyone who suffered by comparison to the S&P 500 is being set up for vindication and possibly some healthy client inflows.2. Compensation Plans Are Being Tailored to Business ModelsHistorically, many RIAs were a variable-revenue, fixed-cost business. That works when markets are steadily rising, but not in times like this. Margin of profitability is also a margin of safety.Volatile markets have wreaked havoc on industry profitability this year, both because of downward pressure on AUM and because institutional investors are increasingly asking to pay lower base fees plus performance fees. In an effort to match expenses with revenues, RIAs are responding by increasing variable pay: bonus structures and equity compensation that directly share in the profitability of the business. In many firms, leaning more on variable compensation can be a smart risk management tool both for bad markets (mitigating margin impact when revenues sag) as well as good markets (paying to retain key staff when money is plentiful).3. Borrowing Costs to Affect M&AFor most of this year, we’ve been writing that Fed behavior was going to rein in transaction activity. Like many market prognosticators, so far, we’re “not wrong, just early.” Historically, transaction activity in the RIA space is a lagging indicator, and the steep rise in rates this year is starting to have an impact.Last week, both Focus Financial and CI Financial announced debt refinancing at higher rates than they’ve had to pay in a long time. Focus closed term financing at SOFR plus 250 bps and SOFR plus 325 bps for maturities between 5 and 5.5 years. If SOFR peaks at 5% or a little higher, Focus will have term borrowing costs on the order of 8%. CI Financial is paying a fixed rate of 7% over the next three years and wants to deleverage. Focus isn’t looking to increase its leverage ratios. Our read on private acquirers aligns with these two publics. We don’t see as much dry powder available to fund M&A in 2023, and that which is available will be deployed more judiciously.4. Minority Transactions Provide the Opportunity to Wait and SeeAs M&A slows, minority transactions are being viewed by many as a way to kick the can down the road. Rather than cede control in an atmosphere of lower AUM, revenue, margin, multiples, and—therefore—value, minority sellers can take some money off the table, satisfy a near-term liquidity need, cash out one or a handful of retiring partners, or otherwise satisfy their basic ownership requirements. Key players can stay in the saddle for markets to recover and sell more in a few years.Regardless of the present conditions, we’ve heard investors in the RIA space make a compelling argument that minority investments work better anyway. Financial buyers don’t want to run RIAs, they just want to own a piece of the success brought about by committed and talented management. If management owns a meaningful stake in the business, outside investors can rest easy. We anticipate an increase in merchant banking over the next few years, especially if markets remain unsettled and interest costs are meaningfully higher.5. Fortune Favors the Bold…and So Do EarnoutsJust as we see institutional investors wanting pay-for-performance relationships and firms using variable compensation, volatile markets and higher borrowing costs favor pushing more transaction consideration toward contingent payments. It gives buyers comfort and sellers opportunity, and we think the prominence of earnout consideration will only increase.6. Buy-Sell Pricing to Mimic Transaction BehaviorBuy-sell agreements provide ownership structures with a contractual mechanism to determine how ownership interests in closely-held businesses will transact. They are a must-have for RIAs with multiple owners, and in our experience, most have some form of buy-sell agreement in place. Unfortunately, many buy-sells are not well-engineered. We get more work than we should helping disentangle disputes involving internal transactions which were supposed to happen smoothly.One recurring issue involves buy-sells that price ownership interests using formulas. Formula pricing promises simplicity, but life is rarely simple. It’s common to see formulas using industry multiples derived from rules of thumb, which might work fine under “normal” conditions.Buy-sells are usually triggered under abnormal conditions, though, when such rules of thumb could dramatically undervalue or overvalue a business. RIAs usually transact with some money paid upfront and the rest contingent on the post-transaction performance of the firm. We wonder why buy-sell pricing isn’t structured the same way.

M&A in Marcellus & Utica Basins

Shareholder Value Creation Abounds; ESG Interest Waning

Through November 2021, there were three M&A deals in the Marcellus and Utica shales. Compared to the 16 deals in the same period in 2020, companies looking to get into or out of the Appalachian basins effectively did so in 2020. The following table summarizes transaction activity in the Marcellus and Utica shales in 2021:Click here to expand the image aboveAs shown in the following table, M&A activity picked up in 2022 year-to-date, with twice as many transactions announced.Click here to expand the image aboveWhat has caused the slight rebound in M&A activity in the Marcellus and Utica shales? Companies are focusing on asset quality, strong balance sheets, prudent capital structures, and free cash flow growth. Below we examine the two largest transactions that occurred in but were not limited to the Marcellus and Utica shales in 2022.Sitio Royalties and Brigham Minerals, Inc. Merge to Create the Largest Public Minerals OwnerOn September 6, Sitio Royalties Corp. (NYSE: STR) (“Sitio”) and Brigham Minerals, Inc. (NYSE: MNRL) (“Brigham”) announced a definitive agreement to combine in an all-stock merger, with an aggregate enterprise value of approximately $4.8 billion based on the closing share prices of Sitio and Brigham on September 2, 2022. The combination brings together two of the largest public companies in the oil and gas mineral and royalty sector. Upon completion of the merger, the combined entity will retain the name Sitio Royalties Corp.Under the merger agreement's terms, Brigham shareholders will receive a fixed exchange ratio of 1.133 shares of common stock in the combined company for each share of Brigham common stock owned. Sitio’s shareholders will receive one share of common stock in the combined company for each share of Sitio common stock, based on ownership on the closing date. Brigham’s and Sitio’s Class A shareholders will receive shares of Class A common stock in the combined company, and Brigham’s Class B and Sitio’s Class C shareholders will receive shares of Class C common stock in the combined company. Upon completion of the transaction, the former Sitio shareholders will own approximately 54%, and the former Brigham shareholders will own about 46% of the combined entity on a fully diluted basis.Robert Rosa, CEO of Brigham, commented,“Our merger with Sitio creates the industry-leading powerhouse in the minerals space … with approximately 100 rigs running across all of our operating basins and greater than 50 activity wells to continue to drive production and cash flow growth.”The Sitio-Brigham deal press release discusses operational cash cost synergies, a balanced capital allocation framework that aligns with shareholder interests to drive long-term returns, enhanced margins, and increased access to capital. But, as a recent Forbes article points out, despite Kimmeridge Energy, which owns approximately 43.5% of Sitio, being a heavy promoter of ESG in the shale business, the press release has only a slight mention of ESG. The only direct mention of ESG is in the last bullet point of the strategic rationale behind the deal.EQT Corporation Continues to Add to Core Marcellus Asset BaseOn September 8, EQT Corporation (NYSE: EQT) (“EQT”) announced that it entered into a purchase agreement with THQ Appalachia I, LLC (“Tug Hill”) and THQ-XcL Holdings I, LLC (“XcL Midstream”) whereby EQT agreed to acquire Tug Hill’s upstream assets and XcL Midstream’s gathering and processing assets for total consideration of $5.2 billion. The purchase price consists of cash of $2.6 billion and 55 million shares of EQT common stock worth $2.6 billion. The transaction is expected to close in the fourth quarter of 2022, with an effective date of July 1, 2022. Transaction highlights include:~90,000 core net mineral acres offsetting EQT’s existing core leasehold in West Virginia95 miles of owned and operated midstream gathering systems connected to every major long-haul interstate pipeline in southwest AppalachiaCombined upstream and midstream assets at 2.7x next-twelve-month (“NTM”) EBITDAUpstream-only valuation of 2.3x NTM EBITDA300 untapped drilling locations in the Marcellus and Utica shales The deal is the largest U.S. upstream deal since Conoco Phillips purchased Shell’s Permian Basin assets for $9.5 billion in September 2021. EQT President and CEO Toby Rice commented, “The acquisition of Tug Hill and XcL Midstream checks all the boxes of our guiding principles around M&A, including accretion on free cash flow per share, NAV per share, lowering our cost structure and reducing business risk, while maintaining an investment grade balance sheet.” The Tug Hill/XcL Midstream transaction piggybacks EQT’s May 2021 $2.93 billion acquisition of all of the membership interests in Alta Resources Development, LLC’s (“Alta’) upstream and midstream subsidiaries. Consistent with his comments on the Tug Hill/Xcl Midstream deal, Mr. Rice commented that the Alta deal would provide attractive free cash flow per share accretion to EQT shareholders. As with the Sitio-Brigham deal, Forbes points out that the EQT-Tug Hill-XcL Midstream press release provides only a token reference to ESG in a quote by the CEO of Quantum Energy Partners, the private equity backers of Tug Hill and XcL Midstream.ConclusionM&A transaction activity in the Marcellus & Utica shales increased in 2022 relative to 2021, with large industry players motivated by free cash flow growth and creating shareholder value and less motivated by championing the ESG cause.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We can leverage our historical valuation and investment banking experience to help you navigate a critical transaction in the oil and gas industry, providing timely, accurate, and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

The Top 2022 Blog Posts from Auto Dealer Valuation Insights

Despite existing operational and new economic headwinds in 2022, auto dealers continued to produce record profits. As we wind down the year and look towards next year, we look back to see what was popular with you—our loyal readers. These are your favorite posts of 2022, which all highlight opportunities or threats to the traditional auto dealership.Future of Auto Dealerships In this blog post, David Harkins discussed the inventory challenges dealers continued to face in 2022. David also posed the question: would prevailing supply conditions fundamentally change the franchise dealer model? After reviewing the history of the franchised dealer network in the United States, David highlighted the concept of direct selling. We have definitely seen some shift to direct selling with some manufacturers more so than others, mostly with their Electric Vehicles (EVs).Succession Planning Just as our recent World Cup post paired an auto dealer topic to sports, Scott Womack paired auto dealer succession planning to the NCAA March Madness tournament. This post explained some of the key considerations for business valuations in connection with succession planning in a March Madness-style bracket. Succession planning continues to be top of mind for aging dealers as they identify the next generation of owners within their immediate or extended families.Rideshare: Friend or Foe to Auto Dealers and Manufacturers The current batch of threats to the auto dealerships' success seemed to center around the adoption of EVs and the continued development of autonomous vehicles. A few short years ago, the newest/biggest threat to auto dealers was thought to be rideshare. In this post, Harrison Holt presented the anticipated effects of ridesharing on the auto industry, along with the resulting shift from the pandemic. While we expect rideshare to continue coexisting with auto dealers, the industry has proven that it can survive and flourish despite these outside threats.SmartConnected Cars, OTAs, and Their Impact on Auto Dealers No, we weren’t commenting on the compact, fuel-efficient design models resulting from the discontinued venture between Swatch and Mercedes-Benz. We were referring to connected cars that operate like smartphones or smart appliances. In this post, Scott Womack discussed the size of the connected car market and informed our readers about Over the Air Updates (OTAs) and their ongoing connection with auto dealership service departments. Despite having disadvantages, OTAs provide some advantages and opportunities for auto dealers with new service department revenue sources.Carvana Is Looking More Like Icarus Another market disrupter to auto dealers has been Carvana. With its iconic car vending machines, Carvana attempted to reduce its real estate footprint compared to traditional auto dealerships. The company initially stood out with its online-first presence to capture digital sales. In this post, David Harkins discussed Carvana’s strategies to scale its business platform and its most recent challenges and struggles. Along the way, the Carvana narrative provided several key takeaways for auto dealers to capitalize on consumer-centric shifts in the car buying space.Powersports: Alternative Growth Opportunity for Auto Dealers Another emerging opportunity for auto dealers with excess cash from continued profits or remaining PPP funds is an investment in powersports. Powersports franchises operate similarly to traditional auto dealerships. Auto dealers with the skills and experience to sell high volumes of automobiles would also possess the necessary skills to succeed in the powersports industry. In this post, Scott Womack educates readers on the powersports industry, including the similarities and differences to traditional auto dealerships. More of our dealership clients continue to add alternative investments in powersports franchises adjacent to their existing markets.ConclusionWe look forward to 2023 and appreciate your interest in our Valuation Insights blog. We will round out the year with the final SAAR blog post and another installment of our ‘Twas the Blog Before Christmas,” highlighting the past year in the auto dealer industry. May you and your family enjoy a happy holiday season and a prosperous new year!

Westwood Looks to Replace Lost AUM and Revenue with Salient Partners Acquisition

Two weeks ago, Westwood Holdings Group (ticker: WHG) completed its acquisition of Salient Partners’ asset management business. The purchase price consisted of $35 million in cash at closing plus a potential $25 million in earn-out payments (in WHG stock and cash) contingent upon hitting specific revenue retention and growth rates over the next 2-3 years. The deal is expected to add $4 billion in AUM and $31 million in annual revenue to WHG, pricing the total consideration (cash up front plus earn-out payments) at 1.5% of AUM and just under 2x revenue, which is right in line with WHG’s public peers.Click here to expand the image aboveThis valuation seems reasonable, especially considering 42% ($25 million) of the $60 million purchase price is contingent upon hitting specific revenue retention and growth objectives after closing. These metrics support WHG management’s assertion that the deal represents an “attractive valuation, structured with back-end protection through prudent growth and revenue retention hurdles.”Another (unstated) rationale for the deal is AUM and revenue replenishment. WHG assets under management and revenue peaked in 2017 at $24 billion and $134 million, respectively, and have since fallen to $11.5 billion and $68 million, respectively (prior to this acquisition). Westwood’s stock price has followed a similar trajectory, peaking at $70.84 in October 2017 and currently sitting at $11.27. This acquisition added 33% in AUM and 47% in revenue and should be immediately accretive to earnings. The Street agreed, and WHG’s stock price increased 6% on the day of the announcement.Masking losses through acquisitions is typically a risky proposition, but this may be an instance where it actually makes sense. WHG had some excess cash and investments on its balance sheet, which it employed to purchase a sizeable asset management business at a reasonable price. By acquiring an asset manager with distinct energy infrastructure, private investment, tactical equity, and real estate strategies, WHG will be able to diversify its predominantly U.S. value product offering while earning a higher effective fee on total client assets. As part of the transaction, Westwood will also acquire a 47% stake in Broadmark Asset Management, which subadvises a liquid alternative strategy on the Morgan Stanley platform.In a year where most investment management firms have endured a precipitous drop in AUM, revenue, and earnings, this acquisition could be a blueprint for future transactions. Asset manager values are down significantly over the last year, so there’s ample opportunity to add client assets and revenue for a reasonable price. These deals also tend to accrete immediately, and earn-out consideration provides downside protection against adverse market events or client losses. We’re still seeing strong deal flow for wealth management firms without the corresponding gains for asset manager M&A. If this deal goes well, we could finally see a year where asset management dealmaking outpaces RIA M&A. As always, we’ll keep an eye on it and report back.

Themes from Q3 2022 Earnings Calls

Part 2: Oilfield Service Companies

In a previous post, we highlighted common themes from OFS companies’ Q2 earnings calls, which included the role of OFS in energy security, OFS operators’ focus on margins rather than market share, and industry optimism. In last week’s post, we noted common themes from E&P companies, including a continued focus on share buybacks, moderate production growth, and the effects of inflation. This week we focus on the key takeaways from the OFS operators’ Q3 2022 earnings calls.Expanding Role of International Business SegmentsA common theme among OFS operators included the prevalence of quarterly growth in international segments and expectations of continued optimism among international segments. Executives noted that this growth is primarily driven by the need for updated oilfield equipment and technology outside the U.S. Their optimism is further enhanced by the surging U.S. dollar’s effect on overseas freight costs and labor. As broad-based activity increases tighten equipment availability, this will further drive price increases within global business segments.“Over the last few months, we booked orders for equipment into the Middle East and Africa. We’ll continue to selectively target international markets as we progress plans for more meaningful growth abroad. On the supply chain front, transit times and overseas freight costs are improving…while a strengthening dollar further supports improving margins.” – Scott Bender, CEO, Cactus Inc.“Our third quarter performance demonstrates the strength of our strategy to deliver profitable international growth through improved pricing… International revenue in the third quarter for the C&P [Completion and Production] and D&E [Drilling and Evaluation] divisions grew year-over-year from a percentage standpoint in the high teens and mid-20s, respectively, which outpaced international rig count growth and reflects our competitiveness in all markets. Our year-over-year growth and the margin expansion demonstrated by both divisions give me confidence in the earnings power of our international business.” – Jeff Miller, Chairman & CEO, Halliburton Company“I think international markets, in particular, have a long way to go in stepping up their technology that they apply in… in their drilling operations.” – Clay Williams, Chairman, President & CEO, NOV Inc. The Suspected Result of Near-Term Market Tightness — Long-term Sustainable Growth for Oilfield Service CompaniesOFS operators attributed expectations of steady and sustainable growth in their business to near-term tightness in the hydrocarbon commodity market. Without an immediate fix to the current supply and demand imbalances, equilibrium in the global oil and gas commodity marketplace will require years of investment to level. The imbalance may be further prolonged by E&P companies focusing on returning cash to shareholders.“While broader market volatility is clear, what we see in our business is strong and growing demand for equipment and services. There is no immediate solution to balance the world’s demand for secure and reliable oil and gas against its limited supply. I believe that only multiple years of increased investment in existing and new sources of production will solve the short supply… [E&P operators’] commitments to investor returns require a measured approach to growth and investment. Service companies follow the same discipline, delivering on their commitments to investor returns and taking a measured approach to growth and investment. What I think is underappreciated is how this results in more sustainable growth and returns over a longer period of time.” – Jeff Miller, Chairman & CEO, Halliburton Company“There’s very little used equipment that really can be refurbished economically, and what we’ve seen over the past year is more and more pressure pumpers in North America are pivoting towards buying new and the longevity and sort of the overall value offered by going to new versus used, I think, is a lot stronger.” – Clay Williams, Chairman, President & CEO, NOV Inc.“And there’s some drill out rigs that, again, what a couple of our customers have said is that they wanted to --they were out of budget, they were out of wells to complete. They wanted to stop that in kind of mid-Q4 and then pick them back up in Q1. Now we’ve had demand that’s kind of been building up behind, and so most of those rigs have already been redeployed… We’re now in a situation where even though there was some budget exhaustion, those rigs are now being put to work. And we know we have demand coming on the backside and 2023.” – Melissa Cougle, CFO, Ranger Energy Services Inc.E&P Production Growth Plans Concentrated Amid Strict BudgetsAs highlighted in a theme from last week’s post, domestic E&P production is expected to rise, albeit modestly. This growth is concentrated among certain large contracts; though the top lines may indicate relatively gradual and steady growth across the board, production growth is more concentrated among certain E&P operator plans. More generally, a limitation on broader growth for oilfield services companies in the near term is attributable to the E&P’s limited budgets. Considering the fragmentation in domestic production plans, some OFS companies have sought growth through acquisitions.“In terms of concentration, I’m going to guess that two-thirds — maybe a half to two-thirds — have to do with additions from our existing customers, which would be the publics and the other would be new logos. So, I guess the short answer is, [plans for production growth are] certainly concentrated with the large publicly traded E&Ps, at least ours.” – Scott Bender, CEO, Cactus Inc.“For the fourth quarter, we expect growing opportunities associated with our Completion & Production Solutions segment’s backlog to be mostly offset by certain projects that were pulled forward into the third quarter and supply chains that remain elongated, resulting in revenues that should be relatively flat.” – Jose Bayardo, SVP & CFO, NOV Inc.“It is clear that our acquisitions executed last year are now delivering strong returns, demonstrating the value of our consolidation strategy for Ranger and for the sector more broadly. The Ranger management team and board believe that consolidation remains an essential and ongoing process for the company within both existing and adjacent product lines. And we continue to be actively engaged on this front.” – Stuart Bodden, CEO, Ranger Energy Services Inc. Mercer Capital has its finger on the pulse of the OFS operator space. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the ancillary service companies that help start and keep the stream flowing. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.

December 2022

In this issue: Bank M&A 2022 — TurbulenceThe outlook for deal making in 2023 is challenged by significant interest rate marks, uncertain credit marks given a potential recession and soft real estate values, and the bear market for bank stocks that has depressed public market multiples. However, core deposits and excess liquidity of potential sellers is highly prized today given tight balance sheet liquidity and an inability to sell bonds to generate liquidity given sizable unrealized losses. A rebound in bank stocks and even a modest rally in the bond market that lessens interest rate marks could be the catalysts for an acceleration of activity in 2022 provided any recession is shallow.

Bond Portfolio Update

The U.S. bond market is undergoing its worst bear market in decades. Barclays U.S. Aggregate Bond Market Index produced a total return of negative 14.5% through September 30, 2022 and negative 16.0% through November 8, 2022. Excluding coupon income, the year-to-date loss was 17.2% which speaks to how low coupon income is given the nominal difference between price change and total return.Click here to expand the image aboveAs shown in the figure below, U.S. commercial banks have suffered unrealized losses in their bond portfolios equal to roughly 10% of the cost basis of both AFS and HTM classified portfolios as of September 30, which compares to a price reduction of 15.6% in the Barclay’s index as of quarter end.The less-worse performance by U.S. banks likely reflects less duration than the index, which has an effective duration of 6.25 years and weighted average maturity of 8.25 years. Our observation is that for the most part outsized losses among U.S. banks reflect an outsized position in municipals and/or MBS. The index composition is heavily skewed to U.S. Treasuries and U.S. Agency obligations given the heavy issuance of government backed debt the past 15 years or so.While management and directors at most banks are unhappy with their bond portfolios, institutional investors have taken a more nuanced view of the impact of rising rates based upon the tenor of third quarter earnings calls and the reaction of most stocks upon the release of earnings. Rising rates have supported bank earnings even though fixed-rate loan and bond portfolios are slow to reprice as floating-rate loans have repriced and banks have lagged deposit rates.Investor concern is more focused on liquidity risks. Some (or many) banks eventually may have to raise deposit rates sharply to stem outflows and/or fund loan growth because selling bonds is not a viable option given the magnitude of unrealized losses that if realized will reduce regulatory capital.Our prior commentary on bank bond portfolios following the release of the first and second quarter Call Reports can be found here and here.

Community Bank Loan Portfolios Have Unrealized Losses Too

Fixed income is undergoing one of the deepest bear markets in decades this year.There has been a lot of discussion surrounding the impact of rising rates on bank bond portfolios and bank stocks as rising rates have resulted in large unrealized losses in bank bond portfolios. My colleague, Jeff Davis, provides an update to his previous commentary on the topic based on third quarter Call Report data here.If subjected to mark-to-market accounting like the AFS securities portfolio, most bank loan portfolios would have sizable losses too given higher interest rates and wider credit spreads; however, unrealized “losses” in loan portfolios do not receive much attention because there is not an active market for most loans unlike most bonds that populate bank portfolios. Further, accounting standards do not mandate mark-to-market for loans other than those held-for-sale.While the trend in loan portfolio fair values is harder to examine given the lack of data, the following charts provide some perspective based on a survey of periodic loan portfolio valuations by Mercer Capital. To properly evaluate a subject loan portfolio, the portfolio should be evaluated on its own merits, but markets do provide perspective on where the cycle is and how this compares to historical levels.Fair value is guided by ASC 820 and defines value as the price received/paid by market participants in orderly transactions. It is a process that involves a number of assumptions about market conditions, loan portfolio segment cash flows inclusive of assumptions related to expected prepayments and expected credit losses, appropriate discount rates, and the like.The fair value mark on a subject loan portfolio includes two components – an interest rate mark and a credit mark. The interest rate mark is driven by the difference in the weighted average discount rate and weighted average interest rate of the subject portfolio. The discount rate that is applied to a subject loan should reflect a rate consistent with the expectations of market participants for cash flows with similar risk characteristics. The credit mark captures the risk that the borrower will default on payments and not all contractual cash flows will be collected.Since the end of 2021, rising market interest rates have been the predominant factor driving the change (i.e., reduction) in loan portfolio fair values. As shown in Figure 1, the median interest rate mark for our data sample has fallen from a modest 0.55% premium at December 31, 2021 to a 5.65% discount as of September 30, 2022. While bank earnings benefit from a higher rate environment and net interest margin expansion, it takes time for the increase in market rates to be passed on to customers via higher loan rates and for lower, fixed-rate loans to roll out of the portfolio. In talking with Mercer Capital clients and in our loan portfolio valuation practice, so far it seems that banks have been unable to fully pass on the increase in rates to loan customers.Figure 1: Trends in Interest Rate MarksClick here to expand the image aboveThe shift in the valuation adjustment attributable to interest rates reflects an increase in market interest rates.Figure 2 depicts the LIBOR forward curve at December 31, 2021, March 31, 2022, June 30, 2022, and September 30, 2022.Relative to December 31, 2021, forward LIBOR rates have increased 66 bps to 394 bps on average with the largest increases occurring for periods ranging from 1 to 12 months following the valuation date.Figure 2: LIBOR Forward CurveFigure 3 depicts the trend in the credit mark for our data sample relative to credit spreads. Credit spreads provide perspective on a number of factors, including where the credit cycle has been and where we may be headed.Figure 3: Trends in Credit MarksClick here to expand the image aboveOver the period shown in Figure 3, credit marks peaked at the start of the pandemic given the uncertainty and expectation of higher losses on loan portfolios. Credit marks trended down from the March 31, 2020 peak through the first quarter of 2022, as did banks’ loan loss provisions, as credit quality remained stable. While credit quality continues to remain strong, both credit spreads and credit marks have ticked up in 2022 with the weakening economic outlook and concerns that the Federal Reserve’s tightening interest rate policy may trigger a sharper downturn in economic activity.Mercer Capital has extensive experience in valuing loan portfolios and other financial assets and liabilities including depositor intangible assets, time deposits, and trust preferred securities. Please contact us if we can be of assistance.

Auto Brands and the 2022 World Cup

Who Are the Top Ranked Countries?

After failing to qualify in 2018, the United States Men’s National Soccer Team went over 3,000 days between World Cup matches. After returning to the World Cup stage this year, the U.S. team notched draws against Wales and England, meaning that the U.S. will advance to the knockout stages if they win against Iran.In the spirit of the Cup, we compare the FIFA rankings of the world’s largest vehicle-producing countries. Spoiler alert: there is no correlation. But in our research, we found plenty of interesting nuggets. We also discuss top vehicle-producing nations that did not qualify for the World Cup and nations that did but do not have a significant presence in auto production. We also get into brand presence and Blue Sky multiples of these nations’ vehicle brands.FIFA Rankings, World Cup Groups, and Vehicle Production DataAs the industry’s supply chain issues have shown us in 2022, the world economy is interconnected. Both the World Cup and personal vehicles demonstrate a wide variety of cultures and consumer preferences. Vehicle production data in this piece is based on depressed 2022 levels reported by the International Organization of Motor Vehicle Manufacturers, or "OICA." We note this data may not perfectly illustrate nuances between manufacturing vs. assembly. For example, none of the top 10 most popular vehicle brands in Brazil in 2021 were actually Brazilian, which ranks 6th globally in population as well as car production.The table below shows all 32 countries in the World Cup that are also captured in the reported 37 largest global auto producers for 2022. Only Brazil and Spain are ranked in the top 10 of both categories, with reigning World Cup champion France producing the 12th most cars in 2022 according to OICA. Germany is also ranked highly in soccer and car production, coming in 5th in cars produced and 11th in the World FIFA Rankings.The “Group of Death”In world soccer, the "Group of Death" refers to which group looks to be the most difficult to advance to the knockout stages. With the expanded tournament and group determination based on FIFA rankings, the odds of a prohibitive favorite being in the same group as two other favorites are significantly reduced. However, the Russian invasion of Ukraine meant the last three spots had not been determined at the time of the drawing. These three spots, eventually won by Wales, Australia, and Costa Rica, were placed into Pot 4 despite their FIFA rankings. This led to Group B having teams currently ranked 5, 16, 19, and 20, or a sum of 60. The next toughest World Cup group in terms of combined FIFA ranking is Group E with Spain, Germany, Japan, and Costa Rica. In terms of vehicle production, this would certainly be the Group of Death with three of the top seven vehicle-producing countries. When you consider that China (FIFA 79) and India (FIFA 106) are two of these, that’s some heavy concentration in Group E. Group A is the only group that does not have one of the world’s largest auto-producing countries.Top Vehicle Producers That Missed Out on the World Cup Now that we have looked at World Cup participant nations’ auto production industries let’s look at nations that did not qualify. While China and India have no significant soccer history, some high-level soccer teams are also top car producers, including Russia, the Czech Republic, Slovakia, Turkey, and Italy. See the table "Other Top Car Producers" for the OICA rankings of the nations that missed out on this year’s contest in Qatar. Russia hosted the 2018 World Cup and advanced to the knockout stages but was disqualified from the 2022 tournament given the ongoing conflict with Ukraine, who failed to qualify after a 0-1 loss to Wales (which was delayed due to the war). Perhaps the biggest shock to the casual observer is the omission of Italy, who won the World Cup in 2006 and the European Championships in 2020. A poor showing in the notoriously difficult European qualifying process ended for Italy after a shocking loss to tiny North Macedonia, who went on to lose to Portugal in the playoff.World Cup Teams That Do Not Produce Many AutomobilesAs noted previously, no teams from Group A are considered top auto producers. Based on geography, each of the six World Cup confederations has at least one World Cup participant without significant auto production. Costa Rica is the only country from CONCACAF (North and Central America) omitted from the OICA list though it is a relatively short distance from Mexico. Conversely, Morocco is the only African team on the top producer list. Strictly by these rankings, both Spain (7) and Morocco (22) are equally capable of playing professional soccer and producing vehicles.Auto Brands by CountryShifting away from production, there are four countries with brands that have a significant presence in the U.S.: Japan, the U.S., Germany, and South Korea. While German vehicles are associated with luxury, Japanese vehicles are viewed as more durable. German dealerships tend to fetch higher Blue Sky multiples in the U.S., but there’s an interesting comparison with their soccer teams here. While Germany is a favored high performer, Japan is viewed as more durable. Perhaps this is how Japan came from behind in the 2-1 upset when it looked like Germany might run away with it at halftime last Wednesday.Brands by country are shown below. Other major brands in the U.S. are Jaguar/Land Rover and Volvo, which are from the U.K. and Sweden, respectively.Auto Brands by OEM and Blue SkyBelow, we’ve tabulated major brands in the U.S. market, sorted by Blue Sky value according to the Q3 Haig report. We’ve included the OEM for each brand and their home country. While Acura is Honda’s luxury brand, it was first launched in the U.S. and Canada in 1986 and is primarily based in North America today. In 1989, Toyota and Nissan responded by launching Lexus and Infiniti, respectively. Other OEMs with multiple dealerships brands in the U.S. market include:VW (Audi is a luxury offering acquired in the 1960s)GM (Cadillac is a luxury offering acquired in 1908)Hyundai (also owns Kia; neither of which are considered luxury)Ford (Lincoln is a luxury offering acquired in 1922) While Toyota has become one of the most desirable dealership brands, they are still deemed less valuable than Lexus dealerships. Audis have declined from their runup in popularity about ten years ago, but they remain considerably more valuable than their VW counterpart, who continues to climb out of its emissions scandal. While Blue Sky multiples are positively correlated to luxury brands compared to the domestic/mass market, Cadillac, Infiniti, and Lincoln are all less valuable than the mass market version offered by their OEMs. According to Haig’s Blue Sky multiples, Cadillac is below all GM brands (Chevy and Buick-GMC), Infiniti is below Nissan, and Lincoln is below Ford. Whether it’s an issue of product mix or lack of attention/investment compared to core brands, there’s a clear dichotomy in performance compared to Lexus and Audi.ConclusionWhile we would have liked to run a statistical model based on brand desirability or production, we know the correlation would be spurious at best. But that won’t stop us from cheering on the boys in red, white, and blue!Mercer Capital follows key trends in the auto industry to stay current with the operating environment of our privately held auto dealer clients. To see how prevailing trends may impact your dealership, contact a Mercer Capital professional today.

Themes from Q3 2022 Earnings Calls

Part 1: Upstream

In Part 1: Themes from Q2 2022 Earnings Calls, the common themes among E&P operators and mineral aggregators calls included the strengthening of balance sheets to offset price volatility, the increasing role of share buybacks, and the persistence of supply and demand imbalances. This week we focus on the key takeaways from the Upstream Q3 2022 earnings calls.Continued Focus on Share BuybacksAs we noted in our analysis of last quarter’s earnings calls, E&P operators and mineral aggregators have seen exceptional profitability since the start of the upcycle in late 2021; companies accentuated paying down their debt and distributing to shareholders. With the continuance of stable cash flows, the role of share buybacks has increased as a source of returns in lieu of bolt-on acquisitions or other investment opportunities.“Look, we've seen the volatility in the market that every quarter, we've had the opportunity to buy shares back, and when that opportunity presents itself, we'll do so aggressively. I think the key to any of those questions is the ability to generate free cash flow. And that's certainly what our focus is… [as well as] maintaining the flexibility on how the return of that free cash flow gets prosecuted. I will say that in conversations with our long-only shareholders, a lot of those guys prefer to get the cash back. But again, we believe that we'll have opportunities to repurchase shares back.” – Travis Stice, CEO & Chairman, Diamondback Energy Inc.“While we had guided third quarter return of capital to at least 50% of our CFO due to strong operating and financial performance, our financial strength, including our replenished cash balance and favorable market conditions, [and] including clear value in our stock price, we saw an opportunity to materially step-up the pace of repurchases. We bought back $1.1 billion of stock during the third quarter.” – Dane Whitehead, Executive Vice President and CFO, Marathon Oil Corp.“On the capital allocation side… we continue to take advantage of current equity market conditions by repurchasing 8.4 million shares in the quarter and another 3.2 million shares after the close of the quarter through October 21. Said differently, we bought back another 4% of our total shares outstanding. And over the last eight quarters, we have repurchased approximately 20% of the outstanding shares of the company. We continue to see this as a remarkable low-risk capital allocation opportunity moving forward. And although we have not given an explicit capital allocation framework, if you extrapolate these levels of buybacks moving forward, you can see that we will continue to dramatically reduce our denominator and thereby meaningfully grow our free cash flow per share.” – Alan Shepard, CFO, CNX Resources Corp.Moderate Production GrowthAs a consequence of a favorable pricing environment and continued tightness on the supply side, industry operators are increasing production in order to capitalize on strong market conditions. Ultimately, firms may not be able to fully capitalize on high prices due to increased labor and equipment costs as well as other miscellaneous supply-side challenges.“We generated total production volumes for the quarter of 40,000 Boe per day, an increase of 19% over our second quarter volumes. All that increase was from royalty volumes, which were up 23% to 37,300 Boe per day. Our base production is trending up as development activity remains robust across our acreage and as our target development programs with operators in the Shelby Trough, Haynesville and East Texas, Austin Chalk continue taking shape, while growing and moving forward. Production from the quarter exceeded expectations due to certain operators, particularly in Louisiana Haynesville, bringing new wells on line at more aggressive initial flow rates to take advantage of higher natural gas prices.” – Tom Carter, Chairman and CEO, Black Stone Minerals, L.P.“We posted strong results this quarter that were underpinned by sequential production growth of 7% on a BOE basis and 8% on an oil-only basis, exceeding both our guidance and consensus estimates. These gains were driven by well performance that was above expectations and consistent execution in the field, particularly on the completions front with reduced cycle times in the Permian and Eagle Ford. At a bigger picture level, our commitment to a life of field development philosophy of our multi-zone resource base, paired with continuous improvements in drilling and completion designs, has resulted in year-over-year improvements in Callon's well performance at a time when concerns around inventory degradation are increasingly becoming a focal point of the industry.” – Joe Gatto, President & CEO, Callon Petroleum“I think there is asset maturation. I think certainly, supply chain constraints are also limiting growth... I think all of those factors weigh into more of a muted production growth from US shale going forward. That said, out here in the Permian, I think we're still continuing to hit production records every month, somewhere close to 5.3 million to 5.5 million barrels a day. But that's going to be challenged to continue to grow that into the future. Do we have the assets out here? Yes, we do. But some of those other topical constraints that I mentioned are going to be impediments to efficient growth.” – Travis Stice, CEO & Chairman, Diamondback Energy Inc.“I think, just generally we see some large pads coming on [in] Q2 and beyond… The Diamondback piece, which we have 100% visibility on, will grow 10%. It's just going to start growing in Q2 and Q3… the way we see it right now is basically flat oil from Q3, which was an all-time high into Q4 and Q1 and then the ramp starts to begin again in… Q2 of next year.” – Kaes Van’t Hof, President, Viper Energy Partners, L.P.Inflation Continues To Limit GrowthThe current high-price environment incentivizes operators to grow rapidly. While most industry participants certainly would like to increase the scale of their output, multiple executives discussed how high inflation has constrained their efforts. The impact from inflation is evident in multiple areas, but especially in the cost of raw materials and labor.“One of the major topics of the year continues to be the inflation story. The price pressure we are seeing on steel, fuel and labor continues to be persistent. Our employees are maintaining their focus on finding ways to mitigate inflation through innovation and efficiencies in our operations. Through their efforts, we now expect our average well cost to increase a modest 7% as compared to last year.” – Billy Helms, President, and COO, EOG Resources Inc.“The biggest concern we've got is not so much labor inflation or service inflation outside the company as much as it is… the quality of the available labor set or the quality of the available service skill set. And that's where we spent most of our time. So it's not just the easy question of will the individuals and the service provider be available. It's more a question of can we get the best of the individuals and the best of the service providers available.” – Nicholas Deluliis, President, CEO & Director, CNX Resources Corp.“Casing has been a massive headwind for us and for the industry. Midland Basin casing is now $110 a foot, that is a huge number of… fixed cost that we can't really control here.” – Kaes Van’t Hof, President & CFO, Diamondback Energy Inc.“I think on the labor inflation side, that's subject to kind of more of the macro environment. I mean you could potentially paint a scenario where if the company slips -- or the country slips into recession, some of those pressures ease. And conversely, if we avoid that, you can continue to see pressure on those fronts. So again, this just goes back to kind of the wider guidance we provided on this call, and then we'll have some more color as we move forward. I think we'll know a lot more a quarter from now about where things are headed.” – Alan Shepard, CFO, CNX Resources Corp. Mercer Capital has its finger on the pulse of the minerals market. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the E&P operators and mineral aggregators comprising the upstream space. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.

Buyer’s Remorse? CI Financial’s M&A Binge

On the earnings call last week, CI Financial reiterated intentions to separate its U.S. wealth management business and Canadian asset management business through an IPO of its U.S. wealth management business.CI’s CEO Kurt MacAlpine reported continued progress toward the IPO and announced an anticipated S-1 filing later this month. After the transaction, the U.S. wealth management business will trade on the U.S. exchange, while the legacy Canadian asset management business will be delisted from the NYSE and traded exclusively on the Toronto Stock Exchange.Since MacAlpine took the helm as CEO in 2019, CI has quickly made a name for itself as one of the more prolific acquirors of U.S. wealth management businesses. Driven by a rapid succession of deals, CI increased its U.S. wealth management AUM more than tenfold in just two years—from C$15.5 billion on October 31, 2020, to C$171.9 billion on October 31, 2022.CI’s share price has fallen over 40% this yearWhile CI has had apparent success at completing deals, investors have not been on board with the strategy. CI’s share price has fallen over 40% this year, and many have publicly speculated that CI’s substantial deal volume is at least partially attributable to its willingness to overpay. While the pricing of CI Financial’s acquisitions is generally not disclosed, the volume of deals that CI has strung together during intense competition from buyers and record high multiples suggests it’s not accustomed to being the low bidder.This year, souring market conditions have thrown cold water on CI’s M&A binge. The firm’s deal pace is slowing, and the focus has shifted to deleveraging and attempting to unlock the value of the U.S. wealth management business built through the planned spinoff. By selling off a portion of the wealth management business via IPO, CI will raise funds that it can use to pay down its debt balance. The spinoff will also present a stand-alone, pure-play wealth management business to the public markets that (CI’s management hopes) will be valued more like a private wealth manager and less like a public asset manager.DeleveragingAfter the transaction, the existing debt and guaranteed payment obligations related to CI’s wealth management acquisition spree will be retained by the Canadian asset management business, while the U.S. business will retain the contingent consideration obligations related to prior acquisitions. The Canadian asset management business will then use the proceeds from the spinoff to pay down its debt balance, which stood at C$3.9 billion on September 30, 2022. After the IPO, CI’s management expects that the Canadian business will not fund any future U.S. acquisitions, nor will it pursue large M&A opportunities in Canada. Future inorganic growth of the U.S. business will be funded by cash flow, partnership units, and public company stock.The focus on deleveraging comes at a time when debt costs have been soaring, putting additional strain on leveraged consolidator models beyond declining revenue and rising costs for component firms. Amidst this environment, early warning signs for CI have started to emerge; in April this year, CI Financial’s issuer credit rating was downgraded by S&P from BBB to BBB- (the lowest investment grade rating). In early November, CI’s credit facility was amended to increase the maximum leverage ratio (funded debt to annualized EBITDA) to 4.5x (previously 4.0x). On September 30, CI’s leverage ratio stood at 4.0x—exactly in line with the covenant prior to amendment.While CI initially targeted a 20% spinoff of the U.S. wealth management business, CI’s CFO hinted that the amount could now be higher. A larger spinoff would presumably allow for greater deleveraging.Unlocking Value?Beyond deleveraging, CI hopes that a pure play U.S. wealth management business will be valued differently from the combined asset and wealth management business. CI’s Enterprise Value / LTM EBITDA multiple peaked at close to 12x late last year, and today CI trades at roughly 7.7x trailing twelve-month EBITDA. Back in February, MacAlpine remarked on CI’s fourth-quarter earnings call that he felt the company was “criminally undervalued” based on where it was trading at the time. “We’re not getting credit for the shift of our business to the U.S. nor the rapid growth of our wealth management business,” MacAlpine added.The disparity between publicly traded asset manager valuations and privately transacted wealth manager valuations has become more pronouncedWhile we doubt CI’s valuation is a criminal offense, MacAlpine may be on to something. The disparity between publicly traded asset manager valuations and privately transacted wealth manager valuations has become more pronounced in recent years. EBITDA multiples for most smaller publicly traded asset managers have trended downwards, reflecting adverse trends like pricing pressure and asset outflows that have plagued the asset management industry. On the other hand, wealth management firms have been less exposed to these pressures and have seen multiples trend up (at least through the end of last year) as a proliferation of capital and acquiror models have competed for deals.We suspect that CI has paid a higher multiple for many of its wealth management acquisitions than it trades at itself. Undoing that reverse multiple arbitrage is something that CI’s management hopes will happen with the spinout, but the current market environment will likely make this an uphill battle. Along with almost everything else, multiples for publicly traded asset/wealth managers have declined this year. According to MacAlpine himself, private market valuations have declined “in lockstep” with public markets. All of this suggests that achieving an attractive valuation for the U.S. wealth management business may prove difficult.

Meet the Team

Harrison Holt

In each “Meet the Team” segment, we highlight a different professional on our Auto Dealer Industry team. This week we highlight Harrison Holt, Financial Analyst.Harrison Holt began his valuation career at Mercer Capital as an intern in the summer of 2019. After finishing his degree at Rhodes College in 2020, Harrison joined Mercer Capital as a financial analyst in the Memphis office. In 2022, he moved to Mercer Capital’s Nashville office.What influenced you to pursue a career at Mercer Capital?Harrison Holt: I have always been very intrigued and excited by math, problem-solving, and storytelling. Luckily for me, valuation work is the intersection of the underlying story behind a business's performance and the value indications that established financial models imply for that business. These two forces have to reconcile with one another, and I really enjoy telling the stories of numerous businesses through my valuation work. Each valuation engagement is unique and offers many specific research and learning opportunities. My work with auto dealerships has been the most rewarding, as I have the opportunity to consistently study the auto dealer industry for market insights that pertain to various valuations. Location is also a huge benefit of working for Mercer Capital. As a native Tennessean hailing from Jackson, starting my career in West Tennessee was a great way to stay close to family and challenge myself professionally. After my recent move from the Memphis office to the Nashville office, I feel grateful that I can do the type of work that I love in a part of the country that I love.What types of auto engagements have you worked on?Harrison Holt: There are many reasons an auto dealership would need a valuation from Mercer. For example, divorce proceedings, estate planning, and buy-sell issues are a few of the reasons why an auto dealership has crossed my desk. In my valuation work, I have valued dealer operations, entities that own the underlying dealership real estate, and powersports dealerships.Tell me about any interesting takeaways from your experience writing the monthly SAAR blog.Harrison Holt: Starting my career at the beginning of the COVID-19 pandemic came with its fair share of challenges, and this was especially true for the automotive industry. I have followed the monthly Bureau of Economic Analysis (BEA) SAAR data releases for two consecutive years now. When I first started studying the SAAR, I became very comfortable with the data set as a whole. I started by reviewing the industry's history so that I could draw relevant conclusions about where automotive retail stands today. As most of our readers know, the last two years have been a roller coaster for auto dealers and the broader economy. When I first began covering the industry, high inventory volumes and low selling activity were the auto dealerships' challenges. Mere months later, low inventory balances and red-hot demand pushed sticker prices and profitability through the roof. Supply chain issues, pent-up demand, and a volatile affordability environment have made following the industry exciting. While it's been challenging to keep up, I am grateful that it's an intriguing story to tell.What has surprised you the most about valuing auto dealerships compared to businesses in other industries?Harrison Holt: From time to time, I have found myself asking questions like “How can a dealership with only twenty units on the lot sustain record profitability over so many consecutive months?” and “Does it make sense to sell this dealership at elevated earnings and elevated blue sky multiples when the business itself is a premier cash flowing asset?”. These questions come from observing the situation in which most of our clients find themselves. It has been nice to see how well these clients are doing, especially when many other industries are struggling to adapt to a rapidly changing economic environment. While client success is always good to see, valuing auto dealerships in the current environment does not come without challenges. One challenge I have encountered while valuing auto dealerships has been estimating ongoing performance, which is a crucial step in the valuation process. Dealership performance over the past two years has been encouraging for our clients, but estimating the ongoing earning power of their dealerships into the future requires us to temper our expectations from currently elevated levels. The industry as a whole has addressed this issue by changing the standard for calculating ongoing earnings used in deal pricing. Prior to the pandemic, trailing twelve-month earnings were the standard. Since then, industry participants such as Haig Partners have suggested multiple iterations of how to calculate ongoing earnings in an attempt to:Exclude the initially uncertain COVID-19 impact,Partially consider elevated earnings but place more weight pre-COVID performance, andPlace more reliance on recent outperformance due to COVID and the chip shortage. Now approaching three years since the pandemic began, it is increasingly difficult to derive a one-size-fits-all formula for how to determine ongoing earnings for all the 16,000+ dealerships across the country.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of November 14, 2022

Rough Quarter in a Rough Year

Q3 RIA Performance Was Mostly Bad, But in Lots of Different Ways

Most of the 9/30 quarterly results are in, and public RIA performance was all over the map. Mostly, it was a rough quarter in a rough year. Sagging AUM led to revenue cuts which dropped straight to the bottom line. Some firms mitigated their downside by cutting bonus compensation and marking down earnout payments for acquisitions. We did a survey of a cross-section of asset and wealth management firms. Ultimately, it appears some business models are working better than others.Click to View Full Screen

45Q Tax Credit Boosts Values Of Carbon Sequestration Projects, Yet Most Still In Development

Approximately half of the Inflation Reduction Act’s budget ($369 billion) has been authorized for spending on energy and climate change. One of the components buried in that act was the supercharging of an existing tax credit—45Q. This tax credit expanded from $50 per ton of sequestered CO2 to $85 per ton. What does this mean for potential carbon capture sequestration projects around the country? Perhaps a lot. However, it is too early to tell. According to Robert Birdsey of Greenfront Energy Partners, it would be like asking the pilgrims what they thought of America as they stepped off the boat.That has hardly kept interest and activity from moving forward. A few weeks ago, Exxon and EnLink announced a largest-of-its-kind commercial deal in Louisiana to capture emissions from CF Industries’ Ascension Parish and transport it on EnLink’s transportation network to store it underground on Exxon property. Start-up is expected in 2025 and will sequester up to two million metric tons of CO2 annually. At $85 per ton, that’s a commercially significant tax credit—$170 million. It won’t be the last one. There are dozens of projects at various points in the development pipeline for this space. In addition, capital has been flowing freely into the broader “sustainability” space. According to Morningstar, in the first half of 2022 alone, there was approximately $33 billion of net cash inflow into that sector, along with 245 new funds launched.Last week, I attended the Hart Energy Capital Conference, whereby Mr. Birdsey gave a presentation. I also spent some time with Mike Cain of U.S. Carbon Capture Solutionsto find out more. Some interesting facts and issues arose.IncentivesThis effect helps remove financing bottlenecks for a number of these green projectsThe White House has placed a value on the social cost of carbon at $51 per ton, which is partly why the tax credit was included in the Inflation Reduction Act (“IRA”). This effect helps remove financing bottlenecks for a number of these green projects. It can be, in effect, like the government financing approximately 30% of one’s equity in a project. In a space where being the low-cost producer is the name of the game, this puts a lot more players in the game. In fact, Carbon Capture Sequestration (“CCS”) volume could reach 200 million tons by the year 2030, a 13-fold increase relative to pre-IRA estimates, according to Net Zero Labs. Ironically, the upstream industry is the most qualified to capitalize on this incentive, giving traditional E&P players more opportunities to execute projects.IssuesEven so, most of the potential projects in the CCS pipeline remain in development, where memorandums of understanding and letters of intent abound. However, binding contracts are fewer and far between, and there are reasons for this. First, from the standpoint of the 45Q credit itself, there is a potential time-matching issue here. Projects like this are multi-year—even over a decade if permits get held up. If a small government congress comes along and abolishes the incentive, it would almost certainly submarine the economics of the project. At this point, the 45Q credit is at the heart of the project’s economic viability, so if it goes, the project goes. There could be a lot of elections between now and 2030, which makes some investors nervous.However, that’s less of an issue compared to others. There are three main elements to a successful CCS project: (i) an emitter, (ii) transportation, and (iii) a sequestration site. There are issues with all three. Emitters have been cagey about these projects because they are reticent about third parties adding infrastructure to an expensive asset such as a power plant. In addition, the long take-or-pay contracts that have been proposed for a lot of these projects are risky themselves. From the transportation aspect comes most of the same issues as other pipelines. Just ask the Keystone or Atlantic Coast Pipeline proponents. In addition, CO2 has to be transported at high pressures (say 1,100 PSI) in semi-liquid, low-temperature form. That makes the infrastructure potentially different than a conventional natural gas pipeline. Then, there are sequestration site issues. The injection sites for CO2 are known as Class VI wells. To date, there are only two active Class VI wells in the U.S., so permitting is a big unknown and presents a binary risk profile. Get your well approved, then move forward. If it gets rejected, your project could be finished. Oh, and did I forget to mention that these projects can be in the hundreds of millions of dollars of capital? That’s a lot of money that could wait a long time for a return.Many investors look for emitter and sequestration sites that are proximate to each otherBecause of this, many investors look for emitter and sequestration sites that are proximate to each other, which is not always easy to find. Emission concentration economics, issues with monetization of 45Q credits (there is not currently a robust trading market for these), and other issues can sideline a project.The Future?Nobody really knows, yet optimism remains. It’s an emerging market. U.S. Carbon Capture Solutions is pushing forward with its Wyoming project, even though it may be 2030 before it comes online. The 45Q appears to have given this space a shot in the arm; we’ll see in five or more years from now what that turns into.Originally appeared on Forbes.com.

October 2022 SAAR

The October 2022 SAAR was 14.9 million units, up 12.7% from October 2021 and up 9.8% from last month. This month’s SAAR comes as a bit of a surprise, as the last three months’ sales pace settled at around 13.4 million units and seemed to have stabilized at a short-term equilibrium. However, meaningful improvements in inventory balances and other tailwinds like natural disaster-related demand contributed to the second-highest monthly SAAR total this year. For perspective, from 2014-2019, there were zero months where SAAR was below this recent high in the inventory-constrained 2022.On a full-year basis, this month’s SAAR moved the 2022 average SAAR from 13.6 million units at the end of last month to 13.73 million units. Despite this turning of the tide, it remains unlikely that the full-year 2022 SAAR will exceed 14 million units, as there is not much time left in the year to pull the average up above that threshold. For perspective, the November and December SAAR would need to average 15.4 million units for the full-year average to arrive at 14 million units. Furthermore, as auto sales are a function of both supply and demand, it will also be interesting to keep an eye on the demand side of the auto sales equation as recessionary fears intensify. Stay tuned over the next two months to see if the national sales pace continues to improve.Unadjusted sales trends on a relative basis are mainly in line with the last several months. October 2022 unadjusted sales are markedly better than October 2021 but remain depressed when compared to October 2015 through 2020. However, the gap between current sales and what was observed prior to the auto inventory crunch seems to be shrinking as the months go by, which is also an interesting trend to keep an eye on as 2022 winds down.Total Sales - Not Seasonally AdjustedInventoryAccording to the NADA, ground and transit inventory totaled 1.54 million units at the end of October 2022. The industry has not seen this magnitude of inventory flow since May 2021, which is right around when the industry’s inventory crunch began to take hold. In our opinion, we should hesitate before assuming that vehicle availability has fully recovered, as the September 2022 industry inventory-to-sales ratio (0.64x) remains well below its long-run average (2.4x). We will get a better idea of this month’s inventory levels when October 2022 I/S ratio data is released next month. Nevertheless, improved inventory balances are a good sign for consumers and dealers alike, as it seems like it has been ages since the days of full car lots and numerous options for consumers to test drive and choose from.Inventory/SalesTransaction Prices, Incentive Spending, and Monthly PaymentsAccording to J.D. Power, the average transaction price of a new vehicle is expected to be $45,599 in October 2022. After numerous months of increasing transaction prices and new record highs each month, this month’s average transaction price is roughly flat compared to September 2022. Rising interest rates and recessionary fears have cooled transaction activity in many areas of the economy, like the housing market and the mergers and acquisitions market, and we believe it is likely that the same trend will occur with respect to new vehicle purchases over the next several months. Keep in mind that these activities heavily rely on interest rates to support affordable pricing. For dealers, new vehicle prices are still so elevated that profitability can still be achieved at lower volumes. Still, many dealers should expect sticker prices to begin to slip modestly in an effort to keep monthly payments in a reasonable range for consumers. According to J.D. Power, average incentive spending per unit is expected to total $882, down 44.7% from this time last year and marking the sixth straight month below $1,000. It is clear that OEMs are sticking to their guns and keeping incentives low, and we believe that this is likely to continue as long as GPUs remain historically high. However, incentives could creep back up for OEMs and dealers to keep transaction prices higher as consumers have become increasingly accustomed to these rising prices.Hurricane Ian’s Effect On the Automotive IndustryHurricane Ian raked a path of destruction across the southeast United States on September 28, 2022, devastating the state of Florida and its Gulf Coast before making final landfall in South Carolina two days later. The hurricane is now considered the second-deadliest storm to strike the continental United States since Hurricane Katrina in 2005.While the total damage done to the Gulf Coast and its people goes far beyond its effects on the automotive industry, some interesting auto-related effects are worth mentioning to our blog readers.According to Cox Automotive, it has been estimated that the total number of severely damaged vehicles in need of replacement range anywhere from 30,000 to 70,000 as a result of Hurricane Ian. Considering the region’s significant demand for replacement vehicles, retail sales in the affected area are expected to increase in the fourth quarter of 2022. Perhaps the uptick in sales that the entire industry experienced in October has something to do with this acute regional demand.Cox Automotive also posits that about 80% of replacement vehicles will come from the used vehicle market due to difficulties acquiring new vehicles from dealerships. This demand for used vehicles is likely to apply upward pressure on regional pricing and make it more likely that flood-damaged vehicles appear for sale. Generally, totaled cars and trucks are given a “salvage title” and cannot be legally driven in the United States. However, some states allow buyers to repair totaled vehicles and issue a “rebuilt title,” making them legal to drive. This process will likely produce fraudulently “title-washed” vehicles as opportunists can purchase a totaled car or truck at auction, move them to a state where re-titling is legal, and return the car to the Gulf to resell.In any case, filling the void that Hurricane Ian left in the vehicle market should prove difficult in a time of inventory restrictions. While inventory balances seem to be improving on a macro level, a concentrated need in Florida and South Carolina will likely be challenging to fill. Dealers in the region should conduct thorough due diligence on used vehicles they purchase for resale and expect demand to remain elevated throughout the hurricane recovery process.November 2022 OutlookMercer Capital’s outlook for the November 2022 SAAR is cautiously optimistic. Industry supply chain conditions are beginning to improve. However, sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving despite recent signs of improvement. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Perhaps the November SAAR can continue to approach 15 million units and signal a true turning of the tide, but we predict that a 14 million unit SAAR for 2022 is unlikely in the current landscape.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a Mercer Capital auto dealer team member today to learn more about the value of your dealership.

The Truck Is Slowing

Are We Running Out of Gas or Just Coasting?

Most experts agree that rates and demand for transportation services have been trending downward. There has been more disagreement about what that means, though – are we headed for a trucking recession, or are we simply coming down off our COVID-19 induced highs?

Rising Interest Rates Will Likely Affect More Than Just RIA Stock Prices

Higher RIA Aggregator Bond Yields Could Portend Lower M&A and Transaction Multiples in 2023

We haven’t blogged about the bond yields of RIA aggregator firms in the past because there hasn’t been much to report. Before this year, yields didn’t move much and generally stayed between 2% and 8%, depending on the term and credit quality of the issuer. That all changed last November when the Federal Reserve and other central banks began raising interest rates to fight mounting inflationary pressures in the global economy. Now RIA aggregator bond yields are in the 6% to 14% range after fairly steady gains throughout this year.Click here to expand the image above.Corresponding bond prices have fallen over this time, and we use a recent Hightower issuance to demonstrate the inverse relationship between bond yields and prices.Rising interest rates have also affected equity prices, particularly in the RIA sector, which has doubled the market’s loss over the last year.The driving forces behind the sharp decline in RIA stocks are relatively straightforward. Stock prices are strictly a function of earnings and a multiple (E x P/E = P). Earnings are lower because revenue and AUM have declined in the capital markets, with inflationary pressures driving costs up and margins down. Rising interest rates have pushed up the costs of debt and equity capital resulting in higher discount rates and lower multiples. The cumulative effect of these forces is a ~50% decline in RIA aggregator and investment manager stock pricing since last November.We haven’t seen these pressures play out in the M&A market for investment management firms.That could change in the coming quarters as M&A activity is often a lagging economic indicator, as deals can take months or even years to close after their announcement. The adverse effects of rising interest rates, higher inflation, and lower earnings also impact closely held RIAs, so they’re also vulnerable to reduced valuations and transaction multiples as prospective buyers anticipate lower cash flows on a diminished AUM base.Deal volume could also suffer in 2023 as much of it is driven by RIA aggregators, who are reeling from higher financing costs and lower valuations. CI Financials CEO Kurt McAlpine noted that their pace of acquisitions has “absolutely slowed down” in a recent earnings call. The combination of rising debt costs and lower expected returns in the RIA space could cause the other aggregator firms to follow suit, which would likely curtail deal-making in the sector until markets recover. The M&A market for RIA firms tends to be resilient, so we’ll continue following these trends and report back.

Market Insights on Auto Dealer M&A Activity

A few weeks ago, I sat down with Kevin Nill of Haig Partners to discuss the current state of the M&A market and other timely trends in the auto dealer industry. Specifically, I wanted to discuss some of the movements in Blue Sky multiples for various franchises and interpret the range of multiples that Haig Partners recently published with the release of their Second Quarter 2022 Haig Report (subscription required).What is the current state of the M&A market for auto dealerships? Any signs of transactions slowing down? Are you seeing earnings or multiples start to plateau or revert?Kevin: The market continues to be quite active, with a nice balance of buyers focused on strategic growth opportunities and sellers who see valuations still at or near peak levels. The pandemic accelerated the need for scale to effectively compete in a changing retail environment—consumers are ever more focused on a seamless buying experience and are embracing a digital world for researching, negotiating, and transacting the retail purchase. Couple that with the benefits of marketing a broad and large selection of inventory and dealers recognize they need more franchises and locations to effectively compete.Our analysis indicates there may be over 8 million units of pent-up demand in the marketplaceNADA has suspended the publication of data on the performance of the total dealer body, but public company financial results do indicate we may have seen a plateau in earnings. Based on our analysis, the average public dealership earned $7.0M through the Last Twelve Months (LTM) ended 2Q 2022, down just slightly from $7.1M for the quarter ended 1Q 2022. However, that’s still up approximately $5M from 2019’s average of $2.1M!! From the data and research we are seeing, inventory constraints should continue for the next several years and ensure the dealer enjoys strong gross margins for some time. Our analysis indicates there may be over 8 million units of pent-up demand in the marketplace. Additionally, the high gross F&I and service departments continue to see an upward trajectory in results.As for multiples, our firm tracks this very closely by monitoring transactions we represent alongside ongoing discussions with industry leaders in finance, accounting, and the legal communities. In summary, multiples overall have changed little since the pandemic: it’s the underlying earnings that have contributed to the elevated valuations. That said, some franchises are gaining traction and are more appealing to buyers. These include Toyota, Hyundai/Kia, and Stellantis.Scott: With NADA’s suspension of dealership performance data, Mercer Capital has also pivoted to supplying information and trends from public companies in our recently published Mid-Year 2022 newsletter. Despite positive revenue growth in the last twelve and six months, revenue growth in the more recent period is less in all six public companies showing signs of slowing down. Additionally, public companies have continued to enjoy heightened gross profit from new and used vehicle departments compared to historical averages.Any new trends in buy/sell negotiations in the last few months? Any sticking points?Kevin: There really haven’t been any “new” issues that have arisen in buy/sell negotiations, but one trend we are seeing both in the industry and our practice is a willingness of sellers to entertain either a sale of just some of their dealerships or a minority/majority ownership stake in the entire enterprise.The willingness of sellers to entertain either a sale of just some of their dealerships or a minority/majority ownership stake in the entire enterprise is a recent trendSellers are seeing these alternatives as additional strategic options for their families and organizations. In some cases, a seller may choose to take some proverbial chips off the table by exiting a market or selling a couple of stores. Further, as outside capital investors continue to target auto retail due to strong and consistent returns, some dealers are selling a percentage of the business, which allows them to stay on and operate the business. Our recent publications have gone into greater detail on this subject if readers want to know more about this trend.Scott: The trend for dealers to sell a small minority stake in their entire group (or perhaps only divest of a rooftop or two) seems to be a new and interesting phenomenon. This trend appears to be a shift from dealers selling the entire enterprise or a majority stake in the dealership holdings. Auto dealers clearly value maintaining control and not having to answer to a family office group, private equity holders, or a third-party controlling stakeholder.Operating an auto dealership is very much a day-to-day and month-to-month business. Auto dealers are usually heavily invested in their communities and care deeply about their legacies.Selling a minority interest gives the auto dealer some liquidity. While dealerships have become very valuable and have generated record profits, often those profits are reinvested in the business or are leveraged against other assets, while the heightened value of the dealership only represents value on paper until a transaction or liquidation event occurs.Mercer Capital provides estate planning valuation services that may benefit owners who take some chips off the table once a firm like Haig Partners has helped them negotiate a minority investment.The latest Haig Report mentions Toyota is the most desirable brand. Is there any reason it would not obtain the same multiple as luxury brands?Kevin: It’s no surprise to anyone active in the auto retail space that Toyota dealerships are in high demand. Manufacturer relations are best in class, and the underlying product continues to resonate with consumers. Our firm has sold 33 Toyota dealerships, including the 2nd highest-valued dealership ever in August 2022 (John Elway’s Crown Toyota). Buyer interest is always substantial. In most cases, Toyota stores will bring better multiples than some of the smaller luxury makes like Jaguar, Land Rover, and Audi. But in general, the high-profile luxury nameplates still command a higher multiple. There are a number of reasons, but the most impactful cause is there are far fewer Lexus, Mercedes-Benz, or BMW dealerships in the market and even fewer for sale. So “Economics 101” is in play—limited supply and high demand bring higher multiples. Scott: Kevin’s comparison of a Toyota dealership investment to a luxury brand is equivalent to the allure of owning a professional sports franchise. Interested investors in luxury brands covet the exclusivity and market appeal of owning one of these franchises. There may only be a few luxury brands in each market, and if one becomes available, it may be a long time until another luxury franchise becomes available. To Kevin’s point, the approximate number of Toyota and various luxury brand franchises in the United States are as follows: Will the shift for Cadillac, Infiniti, and Lincoln blue sky from a dollar amount to a multiple materially shift the value of these franchises?Kevin: Over the past several years, several weaker franchises traded for a hard dollar amount rather than a multiple of earnings, given the lack of repeatable earnings. Buyers placed a value on the “shingle” and looked at used cars and fixed operations as their way to make money from these stores. However, as some of these brands have seen a resurgence in performance, partially from the post-pandemic bump but also from developing more appealing products, we have seen buyers take a more bullish approach. So, yes, these franchises have definitely seen an improvement in value. Nissan is another brand we have seen improve in the eyes of buyers. The franchise still has a way to go, but many believe the worst is behind Nissan — their products are solid, and the OEM has learned from its “volume at all costs” approach.Are there any new threats to the auto industry?Kevin: Open any automotive periodical, and you will see discussions about the potential impact of EVs. One consequence of the forecasted shift away from ICE to EV is the desire of some OEMs to modify their retail strategies. Tesla and other EV startups have gone the direct selling route, foregoing the traditional franchise model, and some major manufacturers are eyeing this strategy with jealousy. All despite historically failed attempts to replicate the proven ability of the franchise retailer to best serve the consumer’s needs. Ford, Hyundai, Mercedes-Benz, Volvo, and Polestar are examples of manufacturers who are overtly or quietly trying to change the retail model more toward the agency model seen in Europe. Haig Partners encourages dealers to be active participants with their state dealer associations to ensure franchise laws remain robust and protective of retailers. Scott: Despite the news and headlines dominated by EVs, the implications of EVs can vary drastically by brand. In other words, some OEMs are further along in producing EV models, while others do not anticipate producing EVs before 2024 and 2025. Additionally, the requirements of the various OEMs to auto dealers are also quite different. Some brands do not require any additional dealer commitments, while others, such as Ford, are forcing auto dealers to declare at what level they want to opt-in for selling EVs. Ford’s financial requirements can range from $0 for dealers that do not opt-in to selling EVs (only selling ICE vehicles) to $1,200,000 for dealers that opt-in to selling EVs at the premium level.What are the typical adjustments seen in negotiations for buy/sells?Kevin: One of the most important aspects of representing a seller is ensuring the buyer has a solid understanding of the historic and expected cash flows generated by the dealership. Just looking at the dealership’s financial statement doesn’t accurately depict the earnings opportunity of the store.Just looking at the dealership financial statement doesn’t accurately depict the earnings opportunity of the storeWe extensively analyze the dealership to understand what add-backs and deducts should be applied to reflect recurring cash flow. Some are non-cash entries; others are one-time expenses or income that should be adjusted.Some common add-backs are LIFO expenses, owner’s compensation (if excessive and/or not to be recurring for a future owner), owner’s perks that run through the statement (travel, airplane, etc.), and F&I over-remits/mailbox money that is generated outside the dealer statement.Deductions to earnings include PPP funds and one-time settlement funds or gains from asset sales.Scott: Similarly, Mercer Capital reviews the balance sheets of auto dealers for potential adjustments to inventories, fixed assets, working capital, goodwill, non-operating assets, and owner accounts receivable. Some typical areas for potential adjustments on the income statement include inventories, owner compensation, rent, other income, owner perquisites, and remittance, to which Kevin refers.Remittance is related to the service contract and other warranty-related products the dealership offers in connection with the purchase of a vehicle. A dealer can act as an agent in this process by offering products from multiple third-party vendors or acting as the principal, whereby they own a reinsurance company that offers those products to their customers. In either case, the dealership retains a portion of the service contract or warranty product and remits the other portion to the obligor or administrator of the contract. In an example where a vehicle service contract is $800, the dealership might retain $400, report that as income, and remit $400 to the obligor/administrator.In some cases, the dealer may have an “overpayment” arrangement in place with the third-party administrator or their reinsurance company, whereby the dealer might retain $250 in the previous example and then remit $550 to the obligor/administrator. The “overpayment” arrangement allows the dealership to determine the amount of the overpayment and designate a beneficiary outside the dealership to receive the overpayment amount. These arrangements effectively reduce or shift income out of the dealership. The presence and amounts of overpayments or over remittances should be considered as potential normalization adjustments to earnings when determining the value of a dealership.We thank Kevin Nill and Haig Partners for their insightful perspectives on the auto dealer industry. To discuss how recent industry trends may affect your dealership’s valuation, feel free to reach out to one of the professionals at Mercer Capital.

November 2022

In this issue: Community Bank Loan Portfolios Have Unrealized Losses Too and Bond Portfolio Update

How Are Tech-Forward Banks Performing?

In the year-to-date period, the KBW Nasdaq Bank Index has declined 22%, compared to a decline of 20% in the S&P 500 through October 27.Tech-forward banks have underperformed the broader banking sector, down 60% in the year-to-date period.1This is a reversal of the trend in 2021 when tech-forward banks outperformed the broader banking sector, logging a 70% increase compared to an increase of 35% in the KBW Nasdaq Bank Index.Figure 1 :: Year-To-Date Performance (Through October 27, 2022)Source: S&P Capital IQ Pro. Figure 2 :: 2021 PerformanceSource: S&P Capital IQ Pro. The tech-forward bank landscape encompasses a variety of business models but generally refers to banks utilizing technology or partnering with fintechs to deliver financial products or services.Banks that partner with fintechs are often referred to as providing “banking as a service (BaaS)”.This model involves an FDIC member bank offering bank products to fintech customers, for example, credit and debit cards or personal loans.The bank holds the deposits associated with the accounts and earns a fee based on a percentage of interchange income specified in an agreement negotiated with the fintech partner.Other models are focused on facilitating payments or providing financial services to a specific niche, such as cryptocurrency.While the largest banks have the resources to be at the forefront of technology adoption, many smaller banks have partnered with fintechs in recent years. This is due in part to the Durbin Amendment which places limits on interchange income for banks above $10 billion in assets.In many cases, the partnerships have accelerated growth and created new income streams for the bank partners.However, bank partners also face unique risks.As displayed in the market performance, tech-forward banks have been more volatile than traditional banks.Tech-forward bank performance has been moored, to some degree, to more volatile technology stocks, which explains the stock market outperformance in 2021 followed by a larger retrenchment in 2022.For a community bank pursuing a fintech partnership strategy, there are multiple considerations, including the following.Deposit GrowthMany fintech partner banks have continued growing deposits this year even though most banks have seen deposit growth stagnate or turn negative in the rising rate environment.An analysis performed by S&P Global Market Intelligence showed that fintech partner banks with assets between $1 billion and $3 billion experienced deposit growth of 15% (annualized) in the first half of 2022.This compares to deposit growth of 3% for commercial banks in the same asset size range.The deposits generated from fintech partnerships are often noninterest bearing accounts, which are especially valuable in the currentrising rate environment. Bank partners earn spread income from the deposits, often holding them at the Federal Reserve due to their volatility and uncertain duration. Balances at the Fed reprice immediately with changes to the Fed’s benchmark rate.Noninterest IncomeThe largest impact on the revenue side typically shows up in noninterest income.Fintech partner banks tend to have a higher ratio of noninterest income to total income relative to traditional banks as they earn a share of the interchange income.In a period of flat or declining interest rates, this diversification of revenue can help to offset net interest margin compression.For the tech-forward banks included in Figure 1 and 2, the median ratio of noninterest income to operating revenue was 29% in the trailing twelve month period.Concentration RiskWhile fintech partnerships can be a source of growth, bank partners should be cautious about revenue or deposit concentrations. Fintechs can grow rapidly, and, as a result, a bank partner may develop a concentration within their deposit base or revenues.Banks must periodically renegotiate contracts with fintech partners, and there is a risk that the fintech will find another bank partner or demand more favorable terms.This single event could eliminate a major source of deposits or reduce noninterest income, causing a much greater impact than the ordinary loss of traditional bank customers.For example, Green Dot Corporation (GDOT) provides the Walmart MoneyCard product and offers other deposit account products at Walmart. Green Dot’s second quarter 10-Q discloses that approximately 21% of its operating revenue in the year-to-date period was derived from products and services sold at Walmart locations.Regulatory RiskRegulators have stepped up their scrutiny of bank-fintech partnerships this year, focusing on risk management controls.Many banks partnering with fintechs have less than $10 billion in assets, and banks that do not currently serve fintechs may not have the necessary compliance infrastructure to effectively manage potential fintech relationships. Compliance capability must be built over a long period of time and serves as somewhat of a barrier to entry for banks desiring to pursue this strategy.Additionally, certain fintech partnerships may present an added element of risk as the bank could be impacted by the regulatory and compliance practices of the fintechs or the evolving regulatory/compliance landscape.One recent example of this risk arose in the crypto fintech niche as the FDIC released an order to a crypto brokerage firm demanding that it cease and desist from making false and misleading statements about its deposit insurance status, while the FDIC contemporaneously issued an advisory to insured institutions regarding FDIC deposit insurance and dealings with crypto companies.2Valuation & PerformanceBank stocks’ underperformance in 2022 has largely been attributed to economic uncertainty and the potential for recession brought on by the Fed’s aggressive rate hikes. Fintech partner banks have been more volatile than the broader banking market.The business models entail certain risks, as detailed above, that do not pertain to traditional banks to the same degree.In addition, the earnings from fintech partnerships are less predictable and potentially further out in the future.As seen in figure 3, the range of valuation multiples observed for tech forward banks is wide, with forward P/Es ranging from 6.6x to 16.1x but most trade at 7x to 9x estimated 2023 earnings.It is important to note that the banks included in the table above represent a variety of sizes, strategies and niches, so comparability may be somewhat limited.Tangible book multiples likewise exhibit a wide range, but in general are high relative to the broader banking sector.In valuing fintech partner banks, investors weigh the growth potential provided by the partnership versus the risk that earnings growth does not materialize.Figure 3 :: Multiples and Price Change of Tech-Forward BanksClick here to expand the image aboveConclusionMercer Capital has experience valuing and advising both banks and fintechs.If you are considering partnership opportunities or have questions regarding their valuation implications, please contact us.1Tech-forward banks include AX, CCB, GDOT, LC, LOB, MVBF, CASH, SI, SIVB, TBBK, and TBK.Year-to-date performance through 10/27/222https://www.arnoldporter.com/en/perspectives/advisories/2022/08/regulators-crack-down-on-fintechs

Takeaways from Two Recent Energy Events in Dallas

Strong Industry Fundamentals, Capital Markets Showing Signs of Resurgence, and Energy Security

In the past week, several energy-related gatherings have been held in the Dallas area. We attended two of them: the D-CEO Energy Awards and Hart Energy’s Energy Capital Conference. We had numerous discussions with company representatives, dealmakers, and service providers. The marketplace appears excited about the potential for the upcoming year amid challenges. At both events, several industry themes were evident including: the energy industry has strong fundamentals, capital markets are showing signs of a resurgence in needed capital, and energy security is returning to the lexicon.Strong FundamentalsSeveral speakers and panelists at both events expressed optimism and confidence in the important role that the sector is playing both today and in the future. “This will be the golden decade for hydrocarbon production,” said Kyle Bass of Hayman Capital at the D-CEO Energy Awards. In this inflationary environment, the best place to be in energy, according to Mr. Bass, is royalties because they capture all the cost issues beneath them.This will be the golden decade for hydrocarbon productionAt the Hart Energy Capital Conference, Tim Perry of Credit Suisse said that returns are very strong considering high profits coupled with lower than historical valuations. Upstream companies that used to trade at 6-8 times EBITDA now trade between 3-5 times. IPOs are coming out at higher discounts to these multiples, and as such, returns expected are higher. Mr. Perry pointed out that energy occupies only about 5.1% of the S&P market capitalization, whereas historically, it has typically been between 8 - 13%.Which upstream area (oil vs. gas) was a better place to be right now has been a big boardroom discussion, with oil producers getting higher margins but gas producers facing a bright future with the major energy transition fuel.Capital Resurgence?Another theme was the prospect of capital returning to the space. Considering the deleveraging trend that has been happening for several years now, it was interesting to hear from multiple panelists that capital sources are coming back to the space. Banks are starting to return and borrowing bases, which were hard to come by, are now becoming more available to upstream producers. Over the past five years or so, so-called “casual” investors have left the space. The smaller landscape is now populated with sophisticated investors who are interested in energy’s strong tenets.Due to the fundamentals, private capital has also been responsive to filling the void with more unconventional sources, such as private placements and even family offices offering debt and equity capital. The space has become more attractive as what was described on one panel as the 3 “R”s – returns; realization of the industry’s importance; and regulatory framework to allow more investing.These trends have also begun to creep into the institutional space as well. It has become less polarizing in the past year, and more people are willing to listen to energy-oriented investment theses. One panelist remarked that some larger institutional shops are quietly “repurposing’ some of their internal talent to the oil and gas space, with some even planning to hire energy industry teams.Energy Security Part of the optimism for the space is the realization that the geopolitical landscape is not as stable as it has been. Both conferences referenced the likelihood of food and energy shortages in the next decade. “There are going to be riots in Europe this winter,” said Jim Wicklund of Wicklund & Associates. With issues ranging from wars to fertilizer to pipelines; the focus in the U.S. on energy transition in the longer term may have overlooked energy security in the shorter term.Part of the optimism for the space is the realization that the geopolitical landscape is not as stable as it has beenWe can export 12 BCF a day now, but will that be enough for Europe’s needs this winter? Mohit Singh, Chesapeake’s new CFO said that 75% of future demand growth in gas will come from LNG. The key will be takeaway, and the next wave of LNG completions are supposed to be in 2025 or 2026, where we may be able to export closer to 28 BCF per day. However, in the meantime, there may be more turmoil as energy markets attempt to get energy where it is needed now in both Europe and Asia.Multiple speakers and panelists lamented the overreach of the idea of energy transition to renewables at the expense of potentially available energy today. Some expressed optimism that the Inflation Reduction Act would help remove bottlenecks on a lot of renewable projects; however, they conceded that it still won’t change the situation in the shorter term. In addition, most panelists agreed that disincentivizing and demonizing the oil and gas industry during this energy transition has been a mistake.Jay Allison of Comstock Resources, who received the Energy Executive of the Year award at the D-CEO Awards Dinner, put it this way: “When Henry Ford invented the Model T, he didn’t kill all the horses.”Thanks again to everyone we connected with this week. The conversations were terrific, and we enjoyed seeing all of you.

Multiple Contraction Drives Returns for Publicly Traded Asset/Wealth Managers

So far this year, many publicly traded investment managers have seen their stock prices decline by 30% or more. This decrease is not surprising, given most firms’ broader market decline and declining fee base. With AUM for many firms down significantly from year-end, trailing twelve-month multiples have declined, reflecting the market’s expectation for lower profitability in the future. For more insight into what’s driving the decrease in stock prices, we’ve decomposed the decrease to show the relative impact of the various factors driving returns between December 31, 2021, and October 25, 2022 (see table below).Click here to expand the image aboveFor publicly traded investment managers with less than $100 billion in AUM, the last twelve-month (LTM) revenue for the most recent available twelve-month period increased about 2% relative to year-end. Due to the operating leverage in the RIA business model, the decline in revenue also resulted in a higher EBITDA margin. The net effect is that LTM EBITDA increased about 5% on average year-over-year for these firms. The fundamentals for the larger group (firms with AUM above $100 billion) fared worse, with profitability generally decreasing due to modest revenue declines and margin compression.While the sub-$100B group generally saw better actual performance than the larger group, both groups saw significant declines in the LTM EBITDA multiple, which was the primary driver of the stock price decreases. Year-to-date, the median multiple for the larger group (AUM above $100 billion) has been cut by nearly a third. In comparison, the smaller group (AUM below $100 billion) saw the median multiple decrease by about 12%.The multiple compression relative to year-end is not surprising, given the market’s trajectory this year. While LTM EBITDA declines have been modest for the larger group and performance has increased for the smaller group, market participants value these businesses based on expectations for the future, not on LTM performance.What’s Your Firm’s Run Rate?The multiple contraction seen in the publicly traded investment managers over the last year illustrates the importance of expected future performance on RIA valuations. The market decline and inflationary pressures that have manifested this year have yet to be fully reflected in LTM performance metrics. But as AUM has declined for most RIAs, so too has the run-rate revenue and profitability. The decline in run-rate revenue and profitability (and expectations for the same) is a driving factor behind the multiple compression observed over the last year in public companies.Market participants tend to focus on the run-rate level of profitability because it’s the most up-to-date indication of a firm’s revenue and profitability and the baseline from which future performance is assessed. This is increasingly true in today’s volatile market as buyers seek to determine a firm’s ongoing profitability after giving effect to the market movements and inflationary pressures that have impacted firms this year.Consider the financial results for a hypothetical firm (ABC Investment Management) shown below. While illustrative, the AUM trajectory and cost structure of this firm since year-end are not unusual relative to those exhibited by publicly traded investment managers and many of our privately held RIA clients.Click here to expand the image aboveIn the example, we assume that ABC began the fourth quarter last year with $2.0 billion in AUM. Market movement is estimated using the market performance of VBIAX (a rough proxy for a traditional 60/40 portfolio). Assuming zero net inflows over the last year, ABC would have ended the third quarter of 2022 with a little over $1.6 billion in AUM, down nearly 20% from a year prior. Given the operating leverage of the business, ABC’s EBITDA in the third quarter declined by over 40% relative to the fourth quarter of last year.On an LTM basis, ABC generated revenue of about $12.4 million and EBITDA of $3.3 million (representing a 27% EBITDA margin). On a run-rate basis, however, the performance is markedly different. Given current levels of AUM and operating expenses, ABC’s run-rate revenue is $10.6 million, and run-rate EBITDA is just $2.1 million—a nearly 40% decline relative to LTM EBITDA. This example illustrates the differing perspectives that emerge in down markets: While sellers focus on LTM metrics, buyers focus on the run rate.Implications for Your RIAWhile multiples for publicly traded asset and wealth managers have been hit hard this year, RIA valuations in the private market have been more resilient as a proliferation of professional buyers and capital in the space have supported deal activity and multiples. Nevertheless, market conditions are beginning to have an effect. Run rate performance for most firms is down significantly, and borrowing costs for leveraged consolidators are rising. The upward momentum in multiples that persisted throughout last year has stalled, and deal structures have started to shift more of the purchase price into contingent consideration to bridge increasingly divergent buyer and seller expectations.

Mid-Year 2022 Auto Dealer Industry Newsletter Release

We are pleased to release our Mid-Year 2022 Auto Dealer Industry Newsletter after taking a brief hiatus.Beginning in the fall of last year, NADA suspended publication of its Dealership Profile data which was a helpful resource to industry participants and to our industry newsletter. We have pivoted by providing additional data from the public auto dealer groups, which we hope you will find insightful.Recurring Trends and What They Mean to YouThe first half of 2022 continued to present challenges to auto dealers. Once again, auto dealers have proven their resilience and adaptability to continue operating at heightened profitability.Recurring trends such as a lack of new vehicle supply and a shortage of microchips persist, while new challenges such as inflation, rising interest rates, and increasing gas prices began to emerge. We highlight and discuss these trends and provide key industry metrics, including total retailer profit per unit on new vehicles, supply of new vehicles on dealer’s lots, the average age of new cars, average trade-in equity on used vehicles, and fleet sales.Additionally, we recap the second quarter earnings calls of public auto companies, which further touch on these trends.Blue Sky Multiples Have Jumped for SomeAlso included in this newsletter is a discussion of blue sky multiples across various franchise segments, including luxury dealerships, mid-line dealerships, and domestic dealerships.While most blue sky multiples have remained flat for the last several quarters, there are interesting discussions on their application between buyers and sellers during continued periods of heightened earnings. Several franchises have seen their blue sky multiples jump after a period of stagnant value.What the Publics Can Tell UsFinally, this newsletter provides financial data and metrics from public auto companies that we believe are informative to single-point or smaller private auto dealers. Specifically, we analyze the market capitalization, dealership count, gross profit by segment, and the implied blue sky multiples from public earnings data for the second quarter of 2022 and the prior year-end 2021.What Other Topics Would You Like to Know More About?We hope you find this newsletter to be a helpful resource and appreciate any feedback along with way. Please send suggested content topics or ideas that you’d like to see in future editions to Mercer Capital’s Auto Dealer Industry Group Leader, Scott A. Womack, ASA, MAFF, at womacks@mercercapital.com. Click the link below to download this latest issueValue Focus: Auto Dealer IndustryDownload the Mid-Year 2022 Newsletter

One Step Forward, Two Steps Back: RIA Stocks Finish the Quarter Down 10% after a Fast Start

Most RIA Stocks Have Lost Nearly Half Their Value Since Peaking Last November

The RIA industry extended its losing streak last quarter with all classes underperforming the S&P, which also continued its decline. The market itself is part of the problem as this industry is mostly invested in stocks and bonds, which have been down considerably since the first of the year. The additional underperformance for asset and wealth managers is likely attributable to lower industry margins as AUM and revenue fall with the market while labor costs continue to rise. Rising interest rates have exacerbated this decline for alternative asset managers and RIA aggregators, who frequently employ leverage to make investments. The one bright spot for the industry is the group of smaller (under $10 billion in AUM) publicly traded RIAs, which is the only segment to outperform the market over the last year. This group is still down over this time but holding up relatively well due to the lack of aggregator firms in its composition. These smaller firms have also tended to trade at more modest multiples with higher dividend yields, so these lower-duration stocks have held up reasonably well in a rising interest rate environment. As valuation analysts, we are often interested in how earnings multiples have evolved over time since these multiples can reflect market sentiment for the asset class. After steadily increasing over the second half of 2020 and throughout 2021, LTM earnings multiples for publicly traded asset and wealth managers have dropped nearly 40% this year, reflecting investor anticipation of lower revenue and earnings from the recent market decline and rising cost structure. Implications for Your RIAThe value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with closely held RIAs should be made with caution. Many smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds such as fee pressure and asset outflows to passive products. Also, most closely held RIAs are smaller than their public counterparts and often transact at lower multiples because of the heightened risk profile associated with smaller businesses.Despite industry headwinds, the M&A market for the RIA industry has remained strong though valuations have started to level off a bit. M&A is often viewed as a lagging economic indicator since deals take several months or even quarters to complete, so we may not see multiples start to come down for a few more months. As always, we’ll keep an eye on it and report back next quarter.

Now Available: Mercer Capital's 2022 Energy Purchase Price Allocation Study

Mercer Capital is pleased to announce the release of the 2022 Energy Purchase Price Allocation Study.This study researches and observes publicly available purchase price allocation data for four sub-sectors of the energy industry: (i) exploration & production; (ii) oilfield services; (iii) midstream; and (iv) downstream. This study is unlike any other in terms of energy industry specificity and depth.The 2022 Energy Purchase Price Allocation Study provides a detailed analysis and overview of valuation and accounting trends in these sub-sectors of the energy space. This study also enables key users and preparers of financial statements to better understand the asset mix, valuation methods, and useful life trends in the energy space as they pertain to business combinations under ASC 805 and GAAP fair value standards under ASC 820. We utilized transactions that closed and reported their purchase allocation data in calendar year 2021.This study is a useful tool for management teams, investors, auditors, and even insurance underwriters as market participants grapple with ever-increasing market complexity. It provides data and analytics for readers seeking to understand undergirding economics and deal rationale for individual transactions. The study also assists in risk assessment and underwriting of assets involved in these sectors. Further, it helps readers to better comprehend financial statement impacts of business combinations.>> DOWNLOAD THE STUDY <<

Five Trends to Watch in the Medical Device Industry: 2022 Update

Medical Devices OverviewThe medical device manufacturing industry produces equipment designed to diagnose and treat patients within global healthcare systems.Medical devices range from simple tongue depressors and bandages to complex programmable pacemakers and sophisticated imaging systems.Major product categories include surgical implants and instruments, medical supplies, electro-medical equipment, in-vitro diagnostic equipment and reagents, irradiation apparatuses, and dental goods.The following outlines five structural factors and trends that influence demand and supply of medical devices and related procedures.1. DemographicsThe aging population, driven by declining fertility rates and increasing life expectancy, represents a major demand driver for medical devices.The U.S. elderly population (persons aged 65 and above) totaled 40.3 million in 2021 (13% of the population). The U.S. Census Bureau estimates that the elderly will more than double by 2060 to 95 million, representing 23% of the total population.The elderly account for nearly one third of total healthcare consumption in the U.S.Personal healthcare spending for the population segment was approximately $19,000 per person in 2014, five times the spending per child (about $3,700) and almost triple the spending per working-age person (about $7,200).According to United Nations projections, the global elderly population will rise from approximately 608 million (8.2% of world population) in 2015 to 1.8 billion (17.8% of world population) in 2060.Europe’s elderly are projected to reach approximately 29% of the population by 2060, making it the world’s oldest region.While Latin America and Asia are currently relatively young, these regions are expected to undergo drastic transformations over the next several decades, with the elderly population expected to expand from approximately 8% in 2015 to more than 21% of the total population by 2060.2. Healthcare Spending and the Legislative Landscape in the U.S.Demographic shifts underlie the expected growth in total U.S. healthcare expenditure from $4.1 trillion in 2020 to $6.2 trillion in 2028, an average annual growth rate of 5.4%.This projected average annual growth rate is faster than the observed rate of 3.9% between 2009 and 2018. Projected growth in annual spending for Medicare (4.3%) and Medicaid (5.6%) is expected to contribute substantially to the increase in national health expenditure over the coming decade.However, growth in national healthcare spendinghas slowed in 2021 to 4.2%, down from 9.7% in 2020. Healthcare spending as a percentage of GDP is expected to remain virtually unchanged from 19.7% in 2020 to 19.6% by 2030.Since inception, Medicare has accounted for an increasing proportion of total U.S. healthcare expenditures.Medicare currently provides healthcare benefits for an estimated 60 million elderly and disabled people, constituting approximately 15% of the federal budget in 2018 and is expected to rise to 18% by 2028.Medicare represents the largest portion of total healthcare costs, constituting 20% of total health spending in 2020.Medicare also accounts for 25% of hospital spending, 30% of retail prescription drugs sales, and 23% of physician services.Due to the growing influence of Medicare in aggregate healthcare consumption, legislative developments can have a potentially outsized effect on the demand and pricing for medical products and services.Net mandatory benefit outlays (gross outlays less offsetting receipts) to Medicare totaled $776 billion in 2020 and are expected to reach $1.5 trillion by 2030.The Patient Protection and Affordable Care Act (“ACA”) of 2010 incorporated changes that are expected to constrain annual growth in Medicare spending over the next several decades, including reductions in Medicare payments to plans and providers, increased revenues, and new delivery system reforms that aim to improve efficiency and quality of patient care and reduce costs.While political debate centered around altering the ACA has been a continuous fixture in American politics since its passing, it is unlikely that material reform to the ACA occurs in the near future under the Biden Administration.Total Medicare spending is projected to grow at 5.6% annually between 2025 and 2030, compared to year over year growth of 11.3% in 2021 and 3.5% in 2020.3. Third-Party Coverage and ReimbursementThe primary customers of medical device companies are physicians (and/or product approval committees at their hospitals), who select the appropriate equipment for consumers (patients).In most developed economies, the consumers themselves are one (or more) step removed from interactions with manufacturers, and therefore pricing of medical devices.Device manufacturers ultimately receive payments from insurers, who usually reimburse healthcare providers for routine procedures (rather than for specific components like the devices used).Accordingly, medical device purchasing decisions tend to be largely disconnected from price. Third-party payors (both private and government programs) are keen to reevaluate their payment policies to constrain rising healthcare costs.Several elements of the ACA are expected to limit reimbursement growth for hospitals, which form the largest market for medical devices.Lower reimbursement growth will likely persuade hospitals to scrutinize medical purchases by adopting i) higher standards to evaluate the benefits of new procedures and devices, and ii) a more disciplined price bargaining stance.The transition of the healthcare delivery paradigm from fee-for-service (FFS) to value models is expected to lead to fewer hospital admissions and procedures, given the focus on cost-cutting and efficiency.In 2015, the Department of Health and Human Services (HHS) announced goals to have 85% and 90% of all Medicare payments tied to quality or value by 2016 and 2018, respectively, and 30% and 50% of total Medicare payments tied to alternative payment models (APM) by the end of 2016 and 2018, respectively.A report issued by the Health Care Payment Learning & Action Network (LAN), a public-private partnership launched in March 2015 by HHS, found that 35.8% of payments were tied to Category 3 and 4 APMs in 2018, compared to 32.8% in 2017.In 2020, CMS released guidance for states on how to advance value-based care across their healthcare systems, emphasizing Medicaid populations, and to share pathways for adoption of such approaches. Ultimately, lower reimbursement rates and reduced procedure volume will likely limit pricing gains for medical devices and equipment.The medical device industry faces similar reimbursement issues globally, as the EU and other jurisdictions face similar increasing healthcare costs.A number of countries have instituted price ceilings on certain medical procedures, which could deflate the reimbursement rates of third-party payors, forcing down product prices.Industry participants are required to report manufacturing costs, and medical device reimbursement rates are set potentially below those figures in certain major markets like Germany, France, Japan, Taiwan, Korea, China, and Brazil.Whether third-party payors consider certain devices medically reasonable or necessary for operations presents a hurdle that device makers and manufacturers must overcome in bringing their devices to market.4. Competitive Factors and Regulatory RegimeHistorically, much of the growth of medical technology companies has been predicated on continual product innovations that make devices easier for doctors to use and improve health outcomes for the patients.Successful product development usually requires significant R&D outlays and a measure of luck.If viable, new devices can elevate average selling prices, market penetration, and market share.Government regulations curb competition in two ways to foster an environment where firms may realize an acceptable level of returns on their R&D investments.First, firms that are first to the market with a new product can benefit from patents and intellectual property protection giving them a competitive advantage for a finite period.Second, regulations govern medical device design and development, preclinical and clinical testing, premarket clearance or approval, registration and listing, manufacturing, labeling, storage, advertising and promotions, sales and distribution, export and import, and post market surveillance.Regulatory Overview in the U.S.In the U.S., the FDA generally oversees the implementation of the second set of regulations.Some relatively simple devices deemed to pose low risk are exempt from the FDA’s clearance requirement and can be marketed in the US without prior authorization.For the remaining devices, commercial distribution requires marketing authorization from the FDA, which comes in primarily two flavors.The premarket notification (“510(k) clearance”) process requires the manufacturer to demonstrate that a device is “substantially equivalent” to an existing device (“predicate device”) that is legally marketed in the U.S.The 510(k) clearance process may occasionally require clinical data and generally takes between 90 days and one year for completion.In November 2018, the FDA announced plans to change elements of the 510(k) clearance process.Specifically, the FDA plan includes measures to encourage device manufacturers to use predicate devices that have been on the market for no more than 10 years.In early 2019, the FDA announced an alternative 510(k) program to allow medical devices an easier approval process for manufacturers of certain “well-understood device types” to demonstrate substantial equivalence through objective safety and performance criteria. The plans materialized as the Abbreviated 510(k) Program later in the year.The premarket approval (“PMA”) process is more stringent, time-consuming, and expensive.A PMA application must be supported by valid scientific evidence, which typically entails collection of extensive technical, preclinical, clinical, and manufacturing data.Once the PMA is submitted and found to be complete, the FDA begins an in-depth review, which is required by statute to take no longer than 180 days.However, the process typically takes significantly longer and may require several years to complete.Pursuant to the Medical Device User Fee Modernization Act (MDUFA), the FDA collects user fees for the review of devices for marketing clearance or approval.The current iteration of the Medical Device User Fee Act (MDUFA IV) came into effect in October 2017. Under MDUFA IV, the FDA is authorized to collect almost $1 billion in user fees, an increase of more than $320 million over MDUFA III, between 2017 and 2022. Intended to begin in 2020, negotiations for MDUFA V were delayed due to the COVID-19 pandemic. The FDA and industry groups reached a deal for MDUFA V, slated to go into effect beginning fiscal 2023, which would generate up to $1.9 billion in fees to the agency over five years. The U.S. House of Representatives passed MDUFA V in June 2022 and the Senate is expected to follow suit by September 2022.Regulatory Overview Outside the U.S.The European Union (EU), along with countries such as Japan, Canada, and Australia all operate strict regulatory regimes similar to that of the FDA, and international consensus is moving towards more stringent regulations.Stricter regulations for new devices may slow release dates and may negatively affect companies within the industry.Medical device manufacturers face a single regulatory body across the EU. In order for a medical device to be allowed on the market, it must meet the requirements set by the EU Medical Devices Directive.Devices must receive a Conformité Européenne (CE) Mark certificate before they are allowed to be sold in that market.This CE marking verifies that a device meets all regulatory requirements, including EU safety standards.A set of different directives apply to different types of devices, potentially increasing the complexity and cost of compliance.5. Emerging Global MarketsEmerging economies are claiming a growing share of global healthcare consumption, including medical devices and related procedures, owing to relative economic prosperity, growing medical awareness, and increasing (and increasingly aging) populations. According to the WHO, middle income countries, such as Russia, China, Turkey, and Peru, among others, are rapidly converging towards outsized levels of spending as their incomes increase.When countries grow richer, the demand for health care increases along with people’s expectation for government financed healthcare.Middle income country share, the fastest growing economic sector, increased from 15% to 19% of global spending between 2000 and 2017.As global health expenditure continues to increase, sales to countries outside the U.S. represent a potential avenue for growth for domestic medical device companies.According to the World Bank, all regions (except Sub-Saharan Africa and South Asia) have seen an increase in healthcare spending as a percentage of total output over the last two decades.Global medical device sales are estimated to increase 5.4% annually from 2021 to 2028, reaching nearly $658 billion according to data from Fortune Business Insights.While the Americas are projected to remain the world’s largest medical device market, the Asia Pacific and Western Europe markets are expected to expand at a quicker pace over the next several years.SummaryDemographic shifts underlie the long-term market opportunity for medical device manufacturers.While efforts to control costs on the part of the government insurer in the U.S. may limit future pricing growth for incumbent products, a growing global market provides domestic device manufacturers with an opportunity to broaden and diversify their geographic revenue base.Developing new products and procedures is risky and usually more resource intensive compared to some other growth sectors of the economy.However, barriers to entry in the form of existing regulations provide a measure of relief from competition, especially for newly developed products.

Regulatory Update: Amendments to FTC Safeguards Rule

Impacts to Auto Dealerships

Over the last month, the Mercer Capital Auto Team attended several October meetings with the Tennessee Automotive Association. The featured presentation by ComplyAuto discussed the features of the Federal Trade Commission’s (“FTC”) Safeguard Rule (“Safeguards Rule” or “Rule”) and the amendments with which must be complied by early December 2022. In previous posts, we have discussed advancements in auto retailing and vehicles and how added technology brings added risks to cybersecurity and the protection of customer information. This post discusses the FTC Safeguards Rule and what auto dealers and their advisors need to know.What Is the FTC’s Safeguards Rule?The official title of the Safeguards Rule is “Standards for Safeguarding Customer Information.” The original Rule took effect in 2003 and was intended to ensure that entities covered under the Rule maintained safeguards to protect the security of customer information. Few changes were made to the Rule since 2003 until the FTC’s proposed amendments in December 2021. These amendments sought to make changes to the original Rule to keep up with advancements and changes in technology. More importantly, qualified businesses must comply with the FTC’s Safeguards Rule by December 9, 2022.Why Does the FTC Safeguards Rule Impact Auto Dealerships?The Safeguards Rule applies to financial institutions subject to the FTC’s jurisdiction that are not subject to the enforcement of a separate authority or regulator under Section 505 of the Graham-Leach-Bliley Act. Further, the Rule defines a financial institution as “any institution of business of which is engaging in an activity that is financial in nature or incidental to such financial activities.” While on the face, this appears to be speaking primarily about banks or other similar financial institutions, Section 314.2(h) explicitly cites auto dealerships as an example of a financial institution given the nature of its leased and purchased transactions and participation in the financing activities of the transactions.NADA estimates that auto dealerships could face up-front costs of up to $294,000 per rooftop to comply with the Safeguards RuleNADA estimates that auto dealerships could face up-front costs of up to $294,000 per rooftop to comply with the Safeguards Rule, with additional ongoing costs in the neighborhood of $277,000 annually. These numbers may seem staggering at first, but what are the costs of not complying? The NADA estimates the average fine for a violation under the Rule is $47,000. While this number appears steep, it is also unclear how the FTC would view a security breach. In other words, if a security breach compromised the personal/financial information of multiple consumers, would that be one violation, or would each consumer breached be a separate violation? If the latter occurs, fines could quickly escalate into the high six digits for a more significant volume breach. This ambiguity makes it more impactful for dealerships that might otherwise “risk” the possibility of a $47,000 fine compared to annual costs of $277,000, not to mention the upfront costs.The Safeguards Rule is meant to work in tandem with consumer privacy rights and policies enforced by state attorneys general and the FTC. All 50 states have enacted some state cybersecurity requirements to protect data breach laws, with some instituting specific cybersecurity laws.What Are the Guidelines Under the FTC Safeguards Rule?Rule 1 – Four Written PoliciesAuto dealers are required to adopt, maintain, and adhere to four written policies: data retention plan, incident response plan, information security plan, and IT change management procedures. These policies must be written and the appropriate size as it relates to the complexity of your auto dealership business, the nature and scope of your business activities, and the sensitivity of the information in issue. These written policies should aim to ensure the security and confidentiality of customer information, protect against anticipated threats or hazards to the security and integrity of that information, and protect against unauthorized access to information that could lead to substantial harm or inconvenience to any customer. To comply with the information security plan, auto dealerships should have a designated/qualified individual to implement and supervise the company’s information security program.Rule 2 – Annual Risk Assessment On an annual basis, auto dealerships must complete a formal risk assessment to determine foreseeable risks and threats – both internally and externally – to protect customers’ information security, confidentiality, and integrity. Compliant assessments will also document attempts to mitigate these threats and any updates to the four written policies in Rule #1 resulting from items discovered during the annual risk assessment.Rule 3 – Annual Employee Security Awareness TrainingAn auto dealership’s security program is only as effective as its least vigilant staff member. All employees must be trained on overall awareness as well as the specific components of your information security program, policies, procedures, and safeguards. Further, the Rule insists on specialized training for those employees, affiliates, and providers with hands-on responsibility for carrying out your dealership’s information security program.Rule 4 – Phishing and Social Engineering SimulationsAs part of the new amendments, the FTC Rule requires dealerships to test their employee’s susceptibility to social engineering and phishing scams. In other words, how likely are your employees to fall for these phishing scams? Would regular testing and simulations give the dealer principal an idea of how easily or frequently these threats could become reality? Hopefully, regular simulations would also raise employees’ awareness that such threats exist daily.Rule 5 – Service Provider ContractsDuring a lease or purchase transaction, auto dealerships may require service providers that access non-public personal information (“NPI”) to sign a specific contract whereby they also promise to adopt and adhere to reasonable safeguards. Dealers will want to establish or work with pre-vetted contracts signed by their vendors and must be mindful of built-in e-sign functionality to increase efficiency with vendors.Rule 6 – Annual Service Provider and Risk AssessmentsDealers must select service providers with the skills and experience to maintain appropriate safeguards. Under the Rule, dealers are actually required to assess and monitor their service providers for continued adequacy of safeguards, even when that can often be accomplished through a security questionnaire or checklist. Dealers should consider periodic reassessments of their service providers to ensure safeguards are maintained.Rule 7 – Annual Penetration Test and Bi-Annual Vulnerability ScansDealers are required to perform annual internal penetration testing of their networks to simulate internal and external hacking. To comply with the Rule, they must also perform biannual vulnerability assessments for known exploits. As part of the total ongoing costs estimated earlier in this blog, NADA estimates that the average cost of an annual penetration test is $23,000. This cost could be increased by the number of individual rooftops that a particular dealer owns, which could rise significantly for bigger private auto groups. In addition, dealers should test whenever there are material changes to their operations or business arrangements or when they know circumstances may have occurred that could have a material impact on their information security system.Rule 8 – Device, Data & Systems InventoryDealers are required to perform a regular inventory of their data and systems. Inventory procedures would include identifying all data in their possession, tracking where the data is collected and by which vendor and system, and understanding how the data is stored and transmitted. Has your dealership added a new server? Because systems, networks, and operations like this constantly change, an auto dealer’s safeguards cannot remain static.Rule 9 – Annual Report to the Board of DirectorsAuto dealers must submit a regular written report to the Board of Directors or governing body. If your dealership does not have a Board of Directors, the report must go to a senior officer responsible for the information security program. Ideally, the report would be written and delivered by the qualified individual established to run your information security program in Rule #1. The report should include the overall assessment of your dealership’s compliance with its information security program and would discuss test results and responses to threats, including any amendments or changes to the dealership’s written policies.What Additional Guidelines Does the Rule Require Concerning Advanced Cybersecurity and Device Protection?Rule 10 – Intrusion and Attack DetectionFTC Safeguards Rule, along with most OEMs and cybersecurity insurance carriers, will require that dealers have an established system to detect intrusions and attacks on your network.Rule 11 – User and Employee Monitoring and LoggingDealers must have a security system that restricts how users and employees log into and use their information security system. Dealers must be able to detect who is on the system at all times while detecting and preventing unauthorized access, sharing, use of, and tampering with customer information.Rule 12 – Device EncryptionThroughout auto dealerships’ operations, employees utilize devices such as laptops, tablets, and mobile devices–all of which contain customer information. The Rule requires that the hard drives of each of these devices be encrypted. However, compliance with these terms can become complicated with the increase of remote employees and remotely-enabled devices.Rule 13 – Multi-Factor Authentication (“MFAs”)Dealers must implement multi-factor authentication on any system used to access customer information, including device-level MFAs. Specifically, the Rule requires at least two of these authentication factors: a knowledge factor (such as a password) and an inherence factor (such as biometric characteristics like a fingerprint, facial features, face recognition, etc.).ConclusionsThe clock is ticking for auto dealers unaware of the FTC's new amendments to the Safeguards Rule and the compliance deadline of December 9, 2022. With changes to existing and emerging technology, protecting private/confidential consumer information becomes more critical. Cybersecurity and hacking threats seem to multiply every day. Could your dealership be next? Have you taken the necessary steps to bolster your information security programs? If your auto dealership is not compliant with the FTC's Safeguards Rule, seek a professional vendor to assist you in this area.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Asset Management Without a Net

This Time, There Is No Fed “Put”

When the economic mood soured in 2008, I called an older friend to get his thoughts on the credit crisis and what it would mean. “Jerry” had spent his career running a large heavy truck distributor, and he had visceral experience in more than a few economic cycles. Jerry told me two things on that phone call that have stuck with me.“My manufacturer’s rep called last week and asked me ‘what would I have to give you to put some of my trucks on your lot.’ I answered: A lobotomy.” Jerry then explained that most people are blinded by their own optimistic leanings to underestimate how bad things can get in a recession, and how long they can last.As September of 2022 came to a close, asset management is experiencing one of the most challenging years in history.As September of 2022 came to a close, asset management is experiencing one of the most challenging years in history. Losses are both deep and widespread. The consequence is a tough quarterly letter to pen to investors, a hit to revenue, and an even bigger impact on profitability.A few notes on where things stand:U.S. equities experienced their third straight quarterly loss, which hasn’t happened since 2008.The S&P 500 has lost a quarter of its value this year. The Nasdaq is down a third.Many indexes hit new lows on September 30.Bonds are having their worst year since 1976, with the U.S. Core Bond index falling 16% through September 30.Asset correlations are high, leaving no path for escape through diversification. The classic 60/40 portfolio is said to be having its worst year since 1980. Even TIPS (Treasury Inflation Protected Securities) are down YTD.30-year U.S. mortgage rates are hovering around 7% for the first time since before the credit crisis.The U.S. dollar has surged against other major currencies, eclipsing parity with the euro and threatening parity with the British pound. The dollar has also blasted through previous resistance levels with the Japanese Yen and the Chinese Yuan.Currency fluctuations are straining economies and asset prices globally. The breadth of the financial market strain is not without precedent, but you have to look far back to find a market as bad or worse for so many investors. Asset correlation was a tremendous issue in the credit crisis, and this bear market is seeing deep drawdowns across most asset classes. This doesn’t bode well for industry margins, as AUM declines coupled with fee pressure hit revenues, and inflationary increases in RIA expenses don’t offer a cushion for profitability.According to Morningstar, U.S. fund flows have been net negative so far in 2022, after a reasonably strong performance in 2021. Risk asset flows like equity and high yield have been hit particularly hard, both domestic and foreign. With a few exceptions active funds continued to lose AUM to passive funds, after better performance in 2021. Fixed income has lately been attracting more AUM than we’ve seen in recent memory, as the risk-off mood of the market manifested in asset rotation. Also for the first time in recent memory, there appears to be a pivot from growth to value.One bright spot for asset managers in 2022 is that many more active managers are beating passives. So far in 2022, Morningstar reports that nearly two-thirds of large cap value PMs are beating the Russell 1000 value index, and just over half of large blend managers are beating the S&P 500. Unfortunately, this “beat” means being less down than the index, and despite the win passive strategies are having more success in attracting funds.Perhaps the best metaphor for the moment is a video of Cathie Wood, CEO of Ark Invest, offering an open letter to the Federal Reserve. Wood accused the Fed of misappropriating data to rationalize policy errors which she believes will over-correct and cause damaging deflation. Wood has personal experience with asset deflation; her Ark Innovation Fund (ARKK) ended the third quarter with a year-to-date loss of more than 60%.Unfortunately for Wood and others who worry the Fed is moving too far, too fast, Fed Chair Jerome Powell has repeatedly stated that the Federal Reserve understands the damage potentially caused by their rapid increase in short term interest rates, but that they think it’s worth it to contain inflation. In other words, no matter how far asset prices fall, this time there will be no Fed “put.”

How Waves Of Reality Are Swelling Upstream Returns

Upstream and oilfield service companies have bucked trends most of this year.While other industries have had stagnant to negative returns, the oil patch has outperformed them all, as I highlighted earlier this summer. Since then, market capitalizations have stagnated. Yet, the reality is that equity returns are soaring on a wave of cash flow right now.Operational cash flow for the sector was at its highest in the five year period since 2017 at $203 billion, according to the EIAs’ Financial Review of the Global Oil and Natural Gas Industry: Second Quarter 2022 report.This led to a 22% return on equity which was notable not only because it was the highest recorded return in the survey period, but also because it usurped U.S. manufacturing companies' returns on equity for the first time in the survey period.It has been a long time coming, but several realities have been coming to the forefront to build this wave: world realities, production realities, and capital realities.World RealitiesThe energy industry’s reality is one tethered to the zeitgeist. Few if any other industries are as sensitive to the volatility of politics, regulation, and events. A year ago, longer-term supply and demand trends were pushing tailwinds for upstream producers, but those winds blew up into a storm when Russia invaded Ukraine. Several of my contributing colleagues here at Forbes.com have done good work covering these developments. That has Russian oil production likely dropping around 20%, with an accompanying impact to prices. In addition, OPEC+ has reduced oil production quotas for October.The energy industry’s reality is that some unintended consequences regarding the scramble for energy transition away from fossil fuels have collided with “contingencies.” Aramco’s CEO Amin Nasser was very blunt about this in Switzerland last Tuesday (before the Nord Stream incident).Perhaps most damaging of all was the idea that contingency planning could be safely ignored“Perhaps most damaging of all was the idea that contingency planning could be safely ignored,” said Nasser, “Because when you shame oil and gas investors, dismantle oil- and coal-fired power plants, fail to diversify energy supplies (especially gas), oppose LNG receiving terminals, and reject nuclear power, your transition plan had better be right.”“Instead, as this crisis has shown, the plan was just a chain of sandcastles that waves of reality have washed away.And billions around the world now face the energy access and cost of living consequences that are likely to be severe and prolonged,” said Nasser.There has been a flurry of speculation as to who is responsible for the explosions emanating from the Nord Stream pipeline, but what is now concerning is Europe’s ability to keep warm this winter. The U.K. reversed its fracking ban to help secure its energy supply. It may be too little too late this winter for the Brits.In the meantime, Europe’s eyes look to the U.S. to stand in the growing energy gap, particularly gas. The U.S. has skyrocketed to become the top exporter of LNG in the world this year. This won’t change any time soon and is expected to continue to expand and grow.At the same time, U.S. domestic demand has been growing too, thus multiplying natural gas prices compared to two years ago.Production RealitiesWhile demand has resurged domestically and abroad, upstream production has not been keeping up the same way it has in the past. The good news is that production is growing and will continue to. However, there are several things limiting growth. As I have written before, producers have been cautious for a myriad of reasons and as such, new major investments in development and drilling have been stalled. According to the EIA Financial Review, Capex of the companies surveyed was $59 billion in the 2Q of 2022, only 8% higher than the 2Q of 2021.Rig counts are growing, but not at the same pace as they did the last time commodity prices were this high.DUC wells are at the lowest level in almost a decade, so drilling inventories continue to shrink.Another reality is that productivity at the individual rig level is waning. This comes in two ways: 1) the form of productivity for new wells drilled, and 2) existing legacy production is declining faster than before.Explanations for this are not entirely clear. Perhaps it is the exhaustion of top-tier PUD well locations, continued permitting problems that Joe Manchin could not fix, or the flight of talent from the oilfield in the last few cycles. Costs increased for the seventh straight quarter in the Fed Survey – near historical index highs. Nonetheless – it is happening and fueling a bevy of comments like this from the Dallas Fed Survey: “Uncertainty on the political front continues to be a major concern. The withdrawal of leases that have already been issued is an example. Inflationary pressure is eating significantly into discretionary cash flow, limiting the amount of money allocated to new projects.” 85% of survey participants expected to see a significant tightening in the oil market by the end of 2024 given the underinvestment in exploration. Capital RealitiesIn the past several years there simply has not been enough capital deployed in the sector to defray some of the shorter-term event volatility such as Ukraine’s war with Russia.79% in the Fed Survey expect to see some investors return to the spaceWith the spike in prices, 79% in the Fed Survey expect to see some investors return to the space, attracted by superior returns. However, it may be some time for that to matter. In this business, measured in years and decades, investments that can move the world needle take time to come to fruition. In the meantime, 69% of respondents in the Fed Survey expect to see the age of inexpensive gas ending by 2025. Existing capital remains focused on paying off debt and dividends, not drilling. Cash flows from Operations of $203 billion and Capex of $59 billion clearly communicates this reality.In the long run, prices ultimately communicate reality in a commodity business, so the expectations of higher prices should be the instigator to change behavior to a more balanced energy policy for much of the developed world.In the short run, oil and gas investors are getting exceptional returns. That should not change any time soon.Originally appeared on Forbes.com.

September 2022 SAAR

The September SAAR was 13.5 million units, up 2.3% from last month and up 9.6% from September 2021, when the industry had less than one million vehicles available for sale. While this month’s SAAR highlights a year-over-year improvement and gives us context around how low inventory managed to fall in 2021, this month’s data release does not indicate a “return to normal” by any means. The Q3 2022 SAAR averaged 13.3 million units, roughly flat with Q2 2022’s average and consistent with the last three months of the industry’s sales pace, indicating no fundamental changes. Looking at the 2022 SAAR as a whole, the previous three months of this year have displayed stability at around 13.0 million units, while the first six months of the year were significantly more volatile.Looking at unadjusted sales numbers, September 2022 also showed a real improvement from this time last year. While this month’s unadjusted sales (1.16 million units) were certainly still limited by supply-side inventory issues and much lower than sales levels observed from 2015-2020, it is clear that September 2021 (1.05 million units) was a low point that makes the last month look good by comparison. See the chart below for unadjusted sales numbers from the previous eight September releases:InventoryOn the supply side of the vehicle sales equation, inventories have remained low but seem to be marginally improving. The industry inventory to sales (“I/S”) ratio was 0.67x in August, the most recently available month of data. August’s I/S ratio compares to 0.51x in July and an average of 0.47x from January 2022 to July 2022. For the remainder of the year, we expect industry-wide inventory levels to slowly improve. However, it is unclear how long auto manufacturers will take to bring the industry I/S ratio up to the long-run average of 2.4x. As this recovery unfolds, it will be important to keep an eye on efforts to bring more domestic semiconductor facilities online, the ongoing status of the war in eastern Europe, and the availability of key inputs from Asian markets like China. These underlying factors are key levers that would allow the domestic production of vehicles to improve in a meaningful way.Transaction Prices, Incentive Spending, and Monthly PaymentsTransaction prices remained at near-record levels in September. According to J.D. Power, the average new vehicle transaction price is projected to reach $45,622 this month, a 10.3% increase from this time last year and the fourth highest average transaction price ever. In terms of monthly payments made by consumers, rising interest rates on elevated sticker prices drive monthly payments up to an average of $667 per consumer. Incentive spending by OEMs has remained low in September. The average incentive spending per unit was $936 this month, down 47.8% from this time last year and the fifth straight month of sub-$1000 spending per unit.Is Pent-Up Demand Still Present in the Auto Industry?The sales pace of any industry is a function of a two-sided equation that includes both demand and supply. The first major factor in this equation is demand, which has been considered very high, even “pent-up,” over the last year and a half in most of the industry’s analytical publications (including some of our blogs). We recently tried to quantify pent-up demand in our June 2022 SAAR blog. In this June publication, we wanted to start a conversation around pent-up demand by challenging the idea that sales would suddenly return to 17 million units once the supply side of the equation normalizes. The idea that sales may not return to a 17 million unit SAAR right away is centered around the idea of cyclicality.When supply is so restricted, it’s not a high bar for demand to be above supplyThe auto industry has always been cyclical, with more vehicles sold during the “good times” and fewer vehicles sold during recessionary periods and times of general economic uncertainty. Cyclicality makes sense, as consumers are less likely to make a large purchase like a home or a vehicle during uncertain times when debt is expensive, and recessionary fears are present. Put simply, we are starting to wonder if the industry as a whole has overestimated the level of pent-up demand. When supply is so restricted, it’s not a high bar for demand to be above supply. And over the past two years, with rising vehicle prices, we’ve learned that consumer demand for personal vehicles was more inelastic than previously thought. Even accepting these two premises, we believe the cyclicality of auto sales may mean that by the time inventory issues are alleviated, consumers may be less confident in purchasing new vehicles.Over the last month, the country has found itself anticipating a down cycle of the entire economy as interest rates and other measures of risk increase at a rapid pace. The housing market has cooled off, wage growth has also decelerated, and the market for new and used vehicles is likely cooling off as well. It doesn’t help that near-record transaction prices and the expensive cost of debt are making vehicle purchases more and more difficult to afford. On the Mercer Capital Auto Dealer team, we tend toward the idea that pent-up demand is dissipating or perhaps overstated. We believe that rising transaction prices are more of a function of supply-side constraints than high levels of consumer competition for available vehicles.October 2022 OutlookMercer Capital’s outlook for the October 2022 SAAR is consistent with the status quo. Industry supply chain conditions continue to stagnate. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Perhaps the October SAAR can eclipse 14 million units and signal a turning of the tide, but we predict that a 14 million unit SAAR for 2022 is unlikely in the current landscape. Stability at around 13.0 million units is a much more realistic expectation.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Transportation & Logistics Newsletter

Fourth Quarter 2022

Mineral Interest Owners: How to Know What You Own

Because of the popularity of this post, we revisit it this week. Originally published in 2019, this post is as a guide for mineral owners who are seeking to learn more about what they own.As we’ve discussed, there are plenty of factors to consider when determining the value of mineral interests. While some mineral owners may be very well attuned to decline curves and local pricing dynamics, others may only casually monitor the price of oil and gas to get a general sense of the trend in the industry. This post is geared towards those mineral interest owners who have less knowledge on the subject and should serve as a guide for those seeking to learn more about what they own. We frequently receive calls from mineral interest owners who know little about what they own other than the operator’s name on the check and the amount they receive each month. Besides just the amount paid by the operator, royalty checks provide valuable information to mineral owners that can help determine the value of their minerals.How to Read a Royalty CheckThe information on royalty checks is beneficial because it gives mineral interest owners plenty of granular detail on how the operator calculates their monthly payment. The problem is that companies may issue checks with differing formats (see two examples below) and they can be hard to read. However, with a trained eye, mineral interest owners can learn to read these checks and glean valuable insight into what is driving the value of their interests.The first example is a check one might actually receive in the mail. The second is a sample check provided by an operator to help owners understand what it means. Regardless of the operator, there are a few key items that appear on every check:Ownership PercentageProduct CodeCountyOwnership PercentageA lease arrangement is designed to be a mutually beneficial agreement. Mineral owners own the rights to a valuable commodity, but they lack the ability to harvest it themselves. Operators come in with the equipment and requisite knowledge necessary to extract minerals from the ground. In exchange for the right to drill on the property, operators pay mineral owners a fraction of the revenue generated from the production. This fraction can appear on a check as a string of numbers like 0.0234375. You may be wondering, where does this number come from? This is the product of the net mineral acreage owned multiplied by the royalty percentage negotiated.Most of the United States uses the Public Land Survey System which is divided into townships and further into sections. A township is 36 sections and a section is 640 acres (or one square mile).[1] Sections are further broken down into quadrants, or some other division as the land is passed down over time. For instance, a lease could specify “all of the mineral interest under the E ½ SE ¼ of 11-2N.” This is read “The east half of the southeast quarter of Section 11, township 2 North.” As depicted below, this would be the rectangle in the bottom right quarter, and would represent 80 net mineral acres. That is: 640 acres per section times ¼ times ½. The lease would go on to specify the royalty percentage to be paid, like 3/16. This will frequently be presented in some form similar to the follow: “To pay Lessor for gas (including casinghead gas) and all other substance covered hereby, a royalty of 3/16 of the proceeds realized by Lessee from the sale thereof.” This simply means the operator will pay a royalty of 3/16 of revenue generated from production on the property. Multiplied by the 80 net mineral acres that make up the 640 acre section, we arrive at: 80/640 x 3/16 = 0.0234375Owners will note much larger dollar figures on their checks which represent the gross revenue the operator receives from production of the minerals. This gross value is multiplied by the ownership percentage, which determines the amount actually received by the owner on their check. Knowing the net mineral acreage owned (not determined by the operator) can help determine the royalty rate the mineral owner is being paid, which helps to understand the value ultimately being paid for their interests.Product CodeThe information on royalty checks is beneficial because it gives mineral interest owners plenty of granular detail on how the operator calculates their monthly payment.The revenue received by both the operator and ultimately the owner depends on both the quantity produced and the price achieved. As of the writing of this article, crude oil prices are trading around $53 per barrel for West Texas Intermediate (WTI), the most commonly tracked figure for U.S. crude oil. By comparison, natural gas is trading around $3.04 per Mcf at the Henry Hub, the most common benchmark for natural gas in the country. Knowing what is being produced: oil, gas, NGL, or a combination of these is crucial to understanding the value of the interests. Owners can figure this out by looking at the product code on their checks, which can be expressed as either a letter or number. Our first example lists the product code as 204, and the legend at the bottom of the check indicates that gas is being produced. Even less clearly, our second example shows the letter “G” under the “P” column, and which, according to the legend, means gas is being produced. This can be far from intuitive without some sort of key describing each item.When oil prices decline, as they have since the beginning of October, mineral owners who receive royalty checks based on oil production can expect to see smaller figures on their checks. But the price isn’t purely based on the value listed on an exchange. It also depends on location and infrastructure to bring the commodity to market.CountyThe county where the minerals are produced is another common feature of royalty checks. However, it is not clearly stated as “Gaines County” for example. In our first example, we see the check says /TX/ Gaines which tells us the mineral interests are in Gaines County, Texas, which is located in the prolific Permian Basin. Again, this isn’t very clear just from looking at the check, and someone not from the region may not automatically know the names of counties in different states.Knowing the county where the minerals are located can go a long way to understanding their value. For instance, oil production in the Permian Basin has increased significantly in recent years and has been a very attractive place for industry players. However, a lack of pipeline infrastructure has led to oversupply, meaning operators were forced to take a discount to the WTI price. Mineral owners have no control over where and when operators choose to produce, and current production leads to more upfront revenue, but taking a discounted price to get the revenue upfront could ultimately be detrimental to mineral owners in the long term, given the way production tends to decline significantly.Other Sources of InformationWhile royalty checks are tangible pieces of information sent frequently to mineral owners, there’s more information out there that owners can turn to. The lease agreement itself can be the primary source for determining what you own. While many may look the same, lease agreements are ultimately an economic agreement between two parties and can have a variety of different clauses. However, there are frequently instances where our clients do not have access to these key documents. In the case of interests being passed down or donated, clients are usually dealing with legacy arrangements with operators and may not have all the documents that spell out the specific rights with their particular lease.Royalty checks provide valuable information to mineral owners that can help determine the value of their minerals.There are other potential sources of information published online that owners can access free of charge. For instance, in Texas, there’s the Texas General Land Office and Texas Railroad Commission where mineral owners can, among other things, zoom in on plots of land and see well locations. Mineral owners can also learn about historical drilling permits and activity by region. The FDIC also publishes sales of oil and gas interests which can be helpful to see actual sales prices for mineral interests observed in the market.ConclusionRoyalty checks are hardly intuitive, and not everyone would bother asking too many questions when they regularly receive a check in the mail. However, without putting in some research, it can be hard to know if the next check will be higher or lower, or if there will even be one next month. That’s where it becomes crucial to understand what drives the value for mineral interests and what are the relevant risk factors. For those looking to sell their interests, or simply looking to understand the value of what they own, an appraisal can be a helpful tool in understanding both the value of mineral interests, and what drives this value. It is important to seek advice from someone who has experience valuing mineral interests and is well-versed in all potential sources of information.Mercer Capital is an employee-owned independent financial advisory firm with significant experience (both national and internationally) valuing assets and companies in the energy industry (primarily oil and gas, bio fuels and other minerals). Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors.As a disinterested party, we can help you understand the fair market value of your royalty interest and ensure that you get a fair price for your interest. Contact anyone on Mercer Capital’s Oil and Gas team to discuss your royalty interest valuation questions in confidence.[1] Exampled based on a presentation at the National Association of Royalty Owners (NARO) 2018 Conference in Denver, CO

RIA M&A Update - Through August 2022

Year-to-date RIA M&A activity has surpassed last year’s record levels in 2022, even as macro headwinds for the industry continue to mount. Fidelity’s August 2022 Wealth Management M&A Transaction Report listed 155 deals through August of 2022, up from 112 during the same period in 2021. These transactions represented $212 billion in AUM, up 16% from 2021 levels. The continued strength of RIA M&A activity amidst the current environment dominated by inflation, rising interest rates, and a tight labor market is noteworthy, given that all these factors could strain the supply and demand dynamics that have driven deal activity in recent years. Rising costs and interest rates coupled with a declining fee base will put pressure on highly leveraged consolidator models, and a potential downturn in performance could put some sellers on the sidelines until fundamentals improve. But despite these pressures, the market has proven robust (at least so far). Demand for RIAs has remained strong, with professionalization of the buyer market continuing to be a theme driving M&A activity. Serial acquirers and aggregators increasingly drive deal volume with dedicated deal teams and access to capital. Mariner, CAPTRUST, Beacon Pointe, Mercer Advisors, Creative Planning, Wealth Enhancement Group, Focus Financial, and CI Financial all completed multiple deals during the first eight months of the year. While the current market environment has prompted some serial acquirers to temper their pace of acquisition activity (CI Financial’s CEO Kurt McAlpine remarked on the company’s first-quarter earnings call that their pace of acquisitions has “absolutely slowed down”), we’ve not yet seen that borne out in reported deal volume. Multiples in the industry remain high, although the upward trend in multiples has reportedly leveled off. On the supply side, the current market environment is likely to have a mixed impact on bringing sellers to market. On one hand, some sellers may be reluctant to sell when the markets (and their firm’s financial performance) are down significantly from their peak. On the other hand, a concern that multiples may decline if the current market environment persists may prompt some sellers to seek an exit while multiples remain relatively robust.The current market environment is likely to have a mixed impact on bringing sellers to marketWhile market conditions play a role in exit timing, the motives for sellers often encompass more than purely financial considerations. Sellers are often looking to solve for succession issues, improve quality of life, and access organic growth strategies. Such deal rationales are not sensitive to the market environment and will likely continue to fuel the M&A pipeline even in a downturn. And despite years of record-setting M&A activity, the number of RIAs continues to grow—which suggests the uptick in M&A activity is far from played out.What Does This Mean for Your RIA?For RIAs planning to grow through strategic acquisitions: Pricing for RIAs has trended upwards in recent years, leaving you more exposed to underperformance. While the impact of current macro conditions on RIA deal volume and multiples remains to be fully seen, structural developments in the industry and the proliferation of capital availability and acquirer models will likely continue to support higher multiples than the industry has in the past. That said, a long-term investment horizon is the greatest hedge against valuation risks. Short-term volatility aside, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth compared to broker-dealer counterparts and other diversified financial institutions. For RIAs considering internal transactions: We’re often engaged to address valuation issues in internal transaction scenarios. Naturally, valuation considerations are front of mind in internal transactions, as in most transactions. But how the deal is financed is often a crucial secondary consideration in internal transactions where buyers (usually next-gen management) lack the ability or willingness to purchase a substantial portion of the business outright. As the RIA industry has grown, so too has the number of external capital providers who will finance internal transactions. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and, in some instances, may still be the best option). Still, there are also an increasing number of bank financing and other external capital options that can provide the selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs. If you are an RIA considering selling: Whatever the market conditions when you go to sell, it is essential to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. As the RIA industry has grown, a broad spectrum of buyer profiles has emerged to accommodate different seller motivations and allow for varying levels of autonomy post-transaction. A strategic buyer will likely be interested in acquiring a controlling position in your firm and integrating a significant portion of the business to create scale. At the other end of the spectrum, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Given the wide range of buyer models out there, picking the right buyer type to align with your goals and motivations is a critical decision that can significantly impact personal and career satisfaction after the transaction closes.

Book Review: The Future of Automotive Retail (Part 2)

Discussions and Predictions of Changes to Auto Dealers in the Next 30 Years

In this week’s blog, we continue our review of the excellent book, The Future of Automotive Retail by Steve Greenfield. It covers the changing trends of consumer behavior and technology that will likely continue to shape the automotive retailing experience for decades to come.In part one of this two-part series, we discussed the first part of the book, the “convenience economy,” including predictions of changes to power sources and vehicle production.This post continues to march through the book and focuses on vehicle ownership, autonomous vehicles, connected cars, service and repairs, and the proposed future of the auto dealership.Vehicle OwnershipAs the book's author notes, trends in vehicle ownership have changed several times in the last few years alone. Historically, traditional car ownership dominated the industry, with each household directly owning one or two vehicles. Leasing has continued to provide an alternative form of access to personal vehicles, even with common pitfalls such as mileage restrictions, down payments, expensive insurance, extensive fees, and difficulty exiting the lease. In some instances, these disadvantages have made leasing more complicated and costly than traditional ownership.The proliferation of upstart rideshares such as Uber and Lyft provided additional alternatives to vehicle ownership. Rideshares were supposed to reduce the number of vehicles on the road, reducing traffic as consumers could be paired up with strangers heading in the same direction. While rideshares have disrupted taxis, not enough people are willing or interested in taking a taxi to work every day. The pandemic also caused the pendulum to shift back to direct ownership as fewer people were traveling and commuting, public events were limited, and fears of germs and contamination led consumers to prefer the safety of their own vehicles.Through both undercurrents, subscription services have always existed. The book notes that many experts believe a shift to subscription services could soon be a permanent replacement for vehicle ownership. In fact, a study by McKinsey predicts that at least 20% of all new and used car retail sales will be in the form of a subscription as soon as 2025.Many experts believe a shift to subscription services could soon be a permanent replacement for vehicle ownershipWhat is a car subscription service? Car subscription services contain similar elements as long-term rentals or short-term leases. Subscription services offer the use of the vehicle for one all-inclusive monthly fee that typically includes repair & maintenance, insurance, taxes, licenses, and registration, leaving owners/drivers responsible for gas. One limitation with subscription services is that most packages have mileage limits, much like traditional car leases.What is the value proposition of a car subscription? A vehicle subscription allows consumers to switch vehicles easily and frequently with varying minimum periods, some as short as one month. Are you in a market where it would be appealing to have an SUV for winter conditions but a sedan for commuting during the other moderate seasons throughout the year? The myth behind this value proposition is that most customers retain their current vehicle for an average of 10 - 18 months, according to the CPO for Faaren, an upstart subscription company.However, consumers value the ability to bundle car insurance, service, and occasionally finance in certain subscription packages. The convenience economy is also a factor here, as consumers can experience different vehicle features while enjoying affordable subscription services for around $300 to $500 for small to mid-sized cars. While the upfront monthly cost is likely higher than direct ownership, it comes with more price assurances. Consumers with a subscription service wouldn’t have surprise maintenance bills when their car stops working, and some consumers will likely value not having to worry about such repairs.Another challenge to car subscription services is the demographic of likely consumers. As we discussed last week, the prevalence of the convenience economy is primarily attributed to millennials. Younger consumers are dissuaded from car subscription services because they are unable to find insurance at affordable rates. In contrast, baby boomers, who can obtain car insurance for reasonable rates, are more comfortable with the traditional vehicle ownership market, which might explain why car subscriptions have struggled to gain momentum.Another final challenge to subscription services is depreciation. Most readers understand that a vehicle loses value immediately after driving off the dealership lot. On average, a vehicle depreciates approximately 20% in the first year of ownership, and by the end of year five, a vehicle is generally worth about 40% of its initial value, according to Edmunds. With car subscriptions being shorter in duration, how do companies price in the lost value due to depreciation in the first three years of a car’s life span? Hertz is attempting to bridge this gap by pricing subscriptions in the $999 - $1,399 range to account for depreciation. Only time will tell if consumers will have an appetite for subscription packages at these higher prices.AutonomyJust as the Jetsons and Back to the Future 2 predicted, autonomous vehicles are on the horizon for the auto industry. Perhaps, autonomous taxis will gain popularity before individuals own autonomous vehicles. The auto industry believed autonomous vehicles would come sooner than what has actually materialized. Why have consumers been slower to adopt autonomous vehicles? One primary value proposition for autonomous vehicles is safety. Based on average statistics in the United States, a collision occurs every 500,000 miles, with a fatality occurring every 60 million miles. While that may seem remote, these statistics translate to approximately 1.5 million fatalities on roadways each year worldwide.A large percentage of consumers are not comfortable riding in autonomous vehicles and prefer to continue driving their own cars. They would like to see increased safety precautions and widely support a congressional mandate requiring the installation of manual brakes in self-driving cars.Let’s examine the levels of autonomous vehicles per the book:Level 0 – No Automation – Human driver fully operates the vehicle; added features such as backup cameras or blind spot indicators; this level represents most of the vehicles currently on the road;Level 1 – Driver Assistance – Characterized as having at least one driver-support system involving either braking, steering, or acceleration;Level 2 – Partial Automation – The vehicle can take over steering, acceleration, or braking, but the driver must remain behind the wheel and ready to take action;Level 3 – Conditional-DrivingAutomation – Drivers don’t have to actively steer or brake in certain situations such as a traffic jam; Vehicles monitor the driver’s state if/when they have to jump back behind the wheel;Level 4 – High-Driving Automation – No human interaction; many of these vehicles don’t have a steering wheel or pedals; This level may not work during severe weather conditions or limited visibility; currently limited in testing to specific low-speed geographies and areas;Level 5 – Full-Driving Automation – These vehicles travel anywhere and do anything; Passengers have full autonomy to enjoy entertainment, take a nap, perform work, etc.; Vehicles do not have steering wheels, pedals, or brakes; Interiors are designed more like “smart cabins”; There are currently only 1,400 autonomous vehicles on the road in the U.S.; While the timing and full adoption of Level 5 vehicles is unknown, most experts predict there will be a hybrid mix of autonomous and human drivers for at least the next thirty years. Once fully automated vehicles are integrated into the mainstream market, experts predict that dealers will sell far fewer vehicles. The sale and ownership of autonomous vehicles will be shared or part of the subscription models previously mentioned. Why subscription and shared models? Current vehicle utilization (the percentage or amount of time your car is actually in use) is somewhere in the neighborhood of only 4%. This means that 96% of the time, your car is either sitting idle at your house or in the parking garage at your office. Turo is an example of a service that allows you to list your vehicle on their platform when you’re not using it, like an “Airbnb of Cars.” Autonomous vehicles would improve upon a car-sharing model because they reduce the friction of handing off the car and the deliverer not having a ride back to where they came from. Autonomous vehicles will provide more opportunities to be fully utilized and shared by multiple individuals through subscription-based ownership. Subscription models could take on the form of monthly fees or a price-per-trip basis, like current forms of rideshare or taxi.Connected CarsWe previously wrote a post analyzing the impact of connected cars on auto dealerships. What are connected cars? In short, connected cars can communicate with other systems outside the car, allowing the car to share internet access with other devices inside and outside the car. Just as smartphones are mini-computers, smart/connected cars are also becoming mobile computers with infotainment options. The added connectivity that comes with connected cars can potentially engage the millennial generation, who has a strong affinity for smartphones. As cars morph into smartphone-like electronics, they could become a competitor for the attention of younger generations.Like smartphones and appliances, the connectivity features of cars can be controlled and updated through a technology referred to as Over the Air Updates (“OTA”s). An OTA is a software improvement or upgrade sent directly to the vehicle from the vehicle manufacturers (or “OEM”) or industry software company through a wireless internet connection. Examples of OTAs include heated beam lights during inclement weather, changes to suspension systems, or alerts to the driver if windows, doors, or trunks have been left open.The current struggle between OEMs and auto dealers is who controls the OTAs and, more importantly, who retains the revenue. McKinsey reports that the size of the OTA revenue pool could reach $750 billion by 2030, which equates to $310 of revenue per vehicle and $180 of cost savings per vehicle. Not only could auto dealers be left out of this revenue pool, but OTA updates that occur directly will forgo/reduce the need for vehicle servicing at the dealership.ABI research estimates that 203 million OTA or connected cars will ship in the U.S. by 2022ABI research estimates that 203 million OTA or connected cars will ship in the U.S. by 2022. That figure represents 91% of new, connected vehicles in the U.S. compared to only 51% in Asia-Pacific countries and 37% in Latin American countries. Perhaps dealers can join in the OTA revenue sharing by offering an “AppleCare” subscription for cars. Current examples are GM’s OnStar or NissanConnect, which provide services such as remote door locking, vehicle health reports, maintenance notifications, and others.Two unintended consequences of smart/connected cars will be data collection, privacy, and protection, much like smartphones. What types of data will be collected, and will the data collection be limited? The additional connectivity allows data collectors to track where the vehicle has been or even predict where the vehicle is going next. Smart or connected cars could risk being hacked, not only for customer information but also to automatically unlock a vehicle from a wireless keychain or disable the operation of a connected car. How will this be prevented, and will liability rest with the OEM or the dealer?Service and RepairsHow will all these technological and behavioral shifts impact the fixed operations of a dealership, more precisely, its parts and service department? Recall that the fixed operations department has historically represented the highest margin segment of an auto dealership’s operations. On the surface, electric vehicles, OTA updates, and autonomous vehicles could decimate a dealer’s service department. For example, electric vehicles have approximately 20 moving parts, compared to 2,000 moving parts in a traditional ICE vehicle. Fewer parts mean fewer opportunities for repairs and servicing, not to mention EVs don’t run on oil and will eliminate the need for oil changes.Fewer parts mean fewer opportunities for repairs and servicingThe book describes the onset of EVs as the “Blockbuster” moment for Jiffy Lube, whose core operations have revolved around oil changes. Jiffy Lube’s shift to potentially adding charging stations and other services should serve as an example to auto dealers to avoid their “Blockbuster” moment. The stark reality is that the shift to EVs would eliminate approximately 41% of Jiffy Lube’s core services and render another 18% to a lower level of importance.How can auto dealerships respond to these challenges, and what other opportunities might present themselves? EVs are not all doom and gloom, as previously described. One underreported characteristic of EVs is that they are much heavier than their ICE counterparts. The additional weight provides two opportunities for auto dealers: EVs will wear out tires 30% faster than ICE vehicles, leading to higher purchases of tires, and collisions involving EVs will cause more significant damage, leading to higher-priced repairs at the body shop. Simple parts, like windshields, are much more complicated in EVs, and consumers will be more apt to trust a reliable service department at a dealership to reinstall a smart windshield than a local repair shop. In the future, dealers could leverage that consumer trust to add options like battery swaps and sensor calibrations.As autonomous vehicles become more prominent, dealers could provide other services like late-night cleaning, car washes, or middle-of-the-night repairs. These added services could help dealers get a higher market share of fixed operation work while reducing the need for loaner vehicles if the car could transport itself to the dealership for these maintenance items. Until then, dealers can also offer remote or driveway repair services, including delivery and pick-up services, to compete with Lithia and others. Dealers could participate in the increased tire sales and potentially offer tire subscriptions to EV owners.Finally, revenue from EV recalls may be more lucrative than initially reported. EV recalls will involve more expensive parts such as batteries, which can comprise nearly 40% of the EVs total cost. According to the U.S. National Highway Traffic Safety Administration, about one out of every four vehicles on the road are open to a recall. Higher EV recalls provide auto dealers with two revenue-boosting opportunities: 1) OEMs generally pay for the recall work, and 2) service technicians can diagnose problems and recommend additional service items when the vehicle is in the shop.Future of the Auto DealershipAuto dealers have navigated numerous challenges throughout their history and the last few years. The next five, ten, twenty, and thirty years appear to be continual challenges brought about by technology and shifting behavioral trends. Historically, auto dealers have focused on day-to-day operations: how many cars have I sold today, this week, this month? A majority of the systems and processes have also been manual, as certain functions don’t directly communicate with each other. Auto dealers must also fight the stigma that they are among the least trusted professionals among consumers, with nurses and medical doctors ranking on the other end of the spectrum.The central perspective to point out from the book is that the future of auto dealers is not all doom and gloom. There are plenty of growth opportunities on the horizon, but the key is to adapt and plan for those shifts in advance to avoid their own “Blockbuster” moments. At a recent auto presentation, I heard a motivational speaker use a quote that I think is fitting for today’s auto dealers: “so what, now what…”. Dealers should adopt this attitude while facing a growing market of EVs, autonomous vehicles, OTA updates, etc., and seek service offerings and solutions that will appeal to consumers in the coming years.We highly recommend The Future of Automotive Retail to anyone in the auto dealer space. You will both enjoy the book and learn from it.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Reach out to a Mercer Capital auto dealer team member to learn more about the value of your dealership.

October 2022

In this issue: How Are Tech-Forward Banks Performing?

Medtech and Device Industry Newsletter - Q4 2022

E&P Fourth Quarter 2022

Appalachian Basin

Appalachian Basin // Production in the Marcellus & Utica held steady in 2022 despite historically high commodity price volatility driven by the Russian-Ukraine war, the sabotage of the Nord Stream pipelines, and rising LNG exports to Europe to stave-off potential winter heating shortages.

2022 Core Deposit Intangibles Update

On September 21, 2022, the Federal Reserve increased the target federal funds rate by 75 basis points, capping off a collective increase of 300 basis points since March 2022. With the expectation of additional rate increases this year, it’s a good time to evaluate recent trends in core deposit values and discuss expectations for deposit valuations in the coming months.Mercer Capital previously published articles on core deposit trends in August 2020 during the early stages of the pandemic and again in August 2021. In those articles, we described a decreasing trend in core deposit intangible asset values. In response to the pandemic, the Fed cut rates effectively to zero, and the yield on the benchmark 10-year Treasury reached a record low. While many factors are pertinent to analyzing a deposit base, a significant driver of value is market interest rates. As shown below, we find ourselves in a very different interest rate environment today.Figure 1 :: U.S. Treasury Yield CurveTrends In CDI ValuesUsing data compiled by S&P Capital IQ Pro, we analyzed trends in core deposit intangible (CDI) assets recorded in whole bank acquisitions completed from 2000 through mid-September 2022. CDI values represent the value of the depository customer relationships recorded by acquirers as an intangible asset. CDI values are driven by many factors, including the “stickiness” of a customer base, the types of deposit accounts assumed, the level of noninterest income generated, and the cost of the acquired deposit base compared to alternative sources of funding. For our analysis of industry trends in CDI values, we relied on S&P Capital IQ Pro’s definition of core deposits.1In analyzing core deposit intangible assets for individual acquisitions, however, a more detailed analysis of the deposit base would consider the relative stability of various account types. In general, CDI assets derive most of their value from lower-cost demand deposit accounts, while often significantly less (if not zero) value is ascribed to more rate-sensitive time deposits and public funds. Non-retail funding sources such as listing service or brokered deposits are excluded from core deposits when determining the value of a CDI.Figure 2 summarizes the trend in CDI values since the start of the 2008 recession, compared with rates on 5-year FHLB advances. Over the post-recession period, CDI values have largely followed the general trend in interest rates—as alternative funding recorded by acquirers became more costly in 2017 and 2018, CDI values generally ticked up as well, relative to post-recession average levels. Throughout 2019, CDI values exhibited a declining trend in light of yield curve inversion and Fed cuts to the target federal funds rate during the back half of 2019. This trend accelerated in March 2020 when rates were effectively cut to zero.Figure 2 :: CDI as % of Acquired Core DepositsClick here to expand the image aboveCDI values have showed some recovery in the past few quarters (with an average CDI value of 93 basis points year-to-date in 2022 as compared to 64 basis points for all of 2021). Despite the recent uptick, CDI values remain below the post-recession average of 1.29% in the period presented in the chart and meaningfully lower than long-term historical levels which averaged closer to 2.5% to 3.0% in the early 2000s. They are also markedly lower than one might expect, given the current cost of wholesale funding.As shown above, reported CDI values have not increased in tandem with the recent increase in FHLB rates. The average CDI value increased just 25 basis points from September 2021 to September 2022, while the five-year FHLB advance increased a dramatic 228 basis points over the same period. In late-2018 the 5-year FHLB rate approximated the current, mid-September 2022 level, but the average CDI value at that time was 2.42% (compared to the third quarter 2022 average value of 0.75%). The CDI values in recent quarters are somewhat counterintuitive. There are likely three drivers for the relationship between recently reported CDI values and market interest rates:Reporting time lag. The increase in the 5-year FHLB rate has occurred rapidly over the past few months. The deals that closed in the second and third quarters of 2022 were announced in an extremely low interest rate environment. Following third quarter 2022 filings, we expect some upward migration in CDI values to occur as recently announced deals are completed, which reflect the Federal Reserve’s recent rate actions.Deposit levels. Since the beginning of the pandemic, banks have been inundated with deposits. It was initially expected that the increase in deposits would be transient in nature as the economy re-opened, PPP funds were spent or invested, and consumer confidence improved. However, deposit growth continued through 2021 for nearly all banks and into 2022 for some banks. The growth rate in deposit balances is slowing, and September 2022 balances ($17.95 trillion) were lower than August 2022 balances ($18.0 trillion). Given the low average loan-to-deposit ratios, banks have not been in a hurry to increase deposit rates. With the excess of deposits, there may have been a tendency for bank acquirers to discount core deposit value given the lack of immediate funding needs or concern that, with higher market rates, the long anticipated reversal of the pandemic-related deposit influx may finally occur.Uncertain Rate Outlook. While rates are expected to continue rising in the near-term, some market participants may remain concerned that a zero rate environment will remain the long-term norm. If this view is correct, which implicitly assumes that the Federal Reserve can choke inflation, CDI values will remain constrained. Nineteen deals were announced in August and September 2022, and five of those deals provided either investor presentations or earnings calls containing CDI estimates. These CDI estimates ranged from 1.5% to 2.0%, which is more in line with the numbers we have observed in our valuation analyses. We expect CDI values to continue rising in concert with market interest rates. However, market interest rates are not the only driver of CDI value, and there are some potentially mitigating factors to CDI values in the near term.Deposit levels. Over the past year, consumers were likely hesitant to go to the trouble of seeking higher interest rates as the marginal benefit of a rate enhancement would have been low in comparison to the necessary expenditure of effort. This inertia is not expected to last indefinitely. There is already evidence that excess deposit balances are beginning to exit the system. Higher attrition rates, all else equal, translate into a lower CDI value.Deposit mix. Over the past decade, nationwide average deposit mix has shifted in favor of noninterest bearing deposits. In 2007, retail time deposits constituted an average of 31% of financial institution deposits with noninterest bearing deposits comprising 16%. In 2022, this mix is nearly reversed (28% of balances in noninterest-bearing accounts and 15% in retail time deposits). As banks face increasing interest rate pressure, the deposit mix is likely to begin shifting in favor of interest-bearing deposits that have lower CDI values. Figure 3 :: Deposit Mix OvertimeService charge income. The industry is facing pressure from regulators and the public to reduce overdraft charges and other fees. Lower service charge income produces lower CDI values, all else equal.Deposit interest rate betas. Historical average deposit betas may be insufficient to forecast future deposit interest rates over the life of an acquired deposit base. For example, deposit betas for money market accounts have historically averaged approximately 50%. At September 23, 2022 the national average money market rate was 0.15%. A 50% beta may not be aggressive enough to yield a reasonable ongoing interest rate for an acquired deposit base with a starting interest rate of 0.15%. Using an inappropriately low beta would artificially enhance core deposit value by understating future interest rates on the acquired deposit base.Trends In Deposit Premiums Relative To CDI Asset ValuesCore deposit intangible assets are related to, but not identical to, deposit premiums paid in acquisitions. While CDI assets are an intangible asset recorded in acquisitions to capture the value of the customer relationships the deposits represent, deposit premiums paid are a function of the purchase price of an acquisition.Deposit premiums in whole bank acquisitions are computed based on the excess of the purchase price over the target’s tangible book value, as a percentage of the core deposit base. While deposit premiums often capture the value to the acquirer of assuming the established funding source of the core deposit base (that is, the value of the deposit franchise), the purchase price also reflects factors unrelated to the deposit base, such as the quality of the acquired loan portfolio, unique synergy opportunities anticipated by the acquirer, etc. As shown in Figure 4, deposit premiums paid in whole bank acquisitions have shown more volatility than CDI values. Deposit premiums in the range of 6% to 10% remain well below the pre-Great Recession levels when premiums for whole bank acquisitions averaged closer to 20%.Additional factors may influence the purchase price to an extent that the calculated deposit premium doesn’t necessarily bear a strong relationship to the value of the core deposit base to the acquirer. This influence is often less relevant in branch transactions where the deposit base is the primary driver of the transaction and the relationship between the purchase price and the deposit base is more direct. Figure 5 (on the next page) presents deposit premiums paid in whole bank acquisitions as compared to premiums paid in branch transactions.Deposit premiums paid in branch transactions have generally been less volatile than tangible book value premiums paid in whole bank acquisitions. Branch transaction deposit premiums averaged in the 3.0% to 7.5% range during 2020, up from the 2.0% to 4.0% range observed in the financial crisis. During 2021 and the first quarter of 2022, branch transaction deposit premiums averaged 2.5% to 5.25%. Unfortunately, none of the branch transactions completed in the second or third quarters of 2022 reported franchise premium data.Figure 4 :: CDI Recorded vs. Deposit Premiums PaidFigure 5 :: Average Deposit Premiums PaidClick here to expand the image aboveSome disconnect appears to exist between the prices paid in branch transactions and the CDI values recorded in bank M&A transactions. Beyond the relatively small sample size of branch transactions, one explanation might be the excess capital that continues to accumulate in the banking industry, resulting in strong bidding activity for the M&A opportunities that arise–even in situations where the potential buyers have ample deposits.Accounting For CDI AssetsBased on the data for acquisitions for which core deposit intangible detail was reported, a majority of banks selected a ten-year amortization term for the CDI values booked. Less than 10% of transactions for which data was available selected amortization terms longer than ten years. Amortization methods were somewhat more varied, but an accelerated amortization method was selected in approximately half of these transactions.Figure 6 :: Selected Amortization Term (Years)Transactions Completed 2008 - September 25, 2022Figure 7 :: Selected Amortization Method For more information about Mercer Capital’s core deposit valuation services, please contact a member of our Depository Institution Services Team. 1 S&P Capital IQ Pro defines core deposits as, “Deposits in U.S. offices excluding time deposits over $250,000 and brokered deposits of $250,000 or less.”

Five Takeaways from the Association of Trust Organizations (ATO) 2022 Annual Meeting

Last week, ATO held its annual meeting at the JW Marriott in Las Vegas to discuss industry trends, practice management, and recruitment during the Great Resignation. As a sponsor and panelist, here are our main takeaways from the meeting:1. Your Capital Requirements Might Be Going DownTom Blank of Shumaker, Loop & Kendrick, noted in his regulatory update presentation that Peak Trust Company received conditional approval earlier this year from The Office of the Comptroller of the Currency (OCC) for its national charter, which required a lower-than-anticipated capital base of $7 million. This reduction could mean lower capital requirements for other OCC regulated TrustCos and possibly state-regulated firms moving forward. If industry capital requirements are ultimately reduced, more cash reserves would be available for distributions and acquisitions, but it would also lower the barrier to entry for prospective competitors.2. Service is the New SalesDavid Lincoln of Wise Insights presented on trust company performance trends and reported that a substantial portion of the industry’s new business in 2021 came from net additions from existing clients rather than acquisitions. He recommended maintaining elevated levels of client engagement with existing customers and noted that many firms were developing a more structured approach to client service and outreach strategies. Gaining new business from existing clients is generally much less expensive than revenue gained by acquisition, so retention efforts are typically more accretive to earnings.3. The Best Time to Start Thinking About Succession Planning is YesterdayPaul Lesser of Cannon Financial Institute and I participated in a discussion panel on recruitment, retention, and disruption in the TrustCo space during the Great Resignation. We both acknowledged an increased utilization of equity compensation and more deliberate succession planning to recruit and retain key staff members. It’s never too early for TrustCo owners to start planning for their eventual retirement and identifying future successors for their ownership and managerial responsibilities. Best practices typically involve a mechanism for transitioning equity and client relationships over time, which is more of an ongoing process than an eventual outcome.4. Special Assets Require Special Resources and Special FeesMelody Martinez of Farmers National, Chris Procise of CIBC National Trust Company, Brooks Campany of Argent Financial, and Mike Tropeano of Broadridge Financial Solutions discussed best practices in administering and feeing special assets held in trusts. These closely held assets require increased due diligence with less available information and a specialized skill set to manage, which poses unique challenges to trust administrators with fiduciary responsibilities. These presenters recommended a careful cost-benefit analysis to ensure the fees are commensurate with the risks associated with administering real estate and private equity assets.5. 2022 is Poised to be a Rough Year for TrustCo EarningsAlmost every attendee I spoke to about their business lamented that year-to-date earnings have declined from peak 2021 levels. AUA and revenue are down with the capital markets and costs are rising with elevated inflation levels, so industry margins are feeling the pressure. Many TrustCo principals have responded by reining in new hires and encouraging the next generation of management to buy equity that has suddenly become affordable.The conference was well attended, and there were other great topics and presentations were not referenced in this blog (see meeting slides). We would certainly recommend it for trust company officers seeking intel on the state of the industry and hope to see you at next year’s meeting in New Orleans.

Bakken Regains Its Footing

The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. This quarter we take a closer look at the Bakken.Production and Activity LevelsEstimated Bakken production (on a barrels of oil equivalent, or “boe” basis) increased by 5% year-over-year in September. Bakken production, relative to the September 2021 level, plunged nearly 20% in April due to the impact of back-to-back blizzards but had recovered to the September 2021 level by June 2022. Production in the Eagle Ford and Permian were 13% and 8% higher, respectively than in September 2021, without the short-lived plunge seen in the Bakken. The gas-focused Appalachia region production relative to September 2021 levels was more stable than the oil-focused regions, with relative production only varying within a band of -1% to 4%, ending at a year-over-year 3% increase in September 2022. As of September 16, 2022, 40 rigs were operating in the Bakken, marking a 74% increase from September 10, 2021. Eagle Ford, Permian, and Appalachia rig counts were significantly higher than year-earlier levels at 112%, 35%, and 24% increases, respectively. The Permian continued to command the largest number of rigs at 343, with the Eagle Ford and Appalachia closer in-line with the Bakken at 72 and 47 rigs, respectively. Oil Climbs While Gas Shows Heightened VolatilityOil prices, as benchmarked by West Texas Intermediate (WTI) and the Brent Crude (Brent), rose from $72/bbl and $75/bbl, respectively, in September 2021 to $85/bbl and $90/bbl, respectively, as of September 16, 2022. While the rise in pricing was fairly steady through mid-February 2022, the Russian invasion of Ukraine spurred a series of ups and downs, with prices spiking to a high of $120/bbl (WTI) and $128/bbl (Brent) in early March, immediately followed by a plunge to $94/bbl and $96/bbl in mid-March. Subsequent spikes and dips were somewhat more muted, but prices remained volatile through early June. A general price decline during the third quarter resulted in prices at the $85/bbl and $90/bbl level.Henry Hub natural gas front-month futures prices dipped from a late 2021 high of $5.48/mmbtu to a low of $3.44/mmbtu near 2021 year-end as commodity markets incorporated indications of rising production levels and ebbing weather-driven demand. Pricing subsequently rose to as high as $9.29/mmbtu in June on weather-driven demand and lacking supplies due to a reduction in Russian exports. In mid-June Henry Hub pricing began a sharp decline on the announcement that prices recovered over the remaining two months of the September LTM period, albeit with some volatility, to end at $7.81/mmbtu.Financial PerformanceThe Bakken public comp group's latest twelve-month financial performance (stock price) analysis was reduced to two subject companies and the XOP SPDR, as a result of the Whiting and Oasis merger in March 2022. The combined Whiting/Oasis company, Chord Energy, appears in our analysis as CHRD.The Bakken comp group showed strong price performance from year-end 2021 through early June, with increases ranging from 63% to 83%, largely reflective of oil prices. The subsequent decline in commodity prices, which ran nearly un-checked for two months, slashed the analysis period performance to increases of only 3% and 46%, with Chord posting a decline that nearly wiped out its post September 2021 gains. Prices have recovered since July with one-year gains of 42% (Chord) to 61% (Continental).ConclusionThe Bakken showed a general increase in activity over the last year, albeit with a large winter storm disruption and subsequent production recovery along the way. Rig counts have risen on strong commodity pricing, despite the oil price decline in Q3 2022. Share prices generally increased early in the latest twelve-month period, with a sharp decline in Q3 tied to oil prices slipping. Share prices recovered enough in late Q3 to show reasonably strong year-over-year growth as of September.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

Book Review: The Future of Automotive Retail (Part 1)

Discussions and Predictions of Changes to Auto Dealers in the Next 30 Years

As fall approaches and school is back in swing, the Auto Team has completed our summer reading. Over the next two posts, we review the book The Future of Automotive Retail by Steve Greenfield. This book discusses changes in trends of consumer behavior and technology that will likely continue to shape the auto dealer retailing experience for decades to come. Additionally, the book makes numerous predictions about when and how those changes can pose both opportunities and challenges for auto dealerships. In our review, we discuss the content, trends, and predictions found in the book (and add a few of our own upon occasion).The auto industry has adapted to numerous changes just in the last few years alone: the introduction/proliferation of electric vehicles, online or partially online transactions of new and used vehicles, shortages in new vehicle production caused by the pandemic and microchip crisis, and threats of direct sales from the manufacturer to the consumer directly, to name a few. Moving forward, the auto industry seems to be on the precipice of change as it relates to these shifts and also evolving technology that will impact the ownership of automobiles in the future.Regarding predictions of changes to technology impacting the auto industry, we can look to the big and small screen, specifically, the Jetsons and Back to the Future 2. This iconic cartoon and movie gave us a glimpse of life in the 21st century. The Jetson’s debuted in the 1960s, and while no specific year was ever referenced, trailers for the original series mention that the setting is 100 years in the future, or approximately 2060. In fact, George Jetson’s birthday was just a couple of months ago, according to some fans. Avid viewers of the show will recall that the cartoon correctly predicted many technological advances that have already occurred today or are just on the horizon – video calls, robotic vacuums, tablet computers, robots, flying cars, smart watches, drones, 3D printed food, and flat screen TVs. In Back to the Future 2, Marty McFly travels into the future to the year 2015 where we see technological advances such as drones, tablet computers with mobile payment options, waste fueled cars, flying cars, and robotic/autonomous taxis to name a few.In part one of this blog series, we review the discussions and predictions caused by the “convenience economy,” including changes to power sources and vehicle production. In next week’s post, we will discuss vehicle ownership, autonomous vehicles, connected cars, service and repairs, and the overall future of the auto dealership.Just as auto dealers have proven their resiliency and adaptability to challenges over the last two years caused by the pandemic, they must continue to be aware of oncoming changes to technology and the retail model to stay competitive and not get left behind.Convenience EconomyWhat is the convenience economy? Per the book, the convenience economy is all about consumer empowerment and control. Today’s consumers expect to be able to purchase and receive whatever they want, whenever they want, and however they want. Some credit (or blame) the shift to a convenience economy to millennials. However, the lion’s share of the shift can be traced back to market disruption. Market disruption, in this sense, refers to new service offerings or companies that cause a profound change in the existing business landscape in a particular industry that forces existing businesses to undergo significant transformation to stay competitive. Common examples of market disruption include:Netflix’s impact on video consumption and the shift to streaming services that forced Blockbuster out of business.Uber/Lyft’s impact on getting a ride displacing taxis if not car ownership altogether as initially proffered.Amazon’s impact on ordering and delivering consumer products online. Amazon is most cited for the shift to a convenience economy and referred to as the “Amazon effect.” The auto industry is also not immune to market disruption. Examples include Tesla’s impact on the introduction and popularity of electric cars as well as a shift to direct sales to customers, Carvana and Vroom’s impact on the way vehicles are purchased and delivered, and Lithia’s Driveway impact to mobile servicing and repair.In the convenience economy, today’s consumer places value on convenience over priceIn the convenience economy, today’s consumer places value on convenience over price. Historically, the convenience economy affected lower priced consumer goods. In recent years, the convenience economy is also shifting to higher priced goods, such as the purchase of an automobile. According to the book, research predicts that 80% of all car deals in urban markets will include some components of digital retail elements in the next five years, eschewing the old-school haggling process at a dealership.Auto dealers have responded by adding digital elements to the transaction process to meet the demands of today’s consumer. According to Cox Automotive, this short list of digital changes also allows for dealers to operate more efficiently:Reducing the time that customers spend at the dealershipReducing the number of steps to complete a transactionReduction of time dealership staff spend on completing a transactionFewer staff required to complete a transaction The shift to the digital retail experience doesn’t totally eliminate the physical dealership experience. A study by Deloitte indicates the following reasons why some consumers would not want to completely shift to an online purchase:Ability to see the vehicle before purchaseAbility to test drive the vehiclePreference to negotiate in personDon’t feel comfortable purchasing online In contrast, the same study lists the following as advantages listed by consumers for online components to an auto transaction:ConvenienceSpeedEase of UseNecessityAbility to avoid going to a dealershipHow Should Auto Dealers React to the Convenience Economy?Auto dealers should recognize that they are in another period of market disruption. In an effort to meet consumer demands, auto dealers should continue to offer and improve digital elements to the transaction process. This shift could also present downsizing opportunities for the auto dealership facilities and footprint, as the need for over-the-top showrooms may be less desired by the consumer. Of course, the latter will continue to be a debate and negotiation between an auto dealer and their manufacturer.Power SourcesOf all the headlines in the auto industry in recent years, electric vehicles (EVs) continue to dominate. As discussed earlier, Tesla was an early market disrupter in this area, along with other recent start-ups like Rivian and NIO that have also joined the trend. Additionally, the legacy manufacturers of internal combustion engine (“ICE”) automobiles have also been producing electric vehicles with more models on the way. Auto manufacturers are also seeking to restore the balance of power regarding the profit margins on new vehicle sales, which have shifted to the dealers in the last year and a half or so. Several manufacturers such as Ford, Buick, and Volkswagen have expressed a desire to alter the traditional state franchise law system of the dealer network and explore direct sales models to consumers. We will discuss this trend in more detail in next week’s blog.E&Y estimates that 30% of the group born between the years 1981 and 1997 express a desire to drive electric vehiclesMcKinsey & Company estimates that EVs will comprise more than half of all U.S. passenger car transactions by 2030 if the early adoption momentum continues. Recently, California passed a mandate requiring all new car sales by 2035 to be free of greenhouse gas, aka a mandate pushing EVs.Like the convenience economy, millennials are also being credited with driving the EV movement. E&Y estimates that 30% of the group born between the years 1981 and 1997 express a desire to drive electric vehicles. A study by OC&C Strategy cited the four main concerns that consumers are apprehensive about choosing an EV:RangePriceCharging AvailabilitySpeed of Charging Earlier, we discussed a theme in the book stating that millennials valued convenience over price in the emerging convenience economy. Apparently, there is a limit to the perceived value of convenience with regard to purchasing an EV. The same study by OC&C Strategy discovered that only 16% of consumers polled would be willing to pay $2,500 more for an EV over an ICE vehicle, while 70% would not pay more than a $500 premium for an EV. It’s important to remember that convenience works both ways. While consumers may prefer quicker buying transactions, which many have associated with EVs, they may give back that time and then some awaiting their vehicle to charge as compared to refilling a gas tank.What Alternatives are Being Developed to Relieve Consumer Anxiety Related to Charging Availability?In addition to other federal and state mandates calling for the build-out and development of charging station infrastructure, NIO is also developing a battery swap technology in other countries that might eventually lead to adoption in the U.S. NIO has sold approximately 120,000 EVs to date and has erected 300 battery swapping stations across China. These stations completed 500,000 battery swaps in 2020, and NIO is currently expanding the operation to Norway. Why Norway? Norway has enacted some of the most aggressive legislation against ICE vehicles, charging a 20% carbon tax on those vehicles. The results speak for themselves: 65% of all new cars sold in Norway in 2021 were EVs, up from 54% in 2020 and 42% in 2019.We will discuss the disruptive nature of EVs on an auto dealer’s parts and service operation in next week’s blog.While EVs have fewer moving parts than their ICE counterparts, there are a couple of underreported qualities of EVs that could present opportunities for a dealer’s fixed operations.Another unintended consequence of the EV movement is the further reliance on China for various components in the EV supply chain. We have covered some of this topic in a prior blog. According to Benchmark Mineral Intelligence, China comprises the following in the EV supply chain:80% of the world’s total output of raw materials for advanced batteries90% of rare metals, alloys, and magnets8 out of 14 of the largest cobalt mines are located in the Congo, all of which are Chinese controlled>60% of the world’s graphite, an essential raw material in electric batteries Another important consideration is infrastructure. If the adoption of EVs continues, can the existing power grid support the added demand for charging these vehicles? While most believe utility companies have plenty of bandwidth to handle the extra load, some prognosticators point to the winter storm that besieged Texas in 2021 as evidence to the contrary. If nothing else, that storm and the resulting fallout should serve as a cautionary reminder that upgrades to existing grid infrastructure will be necessary and will not come cheaply. We further note that consumers in California have been urged to not charge their vehicles amid a heat wave. Other items to consider with EVs are as follows:Charging Time – currently, most battery ranges top out at approximately 300 miles; the fastest charging technology takes 40 minutes to charge to an approximate 80% level.Pollution – Part of the value proposition of EVs is to reduce the greenhouse gas effect of ICE vehicles. One unanswered question is how/where will the disposal of batteries take place at scale, and will there be environmental harm caused by that disposal? Some experts just see it as a shift of pollution in urban areas where ICE vehicles are currently operated to battery production/disposal sites in more rural areas.Used EVs transparency – As the EV movement continues to evolve and more used EVs hit the market, how will the consumer be able to discern how much battery life is remaining on the current battery before it will need to be replaced, which is a material ongoing cost with EVs?Margin Compression – If dealers will be allowed to sell and participate in the margins on new EV transactions, how will compressed margins impact the dealers' bottom line (especially in lieu of heightened margins in the last couple of years)? Many of the legacy auto manufacturers are currently selling EVs at a loss which does not provide much incentive to auto dealers.Vehicle ProductionThe vehicle production model has changed dramatically in the last three years because of the impact of the pandemic, followed by the microchip shortage and resulting supply chain issues. As a result, auto manufacturers and auto dealers have grown accustomed to operating with less inventory. Both have thrived in the short term, but how will vehicle production be impacted in the future as ICE and EVs continue to coexist for at least another few decades?The convenience economy shows up again with vehicle production. Consumers want total choice over the trim package, color, features, engine size, infotainment, and other components of their vehicles. This priority has been a struggle for consumers with lower levels of production and inventory over the last few years. As the book highlights, American consumers are not willing to wait weeks/months for customized vehicles in the convenience economy, sacrificing choice for convenience and showing that preferences can be dynamic.How will manufacturers handle vehicle production going forward in a system that most believe will maintain lower inventory levels? Historically, auto manufacturers have relied on crude data to form production decisions. If the manufacturers could anticipate the wishes of their consumers, they could save money by not overproducing the wrong model of cars or by shipping a preset number of vehicles/models to the wrong market. According to Cox Automotive, auto manufacturers and auto dealers need to focus on 12% of vehicle combinations that ultimately comprise 75% of the sales. Further, JD Power estimates that approximately 88% of manufacturers’ combinations sell fewer than fifty units each and account for only 25% of net sales. The consumer and the statistics say it all….give the people what they want.According to Intel, microchips will comprise nearly 20% of the components in premium vehicles by 2030Another technology advancement that could impact vehicle production is 3D printing. Just as the Jetsons predicted 3D printed food, 3D technology is now capable of printing an entire vehicle. Local Motors has focused on a project to 3D print an autonomous electric shuttle called Olli. With current technology, the Olli takes nearly 10 hours to 3D print and is not cost efficient. Perhaps the shorter-term adaptation for 3D printing in the auto industry will be on replacement parts, particularly for later date models where it becomes less economically viable for dealers to hold a significant inventory of these parts.Finally, how will the ongoing impact of the microchip shortage affect the auto industry? We all learned just how important and how many microchips are involved in new vehicle parts and production in the last two years. According to Intel, microchips will comprise nearly 20% of the components in premium vehicles by 2030, representing a 5X increase in their proportion in 2019. EVs will only add to the demand for microchips in the years to come. In a previous blog, we highlighted the timeline and costs involved with building new microchip plants in the U.S. to attempt to relieve some of the ongoing demand.ConclusionAuto dealers have proven that they are an adaptive, resilient bunch; able to navigate the challenges in the economy and consumer behavior in the last few years. Today we seem to be at a crossroads of emerging technology and continual changes to consumer behavior that will impact the future of auto retail. Just as past market disruptions have proven, auto dealers that are resistant to change might be left behind.I attended an auto meeting this week, and one participant made the remark that the auto industry has seen more change in the last five years than the previous 25 and more change in the last two years than the previous five. In part two of the blog next week, we will continue to explore these changes and the potential challenges and opportunities facing auto deals in the coming years.In the meantime, we highly recommend The Future of Automotive Retail for anyone in the auto dealer industry. Readers will be both educated and entertained.Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze key drivers of value. We also help our dealer clients understand how their dealership may or may not fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to learn more about the value of your dealership.

Bakken M&A

Increased Transaction Volume Continues into 2022

Deal flow in the Bakken has been steady over the last twelve months, with 14 transactions announced since October 2021, up from nine deals during the same period in 2020-2021. Devon Energy’s $5.6 billion acquisition of assets from WPX Energy was the only deal in the twelve months prior to September 2021 that exceeded $1.0 billion in value. In comparison, five deals exceeded $1.0 billion during the twelve-month time period ended September 2022, led by the Oasis Petroleum – Whiting Petroleum merger, at $6.0 billion.Recent Transactions In the BakkenA table detailing transaction activity in the Bakken over the last twelve months is shown below. Despite an increase in the number of deals, relative to 2020 – 2021, the median deal size decreased by roughly $215 million, with five deals valued at less than $200 million. The median value per acre and value per Boepd, however, increased over 300% and 100%, respectively.Oasis and Whiting Combine In a $6.0 Billion MergerOn March 7, 2022, Oasis Petroleum and Whiting Petroleum announced a $6.0 billion merger, renaming the combined entity Chord Energy. The deal closed on July 5, 2022. Under the terms of the agreement, Whiting shareholders received 0.5774 shares of Oasis common stock and $6.25 in cash for each share of Whiting common stock owned. Oasis shareholders received a special dividend of $15.00 per share. At closing, Whiting and Oasis shareholders owned approximately 53% and 47%, respectively, of the combined entity on a fully diluted basis. Transaction highlights include:Production (2022 Q1) – 92,000 BoepdAcreage – 480,000 net acres in Montana and North DakotaThe deal creates the Bakken’s second-largest producer and the largest pure-play E&P A pro forma table of the transaction is shown below:Devon Energy - RimRock Oil and Gas DealThe next largest deal exclusive to the Bakken is Devon Energy’s $865 million acquisition of a working interest and related assets from RimRock Oil and Gas (seven of the 14 deals analyzed included acreage or midstream assets in areas in addition to the Bakken, including the $4.8 billion Sitio Royalties – Brigham Minerals transaction and the $1.8 billion Crestwood Equity Partners – Oasis Midstream Partners transaction). The deal was announced on June 8, 2022 and closed on July 21, 2022. Deal highlights include:38,000 net acres in Dunn County, North Dakota15,000 Boep/d as of Q1 2022 (78% oil)88% working interestOver 100 drilling locations Characterized by Devon Energy as a bolt-on acquisition, the 38,000 net acres are contiguous to Devon Energy’s existing position in the Bakken. Production from the acquired assets is expected to increase to approximately 20,000 Boep/d over the next twelve months. RimRock Oil and Gas is backed by private equity sponsor Warburg Pincus, which has held a stake in RimRock Oil and Gas since 2016.ConclusionM&A transaction activity in the Bakken increased through year-to-date 2022 relative to the same time period in 2021 and consisted of a handful of large deals and numerous small deals. Deal activity in the Bakken will be important to monitor as companies continue to find significant opportunities to grow their Bakken positions.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Market Indications of RIA Value are Mixed, To Say the Least

Unicorn or Glue Horse?

Imagine you manufacture luxury products. You've recently had to raise prices substantially, despite your primary markets being headed into recession. Your buyers use leverage to purchase your products, and interest rates are the highest in a decade and are headed up. On the production side, your supply chain is compromised, skilled workers are scarce, and the cost of powering your factories has skyrocketed because your home currency has devalued. Public market investors shun legacy participants like you because your industry subsector is in the midst of technological upheaval, and the cost of retooling is viewed as greater than starting from scratch. Equity markets are sagging, and the IPO market is dormant. To top it off, there's a major war with an uncertain outcome that has already worsened your supply chain issues, and fighting could spill over into nations adjacent to your home country.Does that sound like an "open window" to list as a public company?Next week, Porsche AG is going public for the first time in ten years. Parent company Volkswagen announced the complex restructure and IPO a few weeks ago, and recently confirmed that Porsche would be organized into 911 million shares (a nod to their most iconic model), half of which will be voting, common shares and the other half will be non-voting preferred shares (not preferred in a sense we're accustomed to in the U.S.). Post IPO, the public will own one-eighth of the company (25% of the preferred shares), while the Porsche family will effectively have a controlling stake.The IPO was initially criticized for its complexity, governance plan, and pricing (at $75 billion, Porsche would trade about 10% lower than VW, which sells more than 30x as many cars per year). By Wednesday evening of this week, the order books were full, eight days early. No marathon for the book runners – more of a 5K.It's a Strange MarketLast week, Zach Milam wrote about some of the conundrums we encounter in valuing RIAs. Fair market value pricing has a tendency to lean in the direction of intrinsic value. The reality is, though, sometimes markets have a mind of their own and don't really care what thoughtful, educated securities analysts think. Fundamental analysis suggests many factors working against the value of investment management firms, and trading in public RIAs confirms that view. Transaction activity tells a very different story.Fair market value pricing has a tendency to lean in the direction of intrinsic valueWe're about to close the third quarter of a record number of transactions in the RIA space. In spite of plenty of headwinds: inflation-challenged margins, sagging AUM, and higher leverage costs, the pace of M&A continues and could equal last year. I say could because, even though we'll head into the fourth quarter of 2022 with a strong lead over 2021, the Q4 2021 comp is a tough one. Last year, fear of change in tax law and the breadth of the bull market drove a ridiculous volume of transactions.Nevertheless, momentum is strong. Even though buyers are getting picky, deal terms are less generous, and consideration is starting to shift more to earnouts; pricing is steady.What's Not to Like? One thing that's different than 2021 is that public market activity is anemic. Public RIAs aren't benefiting from any of this private market pricing activity, and the IPO window is – despite what some people have suggested – nailed shut.It’s difficult to reconcile public market pricing with private market sentimentIt's difficult to reconcile public market pricing with private market sentiment. Public RIAs are commonly trading at mid-single-digit multiples of EBITDA. Private company owners scoff at those metrics, and for good reason. Even though transactions may not always be as generous as some think, they're still better than going public. On the private side, consolidators are lauded for building wealth management empires – all while Focus trades just above its IPO price from four years ago, and CI Financial gets criticized for building a wealth management empire. The doublespeak is staggering. One wonders why more public RIAs don't throw in the towel and go private like Pzena.Who wants to go public in this market? In the first quarter of 2022, we heard about Dynasty Financial and Gladstone Companies going public and CI Financial offering shares in its U.S. wealth management business. None of that has happened, and until market conditions change, none of that is going to happen.Your Mileage May VaryI've heard lots of explanations of the private/public discrepancy in valuation, but nothing yet that's altogether satisfying. Depending on who you talk to, one man's unicorn is another man's glue horse.What we can say with certainty is that the differential in interest in public investment management businesses and private investment management businesses isn't sustainable. What we don't know is when or how. Will higher interest rates eventually wear down leveraged acquirers, as they have in other growth-and-income sectors (real estate, anyone?)? Will PE investors start to question the merits of trading companies from fund to fund instead of testing valuations in the open market? Will the public RIA group follow Pzena's lead and go private? Or will public investors' newfound interest in dividend stocks lead them to RIAs?It's tough to forecast a public RIA resurgence but never say never. Investors may not be pricing Porsche like Tesla, but they're giving it a valuation more like Ferrari (RACE) than Ford (F). In a market full of both prancing horses and mustangs, the public companies may yet win by a nose.

Blue Sky Multiples Remain Flat as Earnings Plateau

Dealers Continue to Perform through Negative Economic Indicators

The first half of 2022 was tumultuous, which Haig Partners succinctly summarized in their Q2 Haig Report. Negative headlines and headwinds aplenty:Inflation driving up costs for dealers and reducing affordability for customersInterest rates rising also drives up dealer costs and reduces affordabilityGas prices spiked (and are receding) which also reduces affordability (though this has only indirect impact on dealer costs)The stock market (as measured by the S&P 500) is down 18.2% year to date and GDP growth has been negative for two consecutive quartersThere is geopolitical uncertainty surrounding China-Taiwan and Russia's invasion of UkraineSupply chain issues have plagued the industry for over a year and a half and consumers are well aware of the high transaction prices of vehicles Available monthly data for these economic indicators are displayed since December 2019 in the following graphs below. In spite of these conditions, dealers have navigated this environment to deliver record profits. However, Haig points to the public dealers' earnings in Q2 as an indication that dealer earnings may have plateaued. The future direction of profitability is hard to predict, but with all the historical indicators for the industry flashing red, eventually, even the supply-demand imbalance cannot overcome all of these challenges. Whenever supply starts to rebound, the key question will be the degree to which gross profitability reverts as well.Blue Sky Multiples – Luxury BrandsAfter three straight quarters of changes in 2020, not a single luxury dealership saw a change in its multiple range in the next seven quarters. However, after years of only reporting a value range due to a lack of profitability, Cadillac dealerships reported at a range of 3x-4x in Q4 2021. Similarly, Infiniti and Lincoln reported a multiple range of 3x-4x in the Q2 2022. Value ranges are used instead of multiples when many of the brands' dealers are not profitable, but with improved earnings performance industry-wide, Haig is now reporting a multiple range for every brand covered in its report for the first time since at least Diesel Gate in 2014. We note the 3x-4x range for Cadillac, Infiniti, and Lincoln matches the 3x-4x range of Acura dealerships, which have consistently reported a multiple range at the low end for luxury dealerships.Blue Sky Multiples – Mid-Line Import BrandsDuring the first half of 2022, Hyundai and Kia saw another 0.25x improvement in multiple to a range of 4x-5x, building on a 0.5x improvement in Q3 2021. There are now three distinct tiers of mid-line brands: Toyota paces the top group (followed by Honda and Subaru), Hyundai and Kia, despite improvements, are still 2.0x below the top three, followed by VW, Nissan, and Mazda, which are about 1.0x below Hyundai and Kia and in line with the lowest multiples of the luxury brands.Toyota dealerships still fetch higher valuations than Audi and Jaguar-Land Rover dealerships. While they don't sell luxury vehicles, Toyotas are viewed as dependable vehicles. Potentially more important to dealers, Toyota has indicated it has no plans to replace dealerships with an agency model and is committed to a phased transition into EVs while also offering ICE vehicles and hybrids. Haig declared that Toyota might be the most desired brand in the industry. We find this interesting as Toyota dealerships remain a bargain in terms of Blue Sky's multiple range as compared to the top-of-the-line luxury dealerships. Desirability may also be factoring in cost, and the supply of luxury dealerships for sale may have an impact on the higher multiples for Porsche, Lexus, etc., particularly considering Toyota Motor Corporation owns Lexus.Blue Sky Multiples - Domestic BrandsDomestic franchise multiples have not changed since Q3 2020. With the rise of Hyundai and Kia's multiples over the past year, domestic brands' multiples are now generally in between the second and third tier of mid-line imports, where they once held a slight advantage over some of those brands. One would think that supply chain constraints would more negatively impact import brands than their domestic counterparts. However, the past two years have demonstrated that even domestic brands rely heavily on the global supply chain for their inputs, particularly microchips.In the last four years, domestic brands Ford, Chevrolet and Buick-GMC are the only brands across all of the published Haig multiples that have decreased. In Q2 2018, these brands' multiples were half a turn higher than they are in Q2 2022. Stellantis actually increased over that same period but only by 0.25x.It is important to note that the published blue-sky multiple ranges, while certainly reasonable, do not imply that dealerships are actually transacting at these multiples. With the performance of most dealerships remaining elevated, owners on the lower end of Blue Sky multiples are less likely to transact when the payback period on an investment is so short unless they need liquidity or are approaching retirement without an identified succession plan.ConclusionBlue Sky multiples provide a useful way to understand the intangible value of a dealership. These multiples provide context for someone familiar with the auto dealer space but perhaps not the specific dealership in question. Buyers don't directly determine the price they are willing to pay based on Blue Sky multiples; they analyze the dealership and determine their expectation for future earnings capacity (perhaps within the context of a pre-existing dealership where synergies may be present) as well as the risk and growth potential of said earnings stream. The resulting price they are willing to pay can then be communicated and evaluated through a Blue Sky multiple, and if a dealer feels they are being reasonably compensated, they may choose to sell.For dealers not yet looking to sell, Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze these key drivers of value. We also help our dealer clients understand how their dealership may or may not fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to learn more about the value of your dealership.

Reconciling Real-World Transactions With the Fair Market Value Standard

When business owners think about the value of their firm, they frequently think in terms of the dollar value that they believe they could sell the business for in an arms’ length transaction. However, the nuances of real world transaction terms in the investment management industry can often obscure what’s being paid for the business on a cash-equivalent basis. This blog post explores various industry transaction structures employed in the industry and their relationship to fair market value. The value of asset and wealth management firms depends very much on context. In the valuation community, we refer to the context in which the firm is being valued as the “standard of value.” A standard of value imagines and abstracts the circumstances giving rise to a particular transaction. It is intended to control for the identity of the buyer and the seller, the motivation and reasoning of the Transaction, and the manner in which the Transaction is executed. In our world, the most common standard of value is fair market value, which applies to virtually all federal and estate tax valuation matters, including charitable gifts, estate tax issues, ad valorem taxes, and other tax-related issues. It is also commonly selected as the standard of value in buy-sell agreements for investment management firms. Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60. It is defined by the International Valuation Glossary as follows:A Standard of Value is considered to represent the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, each acting at arms-length in an open and unrestricted market, when neither is under compulsion to buy or to sell and when both have reasonable knowledge of relevant facts. Notably, the fair market value standard requires that the price be expressed in terms of cash equivalents. This is consistent with how many business owners think about the value of their business, but it’s inconsistent with the reality of how many real-world transactions are structured.It’s not unusual for investment management transactions to include earnout structures as a mechanism for bridging the gap between the price the acquirer wants to pay and the price the seller wants to receive. If buyer funding is an issue (as it often is in internal transactions), the deal may include deferred payments or seller financing. It’s also commonplace for the seller to receive all or a portion of their consideration in buyer stock for which there is no active market (if the buyer is private) or which is subject to a lock-up period (if the buyer is public). In order to reconcile real world deal terms with fair market value, it is necessary to reduce the non-cash deal components into a cash equivalent value.Consider the table below, which describes three transaction structures designed to be illustrative of different deal structure components employed in investment management transactions. In each case, we assume that the transactions occur between a willing and able buyer and a willing and able seller acting at arms’ length in an open and unrestricted market, when neither is under compulsion to buy or sell and both have knowledge of relevant facts.Each of the three transactions features a $15 million closing payment and potential additional consideration of $5 million, for total possible consideration of $20 million. In Transaction A, the additional payment is simply deferred for one year, whereas in Transaction B it is contingent on revenue retention, and in Transaction C, it is contingent on revenue growth. In terms of risk, Transaction A offers the most certainty, with the additional payment contingent only on the buyer’s future creditworthiness. In Transaction B, the seller must maintain at least 95% of existing revenue into the second year post-closing. While this is a relatively low bar assuming the firm is able to grow organically and benefits from the upward drift of markets, the payment is at risk if there is significant client attrition or a protracted bear market. In Transaction C, the additional payment is contingent on the acquired firm achieving sufficient net organic growth and market growth over a three-year period in order to generate an 8% revenue CAGR.In each case, we can infer that the Transaction implies a fair market value somewhere between $15 million on the low end and $20 million on the high end. To get more precise, it’s necessary to convert future payments into equivalent cash terms. The methods used for converting contingent consideration to a cash equivalent basis are beyond the scope of this blog post, but as a general rule, the riskier and farther out a payment is, the less such payment is worth on a present value, cash equivalent basis.The figure below illustrates directionally how the transactions compare in terms of the fair market value they imply. The most certain transaction structure (Transaction A) implies a fair market value closest to the top end of the range ($20 million), but still below due to the time value of money and buyer credit risk. The least certain structure (Transaction C) implies a fair market value closer to the bottom end of the range, given the relatively high risk of achieving the growth hurdle. Transaction B is somewhere between the other two transactions in terms of risk and timing of the payment, and as such the implied fair market value lies between the other two.When analyzing real world transactions, it’s important to keep in mind that the headline deal values we see reported are often based on the maximum possible consideration that the seller is eligible to receive under the terms of the purchase agreement. Such headline values may not be indicative of fair market value to the extent that they are not expressed in terms of cash equivalents. As the example above illustrates, making reliable inferences about the fair market value implied by transactions in the industry requires a deeper dive to understand the structure of the deal. Oftentimes, the details of earnout structures are not publicly available, but real world transactions can nevertheless be informative and serve to benchmark thinking regarding the fair market value of investment management firms, provided the transactions are subjected to a proper degree of scrutiny.

August 2022 SAAR

The August SAAR was 13.2 million units, down 1.1% from last month but up 0.7% from August 2021. This month’s data release marks the third month in a row that the SAAR has been in the low 13 million-unit range, with the metric seemingly having stabilized in the short term. To illustrate this trend, the average SAAR has been 13.1 million units over the last four months.Now that the August data has been released and two-thirds of the year is a known commodity, we have much more visibility to what the full year SAAR might look like. Year to date average SAAR is 13.7 million units, which makes it even harder for us to imagine a full year SAAR over 14 million units. To put numbers in a hypothetical scenario, the turnaround that is necessary to reach an average SAAR of 14 million units in 2022 would require the next four months’ SAAR to average 14.7 million units.Unadjusted sales numbers have also kept with the trends we have seen over the last several months. Comparing the previous eight August’s unadjusted sales figures (in the chart below) emphasizes the longevity of the production issues that have gripped the auto industry. In August 2020, unadjusted sales had begun to recover from the steep drop that started in April 2020 in response to the COVID-19 pandemic. While this recovery seemed strong in late 2020 and into the first half of 2021, supply chain issues reared their ugly head during the summer of 2021 and, by August of last year, had completely stagnated. While August 2022’s unadjusted sales show a modest recovery from this time last year, it is clear that the auto industry is still very much in the midst of an inventory crisis.InventorySpeaking of inventory levels, not much has changed since the last time the data was released. Industry-wide inventory balances for July came in at 0.50x, down from June’s figure of 0.56x. The inventory to sales ratio has been under 1.0x since May 2021 and had been climbing the past few months to the highest levels since August 2021 before declining in July 2022 (most recently available inventory data tends to lag by a month).To put context to this ratio, on average, dealers have been selling twice the number of vehicles that are on their lots during the last several months. Consumers have had to get accustomed to pre-ordering vehicles or simply settling for the vehicle that just so happens to be on the lot when they visit a dealership. Pent-up demand for these vehicles has not had a chance to unwind at all, and the most likely scenario that dealerships can expect is that pent-up demand will hang around until meaningful changes in inventory availability come to fruition (when that actually might happen is still a mystery). See the chart below for a look at the industry’s inventory to sales ratio from January 2020 through July 2022.Transaction Prices, Incentive Spending, and Monthly PaymentsFor our weekly readers, it may seem like there has been a new record for the average transaction price set almost every month over the past year, and that is not far from the truth. According to J.D. Power, the average transaction price for a vehicle in August was $46,259, up 11.5% from this time last year and the highest average transaction price on record. Inventory constraints have continued to push prices higher and higher each month, but these constraints are not the only driver of vehicle prices record-setting rise. For example, OEMs have had to prioritize high-demand vehicles like trucks, SUVs and crossovers, all of which are much more expensive than the typical sedan. We believe this is particularly notable in light of elevated gas prices, which, at least in theory, should temper demand for larger vehicles that guzzle more gas.OEMs have also kept incentive spending low. In August, average incentive spending per unit is expected to total $969, a decline of 47.1% from this time last year and the fourth straight month under $1,000. Higher prices, reduced incentives and rising interest rates are also pushing average monthly payments higher. For example, the average monthly payment on a new vehicle contract reached a new record of $716 in August. As interest rates are expected to continue to rise at the Federal Reserve’s next meeting on September 20th, it is unlikely that average monthly payments will decline any time soon.Imports and ExportsImports and exports are not something that we typically touch on in our monthly SAAR blog, but supply chain issues and persistently low inventory levels have raised questions related to the international flow of vehicles. Mexico and Canada are the two primary importers of vehicles into the U.S. due largely to continental trade agreements (NAFTA and USMCA). The chart below shows the flow of vehicles (in thousands) from August 2019 through June 2022, the most recently available month of data. Like automotive retail generally, import activity is seasonal. Later in the winter season is when import activity typically slows down, and the summer and fall are when imports ramp up. Over the last two years since August 2020, seasonality has been present, but the total number of imports, on average, has fallen. For Mexican imports, the average number of vehicles imported from January 2016 to December 2019 was 105,000 per month compared to an average of 72,000 from January 2020 to June 2022. Canadian imports have followed a similar but more drastic trend, averaging 95,000 imports from 2016-2019 compared to 45,500 from 2019 to June 2022. Exports from U.S. have fallen as well, which makes sense. Producers in the country have retained more vehicles to service domestic markets instead of sending units overseas. From January 2016 to December 2019, an average of 105,000 vehicles were exported to international markets. From January 2020 to June 2022, that number fell to 78,500 vehicles per month. See the chart below for auto unit exports from August 2019 through June 2022. From looking at the raw import/export numbers, it is clear that the flow of vehicles across international lines has soften considerably. Globalization of the automotive manufacturing industry has been clawed back during this period of uncertainty and is unlikely to return to pre-pandemic levels until supply chains recover and inventories are replenished domestically and abroad. It will be interesting to follow import and export activity when inventory balances begin to recover to see how much the import/export recovery lags behind. The import/export ratio steadily declined to a recent low of 1.42x in 2021. While this figure represents a low dating back to 1993 (first published data), the supply chain constraints may only exacerbate a secular trend as this ratio was 1.66x in 2019 and 2020. Imports from Canada and Mexico were below 1.4 million for the first time since 2009 and are just above 1993 levels. While 2021 exports are down 21.1% since 2019, this actually represents a 10.9% recovery from 2020’s reduced export levels. While imports from North American trade partners are nearly the same as over 25 years ago, exports have nearly doubled.September 2022 OutlookMercer Capital’s outlook for the September 2022 SAAR is consistent with the status quo. Industry supply chain conditions continue to stagnate. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving. Consumers have largely become conditioned to these higher prices, yet demand remains high due to relatively poor substitutes for personal vehicles, among other factors, of course. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Perhaps the September SAAR can eclipse 14 million units and signal a turning of the tide, but we predict that a 14 million unit SAAR for 2022 is an optimistic assumption in the current landscape. We first need to get back to a monthly SAAR of 14 million.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

How Does Your RIA’s Client Base Affect Your Firm’s Value, and What Can You Do to Improve It?

We’re often asked by clients what the range of multiples for RIAs is in the current market. At any given time, the range can be quite wide between the least attractive firms and the most attractive firms. The factors that affect where a firm falls within that range include the firm’s margin, scale, growth rate of new client assets, effective realized fees, personnel, geographic market, firm culture, and client demographics (among others). In this post, we focus in on the client demographics factor, explain how buyers view client demographics and explore steps some firms are taking to reach a broader client base. Client relationships are one of the most significant assets that RIAs possess, and maintaining and profitably servicing these client relationships is key to an RIA’s financial success. In a transaction context, the strength of an RIA’s client relationships and the demographics of the client base can have a significant bearing on the multiple buyers will be willing to pay for the firm. An RIA’s outlook for future asset growth can be significantly impacted based on factors such as expected client retention, which stage current clients are at in terms of wealth accumulation (are they withdrawing assets or contributing assets), and the prospect for future liquidity events within the client base.Client relationships are one of the most significant assets that RIAs possessMany of these factors can be proxied by the age profile of the client base. For most RIAs, the age of the client base tends to skew older (particularly on an asset-weighted basis) simply because older clients generally have more assets. Decades of compounding returns can create some very large accounts for older clients, and these accounts can often be profitably serviced by the RIA. However, with an older client base, the asset base is usually declining as these individuals are withdrawing, rather than contributing, additional funds. And, of course, the remaining life expectancy for older clients is less. As such, the age profile of the client base is a key area of inquiry for many buyers.Because an older average client base tends to suggest headwinds for future asset growth, an older client base is generally seen as a negative (all else equal) from a valuation perspective. In general, the younger the client base, the better the outlook for future asset growth and the higher multiple the firm commands. RIAs can expand their reach to a younger client demographic by increasing focus on retaining assets to the next generation and by positioning themselves to appeal to a younger client demographic.Retaining Assets to Next GenerationIn general, RIAs are not particularly successful at retaining assets to the next generation. According to Cerulli, more than 70% of heirs are likely to fire or change financial advisors after inheriting their parents’ wealth. However, firms that make it a priority to engage and develop relationships with next generation family members today can significantly improve asset retention once the assets are transferred from the current client to the next generation. The earlier this is done, the better the chance at retaining assets into the next generation.Focusing on asset retention today is particularly important, given that more than $70 trillion is expected to transfer from older generations to heirs or charities by 2042. RIAs that can capture or retain these assets as they transfer to younger generations will have a competitive advantage against those that cannot.Attracting Younger ClientsA Wall Street Journal article published last year highlighted the struggle many advisory firms face in attracting younger clients. See Rich Millennials to Financial Advisers: Thanks for the Golf Invite, but You Can’t Invest My Money. As the article suggests, many younger clients are electing to manage their own assets rather than hire a traditional financial advisor. While DIY investment management is popular among younger clients, many see this preference as temporary. Once these clients reach an asset or life stage threshold where their financial lives become more complicated, it’s anticipated that the need for traditional, personalized advice will increase.While attracting younger clients can be difficult, there are several strategies RIAs can use to position themselves to capture this emerging client segment. For one, RIAs should recognize that investment expertise is table stakes for attracting younger clients. These clients are often looking for financial coaching and holistic financial advice that goes beyond simple asset allocation. By offering these “soft” services in addition to traditional investment management, RIAs are better positioned to win younger clients.RIAs should recognize that investment expertise is table stakes for attracting younger clientsRIAs can also attract younger clients by hiring younger advisers. Anecdotally, advisers tend to attract clients that are within plus or minus ten years of their own age. Thus, having a broader age range of advisors can unlock younger client segments (and also contribute to the stability and continuity of the firm).RIAs can also reevaluate their marketing strategies to appeal to younger client demographics. As the WSJ headline suggests, golf invites have fallen by the wayside for most younger clients. While referrals and word of mouth are the traditional sources for new clients, having a strong online presence and digital marketing strategy is critical for attracting a younger client demographic.In order to effectively service accounts for a younger client demographic, RIAs may also want to reevaluate how they determine fees for these accounts. While the traditional percentage of AUM model works well for many clients, RIAs may find this model difficult to apply to a younger client demographic. For individuals still in the prime of their working career, it’s not uncommon to see a significant a significant amount of their net worth tied up in privately held companies. The value of these assets is not generally included in AUM, and thus does not generate fee revenue. Other clients may have significant incomes and financial planning needs, but have not yet accumulated an asset base significant enough for an RIA to profitably service the account using a traditional percentage of AUM model. Many firms that have been successful at attracting a younger client demographic are able to offer alternative pricing arrangements in order to account for situations such as these.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides asset managers, wealth managers, independent trust companies, and related investment consultancies with business valuation and financial advisory services related to shareholder transactions, buy-sell agreements, and dispute resolution.

Themes from Q2 2022 Earnings Calls

Part 1: Upstream

In the post Upstream Reviews of Q1 2022 Earnings Calls, the common themes among the earning calls of both E&P operators and mineral aggregators included the role of U.S. production in the European market, industry confidence in continued favorable pricing, and the trend of increasing completions.This week, we focus on the key takeaways from the Q2 2022 Upstream earnings calls including strong balance sheets, the increasing role of share buybacks, and supply and demand in the global oil & gas commodities market.Strong Balance Sheets and Cash Positions to Weather Price Volatility and Gain Upside ExposureExecutives zeroed in on the importance of a strong balance sheet amid the continuing volatility of oil and gas commodity prices. Upstream players can utilize robust cash positions to weather different price cycles and increase operational flexibility. Additionally, upstream Q2 earnings calls underlined the greater exposure to the high cycles by minimizing firm debt burden.“My perspective [is] as long as our return objectives are being met, modestly building some cash on the balance sheet is a positive thing. We're obviously in a highly volatile commodity price environment [and] I'd like to have a minimum of $500 million on the balance sheet just to handle intra-month working capital swings. We do have a couple of debt maturities coming up… We intend to retire that debt with cash on hand, so preparing for that time when prices are strong, is a good thing. And then also, it provides us the flexibility… on accretive bolt-on acquisitions that can improve our portfolio… given the macro uncertainties [ and] the volatility. So having a very robust company with strong liquidity, I think is a plus… Our return to shareholder commitment is top priority, but also keeping a bulletproof balance sheet and ample liquidity is right alongside that in our conservative financial model.”– Dane Whitehead, EVP & CFO, Marathon Oil Corp.“We want the absolute debt levels to be at $2 billion or even lower than that. We'd like to approach $1.5 billion over the next kind of medium term… The one times and the $2 billion or less of debt allows us to have a balance sheet that positions us to [future] swings in commodity prices. So, for us it's not as much a mid-cycle price. It allows us to go low and it allows us to go high. And we have a balance sheet that we feel gets us through the different commodity price environments.”– Kevin Haggard, SVP & CFO, Callon Petroleum Co.“The way we think about it is the best hedge is to have a strong balance sheet coupled with the strategy that can pretty much work in [a] multitude of prices and operational environments. So, this allows us to execute through these different commodity cycles. At current prices, our balance sheet is improving rapidly, so I think that's positioned us well to achieve our long-term debt target.”– Tom Mireles, EVP & CFO, Murphy Oil Corp.Increasing Role of Share Buybacks in Capital AllocationE&P operators and mineral aggregators have seen exceptional profitability since the start of the upcycle in 2021; companies started paying down their debt and distributing to shareholders. With the continuance of stable cash flows, the role of share buybacks has increased as a source of returns in lieu of bolt-on acquisitions or other investment opportunities.“So yes, like we’ve mentioned a bunch of different times. I mean, evaluating M&A, we are going to be selective and picky. I mean, we do look at this from an internal kind of risk-adjusted rate of return standpoint -- and as we’ve said before… it has to compete with our other capital allocation opportunities. And right now, at this current time, the best risk-adjusted meaningful for way to grow our free cash flow per share is buying ourselves… We’re always in the know of what’s going on in the M&A space, but with the low-risk opportunity to grow free cash flow per share, so visibly in front of us [by] buying ourselves, it’s hard to compete with that.”– Don Rush, Chief Strategy Officer, CNX Resources Corp.“We certainly think that there's a lot of value in our existing stock price, and we think that, that oil and public equity stocks [are] really undervalued right now… We spent about $500 million in the last 2 to 3 months repurchasing shares, and the Board just essentially doubled our authorization up to $4 billion. So, the base dividend still remains sacred, sustainable and growing followed by this environment share repurchases… [We will] make up the difference... returning at least 75% of free cash flow.”– Travis Stice, CEO & Chairman, Diamondback Energy Inc.“We're always assessing and evaluating bolt-on opportunities in basins where we have a competitive advantage and can generate value for our shareholders… We have a tremendous amount of confidence in our organic case, which delivers market-leading free cash flow and return of capital. And that is [how] we're going to assess all opportunities. So, the bar is quite high, and whatever we do, it's going to have to be accretive to that organic case… So, the same discipline that we show in our business is the same discipline we'll show in assessing inorganic opportunities. But to be clear, we like the assets in our core portfolio, and we're always looking to further improve our core positions.”– Lee Tillman, Chairman, President & CEO, Marathon Oil Corp.Beliefs of a Prolonged Imbalance of Supply and Demand in the Global Oil & Gas Commodities MarketExecutives of E&P companies and mineral aggregators underscored the economic effects of current global events as it pertains to the industry. Global demand for such commodities continues to grow despite the obstacles on the supply side. The current stream of Russian natural gas to Europe is not deemed to be reliable, OPEC+ is either unable or unwilling to meaningfully increase oil production, and U.S. E&P operators can only marginally ramp up production in the near-term. Meanwhile, demand shows no sign of dissipating as China re-opens from Covid-19 lockdowns and European officials attempt to secure enough natural gas in preparation for the winter so as to avoid rationing.“You think about US E&Ps, [and] the inability to really ramp up production because of the supply chain or the return of capital pieces… You think about the current potential issues in Russia and the potential embargo that's going to happen here at the end of December, the need to refill the SPR [Strategic Petroleum Reserve], because we've drawn down on those volumes significantly, and then really kind of the lack of OPEC’s ability to ramp up production here… [it] is really indicative to me of fundamental positives as we think about the second half and into 2023. So, I think you're going to see an improvement in energy markets going forward, and hopefully that yield compresses as well.”– Rob Roosa, Founder & CEO, Brigham Minerals Inc.“As China reopens further [the] utilization rate is expected to climb to the upper 80% range. This higher utilization rate, combined with an estimated 500,000 barrels per day of new PDH capacity coming online in China and over 100,000 barrels per day of new capacity in Europe and North America over the next 18 months, is expected to lead to a tightening propane market as we enter winter, with over 50% of our NGL volumes being exported.”– Dave Cannelongo, SVP of Liquids Marketing & Transportation, Antero Resources Corp.“I'm still very optimistic that the oil price is going to continue to march forward with probably more upside than downside. Demand is coming back. Around the world, people are flying more. China's going to come back and as you know there's not much supply [in] the OPEC agreement… OPEC+ announced a minuscule increase today… They just don't have the supply, [there is] very little left in UAE and Saudi.”– Scott Sheffield, CEO & Director, Pioneer Natural Resources Co. Mercer Capital has its finger on the pulse of the minerals market. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the E&P operators and mineral aggregators comprising the upstream space. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.

RIAs Are a Value Investment in a Growth Obsessed World

Maybe That’s Okay

The holy grail for automotive producers is a high-margin (i.e., high priced) product that they can sell in volume. After watching Porsche revive its failing fortunes with a pair of sport SUVs, Lamborghini jumped into the fray with the Urus. Despite an unfortunate name and a face only a Lamborghini driver could love, the Urus has a top speed of 200 miles an hour, seats four comfortably, and has a hatch large enough for a weekend Costco run (just don’t attempt all three at once). Most importantly for Lamborghini, the Urus sold 20,000 units over the first four years of its production run, a number previously unthinkable for the boutique Italian automaker.That unit volume didn’t happen because the Urus is anybody’s idea of a low-cost solution. At $225K plus per copy, the Lambo is proof that there is substantial demand for that kind of all-around product – whether it’s necessary or not.Are RIAs Growth Stocks or Value Stocks?We think of investment management firms as a “growth and income” play. The space has attracted capital specifically because RIAs produce a reliable stream of distributable cash flow with the upside coming from market tailwinds and new clients. For all the trade press touting interest in RIAs, investing trends over the past fifteen years have had a mixed impact on the investment management community.For asset managers, cheap capital makes stock picking less important. Persistent alpha is harder to prove. Passive and alternative products are more competitive. Investment committees are surly. Fee pressure is rampant.For wealth managers, cheap capital has made diversification look kind of pointless and bordering on stupid. In the rearview mirror, owning anything other than the S&P 500 has, since the credit crisis, looked like a mistake. While this may not have had an immediate impact on revenue and margins, it does nothing to cement advisor/client relationships.But what about valuations? Where do RIAs fit in an environment that favors growth stocks?Can RIAs Be Considered Growth Stocks?If you think of growth stocks as companies producing super-normal increases in revenue – double-digit upside that might even exceed their cost of capital – then it’s difficult to put investment management firms in that category. Growing revenue requires growing AUM. Even with favorable markets, consistent AUM growth greater than single digits is difficult to achieve.Breaking down AUM growth into its constituent parts is revealing. A typical client of ours might enjoy significant market returns, even net of fees. But seasoned firms have seasoned clients, and seasoned clients draw income from their accounts and leave for various reasons. Client additions to existing accounts are sporadic, and new accounts can be hard to win. Even with AUM growth, pressure on realized fees can inhibit revenue growth – and increases in realized fees are rare indeed. So, growing profitability faster than AUM requires margin expansion. Margin expansion at an RIA generally requires managing labor costs. In this labor market, that’s difficult.Margin Matters to Value InvestorsSo maybe RIAs aren’t a growth stock, so what about value?Publicly traded RIAs tend to be priced at a discount to prevailing market multiples. IPOs are backed up this year, with several waiting in the wings. The heads of these companies won’t come right out and say it, but most, if not all, are loathe to go public at the six or seven times EBITDA the market is currently offering. Instead, the public investment management space has been characterized by consolidation and buy-back programs aimed at creating shareholder value in the face of increasingly competitive markets.The private market appreciates the promise of strong and consistent streams of distributable cash flow, which has attracted investment dollars in the hopes of building value through scale, enhancing returns with leverage, and multiple arbitrage. An accommodative Fed has made leverage attractive, and the hope of one day selling to a willing public or an aggressive PE firm has kept transaction activity robust. As interest rates march higher and public markets sag, this narrative may become harder to support. Even so, the play on RIAs as a value investment has endured through strong and weak markets for decades, because consistent cash flow margins appeal to certain types of investors.Growth versus ValueOne of the longest running trends in public equities is the persistent outperformance of value stocks versus growth. For nearly 70 years, from the start of World War 2 until the credit crisis of 2008-09, value stocks usually outperformed growth with the exception of brief periods like the dotcom run of the late 1990s. But for a decade now, quality of earnings hasn’t mattered as much as quantity of growth.The recent growth over value phenomenon is easily explained by unprecedented market liquidity, starting with the credit crisis and extending through the pandemic, that provided ample excess capital to fuel demand for financial securities. A quick glance at equity pricing in a low versus a more normal cost of capital environment reveals the impact of cheap money on equity multiples, vis-à-vis expected growth. The specific impact of an accommodative Fed and massive policy stimulus on the cost of equity capital is debatable, but the impact on equity valuations is not. A lower cost of capital leads to multiple expansion, and directly favors growth stocks relative to value. In this rate environment, it’s hard for investment managers to get noticed in the public markets.Everything Has a PlaceIf the automotive market has a place for Lamborghini SUVs, then surely the investor community has a place for RIAs. As it is, the space tends to get ignored as a value play and oversold as a growth opportunity. It’s a bit of both. Those familiar with investor behavior in the SaaS community know about the Rule of 40, in which the sum of revenue growth and cash flow margin are summed (or portioned in a formula) and “better” models produce growth plus margins in excess of 40%.This blended measure of growth and income doesn’t exactly translate into the RIA space, but if we run a sample DCF with some common assumptions about the cost of capital (mid-teens), fee schedules (50 basis points and flat), and margin sustainability (also flat), then we can see implied valuations (measured as a revenue multiple) remaining fairly consistent if you look at a percentage point of AUM growth being worth about the same as 2.5% in margin (say, 25% margin and 5% AUM growth produces about the same revenue multiple as a 30% margin and 3% revenue growth).This example isn’t meant to be probative of anything, except to say that trading some margin for growth can enhance valuations in the RIA space, but it's not an all-or-nothing proposition. Striking a balance between profitability and upside provides more value for investors, and, ultimately, more value for the investment.

September 2022

In this issue: 2022 Core Deposit Intangibles Update

NIB Deposits Anesthetize Bond Pain

The August Bank Watch looks at unrealized losses in bank bond portfolios based upon Call Report data as of June 30, 2022. Our review of unrealized losses as of March 31 can be found here.Fed Chair Powell gave a short 8-minute speech on August 26 at the annual Jackson Hole, Wyoming economic summit that is hosted by the Federal Reserve Bank of Kansas City. The gist of Powell’s speech is that the Fed is solely focused on reducing inflation. Powell’s speech in 2021 discussed “transitory” inflation and the timing of when the Fed might begin to reduce its monthly purchase of $120 billion of U.S. Treasuries (“UST”) and Agency MBS. At the time consumer prices were then advancing around 5% vs 9% now.Last year, equity markets liked what it heard from Powell at Jackson Hole regarding the liquidity spigot; not so this year as the S&P 500 declined 3.4% and the NASDAQ declined 3.9% the day Powell spoke. The NASDAQ Bank Index declined 2.4% and is down 12.8% year-to-date through August 26.Interestingly, UST yields did not move much even though Powell said it would not be appropriate to stop hiking at a “neutral” rate. As such, bank bond portfolios did not incur additional losses. In fact, the peak loss for most bank bond portfolios was in mid-June when the yield on the 10-year UST rose to 3.49% compared to 2.98% on June 30 and 3.04% on August 26.Based upon our review of bank second quarter earnings calls and analysts’ write-ups, investors seem to be taking the losses in stride given solid growth in spread revenues as NIM expansion has been dramatic. Last spring that was not the case when the ~150bps increase in intermediate- and long-term rates produced significant losses in bond portfolios given little coupon to cushion the higher term structure.As shown in Figure 1, the Fed has hiked the Funds target rate much faster and by a greater magnitude than it did in 1994 when the Fed waylaid the bond market with 300bps of hikes. Bond portfolios were hammered as the hikes and an upturn in inflation drove longer-term rates higher by ~275bps. The curve became flatter but never inverted as investors assumed a recession would not develop.1Figure 1: 1994 Bond Bear Market vs 2022 Bond Bear Market Powell’s comments last week imply short-term policy rates may go as high as 4% by next Spring based upon futures markets. Given little movement in UST yields, bond investors are pricing in slowing economic activity and possibly lower yields to come. If so, the inverted UST curve prospectively will become more inverted if the Powell Fed can stomach the seemingly probable fallout as it pushes short rates higher. Figure 2: Unrealized Bond Portfolio Losses vs Cost Basis and Tier 1 CapitalClick here to enlarge the image aboveFigure 3: Unrealized Bond Portfolio Losses vs Cost Basis and Tier 1 CapitalClick here to enlarge the image aboveAs shown in Figure 2, unrealized losses as of June 30 were significant though losses and gains are excluded from regulatory capital for all but the largest banks.Unrealized losses in available-for-sale (“AFS”) designated portfolios ranged from an average of 5.7% of cost for banks with less than $100 million of assets to 8.0% for banks with $1 billion to $3 billion of assets. As a percent of tier one capital the range was from 11.3% for banks with $100 billion to $250 billion of assets to 22.5% for banks with $100 million to $500 million of assets.Figure 3 provides the same data as of year-end 1994 when the ten-year UST was near a cyclical peak of ~8%. The bear market of 2022 is far worse than the 1994 bear market. Unlike 1994, portfolios today have little coupon to cushion the impact of rising rates. Also, duration may be longer today.The “coupon issue” today is reflected in low portfolio yields. As an example, the average taxable equivalent portfolio yield for banks with $1 billion to $3 billion of assets was only 1.96% in 2Q22 compared to 1.80% in 4Q21 immediately before the Fed began to hike. By way of comparison, the yield on one-month T-bills as of August 26 was 2.21% and 30-day LIBOR was 2.49%. Cash yields more than bond portfolios and prospectively will yield much more if the Fed pushes the Funds target to 4% by next spring.The good news is that portfolio cash flow should be reinvested at much higher yields to the extent it is not used to fund loan growth or deposit run-off. The same applies to fixed rate loans, which are not marked-to-market but may have comparable losses given both higher rates and wider credit spreads.The exceptionally good news is that non-interest-bearing (“NIB”) deposits, which are the core of core deposits, are driving NIM expansion and growth in spread revenues. Rate hikes this year are inflating the value of NIB deposits. There is no mark-to-market report for a board to see this; rather, the value is in the income statement.The unknowable question is if the Fed can push short-term rates higher without producing a sharp downturn or serious credit event that forces the Fed to blink again. The downturn in bank stocks this year primarily reflects investor expectations about the potential impact a recession would have on credit costs next year; it is not about unrealized losses in bond portfolios. Figure 4: Credit Spreads WidenClick here to enlarge the image aboveAbout Mercer CapitalMercer Capital is a national valuation and transaction advisory firm that has advised banks for 40 years through bear and bull markets. Please call if we can be of assistance.1 The Fed rate hiking campaigns of 2004-2006 (425bps of cumulative hikes to 5.25%) and 2015-2018 (225bps to 2.50%) did not produce as great of losses as the current cycle and 1994. The curve was exceptionally steep in 2004 such that long-term UST rates rose less than 100 bps (Greenspan called it a “conundrum”) while it took a couple of years for long-term yields to peak in 2018 around 3% vs the “all-at-once” episode this year.

Rideshare: Friend or Foe to Auto Dealers and Manufacturers?

Fifteen years ago, the term “ridesharing” did not exist. There were taxi and coaching services across the country, but ridesharing as an industry emerged in the late 2000s. It changed how people could “catch a ride” when using a personal vehicle was problematic or not a good decision (For example: driving after a night of drinking alcohol or when the rider is not old enough to drive).Ridesharing differs from taxi services in a couple of ways, the most notable difference being the “network effect.” Taxi services are, or at least were for the most part, city-specific, and the network effect that rideshare applications developed made it so that consumers could download one application and have access to a ride in almost every major city across the country. While many companies may call themselves things like the “Uber of X”, an early pitch deck for Uber called it the “NetJets of car services.”While taxi displacement is core to Uber’s rideshare operations, it’s called rideshare, not taxi replacement, because a key tenet of Uber's pitch was to reduce emissions by allowing strangers to carpool. In theory, this would structurally reduce the number of vehicles on the road, a major potential threat to auto dealers. Individuals could turn on a ridesharing application on their mobile phone while on the way somewhere and make a few extra dollars by picking others up and taking them to their destination as well. While this convention certainly caught on and was to the liking of environmentalists, there was another impact that the creators of ridesharing might not have seen coming, the rise of the “gig economy.” The gig economy propelled ridesharing into the stratosphere by giving people a way to work on their own time and using their own resources, namely their personal vehicles.As mentioned previously, the crux of the rideshare strategy was pitched as reducing the number of vehicles on the road, with Uber replacing taxis and also doubling as personal vehicles. It is important to note, however, that executives and shareholders’ goals for ridesharing companies are primarily to earn profits and expand market share, while other stakeholders may view the ridesharing industry as a means to combat climate change and shift United States’ culture away from an automobile-centric society.This “culture-shift” sentiment contradicts the common goal of auto manufacturers and auto dealers, which is to sell as many vehicles to as many consumers as possible. As the rise of mass rideshare companies took hold in the early 2010s, many players in the auto industry were left wondering what the rideshare wave would mean for auto dealerships.In this post, we focus on the impact of Uber and Lyft on the auto industry as a whole, particularly as compared to initial concerns. We address the questions: “How has the rise of rideshare giants affected the auto industry?”, “How did the COVID-19 pandemic affect ridesharing?” and “What can we expect from the rideshare industry going forward?”Expectations and Results – What Was the Anticipated Effect of Ridesharing on the Auto Industry?After Uber Technologies (founded in March 2009) and Lyft (founded in June 2012) took the main stage, some auto industry experts predicted that vehicle sales would not be heavily affected by the rise of the rideshare industry. These optimists expected regular taxis and public transportation (buses, trains, subways, etc.) would take the largest hit from these companies’ emergence. Vehicle ownership was not expected to decline in a meaningful way, as vehicles were expected to remain a staple of the United States’ culture and the economy.On the flip side of the coin, pessimists predicted that rideshare services would lead to a decline in sales volumes of automobiles as more consumers use rideshare applications in lieu of personal vehicles. To take the pessimists' outlook to the next level, many thought that fleets of autonomous vehicles would soon take over the road, eliminating the need for personal vehicles, especially in larger cities where public transportation has historically cut into consumers’ need for a car or truck.From our viewpoint, with the benefit of hindsight, it appears the optimists’ opinions were on the money. Carmakers were experiencing a record sales pace before the COVID-19 pandemic (more than five years into a world with ridesharing applications). The taxi, luxury coaching, and rental car industries were reeling, however, as rides from rideshare applications were much cheaper than these traditional operators, mostly due to aggressive pricing designed to capture market share during each company’s growth phase.From a macro perspective, auto dealers and manufacturers had to be relieved that the pain was felt elsewhere, despite taxi, coaching firms, and rental car companies' position as an important revenue source for auto dealers through fleet sales. However, fleet sales to these operators have traditionally been at much lower margins than sales of autos to individual consumers who might decide to become rideshare drivers. That shift could actually be a positive development for auto dealers.How Did the COVID-19 Pandemic Affect the Ridesharing Industry?The COVID-19 pandemic brought Uber and Lyft to a halt. In April 2020, ridership from both companies dropped between 70-80%. Both operators went into a “survive until we can thrive” mode, intending to hold out until passengers felt comfortable returning to the convenience of ridesharing. This revenue crater was not to the advantage of public transportation either, as those services saw a nearly 90% drop in ridership over the same time period. As an aside, auxiliary services like Uber Eats cushioned the pandemic’s blow on ridesharing companies (Uber Eats revenues grew more than 50% during the first quarter of 2020). This came as a result of consumers leaning into food delivery as a response to fears of being infected by the virus at the grocery store or at restaurants.The drop in ridership was accompanied by a sharp contraction in the SAAR metric, a measure of sales pace for auto dealers. The sales pace for automobiles across the country slowed to a crawl in April 2020 as dealer lots remained packed with vehicles that had very little interest from cautious and confused consumers. Not many folks were willing to make a large purchase with so much uncertainty abound, especially not the purchase of a vehicle during stay-at-home orders and the work-from-home movement.So did the pandemic change the landscape as it relates to auto dealers and the effect that ridesharing is having on the industry? We would say no. A recovery by both rideshare giants in late 2021 and into 2022 was encouraging to see for their investors, and as many of our readers know, auto dealers have seemingly been printing money in late 2021 and 2022. One industry’s success has clearly not been a bad thing for the other industry. Perhaps the pessimists mentioned earlier in this blog were wrong.What Can We Expect From Ridesharing Going Forward?Can we expect the ridesharing industry to continue to co-exist with auto dealers? Our answer is yes. The rise of Uber and Lyft has certainly impacted overall mobility. However, auto dealers have not borne the brunt of this displacement. The emergence of ridesharing has instead displaced taxis, coaching services, and rental car companies.At Mercer Capital, we follow the auto industry and adjacent industries closely to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation and litigation support engagements.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of August 15, 2022

Far(ther)sighted or Blind Ambition: Tech Platform Nets RIA a Big Price

Farther Finance Advisor’s Recent Capital Raise Implies a Valuation at 20% of AUM and 20x Run-Rate Revenue

We’re sometimes surprised when we hear about buyers paying 20x EBITDA for RIAs with under $1 billion in assets under management, so you can imagine our reaction to MassMutual Ventures, Bessemer Venture Partners, and Khosla Ventures paying an implied valuation at 20% of AUM and 20x revenue for Farther Finance Advisors, a start-up, tech-heavy RIA with $250 million in AUM. We’ll explore the logic and potential pitfalls of this valuation in this week’s post.FarsightedAccording to Farther’s 2020 Form ADV, the firm had $19.5 million in AUM at year-end 2020, and recent reports have client assets at $250 million, which is 12.8x the amount from eighteen months ago with little or no market tailwind. If we extrapolate this growth for another eighteen months then AUM will reach $3.2 billion by the end of 2023, and a $50 million valuation would certainly be justified (1.6% of AUM at that point). We’ve seen RIA start-ups achieve this kind of growth with the right investment performance, market penetration, and/or technology offering. Recent examples include Facet Wealth and Vise AI Advisors, which have both raised significantly more capital with a similar AUM base and trajectory. It’s somewhat rare for RIA firms to achieve this level of growth and investment shortly after inception, but investors are handsomely rewarded if the firm’s ambitious projections are realized.Farther intends to use its proprietary wealthtech offering to enable advisors to focus on client needs and business development rather than the administrative challenges of working for a wirehouse or managing their own practice. This plug-and-play advantage likely explains how it has already recruited 27 advisors from independent channels and wirehouse firms. Farther’s technology also enables these advisors to work remotely, so there are no geographic constraints to serving clients across the country. Continued recruitment of advisors with established books of business should allow the firm to maintain its growth trajectory regardless of market conditions. Current and historic operating losses also create valuable tax shields in future periods to enhance cash flow when the business becomes profitable.ShortsightedIn our experience, RIA investors are generally more focused on earnings (EBITDA or net income) rather than activity (AUM and revenue) metrics since their returns are based on the firm’s underlying profitability. Recent reports state that Farther has 50 employees, so it’s probably safe to assume that it’s still losing money despite its impressive growth trajectory. Much of the firm’s future growth is contingent upon hiring additional advisors and existing advisors growing their book, but the payout to advisors goes from 50% to 75% after their first $500,000 in production, so Farther’s retention ratio declines when this happens. Management fees also start at 1% of AUM (account minimum of $100,000) and decline at higher asset levels, so it's difficult to see Farther entering the black this year even with continued growth in client assets.There’s also the issue of chronic dilution as advisors can gain equity in the firm, which has already completed two capital raises since its founding in 2019. Additional rounds of equity financing may be needed to fund future growth if time to breakeven takes longer than expected.You Have to be Farsighted to Justify This Investment Farther is effectively a long duration asset. It’s currently unprofitable and probably won’t reach breakeven for at least another year, so there’s no real prospect for interim cash flows (dividends) in the foreseeable future. There’s also no immediate market for the stock since it’s illiquid and has only a few shareholders. Farther’s current investors are banking on it to continue its recent growth and eventually hit a normalized margin, but this could take some time given its current headcount and payout structure.We’re used to looking at these businesses through the Fair Market Value lens that focuses on the prospective returns that a hypothetical buyer would reasonably expect to achieve with his or her investment. From that perspective, 20% of AUM and 20x revenue for an unprofitable RIA doesn’t make a lot of sense, but that’s not how its current investors are evaluating this investment. These are sophisticated investors with a long-term horizon and willingness to assume a high level of risk for an investment with extraordinary growth (and value) potential. We hope it works for them and will definitely keep an eye on it.

Powersports: Alternative Growth Opportunity for Auto Dealers

As we’ve written in previous posts, auto dealers have experienced heightened profitability over the last two years. For those without succession in place, the industry continues to experience a high level of M&A and transaction activity. For others interested in growing or scaling operations, bolt-on acquisitions of other franchises in similar or adjacent markets can present an attractive return.While those opportunities don’t always arise, dealers with excess cash from continued profits or remaining PPP funds have alternative investment choices. One such opportunity is entering the powersports industry through an acquisition of a powersports dealership or opening a point themselves. As one auto dealer client recently recounted to us, “if you have the skills and experience in selling high volumes of automobiles to consumers, then you have the necessary skills to also succeed in the powersports industry.”In this post, we discuss what comprises the powersports industry. We also offer some statistics about the size of the market in the United States and highlight similarities and differences to the traditional auto dealer industry.What Is the Powersports Industry?Although not as clearly defined and reported on as often as the automotive or auto dealer market, the powersports industry is a subset of motorsports which generally includes vehicles such as motorcycles, all-terrain vehicles (ATVs), snowmobiles, personal watercrafts, scooters and other alternative vehicles. According to IBIS World, the size of the powersports and related motorcycle dealership industry is expected to reach $34.4B in annual sales in the United States for 2022. The industry is expected to reach $131B globally by 2028, according to Insight Partners, which forecasts annual growth of just under 5% for the next six and half years.Similarities to Auto DealersDealer Agreements – Like traditional auto dealers, powersports dealers have formal agreements with the manufacturer of the vehicles. In powersports, they are referred to as dealer agreements rather than franchise agreements but consist of many of the same elements including territory/area of responsibility, exclusivity of competition, sales volume requirements, etc. One key difference in these arrangements is that most powersports dealers will have dealer agreements with multiple OEMs whereas a higher percentage of auto dealers have only one franchise agreement (single point stores). While all the headlines seem to be about larger public or private auto dealership groups with multiple rooftops in one legal entity, 93% of owners had 1-5 auto dealerships in 2021. By contrast, a powersports dealer may have dealer agreements with Kawasaki, Yamaha, Polaris, Suzuki, Sea Doo, etc.Departments/Profit Centers – Most powersports dealers have four departments or profit centers: new vehicle, used vehicle, service/parts, and finance/insurance. While most powersports dealers do not have rigid/formal financial statements that have to be submitted monthly to the manufactures like their automotive counterparts, there is useful information in their financials to analyze the size and overall profitability and performance of each department. Generally, there is less unit/volume information provided in the financial statements than auto dealers whose manufacturers use this data in order to determine which models are selling better than others.Industry Terminology – The value of a powersports dealership is typically reflected in a single dollar value and as a reflection of Blue Sky or the intangible value of the various brands/dealers they represent. As with auto dealers, the Blue Sky value can be expressed as a multiple of normalized pre-tax earnings. One distinct difference in powersports is the lack of published blue sky multiples. The lack of published multiples makes the valuations, and specifically the market approach, more difficult for powersports dealers. Dealers in this industry subsection also pre-purchase inventory from the manufacturer and refer to the related liabilities as floor-plan debt like their auto dealer counterparts.Recent Industry Conditions – Inventories have also been constrained like traditional automobiles due to ongoing supply chain issues of raw materials and microchips, and also intermittent plant shutdowns of the manufacturers. With tight inventories coupling with high demand, profitability for powersports dealers has also increased in the last two years, but to a lesser degree than the profitability of auto dealers.Pre-order/Direct to Consumer Sales Model – Powersports dealers have shifted more towards pre-orders and several manufacturers have introduced more direct sales models to consumers. Our understanding of this trend in powersports is more directly related to the constraint on new vehicle supply than the struggle over profit allocation between the manufacturer and the dealer occurring in automobiles. Nevertheless, the manufacturer and the dealer are both vying for the ownership of the customer and their related purchasing experience. In our view, direct sales may make more sense for powersports dealers who more frequently see customers wanting customized features on their rides.Zero Emission/Electric Vehicles – The powersports industry is not immune to the increase in investment and the proliferation of electric vehicles that are also occurring with traditional automobiles. Powersports manufacturers emphasize combining electric power trains and battery systems in their vehicles. For example, Polaris introduced a new electric Utility Terrain Vehicle (UTV) Ranger EV equipped with a single 48-volt induction motor with 30 horsepower.20 Group or Peer Groups – Several of our powersport dealer clients belong to peer groups. While not as formal and frequent as their auto counterparts, peer groups can benefit powersports dealers. These groups provide forums for best practices and opportunities to improve the overall management process of the dealership. Further, peer groups can provide comparable sales and profitability data with other dealers in your region that can provide evaluation and benchmarking activities. Powersports dealerships used to be primarily run by enthusiasts who got into the business because they simply enjoyed their vehicles. Over time, management has become more professional particularly as more auto dealers have entered the space, which partly explains why powersports operations have come to more closely resemble auto dealers over time.Differences From Auto DealersMore Dependent on Macroeconomic Factors - Since most of the purchases in the powersports industry represent secondary/alternative or recreational vehicles, this industry is more dependent on macroeconomic factors than the auto industry. As auto dealers have seen in the past year, demand for primary personal vehicles may be more inelastic than previously thought. Specific factors such as the level of disposable income and customer sentiment are important in the powersports industry. Households with median incomes over $100,000 tend to purchase more vehicles in the powersports segment. Consumer sentiment measures the level of optimism consumers feel about their finances and the state of the economy. Consumer sentiment indexes also predict how likely consumers are to buy things based on changes in economic activity. The pandemic had conflicting impacts on the powersports industry. On one hand, business shutdowns and unemployment had a negative impact on the industry. Conversely, the shift to more outdoor recreational activities had a positive impact on the industry. It will be interesting to see how the current economic conditions will impact the industry for the remainder of 2022.More Dependent on Demographics/Geographic Location – While these factors are important for auto dealers, they are perhaps more important for powersports dealers. We have previously written about geographic markets favoring certain brands or types of vehicles, such as trucks in Texas, or SUVs and crossovers in Colorado or Alaska. According to IBIS World, nearly 44% of consumers buying motorcycles and powersports vehicles are between the ages of 25 and 49. Further, since most of these vehicles are used for recreational or secondary purposes, the location of a powersports dealer and the balance of its proximity to rural and urban areas can be critical to performance and success.Less Competition – The number of auto dealerships in the United States has ranged between 16,000 and 17,000 for the last several years, despite the consolidation and transaction volume. While not as clearly defined, First Research reports approximately 7,000 motorcycle dealers. First Research, like IBIS World, are industry research publications that define the industry as including motorcycles, sport vehicles, ATVs, scooters, etc. Whatever the exact comparable number of powersports dealers in the United States, there is much less competition than traditional auto dealerships. Auto dealers compete with countless local/regional dealers in the various franchise segments (domestic, import, mass market, luxury, etc.). Powersports dealers typically compete with 1 to 4 similar dealerships depending on their geographic location. With fewer powersports OEMs and the greater likelihood that a dealer carries these brands themselves, competition on the local level can be a lot easier for dealers that also compete in the auto industry.Repairs & Maintenance as a Percentage of Original Cost – The amount of customization on recreational vehicles is typically a higher percentage of the original cost than for automobiles. Further, powersports vehicles also require more frequent repairs and maintenance than automobiles. Recreational vehicles are subjected to extreme terrain and conditions, such as mud, water, and off-road terrain, causing components to require more repairs or seasonal maintenance. Like auto dealers, these types of services tend to be higher margin and more frequent, which are advantageous from a valuation perspective.ConclusionsThe powersports industry is growing in terms of size and popularity. Numerous similarities to auto dealers could lead to common ownership or potential growth opportunities. Contact a professional within the Auto Team at Mercer Capital if you have a powersports dealership or are evaluating an investment in a powersports dealership.At Mercer Capital, we follow the auto industry and adjacent industries closely to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation and litigation support engagements.

Value Focus | Exploration & Production

Second Quarter 2022 | Region Focus: Permian

Mercer Capital’s Value Focus: Exploration & Production newsletter provides an overview of the industry through supply and demand analysis, commodity pricing, and public market performance. In addition, each issue of this quarterly newsletter focuses on a region, including, Eagle Ford, Permian, Bakken, and Appalachia, examining general economic and industry trends. In this quarter’s newsletter, we focus on the Permian. Notable topics include the impact of Russia’s invasion of Ukraine on oil prices, the deleveraging of the majors relative to the constituents of the S&P 500, the increase in production in the Permian compared to other basins, and Earthstone Energy’s acquisition of Bighorn Permian Resources’ Midland Basin assets. Download the Newsletter below.VALUE FOCUSExploration & ProductionSecond Quarter 2022Region Focus: PermianDownload Newsletter

Five Takeaways for RIAs From Focus Financial’s Earnings Release

As one of the more active acquirors in the investment management industry, Focus Financial Partners (Focus) has a broad perspective into the state of the RIA industry and M&A activity. In the article below, we summarize five key takeaways for RIAs based on Focus’ recent Q2 earnings release.1. Deal Activity Remains Near Record LevelsWhile deal activity declined for the second consecutive quarter in Q2, the pace of deals remains elevated relative to historical levels despite the macro backdrop (see RIA M&A Update). According to data from Echelon Partners, the total deal count in the first half of the year increased 39.2% relative to the first half of 2021. For its part, Focus closed or announced 14 transactions through August 4, 2022, a slight decrease from 17 transactions during the same period in 2021. Focus CEO Rudy Adolf pointed to succession planning, aging founders, and the need for scale as enduring factors that have helped sustain deal activity even in a down market.2. Rising Rates Beginning to Impact Some AcquirorsFocus (along with many other aggregators) uses floating rate debt to finance acquisitions, leaving them exposed to higher borrowing costs as rates rise. All of Focus’ ~$2.5 billion in borrowings are tied to either LIBOR or SOFR at spreads ranging from 175 to 250 bps (although Focus has effectively fixed $850 million of its borrowings via hedges at 262 bps). Focus’ net leverage ratio was 3.90x at June 30 (relative to a target range of 3.5x-4.5x), and it’s Q2 interest expense was $19.9 million. The earnings deck includes a sensitivity analysis that indicates that Focus’ pre-tax interest expense would increase by $11.9 million if LIBOR/SOFR were 300 basis points higher.On an after-tax basis, such an increase works out to about $0.11 per share (Focus’ adjusted net income per share was $0.99 in Q2). Focus’ management doesn’t consider its exposure to increased borrowing costs to be significant relative to the firm’s approximate $2.0 billion in annualized revenue. However, many of the PE-backed aggregators in the industry reportedly run at higher leverage ratios than Focus and have higher borrowing costs, which could lead to financial strain as rates increase and financial performance of the underlying firms takes a hit.3. Deal Competition StabilizingThe proliferation of PE-backed aggregators and the professionalization of the buyer market have led to a significant increase in competition for deals in recent years, but that may be normalizing in the current market. Focus’ CEO Rudy Adolf described competition for deals in Q2 as stabilizing relative to the intensely competitive environment seen last year and indicated that there has perhaps been a softening in multiples and that some of the more aggressive buyers during the flurry of deal activity last year may have slowed down the pace of acquisitions given rising borrowing costs and declining fundamentals of prior acquisitions.4. Margins Are Under PressureWe wrote earlier this year about the two-front assault on RIA margins (see Hot Inflation and Cold Markets: RIAs Hit With a New Storm Front). Not surprisingly, the Focus earnings call confirms that many of its partner firms have been impacted by declining revenues and rising operating costs, and margins have been squeezed as a result. As firms experience the negative effects of operating leverage, they’re faced with the dilemma of whether to cut costs to preserve margins or maintain expenses in order to take advantage of the upside once the macro environment improves. On the earnings call, Focus’ CEO Rudy Adolf indicated that they’re not pressuring partner firms to cut expenses—at least yet—so that they’ll have the necessary resources to take advantage of the eventual upswing.5. Contingent Consideration Taking a HitEarnouts are frequently implemented in RIA transactions in order to bridge the difference between buyer and seller expectations. It’s not uncommon to see a significant portion of total deal proceeds paid after closing and contingent on future performance, and the deals put together by Focus are no exception. When part of the consideration is contingent, the acquiror records a liability equal to the fair value of the contingent consideration payments, and that liability is later remeasured as the fair value changes over the life of the earnout (see Purchase Price Allocations for Asset and Wealth Manager Transactions). In theory, an increase in the fair value of contingent consideration liabilities is a positive for the acquiror since it means that the acquisition target is performing well and more likely to meet its earnout hurdles. From an accounting perspective, however, the reverse is true: increases in the fair value of contingent consideration liabilities are reported as operating expenses, whereas decreases are reported as deductions to operating expenses.Echoing the “bad news is good news” macro environment, write-downs of contingent consideration have boosted the earnings of several acquirers, including Focus this year (see Bear Markets Cost RIA Sellers, But Boost Buyers). In the second quarter, Focus reported a decrease in the fair value of contingent consideration of $42.8 million, which in turn boosted earnings by the same amount. This non-cash write down accounted for nearly 90% of Focus’ $49.3 million in GAAP net income for the second quarter.Also noteworthy is that the total cash that Focus paid for contingent consideration declined from $57.0 million during the six months ending June 30, 2021, to $21.4 million for the same period in 2022. While the timing of earnout payments is subject to the specific terms of each deal, we find it interesting that the cash earnout payments of a firm that’s consistently grown via acquisitions declined by more than half year-over-year. For RIA sellers, the significant decrease in cash paid for contingent consideration along with write downs of contingent consideration reported by Focus (and other acquirors) serve as a stark reminder that headline deal multiples aren’t always what they seem, particularly in down markets.

Q2 2022 Public Auto Dealer Earnings Calls

Persistent New Vehicle Inventory Shortages Keep Days’ Supply Low and Pre-sales High - Consumers May Be on Shakier Ground, But Demand is Still Strong

Earnings Calls: Executive SummarySupply issues continue to dominate the industry with no end in sight. New vehicle days' supply is significantly below used vehicle supply given the numerous channels through which used vehicles can be acquired. As one would expect, supply chain issues have less impact on domestic dealerships than imports, particularly luxury.Many dealers currently have a significant number of pre-sold vehicles, which would account for either 0 or 1 days' supply if these vehicles were on the lot. While days' supply in the teens seems astronomically low, compared to 60+ days pre-COVID, the level of pre-sales some dealers are seeing, in actuality, means either there are timing issues with reporting or the vehicles that aren't pre-sold are staying on the lot much longer. For example, if a dealer has 50% pre-sold and reports 30 days' supply, that means 50 cars are sold in 0 or 1 day, and the others are sitting on the lot for two months. We find this to be an interesting dynamic and wonder if it means OEMs have yet to perfect which models to build even when prioritizing the most popular vehicles.The question was raised: what do long-term expectations look like, given that the benefits of higher prices have largely flowed to the dealers in this cycle? One analyst suggested dealers might be at peak earnings (which Group 1 said wasn't the case) and that OEMs are starting to see that maybe this is a more sustainable model for everyone. Another analyst noted that dealer margins have tripled in the past couple of years while margins of North American producers have been stable and asked why they haven't repriced some of their vehicle invoices. AutoNation's CEO Michael Manley indicated that the reduction in incentives has effectively improved the net transaction price of their vehicles. However, he conceded that OEMs facing rising costs would likely look to adjust margins going forward.We're going to go ahead and call our shot that a theme next quarter may be share buybacks. This type of capital allocation decision is not unique to auto dealers and therefore is not really an industry "theme," but we still find it notable. The recently passed Inflation Reduction Act came together after earnings were released, and each call mentioned share buybacks as an ingredient in the capital allocation strategy with no mention of the Act.Share buybacks will now be subject to a 1% tax, and it remains to be seen whether that will be enough to deter the activity. As Group 1 Automotive's CEO Earl Hesterberg said this quarter, share buybacks come with no execution risk, unlike M&A. While this opportunity is not really available to private auto dealers, both public and private dealers must figure out the best return available on the heightened profits they're receiving while the inventory shortage persists. Winners and losers will likely be separated by what investments are made before profits normalize.As valuation analysts, we like to note any mention of valuation multiples offered by the public auto dealers, which are pertinent to our private dealer clients. Lithia reiterated their valuation targets (purchase prices 15-30% of revenues, 3x-7x EBITDA, and a minimum of 15% after-tax returns). This quarter, Penske offered their views on current valuations in the marketplace, which are more in keeping with how auto dealers communicate value (in terms of Blue Sky multiples). Mr. Penske said,"If you're looking at a premium luxury, German brand, so BMW and Mercedes, Porsche, Audi you're looking at probably eight or nine times trailing 12 EBT for goodwill plus assets would be what we see. We've been able to make acquisitions for less than that where they're smaller and maybe not in the premium luxury side. Toyota and Honda are very strong. And to me, there are some people that just are going to get out of the business at the point. I think there is competition out there to buy these better points. But what's happening is many of us are running into what we call framework agreements which limit the amount of stores you can have in a particular market or with a particular brand."While this appears to be within the range of Haig's quoted multiples for these brands, it's extremely important to note that this is on trailing earnings or, as one analyst suggested on a different call, "peak" earnings. If a dealer was making $1.5 million pre-pandemic and is now making closer to $3 million, Haig's 3-year average might suggest "ongoing" earnings of $2.5 million. Applying Haig's average mid-point multiple for these four brands (approx. 8.2x), Blue Sky would be approximately $20.5 million. Taking Penske's midpoint 8.5x multiple on LTM earnings of $3 million, Blue Sky value is $25.5 million, or an increase of 24.4%.We also found it interesting that Porsche and Audi were put on the same playing field in terms of multiples, while Haig's Q1 newsletter suggested Audi was closer to 6.75x while Porsche was 9.5x.The comment on framework agreements is also perhaps a different spin on this discussion. While the public dealers have been more acquisitive lately, dealers may not want to wait too long to sell as the buyers able to pay the most may soon run out of runway to complete acquisitions unless a fundamental shift occurs in how many dealerships one company can have in a brand or market.Here are some other major themes from the Q2 2022 Public Auto Earnings Calls:Theme 1: Dealers continue to pre-sell a significant amount of their new vehicles, particularly compared to pre-pandemic pre-sales levels. With questions about an agency model, it's unclear what the long-term rate of pre-sales will look like once inventories normalize."I think the new car business is solid, but it's really hard to understand how strong it is because you have such a low days supply. Generally speaking, we're still pre-selling half the cars that are coming in. So a lot of these cars aren't getting to hit the ground. It varies a little bit by brand, but generally, that's where it is overall." – David Hult, CEO, Asbury Automotive GroupWhen you look at our domestic business, about half of our pipeline is pre-sold. When you look at our volume imports, it's 80%, some as high as 95%. And when you look at our luxuries, it's in the 60% range. And that is right where it's been for the last couple of quarters." – Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 Automotive"I would say on new vehicles, about one-third of our product is pre-sold that's coming in. So that's good. And I think it's a lot of high-demand vehicles. The rest of the stuff may be wait-listed, but it's not pre-sold where we have money on the car. […] We don't have the exact data. We got it by franchise somewhere. But I would say it was close to 50% 90 days ago. So since interest rates have come up, it's definitely affected things, but it's still a robust environment where those cars hit the ground. And if someone that wants to drive the car and there's two other people waiting to drive the same car, and it's still a bit of a frenzy." – Bryan DeBoer, President and CEO, Lithia Motors"Demand is strong as we mentioned. Inventory levels are still incredibly low, high turn rates, and really sustained margins over the last few quarters. In the first quarter, from memory, I reported something like 50% of our incoming three months inventory was sold. I would say that on the domestic side, that is now down to about 35%. On imports, it is sustained, and on premium, it is also largely sustained." – Michael Manley, CEO, AutoNationTheme 2: As one might expect, the degree of unavailability when it comes to the inventory shortage depends on both make and model, with more desirable vehicles being in shorter supply. With global supply chain issues, it also makes sense that domestic vehicles are more readily available."Similar to the last few quarters, we continue to see limited new vehicle production and inventory levels due to supply chain disruptions and strong consumer demand for new vehicles. This contributed to a 33% decrease in same-store retail new vehicle unit sales volume higher than the industry retail SAAR decline of 20% due to our luxury and import weighted brand mix, which continues to have lower days' supply of inventory than domestic brands"– David Smith, CEO, Sonic Automotive"Our domestic days' supply on new is around 60 days. So we have pretty good flow even though there's some in-transit on that. Really our softness in days' supply, which is where we really are selling every car that we get about as quick as we can get them is in our imports, which we're sitting at a 16-day supply and our luxuries are sitting at about a 29-day supply."– Bryan DeBoer, President and CEO, Lithia Motors"We have a 21-day supply of new vehicles with premium at 23, volume foreign at 8, and domestic at 21. New vehicle supply is at 12 days in the U.S. and 32 days in the U.K. We continue to sell into our future new vehicle pipeline to support tour customers, maximize inventory turn and minimize our inventory costs."– Roger Penske, Chairman & CEO, Penske Automotive GroupTheme 3: Continuing a theme from last quarter, analysts asked if executives were seeing signs of a struggling consumer. They also wondered if banks were being tighter with credit, given macro headwinds and inflated vehicle prices, though the public auto dealers generally downplayed concerns. When Penske was asked about entering the captive finance space, their response indicated a level of concern about the strength of the consumer. An analyst offered that there was a tiny sequential erosion in the strength of the consumer, but it was still strong relative to pre-pandemic and relative to supply which AutoNation agreed with."With consumers financially healthy, consumer financing readily available, the car park aged to record levels and sizable pent up demand combined with our technology to improve efficiency and productivity, we are well-positioned to weather the current market conditions. […] I would say people were impulsively buying six months ago. They're probably putting a little bit more thought and care into the selection and the pricing right now."– David Hult, CEO, Asbury Automotive Group"We're seeing no tightening whatsoever. When you think about the asset class performed very well in 2008 and '09. And when I talked to the head of these finance companies, as I said, they're seeing some delinquency increase on the lower end but its back to pre-COVID levels. But I think the reassuring part of that is losses are historic lows and the appetite for car loans is robust. So, we have not lost any car business because of the availability of credit."– Peter DeLongchamps, SVP, Manufacturer Relations, Financial Services and Public Affairs, Group 1 AutomotiveThe demand is there, but the demand is not there for a $640 monthly payment for preowned that's what you're getting and you're selling a 1- to 4- year car right now at $30,000 to $31,000. And so retooling to the 5-year-old plus cars, we're able to get that monthly payment back down into the $400 range, which is historically where it needs to be. So, consumers are buying a little higher amount car at a lower payment. And we've been able to continue to keep our warranty penetration up there. So not concerned at all about preowned demand."– Jeff Dyke, President, Sonic Automotive"Today with delinquencies going up on retail across all other markets, I wonder -- and then you're going to blow up your balance sheet. And on top of that you're going to have to take that and sell it into the market and securitize it. And I think today, the people that buy that are going to say is this really what we want to buy 72-month or 60-month paper from the standpoint in the car business with the inflation that we've had on used car prices? So not that we won't ever get into it, but we think it's a bad idea. Right now, we don't think that glove fits our hand."– Roger Penske, Chairman & CEO, Penske Automotive GroupConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Bear Markets Cost RIA Sellers, But Boost Buyers

A Public Service Message That Earn-outs Aren’t Always Earned

The history of the auto industry is full of products that were more hype than reality, but maybe none more than the Fisker Karma. The Karma was the luxury hybrid offspring of legendary automotive designer Henrik Fisker. It was supposed to be the future of four-wheel transport: elegant, comfortable, and efficient. It photographed awfully well, and consequently, Fisker got plenty of free publicity in the automotive press. Unfortunately, the product didn’t live up to the promise, as the Karma was cramped for space, not terribly fuel efficient, and very expensive. Battery problems prompted a recall that ultimately killed the company, after selling less than 2,000 units. As we say in the south, Karma’s a biscuit.Earn-outs and ValuationWe’ve written before about how earn-outs are a key provision in most RIA transactions and recent earnings results from public companies in the space bear that out. What some might have characterized as overpayment for past deals has resolved itself via contingent consideration, resulting in right-sized transaction consideration. This lamentable situation for sellers also represents an earnings cushion for buyers. Consequently, we find that RIA valuations in transactions didn’t get as stretched as they might, to many, have appeared.One impediment to getting deals done in the investment management community is the undercurrent that other sellers have received astronomical multiples for their businesses. Indeed, some nosebleed pricing was achieved in many instances in 2021, prompting Focus Financial’s CEO Rudy Adolf to bewail “drunken sailors” who overpaid for acquisitions. The impact of a few irrational players does more than compete away deals from “disciplined” buyers, it also resets expectations for sellers to stay put unless someone is willing to give them a similar deal. Nobody wants nine times when their industry nemesis got fifteen.Earn-outs Resolve Differences in ExpectationsThe gap between buyer and seller expectations can be thought of as a bid-ask spread, and one which often can’t be resolved simply by splitting the difference.The most common way to bridge the bid-ask spread is by way of contingent consideration, also known as an earn-out, in which the buyer agrees to pay something in addition to upfront consideration if the acquired business achieves certain performance metrics after the deal closes. Earn-outs are commonly tied to:Retention: if the acquired RIA retains, say, 95% of AUM as measured at the closing date for a certain period after the transaction. Such a provision guards against the uncertainty of relationship transitions – especially in smaller wealth management practices – as new advisors take over accounts from sellers transitioning out of the business.Growth: if the acquired RIA increases AUM, revenue, EBITDA, or some other key performance metric in the years following a transaction, buyers might pay more to cover some of the increase in value brought about by post-transaction performance improvement. To the extent that sellers can influence the outcome, growth after the close ensures they get paid for some of the upside in their enterprise, while buyers end up with a stronger franchise and often a lower valuation multiple than if the business underperforms.Margin: to the extent that transaction negotiations involve some debate over cost structure, the maintenance or enhancement of profit margins after the close ultimately prove out, or prove wrong, what operating leverage is inherent in the acquired entity. Earn-outs can be structured any number of ways, but ultimately they resolve something of the differences of opinion about the performance that naturally come up between risk-averse buyers and sellers who don’t want to leave money on the table.Earn-outs Resolve Emotional DifferencesEarn-outs also perform an important psychological function in dealmaking. Buyers can report back to their boards and shareholders that they’re only committed to paying for proven performance. If the deal turns out to be less than advertised, the amount they ultimately paid for the target stays fixed – often much lower than it would have taken to close the transaction with entirely upfront consideration. Sellers get bragging rights, as they often anticipate that they will “easily” achieve the projected performance needed to get earn-out payments.Earn-outs help buyers get over the fear of the unknown, as indeed most post-close surprises are negative. For sellers, earn-outs help them get past what is often called endowment effect, or the syndrome that an asset is usually more dear to its holder than it is to someone else.From an M&A marketing perspective, earn-outs fuel interest in deal activity. Sellers tell their friends they got paid X-teen times, a multiple in which the numerator commonly includes contingent consideration as if it had been paid, in full, at close. Buyers don’t mind this, as it attracts other sellers to their brand. And investment bankers love it because it supports deal flow.When Bad News Is Good News, or #FASBknowsbestRecent activity in public RIAs show the impact of earn-outs on ultimate deal consideration, and why sellers shouldn’t confuse contingent consideration with upfront consideration. Several public RIAs, including Focus Financial Partners, Silvercrest Asset Management Group, and CI Financial, reported writing-down contingent consideration in recent quarters on prior transactions.This write-down activity is a peculiar aspect of GAAP (Generally Accepted Accounting Principles), in which the expectation of the payment of earn-outs is made at the time of the acquisition in what is known as the purchase price allocation.By way of example, consider a deal that includes upfront consideration of $25 million and contingent consideration of an additional $15 million, paid over several years and subject to the performance of the target RIA. The transaction isn’t simply booked at the total potential payments, or $40 million. The contingent consideration is risk-adjusted and present-valued. In this example, the $15 million in earn-out payments might be fair valued at only $10 million, such that the transaction is booked at $35 million (upfront consideration plus the fair value of earn-out payments).Over the term of the earn-out, the value of the transaction is effectively remeasured. If the entire earn-out payment of $15 million is earned, the cost of the transaction is $5 million higher than was estimated at close, and the additional payment is recognized as an expense on the income statement. This has a negative impact on the earnings of the buyer.If, on the other hand, the acquired company underperforms, GAAP prescribes that the contingent consideration is remeasured – for public companies on a quarterly basis – in the form of a write-down. In our example, if none of the $15 million in contingent consideration is ultimately paid, then the $10 million fair value of the earn-out would be written off entirely. That write-off flows through the income statement as an offset to expenses; it is money that was to be paid but instead was not paid. Thus, if a target company underperforms expectations, it can – somewhat perversely – increase GAAP earnings of the acquirer.The impact of these write-downs can be material. Focus Financial announced GAAP pre-tax net income in the second quarter of 2022 of $81.5 million. Of this, more than half, or $42.8 million, was a result of a decrease in expected earn-out payments. At CI Financial, about 25% of their GAAP EBITDA in the most recent quarter was a result of writing down contingent consideration ($75 million of $295 million). And at Silvercrest, a similar adjustment to expected earn-out payments constituted nearly half of GAAP pre-tax net income. Of note, the financial disclosures of each of these companies makes the impact of this adjustment very clear, and each eliminates the impact of changes in earn-out consideration from their adjusted (non-GAAP) EBITDA.Earn-out Support Deal Activity in Bear MarketsOn paper, this is how it’s supposed to work. One reason deal activity can remain strong in tough financial markets is that buyers can use earn-outs to control what they pay for deals, offering more money in the event that markets recover and justify higher valuations, and managing their outlays if performance lags. Recent earnings calls allude to this, subtly, with Jay Horgen from AMG noting “constructive pricing and structure” that “insures to the benefit of our shareholders.” Victory Capital’s David Brown noted “some of the way to deal with the difference between buyer and seller expectation is restructuring and timing of payments and partnering in the future of growth.” As a consequence, Focus Financial’s Rudy Adolf noted “overall industry activity is going to remain high. Competition is kind of…normal.”For sellers, the relevant consideration is bear markets may tank a big part of their expected deal consideration, well beyond their control. A falling tide may not simply work to the detriment of sellers, but also hand buyers a bargain purchase when markets improve. Earn-outs align interests in the near term, but can provide asymmetric benefits in years ahead.Westwood Holdings’s recently announced acquisition of Salient Partners is nearly half earn-out consideration: $25 million on total possible consideration of $60 million. 35 to 60 is a pretty tremendous bid-ask spread, although not uncommon in the RIA space. We don’t know what the exact KPIs are that Salient will have to produce to receive full payment. What we do know is that it’s another example of the prominence of contingent consideration in RIA transactions, a situation that we expect to persist.

What Is a Fairness Opinion And What Triggers the Need for One?

For this week's post, we republish a prior post on the subject of Fairness Opinions. It's proven to be one of the most popular posts on the blog. If you missed it the first time, we hope you find it informative and helpful.What Is a Fairness Opinion?A Fairness Opinion involves a comprehensive review of a transaction from a financial point of view and is typically provided by an independent financial advisor to the board of directors of the buyer or seller. The financial advisor must look at pricing, terms, and consideration received in the context of the market for similar companies. The advisor then opines that the transaction is fair, from a financial point of view and from the perspective of the seller’s minority shareholders. In cases where the transaction is considered to be material for the acquiring company, a second Fairness Opinion from a separate financial advisor on behalf of the buyer may be pursued.Why Is a Fairness Opinion Important?Why is a Fairness Opinion important? There are no specific guidelines as to when to obtain a Fairness Opinion, yet it is important to recognize that the board of directors is endeavoring to demonstrate that it is acting in the best interest of all the shareholders by seeking outside assurance that its actions are prudent.One answer to this question is that good intention(s) without proper diligence may still give rise to potential liability. In its ruling in the landmark case Smith v. Van Gorkom, (Trans Union), (488 A. 2d Del. 1985), the Delaware Supreme Court effectively made the issuance of Fairness Opinions de rigueur in M&A and other significant corporate transactions. The backstory to this case is the Trans Union board approved an LBO that was engineered by the CEO without hiring a financial advisor to vet a transaction that was presented to them without any supporting materials. Regardless of any specific factors that may have led the Trans Union board to approve the transaction without extensive review, the Delaware Supreme Court found that the board was grossly negligent in approving the offer despite acting in good faith. Good intentions, but lack of proper diligence.The facts and circumstances of any particular transaction can lead reasonable (or unreasonable) parties to conclude that a number of perhaps preferable alternatives are present. A Fairness Opinion from a qualified financial advisor can minimize the risks of disagreement among shareholders and misunderstandings about a deal. They can also serve to limit the possibilities of litigation which could kill the deal. Perhaps just as important as being qualified, a Fairness Opinion may be further fortified if conducted by a financial advisor who is independent of the transaction. In other words, a financial advisor hired solely to evaluate the transaction, as opposed to the banker who is paid a success fee in addition to receiving a fee for issuing a Fairness Opinion.When Should You Obtain a Fairness Opinion?While the following is not a complete list, consideration should be given to obtaining a Fairness Opinion if one or more of these situations are present:Competing bids have been received that are different in price or structure, leading to potential disagreements in the adequacy and/or interpretation of the terms being offered, and which offer may be “best.” Conversely, when there is only one bid for the company, and competing bids have not been solicited.The offer is hostile or unsolicited.Insiders or other affiliated parties are involved in the transaction, giving rise to potential or perceived conflicts of interest.There is concern that the shareholders fully understand that considerable efforts were expended to assure fairness to all parties.What Does a Fairness Opinion Cover?A Fairness Opinion involves a review of a transaction from a financial point of view that considers value (as a range concept) and the process the board followed in reaching a decision to consummate a transaction. The financial advisor must look at pricing, terms, and consideration received in the context of the market. The advisor then opines that the consideration to be received (sell-side) or paid (buy-side) is fair from a financial point of view of shareholders, especially minority shareholders in particular, provided the advisor’s analysis leads to such a conclusion.While the Fairness Opinion itself may be conveyed in a short document, most typically as a simple letter, the supporting work behind the Fairness Opinion letter is substantial. This analysis may be provided and presented in a separate fairness memorandum or equivalent document.A well-developed Fairness Opinion will be based upon the following considerations that are expounded upon in the accompanying opinion memorandum:A review of the proposed transaction, including terms and price and the process the board followed to reach an agreement.The subject company’s capital table/structure.Financial performance and factors impacting earnings.Management’s current year budget and multi-year forecast.Valuation analysis that considers multiple methods that provide the basis to develop a range of value to compare with the proposed transaction price.The investment characteristics of the shares to be received (or issued), including the pro-forma impact on the buyer’s capital structure, regulatory capital ratios, earnings capacity, and the accretion/dilution to earnings per share, tangible book value per share, dividends per share, or other pertinent value metrics.Address the source of funds for the buyer.What Is Not Covered in a Fairness Opinion?It is important to note what a Fairness Opinion does not prescribe, including:The highest obtainable price.The advisability of the action the board is taking versus an alternative.Where a company’s shares may trade in the future.How shareholders should vote a proxy.The reasonableness of compensation that may be paid to executives as a result of the transaction. Due diligence work is crucial to the development of the Fairness Opinion because there is no bright-line test that consideration to be received or paid is fair or not. The financial advisor must take steps to develop an opinion of the value of the selling company and the investment prospects of the buyer (when selling stock).ConclusionThe Professionals at Mercer Capital may not be able to predict the future, but we have four decades of experience in helping boards assess transactions as qualified and independent financial advisors. Sometimes paths and fairness from a financial point of view seem clear; other times they do not.Please give us a call if we can assist your company in evaluating a transaction.

July 2022 SAAR

CHIPS-Plus Act Passes: What Does That Mean for Auto Dealers?

The July 2022 SAAR was 13.3 million units, an improvement from last month's 13.0 million units but down 10.2% from July 2021's rate of 14.7 million units. The SAAR continues to reflect depressed sales rates as supply chain shortages restrict volumes across the United States. The first half of 2022's average SAAR was 13.8 million units, and the beginning of the third quarter has already come in below that figure, further dragging down the full-year 2022 average SAAR. It seems unlikely that the full year SAAR will manage to reach 15 million units absent an unforeseen dramatic reversal.In last week's blog post, the Mercer Capital Auto team discussed industry-wide and Mercer-specific 2022 predictions and laid out revised expectations for the remainder of 2022. In the interest of our regular subscribers, we will not lay those points out for two weeks in a row. See below for some of our regular SAAR blog charts comparing sales and inventory metrics over the last several years:"CHIPS-Plus" Passes – What Does That Mean For Auto Dealers?Several of our posts over the last year have covered the persistent semiconductor shortage in automotive manufacturing. This particular shortage, among other parts' shortages, has been a significant drag on production for over a year now. As far as forward expectations go, most folks that follow the industry have assumed that it would take multiple years for domestic chip-making operations to be able to handle the volume needed to make a dent in chip pricing and availability over the long term. This assumption seems reasonable to us, and not much has happened over the past six months that could change that narrative until this past week.The House of Representatives and the Senate just passed a $280 billion "CHIPS-Plus" (Creating Helpful Incentives to Produce Semiconductors for America) bill in a bi-partisan vote on July 28th, sending the measure to President Biden's desk to be signed into law on August 3rd. This bill raises several questions throughout the auto industry: How will this bill affect the consensus timeline for domestic chip-making facilities to come online? Will the bill subsidize chip-making in a way that will take pressure off pricing? Is there an auto-specific clause in the bill, and if so, what does it lay out? In this post, we try to answer some of these questions and lay out the bill's general structure and contents.Key FactsA recent Forbes article highlights some key facts related to the CHIPS-Plus bill:The bill passed 243 to 187, with 24 Republicans voting alongside 219 House Democrats, one day after the Senate passed it in a similarly bi-partisan 64-33 vote.The bill highlights $52.7 billion in subsidies for U.S. computer chip manufacturing, $39 billion in assistance to build semiconductor facilities, $11 billion to support Research and Development, $2 billion for defense-related chip manufacturing, and $1.5 billion for public wireless supply chain innovation.The bill creates a 25% tax credit for semiconductor manufacturing. The bill also appropriates $10 billion for the Department of Commerce to create 20 regional technology hubs. Political supporters of the bill have touted the measure as a way of easing the microchip shortage by helping the United States catch up with East Asia, which currently produces 75% of the world's microchips. Many of these supporters have said that the bill is critical to national security and the United States' economy, especially given the fact that its key economic rival, China, has rapidly increased its market share in recent years. Wall Street is likely to welcome the support as well. According to a recent Bloomberg article, the Philadelphia Stock Exchange Semiconductor Index has fallen 30% over the past year leading up to the bill's passing, marking the index's worst annual performance since 2008. All 30 stocks in the index were down for 2022 prior to the bill's passing. This decline in semiconductor companies' stock prices can be attributed to rising interest rates and is a part of a larger trend in the equities market (the year-to-date S&P 500's performance was -12.11% as of the writing of this blog). It is great for business owners when the capital markets and the United States legislative bodies come to an agreement on any one thing, so this seems like a win for everyone involved, especially auto dealers and manufacturers. See below for some commentary on how this bill is expected to affect the auto industry.How Does CHIPS-Plus Affect Auto Dealers?While this bill is designed to support domestic chip-making for a large swathe of industries, it is clear that auto manufacturers' pain is among the most severe. According to a recent Automotive News Article, The American Automotive Policy Council released a statement in late July, saying that "There is not a single supply-chain shortage with a greater impact on the U.S. economy than the shortage of automotive-grade semiconductors."Lobbyists and spokespeople for the industry have echoed this sentiment, making it very clear that automotive companies are looking for support to come sooner rather than later, as the process of building a semiconductor fabrication plant can take anywhere from 2-3 years and many of the United States' prospective facilities have been underway for some time now. Senator Gary Peters, a representative from Michigan, has been very outspoken in his support for the CHIPS-Plus bill, saying that "This problem only gets bigger as time goes on. […] The demand for chips is increasing every single year, dramatically. We have to get in front of this problem. […] We have to start building these facilities now."This legislative development is clearly a big win for the auto industry. But how so? What specific positive impact might this bill have? Below, we try and answer some of the questions raised earlier in this blog:So does CHIPS-Plus mean that facilities will come online sooner? The short answer is that it is unlikely. While this legislation might help subsidize these facilities and encourage more facility construction to begin, more subsidies cannot speed up the construction process in a meaningful way. The target for many of the domestic chip-making facilities to come online is still mid-2023. The subsidy is more likely to increase the number of facilities rather than the rate at which they appear.Will the bill subsidize chip-making in a way that will take pressure off pricing? Perhaps. In general, government subsidies are designed to either 1.) encourage an economic activity that might otherwise not occur or 2.) take pressure off of the consumer by artificially lowering the costs of the producer. In the first scenario, legislators might believe that the total economy-wide benefits of chip-making will create positive externalities, or side effects, in the economy, making the subsidy worth taxpayers' money. In the second scenario, producers receive subsidies and can lower prices due to costs being artificially lower, encouraging the purchase of chips through bargain pricing. In our opinion, the first scenario makes more sense in this case, as the demand for microchips is already very healthy. Hopefully, the externalities that come from this bill will carry positive side effects with it, especially for auto dealers.Is there an auto-specific clause in the bill, and if so, what does it lay out? Yes and No. There is not an auto section of this bill, but the auto industry is mentioned two times in the text of the actual bill:Auto manufacturing is mentioned in Section 102 of the bill, referring to the $2 billion incentive program aimed at legacy chip production facilities. This money is intended to support existing facilities in "key industries" as they try and meet demand in the meantime while new facilities come online.Auto manufacturing is also mentioned in Section 103 of the bill, clarifying and amending 2021 legislation to fall in line with Section 102 mentioned above. These sections are aimed at a short-term fix to a long-term issue, with the long-term fix being the new facilities mentioned throughout this blog and throughout the legislation. Going forward, hopefully, this government funding can create some breathing room for manufacturers and dealers in the short term while also addressing the long-term solution.August 2022 OutlookMercer Capital's outlook for the August 2022 SAAR is consistent with the status quo. Industry supply chain conditions continue to stagnate. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving. Consumers have largely become conditioned to these higher prices, yet demand remains high due to relatively poor substitutes for personal vehicles, among other factors of course. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Perhaps August's SAAR can eclipse 14 million units and signal a turning of the tide, but we predict that a 14 million unit SAAR for 2022 is an optimistic assumption in the current landscape.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Pzena Going Private Could Have Larger Implications for the Investment Management Industry

Last week Pzena Investment Management, Inc. (ticker: PZN) announced that it had entered into an agreement to become a private company again via a transaction in which holders of PZN Class A common stock would receive $9.60 per share in cash, a 49% premium to its closing price before the announcement ($6.44). In this week's post, we attempt to rationalize this premium and any implications for the investment management industry.We haven't interviewed any members of Pzena's Special Committee or Board of Directors that ultimately approved the deal, but we'll speculate on their reasoning for taking PZN private. An obvious explanation is that Pzena management wanted to avoid the additional costs and scrutiny that come with public filings. PZN is smaller than most public companies, and the publicly traded portion of its stock represented 20% of its equity capital, so it was likely devoting a significant amount of time and resources to a relatively modest float of $163 million (transaction price of $9.60 a share multiplied by 16.9 million publicly traded shares). It's very conceivable that Pzena management thought being public was more trouble than it was worth.Public markets haven't been kind to Pzena, as their stock hasn't performed well. The firm went public in 2007 with an IPO price of $18 per share, and it's lost nearly half its value during relatively favorable market conditions. PZN pays a modest dividend, but not enough to overcome the decline in share price. Much of this decline is attributable to the challenges the asset management industry has faced over this time relating to fee pressure and the rising popularity of passive investment products. The dominance of growth investing since the Financial Crisis of 2008-09 has compounded these issues for value managers like Pzena.PZN Founder and CEO Richard Pzena told Citywire in a 2020 interview, "Value investing is more upbringing and personality. Growing up, we learned that the same stuff you pay full price for, you can get at half price sometimes." If his firm was willing to pay a ~50% premium for PZN stock, maybe he felt it was finally half off.There's also been the recent recovery in value stocks and Pzena's (relatively) strong investment performance with its John Hancock Classic Value fund (ticker: PZFVX) outperforming the S&P 500 by just over 500 basis points year-to-date. Alpha often leads to asset inflows, so PZN management is probably optimistic about the firm's prospects despite its lackluster share price performance since the IPO.Does this mean asset managers are worth more as a closely held firm than a publicly traded company? Not necessarily. All else equal, investors will generally pay less for a nonmarketable interest than an otherwise comparable interest that is freely tradable in a public market. This differential in value is commonly referred to as a discount for lack of marketability or DLOM. DLOMs exist in the investment management industry but are generally lower than discounts in most other industries since RIAs and asset managers tend to fully distribute their earnings to shareholders, which enhances their liquidity and lowers their applicable discount.The implication of this transaction is not that private investment managers are worth more but that the public option may not be a viable solution for asset managers (or RIAs) that are PZN's size ($45 billion in AUM at June 30, 2022) or smaller.The investment management industry is not a fixed asset-intensive business that requires substantial investments in property or equipment, so the need to raise capital through an IPO or other form of financing is usually minimal. They're also typically owned by insiders, so it's not essential for their shares to be publicly traded such that third-party investors can enter and exit their position at will.We could see some of the smaller publicly traded investment managers (GBL, HNNA, DHIL, SAMG, and WHG, to name a few) follow Pzena's lead and pursue the private route, but more likely it will serve as further evidence that it doesn't make economic sense for most RIAs and asset managers to go public. We hope that's not the case since we often find public RIA and asset manager pricing instructive in our industry valuations. Nevertheless, it could be a while before we see another IPO in the space. Investment management principals at sizeable firms that are considering a public offering will likely think twice if the Board of one of the larger asset managers ultimately determined that it was in the shareholders' and company's best interest to go private. There are plenty of other exit and liquidity options for RIA and asset management principals, which we're happy to discuss.

Talk To The Hand: Upstream Industry Eyeing Returns More Than Rigs

Second quarter earnings for publicly traded upstream producers are trickling in, and profitability has returned to the energy sector. In the meantime, government officials have been sending mixed messages to the upstream sector, desiring temporary supply relief in the aim of lowering prices whilst remaining bearish on fossil fuels overall. The industry response: thanks, but no thanks (a polite way of putting it). Producers have largely been holding the course set years ago towards returns and deleveraging, snubbing pressure from the Biden administration. It has been tempting for producers to ramp up production amid $100+ oil prices and gas prices the highest they have been since 2008. However, with supply chain issues and labor shortages, the appeal has been dampened.Cash Flow Remains KingAccording to the latest Dallas Fed Energy Survey, business conditions remain the highest in the history of the survey. Concurrently, profits continue to rise. Analysts are pleased and management teams are eagerly talking about free cash flow, debt management, and stock buybacks. By the way, an interesting factoid from Antero’s investor presentation: most oil and gas companies are now much less levered than their S&P 500 counterparts. When it comes to Net Debt to EBITDAX multiples, the majors average about 0.9x while the S&P 500 averages 2.8x. Most independents that I reviewed were aiming towards around 1x leverage.The industry should be able to keep it up. Last year around this time, I was questioning how long this might be able to continue. I noted drilled but uncompleted well (“DUC”) counts as an inexpensive proxy for profitable well locations. However, at today’s prices, DUCs matter less than they did from an investment decision standpoint.I sampled current investment presentations of six upstream companies (randomly chosen) and read them to discern key themes that they are communicating to investors. Adding new rigs to the mix was not on any of their agendas. Not one has announced a revision to their capex plans from early in the year even amid the changes in the past five months. There have been some companies accelerating plans, but not many. This quote from the Fed Energy Survey was representative of sentiment in this area: “Government animosity toward our industry makes us reluctant to pursue new projects.” There are 752 rigs in the U.S. currently, according to Shaleexperts.com. In early March, the week before the pandemic wreaked its industry havoc — there were 792. Yes - we still have not reached pre-pandemic rig counts. To boot, rigs are relatively less productive on a per rig basis, primarily because most new drilling locations are less attractive and productive than the ones already drilled. The capex calvary is not coming to the rescue either. Capex at the world’s top 50 producers is set to be just over $300 billion this year, as compared to $600 billion in 2013 according to Raymond James. 2013 was the last year oil prices were over $100 a barrel for the year. As has been said before, production should grow, but not at a particularly rapid pace.Energy Valuations: A Bright SpotThese industry and commodity forces have contributed to the energy sector having an outstanding year from a stock price and valuation perspective as well. Returns have outpaced all other sectors, and Permian operators have performed at the top of the sector. While the U.S. suffered its second quarter of GDP decline in a row, and the stock market has officially become a bear but energy returns stand out. Some investors appear to be changing their tune towards the energy sector amid these kinds of results, and the valuations are reflecting this. There are some indicators that suggest we could be entering into a long “super cycle” for the energy sector whereby the industry could outperform for years to come. It bears out that to fruition the sentiment I quoted last year as well from the Dallas Fed’s Survey: “We have relationships with approximately 400 institutional investors and close relationships with 100. Approximately one is willing to give new capital to oil and gas investment…This underinvestment coupled with steep shale declines will cause prices to rocket in the next two to three years. I don’t think anyone is prepared for it, but U.S. producers cannot increase capital expenditures: the OPEC+ sword of Damocles still threatens another oil price collapse the instant that large publics announce capital expenditure increases.” That prophecy has come true.Supply Chain WoesThe challenge for producers may be less about growth and more about maintenance. 94% of Dallas Fed Survey Respondents had either a slightly or significantly negative impact from supply-chain issues at their firm. Major concerns about labor, truck drivers, drill pipe and casing supplies, equipment, and sand are hampering the execution of existing drilling plans, to say nothing about expansion.“Supply chain and labor-shortage issues persist. Certain materials are difficult to access, which is hampering our ability to plan, absent a willingness to depart from certain historical practices relating to quality standards.” – Dallas Fed Respondent.Nonetheless, global inventories continue to decline. The U.S. Energy Information Administration’s short-term energy outlook expects production to catch up, but it appears harder to envision that now and nobody exactly knows what that will look like in the U.S. The EIA acknowledged that pricing thresholds at which significantly more rigs are deployed are a key uncertainty in their forecasts. Who knows how much longer upstream companies will continue to tune out the administration or finally try to rev up their growth plans in response to commodity prices? The December 2026 NYMEX futures strip is over $70 right now. There are a lot of potentially profitable wells to be drilled out there at $70 oil. However, management teams know all too well that prices can change quickly. We shall see. Originally appeared on Forbes.com.

2022: How Is the Auto Industry Doing and What Does the Future Hold?

Status Quo or Winds of Change?

The first half of 2022 is behind us, and with school about to start, report cards will be here before we know it. In that same light, the auto industry has published its statistics for the first six months. This post reviews predictions by industry analysts (and us) made at the beginning of the year by analyzing several key metrics. Additionally, we discuss threats that arose during the first half of 2022 and their impact on the auto industry for the remainder of the year and perhaps longer. Finally, we offer a few predictions for the second half of 2022.Review of 2022 PredictionsMost analysts predicted vehicle sales would continue to improve in 2022 due to pent-up demand from vehicle deficits caused by production shortfalls in the last two years. While demand would continue to outpace supply, analysts believed the tight supply of new vehicles would gradually improve in 2022. Finally, analysts predicted that the production of microchips would begin to see some improvement this year.In terms of predicting the annual SAAR, or estimate of new vehicle sales in 2022, most early estimates ranged between 15-16 million units.Recall the original causes of the microchip shortage stemmed from the following events: 1) OEMs canceled orders of microchips in the early days of COVID-19 as the production of new vehicles waned in the aftermath of shutdown orders for OEM plants and dealerships alike; 2) there was a huge increase in the demand of consumer electronics; and 3) supply chain disruption from the production and plant shutdowns of the microchip factories themselves.Mercer Capital’s predicted a similar bounce back in the production of new vehicles stemming from the vehicle deficit of the last two years. We also predicted there would be fewer incentives offered by the manufacturers, fewer models available, and fewer features on vehicles.We revisit how industry analysts and Mercer Capital fared in these predictions later in this blog.New Threats in 2022Through the first six months of the year, new threats to the auto industry and the general economy have emerged. Headlines have been dominated by inflation (at the highest levels in 40 years), rising interest rates, and rising gas prices. The auto industry is impacted directly or indirectly because these economic headwinds affect a consumer's ability to purchase and finance a new or used vehicle as well as the total vehicle miles traveled.Also contributing to these threats is the Russian invasion of Ukraine and its impact on the production shortage of microchips. Raw materials, such as neon gas that have been compromised during this war, are a key component in the manufacturing of microchips. Additionally, the war has caused production plant shutdowns and further supply chain disruptions for OEM and microchip plants located in/or adjacent to the area.OEMs and the United States are trying to mitigate the impact of the microchip crisis and our dependence on importing these components by opening microchip production facilities domestically, but these will take some time to develop and begin production. Analysts, ourselves included, may have been too optimistic as to how quickly this industry could scale supply to meet increasing demand. (Stay tuned for a microchip update in next week’s SAAR blog).If the current market conditions of inflation, rising interest rates, and rising gas prices lead to a recession, there could be further impacts on the overall auto industry. Yet, depending on your definition, we may already be in a recession. U.S. auto sales declined by 40% during the Great Recession and fell nearly 15% for the first two months of COVID-19, compared to those same two months in 2019.New Vehicle ProfitabilityWith high demand, tight supply, and less incentives offered by the manufacturer, it’s not a surprise that the average transaction prices of new vehicles have been at record levels in 2022. One interesting trend has been the increased shift towards crossovers and light trucks compared to smaller cars which are more fuel efficient. It remains to be seen whether rising gas prices will swing this pendulum back.In addition to high vehicle prices, the total retailer profit per unit realized by auto dealers has also reached record levels. According to the monthly forecasts from JD Power and LMC Automotive, profitability from this metric have been between $4,900 and $5,300 per unit since December 2021. As a point of comparison, this same metric totaled only $2,053 per unit in December 2020, as seen in the graphic below: While the monthly totals in the first and second quarters of 2022 have fluctuated slightly, there doesn’t seem to be any indications yet of this trend changing.Supply of New VehiclesEvidence of the tight supply of new vehicles in the last few years can also be seen in the lack of inventory on auto dealer lots across the country. It’s not uncommon to see more empty spots on the lot than spots filled with new inventory.Another similar measurement of the lack of inventory is the average time in days that a new vehicle sits on the lot before it is purchased. The monthly forecasts provided by JD Power and LMC Automotive report these figures between 19 and 20 days for each month in 2022, a slight uptick in the December 2021 figure of 17 days. As a point of comparison, this metric totaled 72 and 71 days for December 2018 and December 2019, respectively, as seen in the graphic below: In our discussion with auto dealer clients, they continue to indicate that they are operating on a selling volume of 50-75% of pre-COVID years, but at 2-3X greater gross profit – a further reflection of these first two metrics. Dealers and industry analysts both predict the OEMs will increase the supply of new vehicles above current levels when they are able to try and reclaim some of their lost profitability on these units.Trying to predict when supply issues will be resolved feels like predicting when Tom Brady will retire.While most analysts and dealers do not predict the average day's supply will reach pre-COVID levels, there is certainly room between current and prior-year levels. Based on this statistic and overall industry conditions, any improvement in supply seems to be minimal and gradual through the first half of the year. Trying to predict when supply issues will be resolved feels like predicting when Tom Brady will retire.Average Age of CarsS&P Mobility recently released its annual study on the average age of cars on the road in the U.S. As the graphic below indicates, the overall combined average is 12.2 years: This figure shows a slight increase over last year’s study, which concluded the average age to 12.1 years. In fact, this combined figure has grown every year for over a decade. These figures show no signs of decline and could be easily predicted to continue to rise, especially if a recession hits. At some point, conventional wisdom says the average age of cars will peak and begin to decline as consumers have to trade in for a more recent model. However, improvements from OEMs may structurally improve vehicle life cycles just as many hot new features have quickly become standard. The average age of cars also highlights the continued opportunity for auto dealers in terms of fixed operations (service department and parts). Aging cars will require more service than newer vehicles. This opportunity could be mitigated somewhat during a recession, as consumers could be apt to drive fewer miles due to rising costs or lack of employment. In fact, another statistic affected by a recession is total vehicle miles driven. This figure declined sharply for the two years during the Great Recession and also declined rapidly from the effects of COVID-19. The rolling twelve-month average for total vehicle miles driven has finally climbed back to near pre-pandemic levels as of May 2022 (most recently published data). A market recession could easily reverse that trend for the remainder of the year and the length of the recession.Average Trade-In Equity Value of Used CarsLike new vehicles, used vehicle transaction prices also reached record highs in 2022. While the supply of used vehicles has improved gradually, like its new vehicle counterparts, it has not returned to pre-COVID levels. Since fewer new units are available for sale, fewer used vehicles are traded to the dealer. However, the average trade-in equity value for used cars has followed the same trends as profitability on new and used vehicles. According to the monthly forecasts from JD Power and LMC Automotive, the average trade-in equity value has ranged between $9,300 and $10,400 since December 2021, compared to $5,626 just one year prior in December 2020: Rising trade-in values and, perhaps more importantly, equity are key components of rising vehicle prices. Through the first six months of 2022, there is no sign of trade-in values cooling, although those could be impacted in the coming months by the emerging new threats or the onset of a recession. Consumers tend to be more focused on their monthly payment, so a $5,000 increase on vehicles purchased and traded in are a wash to the consumer. If this metric begins to stumble, we expect it to impact transaction prices similarly.Fleet SalesFinally, we examine fleet sales in recent months. In more robust times of new vehicle production, dealers are able to sell off excess inventory in high volumes to rental car companies, government agencies, and corporations, albeit at much lower margins. Fleet sales were also greatly impacted by COVID-19 as rental car companies sold off large portions of their fleet to conserve cash as consumers were no longer traveling during stay-at-home orders.Fast forward two years, rental car companies and others have not been able to replenish their fleets as the entire industry has been operating at a new vehicle deficit. Anyone that has tried to rent a car in the last few years has experienced the lack of availability and heightened prices. We have a friend who recently rented a U-Haul truck on a vacation because the price was half of a rental car. While these conditions have improved recently, fleet sales and corporate fleet sizes still represent a distressed industry segment.As reported by JD Power and LMC Automotive, monthly fleet sales have rebounded some in 2022, but their monthly unit sales are still down almost 50% from prior levels depending on the month, as seen in the graphic below: Another view of fleet volumes can be measured by the percentage of sales of fleet vehicles vs. the overall sales of all new vehicles. According to Cox Automotive, fleet sales have comprised approximately 13-14% of overall new vehicle sales for 2020, 2021, and year-to-date 2022, compared to nearly 19% in 2019. It should also be noted that those reduced percentages representing fleet share are also on greatly reduced overall new unit sales from the same time periods.ConclusionsSo how did industry analysts and Mercer Capital do on their beginning of the year predictions, and where are we headed? Jonathan Smoke from Cox Automotive originally predicted 2022 SAAR at 16 million units. He lowered that prediction to 14.4 million units in the last two months. The predicted trends of high demand, tight supply, and increased profitability have all held through the first six months, although there are signs of softening in new vehicle sales with continued production shortages and rising interest rates. While optimism remains, we’re simply running out of time in 2022 to revert to higher levels, so we expect these predictions to continue to be revised towards where performance has been.How did Mercer Capital do with some of our predictions? While we were correct on fewer incentives from the manufacturer and fewer models available with fewer features offered on those vehicles, we were incorrect in predicting a higher SAAR in 2022.While some of these metrics remained strong, the emerging threats and the onset of a recession could trigger a reversal of fortune for the auto industry and the profitability of auto dealers sooner than most would have predicted at the start of the year.At Mercer Capital, we follow the auto industry closely to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation and litigation support engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Schwab’s 2022 Benchmarking Study Offers Insights Into the RIA Industry

How Does Your RIA Measure Up?

Schwab recently released its 2022 RIA Benchmarking Study. The survey contains responses from over 1,200 RIAs representing $1.8 trillion in AUM to questions about firm operating performance, strategy, and practice management. The survey is a great resource for RIA principals to see how their firm’s performance and direction measure up against the average firm. We have highlighted some of the key results from the study below. You can download the full survey here.Firm PrioritiesAs part of the survey, Schwab asked RIA principals to rank the top priorities for their RIA. Perhaps unsurprisingly, amidst the Great Resignation and continued tight labor market, recruiting staff to increase the firm’s skill set and capacity became the top-ranked priority for respondent firms in 2022.Acquiring clients through client referrals and business referrals remained key focus points in 2022, ranking second and third, respectively. Enhancing strategic planning and execution ranked fourth, followed by productivity improvements at number five and acquiring new clients through digital channels at number six.Employee RetentionFirms over $250 million reported a median staff attrition rate of 6.5%, while top performing firms reported a median staff attrition rate of 0%. The survey indicates that top performing firms are more likely to have nontraditional benefits packages and offer more professional development and career support opportunities, which suggests that such benefits may help to promote staff retention.GrowthThe firms participating in the survey have seen strong five-year growth on average. Between 2016 and 2021, AUM grew at a compound annual growth rate (CAGR) of 14.1%, while revenue and number of clients grew at a respective 11.3% and 5.1% CAGR over the same time period. The top-performing firms (Schwab defines this as the top 20% based on a holistic assessment across key business areas) saw more robust AUM growth than other firms due to extraordinarily strong net organic growth. AUM growth has outpaced revenue growth consistently in recent years, suggesting that there has been some compression in the fees realized by respondent firms. All of the RIA size categories identified in the survey reported double-digit annualized growth in AUM over the last five years, although firms managing less than $2.5 billion in AUM generally experienced marginally higher growth than firms over $2.5 billion in AUM.M&AM&A contributed to growth for many firms over the last five years. 6% of firms acquired new clients by M&A in 2021, and 21% of firms have completed an acquisition in the last five years. Over the past five years, 27% of firms gained new clients by bringing on an advisor with an existing book of business.Succession PlanningSuccession planning is a key concern for the industry, particularly since only 55% of firms under $250M AUM have a written succession plan. The number increases slightly to 65% for firms over $250M AUM and 80% for top performing firms. Eventually, of course, all of these firms will need an exit strategy for the partners, whether through internal succession or a sale to a third party.As indicated by the Schwab survey, many RIAs lack a written succession plan, but it’s nevertheless a critical issue that all firms will have to face eventually. For more information on RIA succession planning, refer to our whitepaper, Buy-Sell Agreements for Wealth Management Firms.ProductivityRespondent firms reported increases in productivity between 2019 and 2021. Over this period, AUM per professional increased from $99 million to $112 million, and the number of clients per professional increased from 53 to 59. Also, over this period, hours per client for operations and administration decreased from 17 to 16, while hours per client for client service decreased from 34 to 31, suggesting that firms have continued to improve efficiency.

Strategic Benefits of Stress Testing in an Uncertain Economic Environment

Having gone on many a camping trip over the years, the only consistency between these trips into the woods is that there is no consistency. While some trips might have beautiful weather, others might be plagued with storms, cold fronts, heat waves, or strong winds. The campsite may or may not have amenities. And most importantly, contending with the wildlife adds another variable that can’t be predicted. However, the key element of how the trip goes is how prepared we are. The trips where we assumed blue skies were by far the most stressful. If we prepared for different outcomes and weather based on the uncertainty of going into the woods, the trip could always be salvaged.Banks and credit unions are currently facing a similar “into the woods” predicament, as the economic environment seems to grow more volatile and contradictory day by day. While hiring remains strong and unemployment continues to stay near historically low levels with the Bureau of Labor Statistics reporting 3.6% as of June 2022, other indicators are flashing warning signs.Inflation concerns continues to plague the economy after accelerating to 9.1% in June 2022, the highest increase since November 1981. Drivers of inflation in the past several months include rising food and gas prices as global supply remains disrupted from Russia’s invasion of Ukraine and the remnants of the pandemic. Economists are taking notice, with nearly 70% of economists surveyed by the Financial Times and the Initiative on Global Markets believing that the National Bureau of Economic Research (NBER) will make a call at some point in 2023 identifying a recession.These conflicting indicators are convoluting the economic forecast through the rest of 2022 and 2023, and the differing potential circumstances would have very different impacts on banks and credit unions. Though this uncertainty can certainly cause headaches and stress for banks and credit unions worried about their capital positions in a severely adverse economic scenario, stress testing can help to prepare your bank or credit union in the face of uncertainty and help to optimize strategic decisions.Stress Test OverviewA stress test is defined as a risk management tool that consists of estimating the bank’s financial position over a time horizon – approximately two years – under different scenarios (typically a baseline and severely adverse scenario). The OCC’s supervisory guidance in October 2012 stated “community banks, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial conditions.” 1 Further, the OCC’s guidance considers “some form of stress testing or sensitivity analysis of loan portfolios on at least an annual basis to be a key part of sound risk management for community banks.” 2 A stress test can be defined as “the evaluation of a bank’s financial position under a severe but plausible scenario to assist in decision making with the bank.” 3There are a few different types of stress tests that banks and credit unions can utilize in estimating their financial position:Transaction Level Stress Testing: This method is a “bottom up” analysis that looks at key loan relationships individually, assesses the potential impact of adverse economic conditions on those borrowers, and estimates loan losses for each loan.Portfolio Level Stress Testing: This method involves the determination of the potential financial impact on earnings and capital following the identification of key portfolio concentration issues and assessment of the impact of adverse events or economic conditions on credit quality. This method can be applied either “bottom up,” by assessing the results of individual transaction level stress tests and then aggregating the results, or “top down,” by estimating stress loss rates under different adverse scenarios on pools of loans with common characteristics.Enterprise-Wide Level Stress Testing: This method attempts to take risk management out of the silo and consider the enterprise-wide impact of a stress scenario by analyzing “multiple types of risk and their interrelated effects on the overall financial impact.” 4 The risks might include credit risk, counter-party credit risk, interest rate risk, and liquidity risk. In its simplest form, enterprise-wide stress testing can entail aggregating the transaction and/or portfolio level stress testing results to consider related impacts across the firm from the stressed scenario previously considered.By utilizing one or more of these stress testing exercises, banks and credit unions can better position themselves for multiple different economic scenarios in order to assure they have sufficient capital and financial strength to withstand an economic downturn if there is one.Economic Scenarios OverviewOne question that often arises is: Given the uncertainty, what economic scenarios should we consider in our stress testing? While it is difficult to answer this question, the most recent Stress Test scenarios prepared by the Federal Reserve are described in a February 2022 report, 2022 Supervisory Scenarios for Annual Stress Tests Required under the Dodd-Frank Act Stress Testing Rules and the Capital Plan Rule, and provide some guidance to assist with this decision. The scenarios start in the first quarter of 2022 and extend through the first quarter of 2025. Each scenario includes 28 variables, nineteen of which are related to domestic variables in the U.S.While the more global economic conditions detailed in the Fed’s supervisory scenarios may not be applicable to community banks or credit unions, certain domestic variables within the scenarios could be useful when determining the economic scenarios to consider. The domestic variables include six measures of real economic activity and inflation, six measures of interest rates, and four measures of asset prices. The baseline scenario includes an economic expansion over the 13-quarter scenario period, while the severely adverse scenario is a hypothetical scenario that includes a severe global recession, accompanied by heightened stress in commercial real estate and corporate debt markets. Below, we have included charts of some of the more relevant domestic variables (GDP, unemployment rates, the Prime Rate, and commercial/residential real estate prices) and their historical levels through year-end 2021 as well as the Fed’s assumptions for those variables in the baseline and severely adverse scenarios. 2022 Supervisory Economic Scenarios OverviewBenefits of the Stress TestAs the U.S. moves into a more uncertain economic environment, a financial institution’s preparation for its trip “into the woods” of this uncertain economic environment can reap dividends. Improved valuation, performance enhancement from enhanced strategic decisions, and risk management are some of these benefits. Greater clarity into the bank or credit union’s capital position, credit risk, and earnings outlook under different economic circumstances helps management to make more informed operational decisions.ConclusionWe acknowledge that bank and credit union stress testing can be a complex exercise. The bank or credit union must administer the test, determine and analyze the outputs of its performance, and provide support for key assumptions/results. There is also a variety of potential stress testing methods and economic scenarios to consider when setting up their test. In addition, the qualitative, written support for the test and its results is often as important as the results themselves. For all of these reasons, it is important that bank and credit union management begin building their stress testing expertise sooner rather than later.In order to assist financial institutions with this complex and often time-consuming exercise, we offer several solutions, including preparing custom stress tests for your institution or reviewing ones prepared by the institution internally, to make the process as efficient and valuable as possible.To discuss your stress testing needs in confidence, please do not hesitate to contact us. For more information about stress testing, click here.Endnotes1OCC 2012-33 “Supervisory Guidance” on Community Bank Stress Testing dated October 18, 2012 and accessed at www.occ.gov/news-issuances/bulletins/2012/bulletin-2012-33.html.2 Ibid.3 “Stress Testing for Community Banks” presentation by Robert C. Aaron, Arnold & Porter LLP, November 11, 2011.4 OCC 2012-33 “Supervisory Guidance” on Community Bank Stress Testing dated October 18, 2012 and accessed at www.occ.gov/news-issuances/bulletins/2012/bulletin-2012-33.html.

Meet the Team: J. David Smith, ASA, CFA

In each “Meet the Team” segment, we highlight a different professional on our Energy team. This week we highlight David Smith, Senior Vice President of Mercer Capital and a senior member of the Oil and Gas Industry Team. The experience and expertise of our professionals allow us to bring a full suite of valuation, transaction advisory, and litigation support services to our clients. We hope you enjoy getting to know us a bit better.What attracted you to a career in valuation?Admittedly, I really didn’t know what a “valuation analyst” was back in 1992 when I responded to a job posting that was distributed by our local CFA Institute chapter – then known as the Houston Society of Chartered Financial Analysts. I had just completed my MBA and was wanting to get into a position that involved more analysis than my then-current job involved, and the Valuation Analyst job description seemed just right to me. I interviewed, got an offer, accepted the position, and was probably a month into the job before I really started to get a good grasp as to what a Business Appraiser “does” – and realized that I loved the job.Once in the job, what really attracted me to making a career in Business Valuation was the combination of applying economics, accounting, finance, investment analysis, equity analysis, fixed income analysis, money and capital markets, as well as so many other disciplines that I’d studied in my undergraduate and MBA programs. Basically, all the interesting parts of the Chartered Financial Analyst body of knowledge. I have a strong curiosity as to “how things work” or “what makes things tick,” and that curiosity is abundantly satisfied in the analysis that takes place in appraising a business.What does your personal practice consist of?As with many in our profession, my Business Valuation career began as a generalist. We performed appraisals for all four primary “purposes” – tax, transaction, financial reporting, and litigation – and we appraised businesses in many different industries. However, having started my Business Valuation career in Houston, our practice always had a double dose of subject companies in the oil and gas industry. Over time, I also developed an industry concentration in the biotech industry. There is plenty there to satisfy my interest in understanding how things work.Also, over my career, I’ve had the opportunity to work on and gain expertise in performing Fairness Opinions and Solvency Opinions. To this day, those types of projects remain a large part of the projects I’m involved in.What types of oil & gas industry engagements do you work on?The types of O&G industry engagements that I work on vary, although they’re somewhat concentrated in oilfield services (OFS). So, I’ve been part of projects involving mud companies, drilling companies, oilfield waste disposal (saltwater disposal) companies, oilfield equipment (pumps, valves, downhole tools, drilling pipe, seismic equipment, seismic vehicles, drilling equipment, offshore floatation equipment, offshore trenching, ROVs, etc.) manufacturing businesses, and a variety of oilfield services companies. The purpose of those projects is quite varied as well, including federal tax, financial reporting, and transaction purposes.What are the capabilities of Mercer Capital’s Oil & Gas Industry team?Mercer Capital’s Oil & Gas Industry Team capabilities are unusually broad. In addition to our capabilities in the exploration and production (E&P), OFS, midstream and downstream areas, we also have top-notch capabilities in appraising reserves, mineral interests, and other O&G “interests,” which is not nearly as common among our peers. In a sense, this broad O&G industry capability isn’t much of a surprise considering our team has four individuals who’ve practiced business valuation for 20+ years in Texas.What is unique about Mercer Capital’s oil & gas industry services/expertise compared to your competitors?Probably the most unique aspect of our Oil & Gas Industry services is our expertise in appraising reserves, mineral interests, and other O&G “interests” (royalty, working, etc.). While there is any number of business appraisal firms that dabble in appraising these types of assets, unless the appraiser has real expertise, you can often end up with a somewhat questionable valuation. Our Oil & Gas Industry Team is a bit unusual, even among our larger peers, as to the depth of knowledge that we bring to appraising these assets. Knowledge of decline curves and the varying geophysics of different oil and gas basins is not a common body of knowledge in the Business Appraisal community, but we have that knowledge – in abundance.What is the one thing about your job that gets you excited to come to work every day?Early in my career, the exciting part of my job was certainly getting to understand what made the subject company tick. It was, and remains, fascinating to me. As I’ve moved deeper into my career, I’ve also grown to really enjoy many of the broader aspects of running a business valuation practice – such as working with our younger analysts to help them advance in their careers, growing our Houston and Dallas offices, continuing to grow and expand our presence in the Oil & Gas industry, and learning new technical skills as our profession develops more and more sophisticated methodologies for modeling value. Over time, I’ve come to realize that this career in Business Valuation — that I sort of fell into back in the early 1990s — really fits me like a glove. I thoroughly enjoy it and can’t see myself doing anything else.

Carvana Is Looking More Like Icarus

How the Pandemic Darling May Have Flown Too Close to the Sun

Lately, Carvana has been in the news for all the wrong reasons.Its share price is down over 90% since its pandemic peak and currently sits below the low levels of March 2020.This post provides an abbreviated history of Carvana from its founding in 2012 to 2022 and discusses what its successes and struggles mean for traditional auto dealerships.Where It All beganThe company was founded by Ernie Garcia III in 2012. Garcia sought to improve the vehicle buying experience for consumers. He attributed the idea partly to how cars are bought and sold at wholesale auctions. These auctions are key sources of supply for auto dealers, particularly used vehicle dealers with limited opportunities to acquire cars via trade-ins. Garcia noted it took dealers all of 30 seconds of seeing a vehicle to purchase it. His vision was to bring this ease of acquisition mainstream.Prior to founding Carvana, Garcia began working at DriveTime Automotive Group in 2007, an auto giant owned by his father. This is where he got the idea of selling cars online, though it would take years for this idea to take off.What Makes Carvana UniqueCarvana has become known for its iconic car vending machines which debuted in late 2015. These worked as a centralized location for customers to pick up vehicles, lowering delivery costs. It was also a novel concept with marketing benefits for the brand. Compared to a traditional dealership, going vertical reduced the upfront investment in real estate compared to large, expansive lots that are largely sitting empty in the current inventory shortage.Another thing that makes Carvana stand out is its online-first presence. Carvana operates as an online platform to buy and sell used cars, but this option for consumers isn't new. The difference with Carvana is that the company acts as the dealership rather than taking a fee for simply listing the vehicles. The company also earns a substantial amount of its gross profit from financing rather than the actual sale of vehicles. Vehicle financing has increasingly become a key aspect of profitability for traditional dealerships as well.While Carvana fixes the vehicles it purchases prior to reselling them, they don't provide after-sale services like repair and maintenance, a key driver of profitability for traditional dealerships.Scaling the BusinessCarvana seeks to provide a uniform buying experience with price transparency, an oft-cited pain point with traditional auto sales for consumers. To achieve this, the company needed to significantly increase scale in order to be profitable.A few years after its founding, the company struggled to gain traction. It resorted to two tactics instrumental to the company's success. First, it subsidized consumers by selling vehicles at or sometimes below cost. This, of course, raised the company's sales from a volume perspective and contributed to significant growth. The company has for years sold a growth story like many other online companies. The thought process is that it can increase its prices once it achieves sufficient scale using its aggressive pricing strategy.Carvana's strategy was to use its aggressive pricing (selling cars at or below cost) to create scale. From there they could increase prices and reach profitability.Carvana's second tactic was listing its inventory in numerous markets. While it had fewer cars to sell than its competitors, it began using virtual addresses in order to appear to have a presence in more markets than it actually did. Consumers surveying their options might go into a dealership if they know the brand they want but aren't sure about the model. Before Carvana, third-party listing sites were a better way to start the research process for consumers that were brand-agnostic.Carvana's strategy enabled its vehicles to show up in more markets, and they subsidized the cost of shipping the vehicle once a sale was recorded. While this strategy was not sustainable from a profit perspective, the investment paid off and generated significant traction. The company's IPO in 2017 further increased its visibility, and its growth story and positioning as a "disruptor" captured public attention in an industry with room for improvement in the customer experience.Flying Too Close to the SunThe company rode its growth story to a stock price of $110 in February 2020. In less than a month, concerns around the COVID-19 pandemic led the stock price to decline 73% to $29. Less than a week later, the stock was back to $63 as the market, at large, sought to reprice all stocks based on uncertain expectations of the path forward.By June 2020, the stock peaked again as the company was viewed as an early "winner" from the pandemic. Auto sales plummeted in March and April 2020 as dealers were thrust into the world of online sales as a means of survival. For Carvana, the forced shift to online played directly to their strengths.Prior to the pandemic, the online market for purchasing vehicles was presumed to be relatively small. While online retail works great for certain products, large purchases like cars and mattresses were supposed to be impervious to the "Amazon-ification" of retail. There were two main reasons for this thesis: life cycle of the purchase and cost.It has long been held that consumers spending large sums of money on products they intend to use for years want to touch and feel what they're buying to ensure they like it. The last thing you want to do is get a bad night's sleep on a bed the first night after you've just shelled out $100s of dollars for a new mattress. The same can be said for the style and feel of automobiles, which is why dealers keep so much inventory on the lots for consumers to test drive various options.Consumer financing for cars can also be difficult to complete online. Having a dealer walk people through their options or direct them to more affordable options is beneficial to the dealer who still gets the sale and the consumer that needs help wading through the financing process. Carvana appeared to solve both of these problems with easy-to-use online financing tools and a 7-day test drive period. This was a plus compared to the traditional ~30 minutes a consumer spends with a vehicle prior to purchasing it from a dealership.Before the end of 2020, it was clear that auto dealers (both traditional and online) were benefiting from the economic environment caused by the pandemic as sales bounced back and an increased reliance on technology and lower headcount, interest rates, and advertising led to lower costs. As the pandemic continued, auto dealerships saw heightened profitability, and Carvana's stock price soared to a high of $370 in August 2021. Conditions were so strong that the growth-focused Carvana actually reported positive earnings per share in Q2 2021. This appeared as though it could be the turning point for the company. Maybe it was reaching the necessary scale to generate large profits in the future.Unfortunately, the wind has been taken out of its sales as the macro environment has changed in 2022 with rising interest rates and now fears of a recession. At $25 as of last Friday (July 22, 2022), the stock now sits lower than it did in the depths of the pandemic and is closer to where it traded in the first half of 2018. It's fair to raise the question: "If the company couldn't make money in the most ideal of conditions for auto dealers (in addition to forced adoption of online retail), what is its ultimate path to sustained profitability?" While the company's innovative ideas generated plenty of traction with consumers, they did not lead to a moat for its operations. Stated plainly, other companies can copy Carvana's offerings, reducing or removing all of its competitive advantages from being the first-mover.Recent StrugglesMatching stock price declines, headlines about Carvana are becoming increasingly negative as its fairy tale ride may be coming to an end. Recently, the company has announced layoffs in order to preserve cash. However, a smaller staff may only exacerbate the back-end paperwork issues the company is currently facing. While the company downplays the pervasiveness of the issue, an article in Barron's (subscription may be required) chronicles consumers' struggles with registration delays and issuance of multiple temporary license plates from various states enabling it to sell vehicles for which it had not yet received the title. In many states in which the company does business, such sales are illegal. For these consumers, the relative ease of front-end purchase as compared to in-store dealerships may not be worth the back-end headaches as Carvana seeks to straighten out these issues. Long-term, Carvana is selling a better customer experience, which will extend beyond the initial purchase by getting all the necessary paperwork completed to be street legal.Anecdotally, we had a colleague last week who spent the better part of a day at the DMV attempting to get his car registered after temporary plates could no longer be extended by law. While the DMV may have shared in some of the blame in this situation, he has yet to receive a title four months after purchase. Interestingly, there were about ten other people at the DMV with similar Carvana issues, though many of them were happy, loyal customers that raved about the front-end experience despite the back-end frustrations.Carvana's core profitability lever (financing) is seeing demand cool.In addition to back-end issues, the company's core profitability lever (financing) is seeing demand cool. While Carvana is well-known for its vending machines and no-haggle pricing on its website, its earnings (or lack thereof) are more dependent on its financing. Instead of marking up the vehicles, it sells to market levels, the company subsidizes lower purchase prices to scale and also makes money on the auto loans it originates. Rather than holding these on its balance sheet, the company packages or "securitizes" these loans and sells them to investors.With near-zero interest rates and a strong economic environment, there was plenty of demand for the increased yield offered on these loans. However, with concerns about the financial strength of consumers and rising interest rates, there is less demand for the loans generated by Carvana. In the second quarter, Carvana didn't sell a pool of non-prime loans. In previous quarters, it had securitized both prime and non-prime loans. The company is due to report "earnings" on August 4, and some analysts are pessimistic.Takeaways for Auto DealersDespite its issues, Carvana is the poster child for many consumer-centric shifts in the car buying space.Consumers across the country now have numerous options to buy vehicles online, with extended test drive options becoming more available. Carvana's decentralized approach and lower investment in real estate may also change the level of investment needed for the dealership of the future, though one could argue the current inventory shortage situation may have pushed the industry in this direction even without Carvana.The auto dealer industry will continue to rely on and require investments in technology, particularly technology centered around the online buying experience. Dealers unwilling or unable to make these investments may opt to divest their dealership while profits and values are at relative peaks.The fortunate thing for dealers is their access to new and used vehicles, in addition to financing and servicing of vehicles, ultimately means there are numerous potential profit centers that provide downside protection through all economic cycles. Online retailers like Carvana are seeking to disrupt the industry, but their lack of new vehicles and service departments put them at a distinct disadvantage that even explosive growth may not be able to overcome.Mercer Capital follows the key players in the auto industry in order to stay current with the operating environment of our privately held auto dealer clients. To see how these trends may impact your dealership, contact a Mercer Capital professional today.

Is the Best Wealth Management Platform Really an Independent Trust Company?

The most frequently ignored topic in the wealth management industry may be its first cousin, the independent trust industry. While many still associate trust work with banks, and banks still represent more than three-quarters of the trust industry, the growing prominence of independent trust companies is causing many participants in the investment management space to take another look. In some regards, independent trustcos look a lot like wealth managers, only more evolved.FeesSince the credit crisis, there has been a broad-based decline in pricing power across the investment management industry. Assets have poured into low-fee passive products, driving down effective realized fees for asset managers. Wealth managers have been more resilient, but the threat of robo-advisors remains. Virtually all discount brokerages have been forced to cut trading fees to zero. The message is clear: assets across the financial services industry are gravitating towards lower-fee products.So how have trust companies fared in this environment? Despite the pricing pressure in the broader industry, trust companies have fared remarkably well, with fees at least flat if not headed higher. For many of our independent trust company clients, the story has been similar. Realized fees have remained steady or even increased over the last five years, while assets under administration have grown through market growth and net inflows.Market CorrelationThe 2022 bear market is having a significant negative impact on the top line for trust companies, as it will for all investment managers that charge a percentage of assets under management. As of the date of this post, equity prices are down around 20% year-to-date.The effect on trust company profitability will depend on the length and severity of the economic slowdown caused by the market dynamics and the potential of a looming recession.Normally, trust would be shielded from some of the market volatility because of a higher exposure to fixed income. Unfortunately, the change in the term structure of interest rates this year means bonds are also well off their prices from a few months ago. Consequently, trust company revenue will take a big hit. The effect on trust company profitability will depend on the length and severity of the economic slowdown caused by the market dynamics and the potential of a looming recession. The range of likely scenarios is beyond the scope of this post, but it suffices to say that there is still significant uncertainty regarding the impact on people, markets, and economic activity.Unlike many asset and wealth management firms, trust companies often have revenue sources that aren’t based on AUM (e.g., tax planning, estate administration fees) which should provide some protection during a market downturn. This, combined with a resilient fee structure, should help trust companies weather the economic climate.Favorable DemographicsAs America becomes older and wealthier, the number of potential clients for the trust industry is poised to grow markedly.Trust companies primarily service high net worth and ultra-high net worth clients, and both demographics are growing in number. Credit Suisse’s Global Wealth Report estimates that fully 1% of Americans are millionaires, numbering almost 22 million people in 2021. This is more than double the number a decade ago, and represents more than a 20% increase over the prior two years. At the same time, the median age in the U.S. has increased by 1.5 years in the past decade, and the oldest members of the baby boomer generation are now in their mid-70s.The average age of millionaires in the U.S. is 62, and over a third of U.S. millionaires are over the age of 65. Consequently, there is a growing pool of clients in need of the kinds of services that the trust industry provides, and that points to a sustained period of organic growth for the industry. While this will also provide a tailwind for wealth management firms – who often start working for clients around the time they retire – it is a more certain opportunity for trust providers, especially to the extent that wealth transfer services are part of a client’s equation.Regulatory TrendsAs trust law has developed, a handful of states have emerged as being particularly favorable for establishing trusts. While the trust law environment varies from state to state, leading states typically have favorable laws with respect to asset protection, taxes, trust decanting, and general flexibility in establishing and managing trusts. Opinions vary, but the following states (listed alphabetically) are often identified as states with a favorable mix of these features.AlaskaDelawareFloridaNevadaSouth DakotaTennesseeTexasWashingtonWyoming Over the last several decades, many states such as Delaware, Nevada, and South Dakota have modernized their trust laws to allow for perpetual trusts, directed trustee models, and self-settled spendthrift trusts (or asset protection trusts). The directed trust model, in particular, is a major change in the way trust companies manage assets, and it has been gaining popularity among trust companies and their clients. Under the directed trust model, the creator of the trust can delegate different functions to different parties. Most frequently, this involves directing investment management to an investment advisor other than the trust company (this could be a legacy advisor or any party the client chooses). The administrative decisions and choices related to how the trust’s assets are used to enrich the beneficiary are typically charged to the trust company.The directed trust model, in particular, is a major change in the way trust companies manage assets, and it has been gaining popularity among trust companies and their clients.The directed trustee model leads to a mutually beneficial relationship between the trust company, the investment advisor, and the client. The trust company avoids competition with investment advisors, who are often their best referral sources. The investment advisor’s relationship with their client is often written into the trust document. And most importantly, this model should result in better outcomes for the client because its team of advisors is ultimately doing what each does best—its trust company acts as a fiduciary, and its investment advisor is responsible for investment decisions.SuccessionIn our experience, the ownership profile at independent trust companies is often similar to that which we see at wealth management firms, and ownership succession is often a topic of conversation. Ownership issues include concentration at the founder level or even extensively held by outsiders who helped capitalize the firm’s startup. As with most investment management businesses, independent trust companies tend to be owner-operator businesses, so finding ways to include younger partners and key staff in equity participation is sometimes a challenge.As we’ve written about in articles, blog posts, and whitepapers on buy-sell agreements, the dynamic of a multi-generational, arms-length ownership base can be an opportunity for ensuring the long-term continuity of the firm, but it also risks becoming a costly distraction. As the trust industry ages, we see transition planning as potentially being either a competitive advantage (if done well) or a competitive disadvantage (if ignored).OutlookMany independent trust companies performed remarkably well over the past decade and much better than expected during the pandemic. The current bear market is an immediate headwind, but demographic trends in the U.S. and the increased visibility of independent firms as an alternative to bank trust departments should form a solid basis of growth for the foreseeable future.

Meet The Team

David W. R. Harkins, CFA, ABV

In each “Meet the Team” segment, we highlight a different professional on our Auto Dealer Industry team. This week we highlight David Harkins, Senior Financial Analyst.David Harkins, CFA, ABV began his valuation career at Mercer Capital as an intern in the summer of 2016. After finishing his degree at Sewanee in 2017, David joined Mercer Capital as a financial analyst in the Memphis office. In 2018, he drove a U-Haul up I-40 to Mercer Capital’s Nashville office and began covering auto dealerships. Since then, he has worked on various types of engagements for auto dealerships including marital dissolution, gift/estate tax planning, shareholder oppression, and limited procedures buy and sell side analysis, among others.What is your favorite part about working with auto dealerships?David Harkins: I like all the analytical detail provided on the monthly factory statements. There is a certain uniformity, even across the various brands, that makes it easier to analyze the dealership and compare dealerships across brands. I know right where to go for the key value drivers, such as the volumetric information and data by department. We started our Auto Dealer blog during the depths of the pandemic, so that timing wasn’t necessarily great. But the discipline of weekly content has been extremely helpful to my understanding of the industry. That is particularly the case when it feels like industry news, trends, and disruptions are occurring on a weekly basis. I enjoy following the industry because of its benefits when discussing expectations for dealerships with our clients. We can speak their language better than a business valuation generalist that may not do another auto dealership that year. We have the greater context of the industry at large, so we can spend more time on the key impacts they see for their brand(s) in their market(s).How does your CFA background assist with analyzing auto dealerships?David Harkins: I think the CFA designation has three primary benefits. The first and most important in my mind is the analytical rigor of the tests and the knowledge gained from committing to passing each level. I did not take many accounting classes at Sewanee, for instance, and it deepened my knowledge of the interaction between the three main financial statements. Additionally, the CFA impressed upon me the importance of valuing the expected cash flows in order to determine the value of any business interest. For auto dealers, cash flows have improved since about mid-2020, and it seems increasingly likely that at least part of this benefit will be retained once the supply chain disruptions moderate. The question for valuation analysts is at what level will earnings settle? The market largely sets the multiple for businesses where high-growth industries (e.g. big tech) are likely to receive higher multiples than declining industries (e.g., big box department stores). If the market sets the multiple, the analyst's job is to understand the expected level of ongoing earnings, which is then capitalized by the multiple. The corollary benefits of the designation are networking opportunities and a recognition that I have a strong analytical background. I believe these will both help me as I develop in my career, but I have yet to be able to use them fully. I received the charter in August 2020, so opportunities to meet more folks have been somewhat limited, though it’s been great to attend events such as TAA and NADC. Hopefully, the CFA will provide a nice complement to these activities.What is a unique challenge when working with auto dealerships?David Harkins: I think parsing the allocation of value by rooftop is interesting. Haig Partners and Kerrigan Advisors publish Blue Sky multiples in a quarterly newsletter that is brand specific (because the market tends to ascribe higher multiples to luxury dealerships, for example). This analysis quickly becomes complicated for auto groups carrying more than one brand. Having multiple rooftops is a great expansion strategy for dealers that provides cross-selling opportunities and risk mitigation if one brand has a lackluster product lineup. It can also expose the auto group to various points along the demand curve where luxury might outperform in a strong market, whereas more economical offerings might do better in periods of market turbulence. If a company has a Lexus and a Toyota dealership whose mid-point market multiples might be 9x and 7x, respectively, what multiple gets applied to a transaction involving both dealerships? Part of the reason dealer principals want to add rooftops is what makes this analysis more difficult: sharing of operating expenses. If a dealer principal is paid $100,000, how much of that salary is attributed to one dealership or another? Without truly separate P&L statements, it takes more art than science to determine the contribution to value of multiple rooftops.What did your internship at Vulcan Materials Company teach you that has translated to your work with auto dealerships?David Harkins: Prior to my internship at Mercer Capital, I got the chance to intern at Vulcan Materials. While I was an intern at Vulcan, I think I gleaned a fair amount about how a public company operates. I worked primarily with the market research department and was impressed by the internal/proprietary research available to the company. Given the large size and intentional growth exhibited by the six public auto dealership companies, I’m sure they have similar departments, which afford them numerous insights into where the competition is and where it’s going. While industry resources are available to analysts at valuation shops like Mercer Capital, it will likely always pail in comparison to the data available to the dealerships themselves, particularly those that operate many brands across many markets. That’s why I find it so valuable to tune into the earnings calls from these companies because they get reports from on the ground relating to the day-to-day changes in supply and demand that shape the industry as a whole.What goals do you have when it comes to working with auto dealerships?David Harkins: I’d like to cover every brand. There isn’t an equal number of dealerships by brand across the country, and some are more prevalent than others. Some may also have different valuation needs than others. While there are some brands I’ve worked with numerous times, there are a few I have not yet had the opportunity to work with. I’ve worked with all the domestic brands and have even been exposed to numerous high-line brands. But there are still a few mid-line import brands and luxury brands that have eluded me.

Another Tumultuous Quarter for RIA Stocks Puts the Industry Firmly in Bear Market Territory

Publicly Traded Alt Managers and RIA Aggregators Have Lost Nearly Half Their Value Since Peaking Last November

The RIA industry extended its losing streak last quarter with all classes underperforming the S&P, which also continued its decline. The market is part of the problem as this industry is mostly invested in stocks and bonds, which have decreased considerably over the last six months. The additional underperformance for asset and wealth managers is likely attributable to lower industry margins as AUM and revenue falls with the market while labor costs continue to rise. Rising interest rates have exacerbated this decline for alternative asset managers and RIA aggregators, who frequently employ leverage to make investments. The one bright spot for the industry is the group of smaller (under $10 billion in AUM) publicly traded RIAs, which is the only segment to outperform the market last quarter. This group is still down over the last three months but is holding up relatively well due to the lack of aggregator firms in its composition. As valuation analysts, we’re often interested in how earnings multiples have evolved over time since these multiples can reflect market sentiment for the asset class. After steadily increasing over the second half of 2020 and first quarter of 2021, LTM earnings multiples for publicly traded asset and wealth managers declined modestly in the back half of last year before dropping nearly 40% so far this year, reflecting investor anticipation of lower revenue and earnings from the recent market decline. Implications For Your RIAThe value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with closely held RIAs should be made with caution. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds such as fee pressure and asset outflows to passive products.In contrast to public asset/wealth managers, much smaller, private RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures asset flows, and deal activity for these companies have reflected this.Notably, the market for privately held RIAs remained strong in 2021 as investors flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer. Deal activity for these businesses continued to be significant in 2021, and multiples for privately held RIAs tested new highs due to buyer competition and a shortage of firms on the market. As these dynamics continue into 2022, the outlook for continued multiple expansion and robust deal activity remains favorable, assuming interest rates and market conditions stabilize in the near future.

U.S. LNG Exports

Part 2: A Closer Look at Projected U.S. LNG Export Terminal Capacity

In Part 1 of our analysis on U.S. LNG Export Terminal Facilities, we examined trends in the number of LNG export facility applications and approval rates from 2010 through 2021 and examined the projected export capacity relative to the projected export volumes of U.S. LNG from 2022 through 2031. In Part 2 of our analysis, we take a closer look at the anticipated export capacity proposed to come online over the near and mid-term horizons to better understand the underlying factors that have spurred so many projects, seemingly far in excess of the projected level of LNG exports from the U.S.Excess Export Capacity?As noted in Part 1 of our analysis, the Federal Energy Regulatory Commission (“FERC”) received approximately 145 long-term applications for export facilities seeking to send liquified natural gas to countries both with and without free-trade agreements with the U.S from 2010 to 2021. Of these applications, 64% were approved, with the vast majority of approvals made from 2011 through 2016. What was particularly striking was the apparent excess capacity of all the export terminals, from both existing and proposed facilities, relative to the export levels as projected by the U.S. Energy Information Administration (“EIA”), as presented in the following chart: What is not so apparent is that very few projects (ergo, capacity) have firm commitments from buyers to purchase the produced LNG, with even fewer projects having reached an affirmative final investment decision (“FID”). The nameplate export capacity from all proposed facilities skews the picture a bit, suggesting the U.S. is well able to ship out LNG as fast as natural gas can be extracted, without considering the financial support backing these major capital builds. When stratifying the export capacities of all facilities for which an in-operation date has been put forth, all facilities for which an affirmative FID has been made, and all facilities which are currently in operation, it becomes clear that the capacity of the last group represents the boundary by which the projected LNG export levels anticipated by the EIA over the next 5 years are limited. Further detail regarding the export terminal facility and capacity expansion projects are provided in Appendices A and B at the end of this post (updated and revised from Part 1 of our U.S. LNG analysis). Furthermore, we see that a total export capacity level is slated to be “operational” over the course of 2023 through 2027, while only a portion of that capacity has affirmative FIDs underlying such progress. In other words, quite a few projects are behind schedule. Far behind. For this reason, we will consider “reasonably-expected” LNG export capacity to be based solely on existing capacity and FID-supported capacity. In order to reasonably include any capacity levels for which an in-operation (but no FID) date is provided, the supporting engineering, procurement, and construction (EPC) activities for those projects would have to be either near completion or well underway. This simply cannot be assumed to be the case given the lack of clarity regarding the expected timing of any FIDs for these projects, and considering the greatly extended lead times on equipment deliveries due to increasing costs, supply chain constraints, and tight labor markets. The projected capacity utilization over the next ten years is as follows: Click here to expand the image aboveAt face value, the projected annual utilization rates indicate potential tightness in the ability to ship out LNG volumes over the next 6-18 months. While this possible bottleneck appears – based on current projections – to ease up over the following 2 to 5-year period, other factors should be considered aside from just export terminal capacity. After all, these facilities can only send out what they receive.Ancillary FactorsOn June 8, the failure of a safety valve caused a pipeline to burst at the Freeport LNG facility, releasing approximately 120,000 cubic feet of LNG. In addition to posing a “risk to public safety, property or the environment,” U.S. natural gas futures prices fell as the spigot was shut and natural gas slated for export had to remain in storage onshore. The EIA expects that the shutdown, projected to last for at least 3- to 6-months, will reduce the total U.S. LNG export capacity by 17%. Widening our focus from the Freeport LNG shutdown, this event reveals the potential risk and impact of total U.S. LNG exports stemming from a significant unforeseen or unplanned shutdown from any of the major (>1.0 Bcfd) 4 export terminals currently in operation. Until more or larger facilities come online, any major shutdown at a currently-operational export facility may impact the ability of the U.S. to serve oversea markets.Until more or larger facilities come online, any major shutdown at a currently-operational export facility may impact the ability of the U.S. to serve oversea markets.Further upstream, midstream O&G operators, such as Williams (NYSE:WMB), are setting up to help supply natural gas to LNG export terminals. On June 29, Williams announced its FID to proceed with its Louisiana Energy Gateway (LEG) project, which will gather and help deliver 1.8 Bcfd of natural gas from the Haynesville Shale to Gulf Coast export terminals by way of several existing and future intermediate trunklines.Beyond the physical capital infrastructure required to move gas volumes from the wellhead to the liquefaction terminal, support for LNG export activity remains constrained by political crosswinds as the Biden administration attempts to balance its initiative of supplying U.S. gas to Europe, in order to reduce its reliance on Russian-sourced fuel, while simultaneously addressing a greater public interest in lower domestic energy prices and progressing a platform to mitigate climate change, primarily by reducing the use of fossil fuels.In an attempt to appeal to the various parties with a particular interest in these respective goals, the Biden administration has sent mixed signals with countervailing rhetoric and actions. Increased LNG exports to Europe directly leads to increased domestic energy prices and does little in the way of improving the current trajectory of climate change. Keeping the supply of natural gas onshore helps mitigate high domestic energy prices, but falls short of helping fuel Europe, and still does little to curb climate change. In the pursuit of meaningful change with respect to transitioning away from fossil fuels, neither LNG exports nor promoting greater levels of natural gas production are truly viable policy options. In the pursuit of all goals, no goals are likely to be achieved. It's a stalemate. Given the factors at hand, it remains to be seen just how U.S. LNG export terminal projects develop. There are clear indications that demand is present, but nebulous political actions, words, and potential regulatory issues still cast a shadow on any perception of a clear path forward.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.Appendix A – U.S. LNG Terminals – Existing, Approved Not Yet Built, and ProposedClick here to expand the image aboveAppendix B – U.S. LNG Terminals – Existing, Approved Not Yet Built, and ProposedClick here to expand the image above

June 2022 SAAR

Quantifying Pent-Up Demand

The June SAAR was 13 million units, up 2.3% from last month but down 16% compared to June 2021. This month's release closes out the second quarter of this year, bringing the total Q2 2022 SAAR to 13.4 million units. Q1 2022 SAAR of 14.1 million units was already considered low compared to pre-pandemic, and the last few months have analysts wondering if the total 2022 SAAR will manage to exceed the first quarter's sales pace at all. It would certainly take a major turnaround in the second half of this year for the 2022 SAAR to normalize by the time it is all said and done.As far as unadjusted sales figures are concerned, June 2022's performance can be put in a more appropriate perspective when compared to the last seven years of June releases (See the chart below). June 2022's unadjusted sales pace narrowly outpaced June 2020, but compared to 2015-19, the unadjusted sales pace over the last month is significantly depressed. Even when compared to June 2021, a month where high demand intersects with dwindling supply for only the second month in a row, the June 2022 SAAR still comes up short. The story behind the slow sales pace remains the same in 2022 as it was this time last year, but to a magnitude that no one expected when we wrote our June 2021 SAAR blog. A lack of available inventory continues to be the largest factor limiting sales. According to Wards Intelligence, inventory at the beginning of June was down 25% from this time last year and was less than a third of pre-pandemic levels. See the chart below for a look at the industry inventory to sales ratio, which has been trending lower and lower since the inventory shortage began to take hold around March 2021. Alongside inventory tightening, other recent trends in the auto industry have also intensified. For example, incentive spending per unit continues to fall, reaching $930 this month (59.4% lower than this time last year). As incentive spending per unit falls, sticker prices have risen. According to J.D. Power, the average transaction price per vehicle was $45,844 over the last month, an increase of 14.5% from June 2021. Furthermore, as a result of climbing sticker prices and rising interest rates, the average monthly payment that consumers are paying for new vehicles has climbed to$686, an all-time high. While almost all consumers that are financing vehicles are feeling the sting of high monthly payments, a growing share of new car buyers are now paying over $1,000 per month. According to a recent WSJ article, over 12% of new car buyers are signing up for monthly payments in excess of $1,000, a much larger proportion of buyers than many would guess. Due to this shift in the environment for the auto consumer, the relative inelasticity of purchasing a new vehicle is being highlighted now more than ever.Pent-Up Demand – What Does That Really Mean During the Auto Inventory Crunch?In several of Mercer Capital's auto blogs (most recently last week's blog) as well as other industry commentaries, there have been references to the idea of "pent-up demand." Pent-up demand has become commonly accepted as a reason for the relative price inelasticity of new vehicles. Inelasticity is the economic concept that a large change in the price of a good, results in a small change in the demand for that good. Pent-up demand can also be predictive. For example, many people following the auto industry have been predicting that once sticker prices eventually "normalize", then many folks that would have bought a vehicle in a more price-friendly environment will finally pull the trigger and make that new vehicle purchase. With prices still climbing and dealers still selling through most all of the inventory they get immediately, we're seeing that some consumers aren't able to wait for a more favorable buying environment.What will "normalized" volumes look like after supply chains recover? From 2015-2018, light vehicle sales in the U.S. exceeded the threshold of 17 million, which has been bandied about as the new normal. Expanding the lookback to 2014-2019, average annual light vehicle sales were 17.1 million, and it has become common within the industry to assume that a return to normal after the pandemic and chip shortage will carry the SAAR back to those levels, if not higher (due to the pent-up demand mentioned earlier).However, is a speedy return to a 17 million unit SAAR a reasonable expectation? And is 17 million even the correct number?We can look at the historical volumes to answer these questions. See below for a chart of the SAAR from 1976 to the first half of 2022. We have included a trend line to show the overall trend of upward movement during this period.It is easy to see that the market for new vehicles has been increasing over time. Population growth and the shift from 1 car households to 2+ car households are two obvious reasons to explain the upward growth of new vehicle sales. It is also easy to see that the market for new vehicles is cyclical. A period of elevated sales is typically followed by a down period where the demand for autos dips due to an economic recession or just general softening of demand. The last period where we saw this occur was centered around the credit crisis in the late 2000's where OEMs particularly struggled. This recovery was also compounded by storms in Asia in 2011.From 2013 to early 2020, the new vehicle market could be characterized as being in an up-cycle. SAAR figures being reported during that period may not have been unsustainable from the perspective of OEMs or dealers. Still, a general softening of demand was bound to happen at some point. While population growth and more vehicles per household lead to a general uptick, OEMs have improved the useful lives of new vehicles as well.However, an organic softening of demand was not allowed to take its natural course due to the COVID-19 pandemic and the resulting supply chain disruptions associated with it. The 17 million units sold prior to the pandemic are above the line of best fit in the data set. With population growth and increases in the number of new vehicles per family, we believe a linear line of best fit is appropriate for the data set. The formula on the graph shows each year, 184 thousand more vehicles are sold than the previous year. It also estimates volumes of about 16.6 million in 2022, which looks very unlikely at this point. While this long-term view is not a good predictor for sales next month, particularly in light of supply chain constraints, we believe it reasonably supports that sustainable sales levels may be lower than the 17 million achieved pre-pandemic.Extrapolating forward with current data, 17 million in annualized volumes wouldn't be anticipated until April 2025. It will be interesting to see how this data changes in the coming months if/when supply constraints are removed. All that being said, perhaps a return to the long-term trend is the most reasonable assumption that industry experts can make. Based on the trend line in the chart above, a normalized SAAR of 16.5 million seems to make sense. While the difference between a predicted 17.5 million unit SAAR and a 16.5 million unit SAAR certainly does not make the largest difference in the grand scheme, it is important to have a more nuanced discussion around what "normalized" sales are going to look like in the wake of the inventory crunch that is gripping the industry in 2022.July 2022 OutlookMercer Capital's outlook for the July 2022 SAAR is consistent with the status quo. Industry supply chain conditions continue to stagnate. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Stay tuned for more updates on next month's SAAR blog.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a Mercer Capital auto dealer team member today to learn more about the value of your dealership.

RIA M&A Update - Through May 2022

Year-to-date RIA M&A activity has surpassed last year’s record levels so far in 2022 even as macro headwinds for the industry continue to mount. Fidelity’s May 2022 Wealth Management M&A Transaction Report listed 93 deals through May of 2022, up from 72 during the same period in 2021. These transactions represented $135 billion in AUM, up 12% from 2021 levels.The continued strength of RIA M&A activity amidst the current environment dominated by inflation, rising interest rates, and a tight labor market is noteworthy given that all of these factors could put a strain on the supply and demand dynamics that have driven deal activity in recent years. Rising costs and interest rates coupled with a declining fee base will put pressure on highly-leveraged consolidator models, and a potential downturn in performance could put some sellers on the sidelines until fundamentals improve. Despite these pressures, the market has proven robust (at least so far). Demand for RIAs has remained strong, with the professionalization of the buyer market continuing to be a theme driving M&A activity. Deal volume is increasingly driven by serial acquirers and aggregators with dedicated deal teams and access to capital. Mariner, CAPTRUST, Beacon Pointe, Mercer Advisors, Creative Planning, Wealth Enhancement Group, Focus Financial, and CI Financial all completed multiple deals during the first five months of the year. This group of companies, along with other strategic acquirers and consolidators, have continued to increase their share of industry deal volume and now account for about half of all deals. In addition to driving overall industry deal volume, the proliferation of strategic acquirers and aggregator models has led to increased competition for deals throughout the industry. This has contributed to multiple expansions and shifts to more favorable deal terms for sellers in recent years. While there are some signs that deal activity from these acquirers may slow down (CI Financial’s CEO Kurt MacAlpine remarked on the company’s first quarter earnings call that their pace of acquisitions has “absolutely slowed down”), we’ve not yet seen that borne out in the reported deal volume.On the supply side, the motives for sellers often encompass more than purely financial considerations. Sellers are often looking to solve succession issues, improve quality of life, and access organic growth strategies. Such deal rationales are not sensitive to the market environment, and will likely continue to fuel the M&A pipeline even in a downturn. And despite years of record setting M&A activity, the number of RIAs continues to grow—which suggests the uptick in M&A activity is far from played out.Whatever net impact the current market conditions have on RIA M&A, it may take several months before the impact becomes apparent in reported deal volume given the often multi-month lag between deal negotiation, signing, and closing. But at least through May, transaction activity has remained steady or even surpassed last year.What Does This Mean for Your RIA?For RIAs planning to grow through strategic acquisitions: Pricing for RIAs has continued to trend upwards in recent years, leaving you more exposed to underperformance. While the impact of current macro conditions on RIA deal volume and multiples remains to be fully seen, structural developments in the industry and the proliferation of capital availability and acquiror models will likely continue to support higher multiples than the industry has been accustomed to in the past. That said, a long-term investment horizon is the greatest hedge against valuation risks. Short-term volatility aside, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth compared to broker-dealer counterparts and other diversified financial institutions.For RIAs considering internal transactions: We’re often engaged to address valuation issues in internal transaction scenarios. Naturally, valuation considerations are front of mind in internal transactions as they are in most transactions. But how the deal is financed is often an important secondary consideration in internal transactions where buyers (usually next-gen management) lack the ability or willingness to purchase a substantial portion of the business outright. As the RIA industry has grown, so too has the number of external capital providers who will finance internal transactions. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and in some instances may still be the best option), but there are also an increasing number of bank financing and other external capital options that can provide the selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs.If you are an RIA considering selling: After years of steadily increasing multiples and fundamental performance, RIA valuations are now at or near all-time highs. But whatever the market conditions when you go to sell, it is important to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. As the RIA industry has grown, a wide spectrum of buyer profiles has emerged to accommodate different seller motivations and allow for different levels of autonomy post transaction. A strategic buyer will likely be interested in acquiring a controlling position in your firm and integrating a significant portion of the business to create scale. At the other end of the spectrum, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Given the wide range of buyer models out there, picking the right buyer type to align with your goals and motivations is a critical decision, and one which can have a significant impact on personal and career satisfaction after the transaction closes.

July 2022

In this issue: Strategic Benefits of Stress Testing in an Uncertain Economic Environment

Medtech and Device Industry Newsletter - Q3 2022

E&P Third Quarter 2022

Bakken

Bakken // Oil prices declined in the third quarter of 2022, as West Texas Intermediate (WTI) and Brent Crude front-month futures ended the quarter at about $79/bbl and $85/bbl, respectively — a decrease from $108/bbl and $112/bbl, respectively, at the start of the quarter.

Transportation & Logistics Newsletter

Third Quarter 2022

Demand for services in the logistics industry is tied to the level of domestic industrial production.

State of the Industry From the Tennessee Automotive Association Convention

Musings From Mercer Capital’s Music City Office

Last week we attended the Annual Tri-State Convention for the Automotive Associations of Tennessee, Mississippi, and Alabama. The event provided a great opportunity to discuss trends in the automotive industry with industry participants and dealers from different manufacturers and geographic areas. In this post, we discuss some of the trends discussed last week, including a variety of topics that we have covered before in this space. We also incorporate highlights of a presentation from noted industry analyst Glenn Mercer (no affiliation with Mercer Capital) regarding the "Dealership of Tomorrow."Supply and PricingAs the last few publications of the monthly SAAR figures (April and May) have indicated, the production of new vehicles by auto manufacturers and suppliers to auto dealerships continues to be impaired by a variety of economic factors.In fact, analysts from Cox Automotive have recently tempered 2022 estimates of new vehicle sales to 14.4 million units, from their original estimate of 15.3 million units. The average annual SAAR for 2016 through 2019 was approximately 17.2 million units. Using this figure as an estimate of the average demand in the United States, the lost sales caused by COVID-19, the microchip crisis, and continuing production issues will total approximately 7.9 million units from 2020 through estimates for 2022.Even if auto manufacturers are able to scale production back to pre-COVID levels plus some excess to account for this pent-up demand, full recovery and stabilization could take 3-4 years.Glenn Mercer forecasts that annual demand should continue at the 17 million unit average through 2030. While we find this reasonable, we plan to delve into this topic further in a future post. With demand exceeding supply for the last several years, auto dealers have continued to capitalize on higher margins for new vehicles. According to Cox Automotive, the average transaction price for new vehicles climbed to $47,148 in May 2022. One byproduct of these trends is that some auto dealers have been able to sell new vehicles for a higher price than the manufacturers' suggested retail price ("MSRP"). As the following chart indicates, the average customer-facing transaction price has exceeded the MSRP for the same vehicles since the fall of last year. The question on most dealers' minds that we spoke with is how long are these trends sustainable? With the rising costs of vehicle transactions coupled with general inflation and rising gas prices, how long will consumers be able to afford new vehicle purchases at these levels? As the chart below indicates, the median number of weeks of income needed to purchase a new light vehicle has risen dramatically to 41.3 weeks in April 2022, fluctuating between 32-36 weeks for the prior decade. This figure will probably continue to climb as average transaction prices rose in May and are expected to climb again in June. Click here to enlarge the imageDemographics of Number of Dealerships and OwnersWith all of the headlines of heightened transaction volume in the auto dealer M&A market and increased activity and investment by the public auto groups, we find two charts from Mr. Mercer's presentation to be informative, which we have attempted to combine for comparative purposes: store count and owner count.We have written numerous times about the resiliency and adaptability of auto dealers and the entire automotive industry during challenging economic times. Despite the challenges, the number of auto dealerships or stores in the United States has remained relatively stable at around 18,000 since 2009.While store count has largely remained unchanged, consolidation has occurred in the owner count. Factors contributing to the decline in the number of owners include the retirement of aging owners, increased size and profitability of the average dealership, and the aforementioned activity and appetite for acquisitions by the public and larger auto groups.The following chart displays the declining owner count from its previous high of just over 10,000 in 2008. While we expect there may be further industry consolidation, conventional wisdom is that this reduction will continue to come in the form of fewer owners than fewer stores. However, as we discussed with Tony Karabon in a recent post, ownership counts may not continue this downward trajectory with the appetite displayed by first-time buyers. Auto dealerships are attractive investments, and many dealers offer a minority equity stake in dealerships as part of the compensation package for GMs. We'll be curious to see how this trend evolves because regardless of who owns the dealership and how many they own, someone still has to run each one. And after you own a piece of an attractive investment, you tend to want one all for yourself. While larger groups benefit from their scale, there are limits to how large OEMs will allow their dealers to grow, and there is an appetite from smaller buyers looking to get involved.Future Impact of Fixed Operations on Auto DealershipsAnother hot-button topic discussed at the Conference was the continued speculation that OEMs might shift to an agency model or direct sales to consumer model, which could decrease the auto dealers' portion of profits from new vehicles. In some discussions, the auto dealers' participation might shift to a delivery center whereby the dealer would receive a delivery fee if the customer selected that particular dealership to pick up their new vehicle.These changes could lead to physical changes at a dealership if there are no longer requirements to house and showcase new vehicles. If costs can be removed from the sales and distribution model and shared in a mutually beneficial way, it may not be the worst thing for dealers, though most are reasonably skeptical.Regardless of the prospects of a changing share of new vehicle profits, dealers would be wise to refocus on their fixed operations, specifically parts and services. Fixed operations have historically been a stabilizing segment for successful dealers. Even with heightened vehicle sales profitability, fixed operations remain the highest margin for a typical dealership, though their contribution to total gross margin has declined with higher GPUs.One trend lost in the shuffle of higher profits is that auto dealers' percentage of the total parts and service market has actually eroded over time to independent and after-market repair centers. These alternative options have climbed in recent years, and consumers often cite their convenience and reluctance to the dealership experience as reasons for their selection.The following chart illustrates that dealerships' total parts and service market percentage has generally declined since 1955, hitting an all-time low of approximately 30% in 2020. The bay and outlet count of the various types of parts and service outlets are as follows. Dealers should strongly consider offering some versions of mobile service or potentially satellite locations to mitigate the locational and convenience factors of the aftermarket alternatives in an attempt to recapture some of this market and high-margin business. And if the industry moves more toward an agency model, there may be fewer bad memories from the purchase experience that could negatively impact the likelihood of capturing after-sales work. We can even envision a situation where OEMs do more to push consumers back to the dealers for service work in order to make up for a decreased role in the sales process. In the transport refrigeration business, it is more difficult for consumers to get repairs from non-dealer repair shops. With increasingly complex light vehicles with all the microchips being used and features being added, it's possible service and repair work will naturally shift back towards auto dealers.Electric VehiclesThe other widely discussed topic continues to be electric vehicles (EV). Industry participants all have their predictions based on early adoption rates, government subsidization, and other factors. While adoption rates are still relatively low, (EVs are ~5% of the market), Mr. Mercer predicts this penetration figure could reach 8% by 2025, but full-scale adoption could be years off.The agency model discussions above have really picked up due to EVs. On the face of it, the sales method doesn't depend on the vehicle's powertrain, whether an internal combustion engine (ICE) or EV.While adoption remains relatively low, there is a clear stratification in the marketplace as current EV buyers tend to come at the upper end of the market. These buyers are less likely to have low credit scores, have negative vehicle equity on their trade-ins, or have any other complications that generally push would-be online car buyers to the dealership for more help in the sales process. These buyers are also generally willing and able to pay for this convenience, so a top-down approach from the manufacturer to sell vehicles to this top end of the market makes more sense than the franchised distribution model utilized when sales become more complicated.Political Considerations of Electric VehiclesOne factor impacting the adoption of EVs may be politics. As seen from the survey conducted by Strategic Vision in 2020, more Republicans purchase trucks and SUVs, while more Democrats have historically purchased alternative powertrain vehicles (APTs), including hybrid electric vehicles (HEVs) and battery electric vehicles (BEVs). It will be interesting to monitor the success of Ford's Lightning (which recently had a recall for low tire pressure warnings) and other EV truck offerings to see if they break these political buying trends and lead to quicker adoption of EVs. Other constraints against EV adoption have also been the battery life and difficulties with public charging stations. While the entire infrastructure of public charging stations would need to be built out with the continued adoption of EVs, consumers currently list the following barriers to their experience in areas where more charging stations currently exist, such as San Francisco: membership requirements, operability issues, price, payment issues, and locating a convenient charging station location. Full-scale adoption of EVs can also lead to other geopolitical factors. Just as the Russia-Ukraine conflict has made us aware of the industry's dependence on Ukraine as a chief exporter of neon that is used in the production of microchips, many of the components in the batteries for EVs are exported from China. The following is a list of some of the key battery components and the share of processing volume by country in 2019: Click here to enlarge the imageConclusionsThe recent Tri-State Convention (Tennessee/Alabama/Mississippi) provided a great forum to discuss current trends in the auto dealer industry and predictions for the future. It's informative to hear how individual dealerships are confronting their own unique challenges.All of the trends/factors discussed in this post will continue to impact the operations of dealerships and, ultimately, their profitability and valuation. We thank Glenn Mercer for his informative talk and him allowing us to reproduce many of the graphics in this post.Mercer Capital provides business valuation and financial advisory services, and our auto team assists dealers, their partners and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your auto dealership.

Bond Pain and Perspective on Bank Valuations

Equity investors define a bear market as a 20% or greater reduction in price from the most recent high price. There is no consensus for fixed income. A bond’s maturity and coupon are key variables in determining the sensitivity of price except when overlaying credit and prepayment variables when applicable.A simple definition might be when the price falls more than three times the annual income for any bond with a maturity greater than five years. If so, it is a low bar when coupons are as low as they are. Definitions aside, the bond market is in a bear market.Figure 1 :: 1994 Bear Market vs 2022 Bear Market The yield on the 10-year U.S. Treasury note (“UST”) was 3.21% on June 27, up from 1.51% as of year-end. Ignoring the impact of the intervening six months for what would be a bond with 9.5 years to maturity, the increase in yield has produced a ~14% loss in value. The last bond bear market that was brutal occurred in 1994 when the Fed raised the Fed Funds target rate from today’s aspirational rate of 3.0% beginning in February to 6.0% by February 1995. The yield on the 10-year UST rose from 5.19% on October 15, 1993 to a peak of 8.05% on November 7, 1994 once the market could see the last few Fed hikes to come. The 286bps increase in yield pushed the price of the 10-year UST down by 17%, which modestly exceeds the 14% loss this year. Coupons matter. Fixed income investors entered the current rising rate environment with little coupon to cushion rising yields unlike in the years immediately after the Great Financial Crisis when the Fed first implemented a zero-interest rate policy (“ZIRP”). Worse, banks entered the current bear market with much bigger securities portfolios given the system was inundated with excess deposits because of actions taken by the Fed and government to offset the COVID-19 recession. To get a sense of the damage in bank bond portfolios consider Figures 2 and 3 where we have compared the unrealized losses in bank bond portfolios as of March 31 with the unrealized losses as of year-end 1994, which roughly corresponded to the bottom of the 1994 bear market. The data reflects averages. Figure 2 :: Unrealized Losses in Bank Portfolios as of March 31, 2022Figure 3 :: Unrealized Losses in Bank Portfolios as of December 31, 1994 We make the following observations for banks with $1 billion to $3 billion of assets: Banks are better capitalized with average leverage and tier one capital ratios of 10.6% and 17.0% as of March 31, 2022 compared to 8.3% and 12.9% as of year-end 1994.Securities classified as available-for-sale (“AFS”) and held-to-maturity (“HTM”) averaged 19.0% and 2.5% of assets as of March 31, 2022 compared to 11.2% and 14.6% as of year-end 1994.The unrealized loss in the AFS portfolio equated to 4.7% of the cost basis and 11.3% of tier one capital (excludes the deferred tax asset adjustment) as of March 31, 2022 compared to 2.8% and 5.7% as of year-end 1994. 1 Unrealized losses in HTM portfolios in Figure 2 may appear too small even though many banks classify long-dated municipals as HTM because these illiquid bonds had not been adequately marked yet to reflect a rapidly declining market.Unrealized losses will increase once June 30 data is available because UST rates have risen ~75bps since March 31. Banks are sitting on large unrealized losses today. Investors know that. The bear market in bank stocks (the NASDAQ Bank Index is down ~19% YTD) primarily reflects investor expectations about the potential impact a recession would have on credit costs next year even though NIMs will increase this year (excluding the impact of PPP loan fees) and next provided the Fed does not pivot and reduce rates. The current equity bear market is not about unrealized losses in bond portfolios; it is about the economic outlook. From a valuation perspective, we primarily look to the impact of rising (or falling) rates on a bank’s earnings rather than how changes in rates have impacted the value of the bond portfolio and tangible book value. Assuming an efficient market, the unrealized losses represent the opportunity cost of holding bonds with coupons below the current market rate. If the underwater bonds are sold and immediately repurchased, then the bonds repurchased will produce enough extra income over the life of the bonds to recoup the loss (assuming an efficient market). Further, the AFS securities portfolio is the only asset for most banks that is marked-to-market other than mortgage loans pending sale. Fixed rate residential and CRE loans would have sizable losses, too, if subjected to mark-to-market. Rates have risen, prepayment speeds have slowed and in the case of CRE credit spreads have widened. Also not marked-to-market are deposits. Though a liability, core deposits are the key “asset” for commercial banks. Value for deposits—especially non-interest-bearing deposits—are soaring given a low beta to changes in market interest rates when loan-to-deposit ratios are low. The monthly report that really matters is not the bond report but the asset-liability model (“ALM”). Banks manage net interest margin (price) and assets (volume) to drive earnings; and earnings (or cash flow) drive stocks over time. Earnings also build book value to the extent earnings are retained. Rising rates—gradually rather than rapid—are a positive development given the commercial bank business model, assuming that credit quality does not deteriorate. Having said that, we cannot completely dismiss the unrealized losses in the bond portfolios. Some investors focus on tangible book value, though we view it as a proxy for earning power because tangible book value is levered to produce net interest income. Also, M&A is more challenging because day one dilution to tangible BVPS is greater to the extent unrealized bond losses are recognized via fair value marks applied to all assets. Of course, earnings then increase from accreting the discounts as additional yield. Aside from the soaring value of core deposits, the glass half full view is bonds and fixed rate loans eventually mature. In the interim, cash flows should be reinvested to produce better yields.About Mercer CapitalMercer Capital is a national valuation and transaction advisory firm that has advised banks for 40 years through bear and bull markets. Please give one of our professionals a call if we can be of assistance.

What’s the Price of Growth?

Infrastructure Spending in the Investment Management Community

In the golden age of asset intensive businesses, companies made giant capital expenditures on fixed assets and research & development to fuel long term growth strategies. In those days, economies had similar opportunities. The U.S. system of interstates, launched by President Eisenhower, is a prime example of major spending in support of long-term opportunities. (I could lament the days of fresh asphalt and real yields, replaced now by potholes and QE, but that’s another blog.)As our economy has evolved to feature more service-based, asset-light businesses, so too has the need to rethink what infrastructure means and what investing in long term growth looks like. Even businesses like investment management have a type of infrastructure, and their long-term growth opportunities require investment in that infrastructure.The Tangible Value of an RIA’s WorkforceOne common feature of RIA financial statements is the simplicity of their balance sheet. We not infrequently work with clients whose asset base consists of little more than a token amount of cash, receivables, and leasehold improvements. On the righthand side of the balance sheet, we commonly see nothing but a few payables and equity.But as the old (pre-pandemic) saw goes, an investment management firm’s assets get on the elevator and go home each night, such that the real infrastructure of an RIA is its staff – sometimes referred to in the valuation profession as the “assembled workforce” – an intangible asset that is more-or-less measurable using a replacement cost methodology (oftentimes achieving a result that is more precise than it is accurate).Our recent blog series has focused on the tradeoffs that RIAs make in providing returns to labor and returns to capital. Ultimately, for each dollar of revenue that an RIA brings in, the process of deriving profitability is largely a function of setting up a compensation structure. The portion of revenue devoted to expenditures other than staff and ownership is comparatively small (and less discretionary in nature).The balancing act between returns to capital and returns to labor is also a balance between current return and long-term growth.But spending on staff isn’t simply a tradeoff with profitability, it is also a tradeoff with growth. Most growth opportunities in the RIA space involve staffing – whether it’s for new initiatives, succession, or further development of the existing business model. Staffing requires spending that may not be immediately accretive to earnings. To the extent that spending on staff is front-loading the costs of opportunities for growth, the margin tradeoff can be rightly characterized as infrastructure spending – building the workforce needed to support more growth and profitability in the years ahead. Most understand the tradeoff, but little has been written about what sort of tradeoff is appropriate.The Rule of 40Elsewhere in the business community, this issue of the tradeoff between growth and margin has been explored thoroughly. In the subscription software industry (SaaS), there is a well-known concept called the Rule of 40. The Rule of 40, or R40, holds that venture investors like to invest in businesses in which the profit margin plus the growth rate adds up to at least 40%.So, if a growing SaaS company shows a profit margin of 30% and a growth rate of 15%, the total margin and growth (30% + 15%) is 45%, exceeding the R40 expectation. Companies with combined growth and margin rates of 50% are top performers and get lots of attention.The R40 function is a shorthand way of determining the strength of a business model, in measuring the degree to which growth requires a tradeoff with profitability (whether through price concessions, marketing, or other customer acquisition costs). If growth plus margin equals more than 40, it indicates a business that can maintain profitability and still expand at better than average levels. Imagine a unique development stage business in a market with lots of upside and little competition – the sort of environment that promotes high growth with the pricing power to maintain substantial margins. On the contrary, a measure below 40 indicates a mature business with few expansion opportunities and increasing competitive threats.Now, which profit margin are we speaking of, and is it unit growth, top-line growth, or profit growth that matters? As with everything, the devil is in the details. But the concept, measuring the aggregate return of growth and margin, has merit in a “growth and income” business like investment management.Is R40 Applicable to RIAs?The most attractive feature of investing in the RIA space is that it generates lots of distributable cash flow and has the market tailwind (recent months notwithstanding) to provide growth. But more margin and more growth is always a better thing. As with SaaS businesses, RIAs that produce more margin and more growth are going to be worth more – ceteris paribus – than those which produce less margin and less growth.What’s a reasonable expectation of “R” for investment management? This is definitely a topic worth further study, but for the time being, let me venture out to offer a few thoughts on using this type of economic thinking to evaluate an RIA’s performance. Established wealth managers commonly produce EBITDA margins in the range of 20% to 30%. So, any measure of the efficacy of an RIA's business model – including evaluating whether it is investing for the long term – should develop an “R” that is in excess of that level. That “excess” metric is growth – but to what extent?Growth from market performance is always welcome, but as we’ve said many times in this blog, organic growth is the key to long term performance. Years like this are a cruel reminder that the market doesn’t always fuel AUM growth, and that a growth minded RIA needs a demonstrable and repeatable strategy to capture new assets. Without real organic growth, clients eventually spend off their assets, pass away, or take their business elsewhere.So, we would look at organic growth. That’s new client assets and additions to existing accounts, net of client terminations and withdrawals. The net growth of AUM, absent any market activity. Organic growth is a question of how quickly one can envision doubling an RIA’s business. 15% organic growth would imply doubling the business every five years. 5% is closer to 15 years. What organic growth rate will your model sustain?R35?If organic growth in the 5% to 15% range can be supported by a 20% to 30% normalized EBITDA margin, the combination of these ranges, or about 35% at the midpoint, suggests that something on the order of R35 is a decent norm to observe – at least in the wealth management space. Totals that far exceed 35% would indicate a more effective business model. RIAs that produce growth plus margin much lower than 25% suggest a comparatively weak model.The Rule of 40 – extended to the RIA space – works pretty well. The higher the “R” (percentage growth plus percentage margin), the better performing the business model – showing less of a tradeoff between margin and growth.We need to develop this idea further, but it’s promising as a diagnostic. R40 works in the SaaS world because the VC community investing in these companies has a cost of capital around 25%. R40 produces approximately the same present value of interim cash flows regardless of the tradeoff between margin and growth, provided they total about 40%. In the RIA space, where WACCs are more in the mid-teens, R35 appears to accomplish a similar parameter.The New GARPGrowth at a reasonable price (margin) is an old concept in investment management, but it bears extending to practice management as well. RIAs are fortunate not to have to spend billions on factories, only to grieve them as “money furnaces” (sorry Elon). But that doesn’t mean RIAs don’t have the same imperative to invest in the people who compose their businesses.

The Importance of a Quality of Earnings Study

This week, we welcome Jay D. Wilson, Jr., CFA, ASA, CBA to the Energy Valuation Insights blog. Jay is a Senior Vice President at Mercer Capital and a member of the firm’s Financial Institutions and Transaction Advisory teams. The post below originally appeared as part of an ongoing series from Mercer Capital’s Transaction Advisory team regarding the importance of quality of earnings studies in transactions for middle market companies.Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).What Is a Quality of Earnings Study?A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.Ongoing earning power is a key component of valuationOngoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring. The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisCustomer AnalysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers' perception of the company and its products.The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situationsThe QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.

An Overview of Auto Finance

Credit Risk, Trends, Used vs. New Vehicle Sales

Auto dealers that sell new vehicles around the country rely on their Finance and Insurance (F&I) departments as an important source of earnings. While top-line revenue in these departments is typically a small portion of a new car dealership’s total revenue mix, these departments have much more favorable margins than their counterparts in the selling division. For used dealers without subsidiary captive finance operations, third-party lenders take a larger role in the financing process and the economics tends to be different than their new vehicle-selling counterparts.In this blog post, we examine the layout and current state of the auto finance industry as well as quotes from public auto executives pertaining to the current financing environment.What Is the Layout of the Auto Finance Industry?The auto finance industry includes establishments that provide financing for both sales and leasing of automobiles. Sales financing establishments are primarily engaged in lending money for the purpose of providing vehicles through a contractual-installment sales agreement, either directly from or through arrangements with auto dealers. Industry participants generate revenue through the interest and fees that are included in the installment payments of borrowers.The auto finance industry includes establishments that provide financing for both sales and leasing of automobiles.There are two major types of auto finance operators: captive finance companies and third-party lenders:Some examples of captive finance companies are Toyota Financial Services, General Motors Financial Company, Honda Financial Services and BMW Group Financial Services. These companies are “captive” to the larger OEM’s leadership and have less decision-making autonomy. The purpose of these captives is to provide the parent company with a substantial source of profit and also limit the company's risk exposure. Captive finance lender loans are typically exclusive to new vehicles.Third-party lenders like Ally Bank, Capital One, Chase, Wells Fargo, and Truist provide insurance and financing to dealerships and their customers that primarily sell used vehicles or new vehicle dealerships without a captive finance subsidiary. Consumers can also decide to use a third-party lender in place of a captive finance company on purchases of new vehicles as well. Banks are not the only entities that participate in the auto lending industry. Credit Unions, Specialty Finance companies and “Buy Here, Pay Here” (BHPH) companies also lend to car buyers. (It is important to note that BHPH companies may hold the consumer’s loan on their balance sheet or sell the loan in the open market. Thus, these companies have attributes of captive finance subsidiaries as well as third-party lenders.) See the graphic below (Source: Piper Sandler) featuring auto finance lenders in different industry classifications. It is easy to see how the different classes of lenders outlined in the graphic above might have different risk tolerances and return targets. For example, the “Buy Here, Pay Here” companies are more likely to lend to subprime borrowers. While these companies have taken scrutiny for charging higher interest rates on said borrowers, they are undoubtedly taking on more risk while demanding a higher return in response. Additionally, the cost of repossessing vehicles is endemic to their operations, not a “normalization” adjustment that one might consider in the valuation of a new vehicle dealership.State of the Auto Finance IndustryExperian releases a “State of the Automotive Finance Market” webinar on a quarterly basis. The information in the most recently released webinar outlines origination, portfolio balances, and delinquency trends observed in the first quarter of 2022. A summary of these trends follows.Origination TrendsOver the last three Q1’s, around 60% of total vehicles financed were used vehicles.Retail volume is down in 2022. Using January as an example, 3.48 million units were financed in 2022 compared to 4.22 million and 3.89 million units in 2020 and 2021 respectively.The market share of total financing has shifted a bit in the past year, with banks and credit unions capturing bigger pieces of the auto finance pie when compared to captives and Buy Here, Pay Here operators. Captives gained some market share following the onset of the Covid-19 pandemic as banks tightened underwriting standards, but banks have recently regained their position.The average credit score by vehicle type has been consistently increasing since the first quarter of 2017 for both new and used vehicles. (Q1 2022: 736 for New and 669 for Used) These scores compare to Q1 2017’s 725 and 644.Prime borrowers (buyers with credit scores between 661-780) made up just over 64% of total financing, while subprime borrowers made up around 17%. The most substantial growth in originations over the past quarter has been with prime borrowers.Despite rising trade-in values, the average amount financed has also been on the rise. The average amount financed and the average monthly payment were $39,450 and $648, respectively in Q1 2022.Portfolio Balances and DelinquencyOverall loan balances grew to $1.37 billion in Q1 2022.Delinquencies have ticked up over the past year. Auto loans that are 30 days delinquent grew from 1.46% of total loans to 1.55%. Auto loans that are 60 days delinquent grew from 0.51% of total loans to 0.59%.Independent, used dealers are seeing the highest rates of delinquency. As discussed above, this is part of the normal course of business for BHPH operators. As prime borrowers are flocking to new car loans and delinquencies on these loans remain low, subprime used car buyers are beginning to show signs of financial stress. Rising sticker prices and monthly payments are the most likely cause of an uptick in delinquencies.Public Auto Executives Chime In – Sonic AutomotiveIn our Q1 Earnings Calls blog, we touched on a theme that came up throughout this quarter’s public auto exec interviews: affordability. Many of the franchised, new vehicle-selling dealers downplayed affordability concerns, which is consistent with what we have seen in the trends outlined above.Heath Byrd, CFO for Sonic Automotive, when asked about new vehicle affordability concerns, said that:“What we’re seeing from a macro perspective is there’s not any material impact to the prime and near prime consumers. […..] Are you starting to see a little bit of degradation in credit and portal in the lower income brackets, which is a very small part of both our franchise as well as our EchoPark consumers? So, what you’re starting to see [is] a little bit on the lower income, but on the upper tier we’re not seeing anything material.”Jeff Dyke, President at Sonic Automotive, echoed these concerns around used vehicle affordability:“The problem is, is that we’re pushing $500 a month payments, and we used to pay $400 a month payments, and it’s too close to the new car pricing. […] You really want your average used vehicle selling price to be one half that of your new vehicle selling price. And in my whole career, it’s always run 50% to 55%, somewhere in there. It’s at 70%. It’s too close to the new vehicle pricing and prices are too high, $500 whatever, $525 a month payment. That’s just not — that’s out of the norm.”With a lack of new vehicle affordability, buyers are increasingly bidding up used vehicles. The explosion of companies like Carvana, Shift, Vroom, etc. has exacerbated used vehicle demand, lifting prices above historical norms, further squeezing subprime buyers.ConclusionRising rates and record levels of inflation may put auto purchases out of reach for some lower income consumers and create hardships for those trying to pay down existing floating rate notes that weren’t locked when interest rates were low. Facing the possibility of a recession and deteriorating credit quality, auto lenders will likely adopt more conservative lending practices and credit portfolios linked to auto loans may trade at steeper discounts to par to recognize the increased risk. While this could impact vehicle sales in the case that would-be buyers are unable to obtain the financing they need, as we’ve seen in the past two years, vehicle demand tends to be pretty inelastic. Ultimately, those focused on prime borrowers seem to be on solid footing for now while lenders with more exposure to subprime borrowers may start to experience more difficulty.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Permian Production Remains Strong

The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. In this post, we take a closer look at the Permian.Production and Activity LevelsEstimated Permian production (on barrels of oil equivalent, or “boe,” basis) increased approximately 11.4% year-over-year through June. This is notably greater than the production increases seen in the Eagle Ford, Bakken and Appalachia (8.0%, 2.2% and 1.9%, respectively). There were 345 rigs in the Permian as of June 10, up 49% from June 4, 2021. The Bakken, Eagle Ford, and Appalachia rig counts were up 131%, 106%, and 34%, respectively, over the same period. In terms of production growth, the Permian has far exceeded the other basins, and Permian production is expected to continue increasing over the next several months based on anticipated increases in the rig count and new-well production per rig. Commodity Prices Continue to RiseOil prices generally rose through the second half of 2021, although they started to decline in mid-Q4. The shale revolution had largely put geopolitics in the back seat as the key driver of commodity prices. However, geopolitics once again came front and center as Russia launched its invasion of Ukraine in late February. Western nations responded with a series of economic sanctions against Russia. Although the sanctions generally included carve-outs for energy exports, issues with financing and insurance, and the exit of Western oil companies and oilfield service providers from Russia resulted in a substantial decline in oil exports from the country. The exclusion of oil from Russia, the third-largest producer of petroleum and other liquids in 2020 according to the U.S. Energy Information Administration, from global markets led to a high degree of volatility in oil prices. WTI front-month futures prices began the latest quarter at ~$99/bbl and were floating around $121/bbl as of mid-June. With no indications of any near-term resolution of the Russian-Ukraine war, and a continued outlook of relatively flat production in the U.S., the upward trajectory of global energy prices has no foreseeable inflection point at the moment. Natural gas prices fluctuated over the past year, albeit with slightly less volatility than oil prices, and have exhibited the same upward trend over the past quarter. Natural gas is becoming more globalized as Europe grapples with replacing imports of Russian gas. In late March, President Biden pledged to boost LNG exports to Europe, which may re-invigorate the advancement of U.S. LNG export terminal projects. Financial PerformanceThe Permian public comp group saw moderately positive stock price performance over the past year (through June 10). The prices of Diamondback Energy and Laredo Petroleum rose 79% and 78%, respectively, and more than the broader E&P sector (as proxied by XOP, which rose 68% during the same period). Pioneer Natural Resources’ stock price rose 66% over the period, and Callon Petroleum rose a relatively tepid 24%.Survey Says Eagle Ford Wells Among Most EconomicAccording to participants of the First Quarter 2022 Dallas Fed Energy Survey (the latest available as of mid-June), wells in the core plays of the Permian are positioned as some of the most economical in the nation. Survey respondents indicated that the average WTI price needed to break even on existing wells in the primary Permian plays was $28/bbl to $29/bbl. This exceeds the average breakeven in the Eagle Ford ($23/bbl) but is still lower than other parts of the U.S. (over $30/bbl). The average breakeven price for new development in the Permian is in the middle of the pack at $50/bbl to $51/bbl, greater than the Eagle Ford’s breakeven ($48/bbl), but notably lower than in other parts of the country ($60/bbl to $69/bbl). ConclusionProduction growth in the Permian continued to exceed growth in the Eagle Ford, Appalachia and Bakken over the past year as the basin remains one of the most economical regions in U.S. energy production. With the surge in commodity prices over the past quarter, it might have been expected that producers would start bringing more rigs online, leading to more production growth than what we saw. However, as upstream companies have signaled, it may not be realistic to expect such increased deployment of capital from public operators in the near future, though private operators may very well move to take advantage of the higher price environment. With greater emphasis on returning cash to shareholders, continued levels of relatively low investment in growth capital may be expected. However, its significantly large contribution to total energy production continues to make the Permian a steady source of growth for overall U.S. oil and gas production.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

Compensation Structures for RIAs: Part II

Last week we introduced our series on compensation structures for RIAs. That post outlined the three basic components of compensation at investment management firms.Three Basic Components of CompensationBase salary/Benefits. This is what an employee receives every two weeks or so. It’s fixed in nature and is paid regardless of firm or employee performance over the short term. On its own, base salary provides little incentive for employees to grow the value of the business over time.Variable Compensation/Bonus. In theory, variable compensation can be tied to any metric the firm chooses. The amount of variable compensation paid to employees varies as a function of the chosen metric(s). Variable compensation is also called at risk compensation because all or part of it can be forfeited if target thresholds are not met. Variable compensation is most often paid out on an annual basis.Equity compensation. Equity incentives serve an important function by aligning the interests of employees with that of the company and its shareholders. While base salary and annual variable compensation serve as shorter term incentives, equity incentives serve to motivate employees to grow the value of the business over a longer time period and play an important role in increasing an employee’s ties to the firm and promoting retention. Last week we focused on variable or bonus compensation, so this post covers the equity component.Equity CompensationIf the other forms of compensation are meant to attract (salary) and retain (bonus) qualified talent, RIA equity is intended to align shareholder and employee interests while rewarding long-term contributions to firm growth and value. This structure inherently blends returns to labor (employee comp) with returns on investment (shareholder distributions) by its very design. It is typically the most complicated and misunderstood component of RIA compensation but can be highly effective when implemented correctly. We often use the following depiction to simplify the distinction between these sources of return: Unfortunately, this distinction between returns to capital and labor becomes blurred when the business is owner-operated like most investment advisory firms: As a result, most investment management firms offer their key employees some form of equity compensation to align their interests with shareholders and incentivize them to continue growing the business. Equity comp can also be a differentiator that allows some RIAs to recruit top talent from other investment management firms that don’t offer any sort of stock consideration to their employees. Equity comp has become more common during the Great Resignation and is part of the reason we’re seeing so much turnover in the industry now.Common Equity-Incentive PlansWhile implementing an equity incentive plan will typically have a dilutive impact on existing shareholders, a properly structured plan will facilitate attracting and retaining the right talent and motivating participating employees to grow the value of the business over time. In that sense, a well-structured equity incentive plan is accretive to existing shareholders, not dilutive.Some of the more common equity-incentive plans are discussed below:Direct Equity Ownership: For most investment management firms, equity is held by senior management. As these executives retire or leave the business, equity is transferred to the firm’s next-generation management. In these cases, the internal market for the company’s shares serves the function of an equity incentive plan by placing equity ownership in the hands of the individuals with the greatest influence on the performance of the company. Direct equity incentive plans are typically the most straightforward way of transferring equity to the next generation but may not be the most practical if the current principals are unable or unwilling to relinquish ownership or control of the business, or if next-generation management is unable or unwilling to purchase equity.Stock Option Grants: Stock option grants give employees the right, but not the obligation, to purchase equity in the company for a specified period of time at a specified exercise price. Typically, the exercise price is equal to the fair market value of the company’s shares as of the grant date, which allows employees receiving the option grants to participate in any appreciation in value over the value at the grant date. Stock option grants may be subject to vesting periods in order to promote employee retention.Synthetic Equity Plans: Under synthetic equity plans, employees receive something that mimics equity ownership from an economic perspective, but typically without the non-economic rights (such as management and voting rights) that accompany direct ownership. Examples of such plans include phantom equity and stock appreciation rights (SARs). Under these plans, a select group of employees (usually senior management) receive payments tied to the company’s stock value at a certain date or dates. In the case of phantom equity plans, the payments can be based on the value of the stock at a certain date (a full value plan) or only the appreciation in value relative to the grant date value (an appreciation only plan). These plans can be highly customizable with respect to dividend participation, vesting schedule, and triggering events for redemption/forfeiture.Profits Interests: RIAs structured as LLCs can issue profits interests, which represent an interest in the future profits or appreciation in value of the firm. Profit interests offer potential tax advantages in that they should not result in taxable income for the recipient when they are granted, and the appreciation in value may be taxed as capital gains rather than ordinary income.ConclusionThere are advantages and disadvantages to each type of plan, and the most appropriate one for your firm will depend on what you and your aspiring owners are trying to accomplish. We’re happy to walk you through this if you need some guidance.

Valuation and M&A Trends in the Auto Dealer Industry

Let the Good Times Roll?

A few weeks ago, Scott Womack sat down with Tony Karabon of DCG Acquisitions to discuss trends in the auto dealer industry. Tony is Managing Director with DCG Acquisitions. Prior to joining DCG, Tony spent 24 years as the Vice President and General Counsel for two large dealership groups.DCG Acquisitions is a national, full-service mergers and acquisitions firm representing buyers and sellers of automobile dealerships. DCG Acquisitions is part of the Dave Cantin Group of Companies along with DCG Capital and DCG Media.What trends do you see with transaction volume and overall multiples paid for auto dealerships?Tony: Transaction activity remains very strong. The volume of dealership sale transactions for 2022 could surpass that seen in 2021 and exceed 400 transactions. Sellers include single-point operators, small and medium-sized groups, and the largest groups, including those that are publicly traded. However, we are also seeing a fair number of first-time buyers. Our firm has an Ownership Accelerator Program which assists first-time buyers in acquiring dealerships. We have had many success stories with the program, so the number of dealership owners might not shrink quite as fast as some are predicting. There is no doubt that larger groups will continue to gain a greater percentage of the dealership market share. Still, dealership ownership is available to entrepreneurs and owning a single dealership can be a very good investment. Implicit in a multiple is risk. There seems to be less risk for dealerships of all brands. Multiples are rising as virtually all brands are doing well. Nissan is recovering, Kia and Hyundai are on a very nice trajectory, and the domestics are doing well. Toyota, Honda, Lexus, Subaru, Audi, Mercedes-Benz, and BMW continue to command high multiples. We look at more than multiples for many reasons, including that the data behind the published multiples is incomplete at best, and multiples are not a perfect science. It is incumbent upon a buyer to consider numerous factors other than multiples. When pricing a dealership, we look at the return on investment, growth and profitability trends for the particular manufacturer, whether real estate is part of the transaction, the amount of leverage in the transaction, the dealership's potential, and many other metrics.The multiple approach as a method to value dealerships will be tested in late 2022 and early 2023.The multiple approach as a method to value dealerships will be tested in late 2022 and early 2023. With 2021 and very likely 2022 representing record profit years for dealers, simply averaging a few years of profits and assigning a multiple may not work if current profits are considered abnormally high. Presumably, as each month passes, the industry should start to resolve the chip and other part shortage issues. Consequently, as vehicle supply ramps up, margins will be reduced along with profits. If the record years 2021 and 2022 and another one or two years of profits are used to arrive at an average profit, the multiple model may be unworkable. By simply including 2021 and 2022 profits in the equation, unless these profits represent a "new normal", the result might be an unrealistic average profit, particularly if lower profits are on the near horizon. And that doesn't even consider the effects inflation, higher interest rates, and increased gas prices will have on profits and consequently on dealership values.Mercer Capital Comment: Mercer Capital's approach to dealership valuation includes the use of published Blue Sky multiples but also incorporates other factors such as ongoing earnings, risk, and growth, among other factors.With regard to multiples and value, do you think the majority of deals, and therefore value paid and implied multiples, reflect strategic control factors in addition to value to a financial buyer?Tony: I think that it is both. There is considerable capital on the sidelines looking for dealership acquisitions. Dealers of all sizes have excess cash and want to deploy it. I have received far more inquiries from dealers concerning what dealerships are available and to help them find additional dealerships to acquire. History has shown that dealerships are good investments, and this is the business dealers know best. However, prices for dealerships are high. Buyers need to justify paying those prices. Certain strategic control factors can, at least in part, provide that justification. Adding a good dealership to one of the buyer's current markets, adding a brand that is a favorite of the buyer, adding a brand that the buyer does not have, or simply providing some diversification can persuade a buyer to pay a higher price, with limits, and we have seen that.History has shown that dealerships are good investments, and this is the business dealers know best.I also think that more buyers are taking a deeper look at the numbers. While the multiple method provides a traditional, easily understood method to price a dealership, the current strong multiples and record profits give buyers a reason to pause. Traditionally, dealerships are priced on past performance. Price is determined by past profits times a multiple that varies by brand, location, dealership size, and other factors. Many other investments are priced based on the expected future performance. When a person buys shares in a publicly traded company, the future, good and bad, is priced into the stock each day, actually constantly. In reality, the buyer of that stock is stating by its decision to purchase, that the stock will do better than the market is suggesting. With higher prices comes more scrutiny of the dealership's past and future performance. We have seen that buyers still expect value for their dollar. Future cash flow, rate of return on the necessary investment, and risk command a greater portion of the discussion.Finally, I have seen a number of groups that own primarily large metro dealerships acquire smaller dealerships in smaller markets, particularly if there are three or four dealerships available in one transaction. These dealerships have long, consistent histories and likely can benefit from the technology, best practices, buying power, and other things that a large group can provide. These dealerships generally have less expensive real estate, better service retention, and a stable workforce. They simply are good investments. Moreover, major metro stores are getting scarcer and those stores can create a bidding war. Buyers are also looking in all parts of the country. The warmer states or "smile" states as we used to call them, being the Southeastern states and all across the South to the West Coast, remain popular, but the Midwest is receiving a lot of attention. The Midwest has many large cities with sizable dealerships.Mercer Capital Comment: The presence of elements of strategic control can partially explain some of the Blue Sky multiples on the higher end of the published ranges for each franchise. Other factors, such as size and location of the dealership, can also impact implied multiples.In buy-sell negotiations, do you see that most deals make adjustments to pre-tax earnings to make them equivalent to FIFO rather than LIFO?Tony: I know some purchasers do analyze the impact of a LIFO recovery on earnings, and it is now top of mind for DCG. I view FIFO/LIFO as a bit of a conundrum. The annual benefits of LIFO are rarely thought about. Still, the recovery of LIFO upon the sale of a dealership or other event that triggers a LIFO recovery are often painful. Typically, for dealers who utilize the method, which are most new car dealers, profits are usually understated each year. That understatement has largely been ignored when valuing a dealership. The amount of understatement annually is not that much in the scheme of things. Recently, we have seen large annual income increases as a result of LIFO recoveries. These recoveries are typically deducted from earnings because these recoveries are abnormal, largely apply to past years, and can be viewed as non-operating at least for evaluating the last two or three years. So, yes, adjustments are made for LIFO recoveries. Mercer Capital Comment: Valuations of auto dealerships are performed for a variety of purposes, including acquisition, gift/estate planning, litigation, and others. While the nature and extent of adjustments to historical earnings may differ depending on the purpose for the valuation, actual buyers and hypothetical buyers focus on ongoing earnings. Those expected earnings should eliminate any non-operating, non-recurring or discretionary items.In your deals and consultations, are you hearing any discussion/concerns about the implications of an agency model for OEMs on either EVs or all vehicles?Tony: Dealers know these are major issues. I think the industry is at the very beginning of what will be a series of discussions, fights, and in some cases, litigation over these proposed changes. The agency model and electric vehicles encompass a multitude of potential issues. There are at least two major aspects to the agency model. One is selling vehicles directly to consumers, typically on the internet, and a second is over-the-air upgrades sold by a manufacturer.The agency model and electric vehicles encompass a multitude of potential issues.Prior to becoming a broker, I was the General Counsel for two large dealership groups for 24 years. The central theme of the various state dealer statutes is to balance or perhaps even protect the dealers from unfair or overreaching activities or treatment by the manufacturers. In a sense, a balance should be struck as manufacturers are much larger than dealers. They control the production and distribution and the like. In order to achieve that balance, manufacturers are generally prohibited from owning dealerships or selling directly to consumers. While some states have made changes to their dealer statutes as a result of the emergence of new manufacturers such as Tesla, it must be noted that Tesla, at least at this point, has no franchised dealers.The future contention will be between the manufacturers who have franchised dealers and their respective dealers and will center on whether a manufacturer is selling a vehicle directly to a consumer. This question is not easily answered and will vary under each state statute. The particular activities of a manufacturer will also affect the discussion. All manufacturers have their own websites with considerable information available. However, does reserving a vehicle, ordering a vehicle, or some similar activity violate any particular state statute? As of today, the final sale transaction is consummated at a dealership, but the manufacturers are pushing hard for that to change.Over-the-air upgrades present another problem. We all appreciate over-the-air upgrades to our cell phones and other devices. These upgrades are often tweaks to improve the performance of the product. With vehicles, a customer could purchase a vehicle without some features such as navigation, working cameras, adaptive cruise control, etc. Suppose a manufacturer, post-delivery, sells these features and options, whether for a certain price or on a subscription basis. Does such activity violate current dealer statutes or adversely impact the manufacturer-dealer relationship? The answer might vary depending on whether the dealers share in the revenue generated from this post-delivery activity by the manufacturers. I also want to make clear that not all dealers are against all of these developments.Electric vehicles present the issues of potentially lower service revenues for dealers and again, direct sales by manufacturers. The lower service revenue for electric vehicles is anticipated because electric vehicles have fewer parts and certainly fewer mechanical or moving parts. It seems like manufacturers are attempting to segregate electric vehicles from their fleets for purposes of selling directly to customers. Other than preferring a direct sales model, I do not see any reason why electric vehicles are not subject to the same direct sales analysis and or criticisms as ICE vehicles, as we discussed earlier.Mercer Capital Comment: In a recent blog, we discussed the over-the-air updates and other issues regarding connected cars.We thank Tony Karabon and DCQ Acquisitions for their insightful perspectives on the auto dealer industry. It will be interesting to see how long the current trends of increased transaction volume, heightened profitability and multiples, and low inventory levels will continue. Will any evolving market conditions such as higher interest rates, inflation, higher gas prices, and the discussion of the agency model begin to impact the industry?To discuss how recent industry trends may affect your dealership's valuation, feel free to reach out to one of Mercer Capital's Auto Dealer team professionals.

M&A in the Permian: Acquisitions Slow as Valuations Grow

Transaction activity in the Permian Basin cooled off this past year, with the transaction count decreasing to 21 deals over the past 12 months, a decline of 6 transactions, or 22%, from the 27 deals that occurred over the prior 12-month period. This level is in line with the 22 transactions that occurred in the 12-month period ended mid-June 2020. It is difficult to interpret the significance with any certainty. On one hand, it could indicate increased trepidation regarding production prospects in the basin. On the other hand, it could simply be a sign that regional E&P operators have started to "right-size" their inventories in the West Texas and Southeast New Mexico basin. Based on the evolving economics of the region, as we will examine further below, the latter case may be closer to the truth.A table detailing E&P transaction activity in the Permian over the last twelve months is shown below. Relative to 2020-2021, the median deal size nearly was $387 million, just 4% lower than the median deal size of $405 million in the prior 12-month period. However, the median acreage purchased over the past year was 21,000 net acres, just over 42% lower than the 36,250 acres among the deals in the previous year. Given the concurrent decrease in acquired acreage and relatively unchanged median transaction price, the median price per net acre was up 16% period-over-period. Looking at acquired production, the median production among transactions over the past year was 5,500 barrel-oil-equivalent per day ("Boepd"), a 39% decrease from the 8,950 Boepd metric from the prior year.Given the relatively unchanged level in the median transaction value in conjunction with a lower median production level, the median transaction value per Boepd, unsurprisingly, jumped 54% from $31,886 in the prior 12-month period to $49,143 in the latest 12-month period. This willingness to pay over 50% more per acre and/or per Boepd suggests that these targets' underlying economics have been, and remain, supportive. However, the marginal costs of these acquisitions may be approaching the perceived marginal returns projected for these properties, as evidenced by the decrease in the transaction count relative to last year.Click here to expand the image above. The approach to the marginal "equilibrium" appears to have been a pretty short runway to land on. Of the 21 transactions completed, 14 occurred from June to December, with the remaining 7 occurring from January 2022 to the present. One metric we analyzed, based on the deal value per production (annualized) per acre, indicates a sharp decline in the "bang for the buck" exhibited by the transactions before and after year-end 2021. As presented below, the median cost per production acre for the 14 transactions from June to December 2021 was $1.072. In contrast, the median metric for the seven transactions from January to June 2022 was $10.762, indicating a 10.0x increase in the cost per production acre.A deeper dive into the details of each transaction would be needed to discern any common causes for this movement, but this could indicate a shift in focus from proven reserves towards unproven acreages. In other words, acquirers may be putting increased value on the potential optionality for greater-but-yet-proven production presented by these targets.Click here to expand the image above.Despite the upward trend in energy prices over the past year, what we are seeing is a likely slowdown in M&A activity in what is generally considered to be the most economical oil and gas basin in the U.S. If the Permian is a bellwether of U.S. production in general, are we likely to see a slowdown in M&A activity in other basins soon? I would venture to say "yes."Earthstone Energy Acquires Bighorn's Permian PortfolioIn late January 2022, Earthstone Energy announced its agreement with Bighorn Permian Resources to acquire its Midland Basins assets for a total consideration of $639 million in cash and 5.7 million shares of Earthstone's Class A common stock (the "Bighorn Acquisition"). The effective date of the Bighorn Acquisition was January 1, 2022, and the deal closed on April 18, 2022. The Bighorn Acquisition included 110,600 net acres (98% operated, 93% WI, 99% HBP), primarily in Reagan and Irion counties, with an estimated production of 42,400 Boepd (57% liquids, 25% oil), and proved reserves of 106 MMBoe (20% oil, 34% NGL, 46% natural gas).Robert Anderson, President, and CEO of Earthstone Energy, commented, "The transformation of Earthstone continues with the announcement of the significant and highly-accretive Bighorn Acquisition. Combining the Bighorn Acquisition with the four acquisitions completed in 2021 and the pending Chisholm Acquisition, we will have more than quadrupled our daily production rate, greatly expanded our Permian Basin acreage footprint and increased our Free Cash Flow generating capacity by many multiples since year-end 2020. The proximity of the Bighorn assets to existing Earthstone operations positions us to create further value by applying our proven operating approach to these assets, primarily in the form of reducing operating costs. The addition of the high cash flow producing assets from Bighorn to the strong drilling inventory of Earthstone, including the Chisholm Acquisition, furthers Earthstone's transformation into a larger scaled, low-cost producer with lower reinvestment in order to maintain combined production levels."Earthstone Energy Acquires Midland Basin Assets from Foreland InvestmentsIn early November 2021, Earthstone Energy announced the completion of its acquisition of privately held operating assets located in the Midland Basin from Foreland Investments LP ("Foreland") and from BCC-Foreland LLC, which held well-bore interests in certain of the producing wells operated by Foreland (collectively, the "Foreland Acquisition"). The aggregate purchase price of the Foreland Acquisition was $73.2 million at signing, consisting of $49.2 million in cash and 2.6 million shares of Earthstone's Class A common stock valued at $24.0 million based on a closing share price of $9.20 on September 30, 2021. The Foreland Acquisition included approximately 10,000 net acres with an estimated production of 4,400 Boepd (26% oil, 52% liquids), and PDP reserves of approximately 13.3 MMBoe (11% oil, 31% NGL, 58% natural gas).Mr. Robert Anderson, President and CEO of Earthstone, commented, "This transaction will be our fourth acquisition this year as we continue to advance our consolidation strategy and enhance our Midland Basin footprint with additional scale. The acquisition of these low operating cost, high margin, producing assets at an attractive valuation is a nice addition to our production and cash flow base. The Bolt-On Acquisition also includes approximately ~10,000 net acres (100% operated; 67% held by production) in Irion County. We expect to benefit from additional operating synergies when production operations are combined with other assets in the area. As we have done in prior acquisitions, we look forward to applying our operating approach to these assets in order to reduce costs and maximize production and cash flows."ConclusionM&A transaction activity in the Permian declined at an increasing rate over the past year, with two-thirds of the 21 transactions occurring in 2021, and the remaining third transpiring in the YTD period ended in mid-June. But the overall upward trend in deal cost per unit (be it per-production level, acreage, or production-acre) indicates buyers' willingness to pay more to achieve their desired asset base. The overall story is one of the companies right-sizing their presence in the basin.We have assisted many clients with various valuation needs in the oil and gas industry in North America and globally. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Compensation Structures for RIAs: Part I

Compensation models are the subject of a significant amount of hand-wringing for RIA principals, and for good reason. Out of all the decisions RIA principals need to make, compensation programs often have the single biggest impact on an RIA's P&L and the financial lives of its employees and shareholders.The effects of an RIA's compensation model are far-reaching, determining not only how compensation is allocated amongst employees, but also how a firm's earnings are split between shareholders and employees, what financial incentives employees have to grow the business, and what financial incentives are available to attract new employees and retain existing employees.Compensation models at RIAs tend to be idiosyncratic, reflecting each firm's business model, ownership, and culture. In an ideal world, these compensation programs evolve purposefully over time in response to changes in the firm's size, profitability, labor market conditions, and various other factors. However, inertia is a powerful force: we often encounter compensation programs that made sense in the past but haven't adapted to serve the firm's changing needs as the business has grown in scale and complexity.Effective compensation programs need to change with the times, and the times have certainly changed. The RIA industry has seen tremendous growth over the last decade. As a result, firms today face increasingly complex compensation decisions that affect a growing list of stakeholders: outside shareholders, multiple generations of management, retiring partners, new partners, possible minority investors, and so on. On top of that, a persistent bull market and the accompanying earnings growth over the preceding decade have made it relatively easy to appease both shareholders and employees. Now, financial market conditions and the state of the labor market have led many RIAs to scrutinize their compensation models more than ever before.Introduction to RIA Compensation ModelsAt the outset, it's important to note what compensation models do and don't do. Compensation models determine how the firm's earnings are allocated; they don't (directly) determine the amount of earnings to be allocated. When it comes to determining who gets what, it's a fixed sum game. The objective of an effective compensation policy is to allocate returns in such a way as to increase this sum over time.Compensation for RIAs are broken down into three basic components, each of which serves different functions with respect to incentivizing, attracting, and retaining employees:Base salary / Benefits. This is what an employee receives every two weeks or so. It's fixed in nature and is paid regardless of firm or employee performance over the short term. On its own, base salary provides little incentive for employees to grow the value of the business over time.Variable Compensation / Bonus. In theory, variable compensation can be tied to any metric the firm chooses. The amount of variable compensation paid to employees varies as a function of the chosen metric(s). Variable compensation is also called at-risk compensation because all or part of it can be forfeited if target thresholds are not met. Variable compensation is most often paid out on an annual basis.Equity compensation. Equity incentives serve an important function by aligning the interests of employees with that of the company and its shareholders. While base salary and annual variable compensation serve as shorter-term incentives, equity incentives serve to motivate employees to grow the value of the business over a longer time period and play an important role in increasing an employee's ties to the firm and promoting retention.Variable CompensationIn this blog post, we focus our attention on the variable compensation component (we'll address the others in subsequent posts).Variable compensation plays an important role in incentivizing employees over the relatively short term (1-3 years). The evidence suggests that such incentives work, too: According to Schwab's 2021 RIA Compensation Report, firms using performance-based incentive pay saw 25% greater AUM growth, 134% greater client growth, 54% greater revenue growth, and 52% greater net asset flows over a five year period than firms without performance-based incentives.What Do You Want to Incentivize?As the name suggests, variable compensation changes as a function of some selected metric, typically revenue, profitability, or some other firm-level metric or individual-level metric, depending on the specific aspects that management intends to incentivize.In our experience, variable compensation pools tied to firm profitability and allocated amongst employees based on a combination of individual responsibilities and performance provide the most effective incentives for most firms to grow the value of the business over time. Such structures tend to work well because linking variable comp to profitability creates a durable compensation mechanism that scales with the business and aligns shareholders' and management's financial and risk management objectives. Variable comp linked to profitability also promotes a cohesive team, rather than the individual silos that can arise out of revenue-based variable comp, which further helps to build the value of the enterprise.In markets like today's, where RIA margins face the dual threat of rising costs and declining AUM, compensation mechanisms that directly link employee pay to firm profitability have the additional benefit of helping to blunt the impact of market conditions on firm profitability. Consider the example below, which shows the impact of a 10% AUM increase and a 10% AUM decrease for a hypothetical firm under two comp programs, one in which all compensation is fixed and the other in which there is a variable bonus pool equal to 20% of pre-bonus profitability.Click here to expand the image above.In this example, both compensation programs result in $4 million in EBITDA and an EBITDA margin of 24.6% in the base case scenario. In the downside scenario, however, the fixed comp structure leads to a high degree of operating leverage. As a result, a 10% drop in AUM leads to a decline in EBITDA of over 40% and a decline in the EBITDA margin to 16.2%. Under the variable comp structure, the variable bonus pool helps to mute the impact of declining AUM. In this example, a 10% decline in AUM results in a 32.5% decrease in EBITDA and a decline in the EBITDA margin to 18.5% under the variable comp program. In the upside scenario, the increase in EBITDA is greater under the fixed comp structure than under the variable comp structure (an increase of 40.6% vs. 32.5%).From a shareholder perspective, a variable compensation program such as the one described above effectively transfers some of the risk borne by equity holders to the firm's employees. In downside scenarios, some of the declines in profitability that would otherwise accrue to shareholders is absorbed by employees. Similarly, some of the increase in profitability is allocated to employees in upside scenarios. The logic of such a compensation program is that employees are incentivized to grow and protect the same metric that shareholders care about—the firm's profitability.ConclusionInvestment management is a talent business, and structuring an effective compensation program that allows the firm to attract, retain, and incentivize talent is critical to an RIA's success. In the coming posts, we'll address additional compensation considerations such as equity compensation options and allocation processes.

May 2022 SAAR

Can Auto Dealers Continue to Outperform OEMs?

The May 2022 SAAR was 12.7 million units down 12.6% from last month and down 24.9% from May 2021. This month’s SAAR did not meet expectations, and the dip in May’s sales pace increases the likelihood that the second quarter of 2022 will not improve on the first quarter’s average SAAR of 14.1 million units. May’s SAAR was low due to limited inventory around the country, which is not news to anyone following vehicle markets over the past year.Vehicle production around the world has been constrained by the lack of manufacturing components available to auto manufacturers. The ongoing invasion of Ukraine, as well as globally lingering COVID-19 related effects, have come together to create a very tough environment for manufacturers to meet the demand for new vehicles (check out our March SAAR blog for insights into Ukraine’s impact on auto manufacturing). While most March and April forecasts reflected the impact of Russia's invasion of Ukraine, updates in May to these projections addressed some additional challenges that have arisen, including a slow recovery in semiconductor supplies, the impact of further COVID lockdowns in China, and the longer-term influence of high raw material prices that put added pressure on new vehicle affordability. In short, May was a month that the production sting was sharp. One example is Toyota, which announced a 10% global production cut in May, citing tightened lockdowns in China.In the U.S., transaction prices remained elevated throughout May, with dealers reporting an average transaction price of $44,832 per vehicle, an all-time May record and up 15.7% from this time last year. Likewise, incentive spending per vehicle has continued to fall, with NADA estimating just $965 per vehicle over the last month. Like new vehicles, trade-ins continue to demand higher values across the country, providing buyers with increased equity in their existing ride to mitigate climbing monthly payments. In May, the average monthly payment on a new vehicle contract was $687, another record high. The Fed’s two rate hikes in the early months of 2022 have not helped the affordability of monthly payments either. J.D. Power reported that the average interest rate on a new vehicle finance contract in May was 4.92%, up 62 basis points from May 2021.Have Higher Interest Rates Hurt Auto Manufacturer Stock Prices?Higher monthly payments on new vehicle financing contracts are not the only impact that rate hikes have had on the auto industry. Domestic manufacturers like the Big 3 (Ford, Stellantis, and GM) have seen their share prices decline, though this drop in market cap was not exclusive to OEMs, as losses were observed throughout the United States economy across many growth-centric industries like technology and data science. The S&P 500 is down 13.3% in 2022 (see chart below). The Nasdaq 100, a technology-heavy index, is down 23.0%. The Dow Jones Industrial Average is also struggling, down 9.5% on the year. An auto manufacturer has not traditionally been considered a “growth company.” In the last decade, that moniker has been reserved for the Apples, Microsofts, and Facebooks of the world. A growth industry is a sector of an economy that experiences a higher-than-average growth rate as compared to other sectors. Growth industries are often new or pioneer industries that did not exist in the past, and their growth is a result of newfound demand for products or services offered by companies in that field. Growth companies may carry large interest-bearing debt balances that finance the research, implementation, and expansion of their products and services. This means that, for a growth company, an increase in the cost of debt could make growth that much more expensive. Tesla (TSLA) is a great example of a growth company. Tesla, which boasts a spot among the highest valuations in auto manufacturing, has benefitted from a changing regulatory environment and the emergence of new electric vehicle technology. From the perspective of Ford, Stellantis, and General Motors, it makes sense to begin investing in similar technologies to cash in on the growth story and unlock higher multiples and valuations, which is exactly what these companies have sought to do. On March 2nd, Ford announced it would boost its spending on electric vehicles to $50 billion through 2026, up from its previously announced $30 billion. In July 2021, Stellantis announced $35.5 billion in investments toward electric vehicles through 2025. Likewise, General Motors released its own plan in 2021 to invest $35 billion through 2025. With the Big 3 committed to significant EV investments over the next five years, there is increased execution risk with delivering vehicles that fulfill the promise of EVs that benefit consumers without representing a trade-off between fuel efficiency and performance. To the extent these investments are financed by debt, the rising cost of financing may drag on profitability. Pushing returns further out into the future also tends to reduce valuations as interest rates rise, as seen in the decline in tech stocks. While the stock price of a public company is subject to exogenous forces outside of the realm of what may impact the valuations of closely-held businesses, the private markets ultimately are impacted by the public markets. See the charts below for a look into the stock prices of Ford, Stellantis, and GM compared to the timing of rate hikes by the Federal Reserve in 2022: OEMs are also likely to see share price declines due to continued production cuts and rising input costs. A decline in the share price does not necessarily affect the company's operations directly, but there are less direct impacts on manufacturers which executives keenly observe. What do lower valuations of OEMs mean for auto dealerships across the country? Over the long-term, OEM executives are not likely to tolerate sluggish shareholder returns while auto dealers are making record profits. While OEMs are down with the market as discussed earlier, it’s important to note that the publicly traded auto dealers are generally worth more than they were to start the year, a sharp contrast. With talks of an agency model growing ever more present, it appears that there will be changes to the current landscape. Hopefully, these changes will benefit all interested parties including OEMs, dealers, and consumers.June 2022 OutlookMercer Capital’s outlook for the June 2022 SAAR is consistent with the status quo. Industry supply chain conditions continue to stagnate. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Long term, it will be interesting to see how the landscape evolves and whether OEMs try to wrestle a greater share of profits from their auto dealer partners. Stay tuned for more updates on next month’s SAAR blog.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership

The Importance of a Quality of Earnings Study

As we’ve been writing in recent blog posts, consolidation efforts in the RIA space are facing multiple headwinds. Among them, market conditions and inflation are motivating buyers to scrutinize profit estimates more than ever. In that light, we thought our readers would appreciate this guest post by our colleague, Jay D. Wilson, Jr., CFA, ASA, CBA, who works with banks and FinTechs. We’re getting more requests for QoE assessments from both the buy-side and sell-side (the latter wanting to buttress their CIMs).Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).What Is a Quality of Earnings Study?A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.Ongoing earning power is a key component of valuationOngoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring. The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisCustomer AnalysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers' perception of the company and its products.The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situationsThe QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of May 12, 2022

June 2022

In this issue: Bond Pain and Perspective on Bank Valuations

Themes from Q1 Earnings Calls

Part 2: Oilfield Service Companies

In a prior post — Themes from Q4 2021 Earnings Calls, Part 3: OFS — we noted common themes from OFS companies’ Q4 earnings calls, including macro headwinds, industry consolidation through M&A activity, and ESG activity.In Themes from Q1 2022 Earnings Calls, Part 1: Upstream, we explored key topics among the upstream segment of the oil & gas industry through the earnings calls of E&P operators and mineral aggregators. These themes included:The future role of U.S. production in the European market as European nations plan to phase out Russian oil & gas;Confidence of continued favorable pricing exhibited through shorter-term deals and unhedged positions;Increasing completion rates in Q1, with expectations of further growth in completions beyond Q1. This week we focus on the key takeaways from the OFS Q1 2022 earnings calls.Short-Cycle Projects to Bolster Near-Term Production Are Those Most Sought AfterOFS companies have highlighted that — as E&P companies remain focused on returning near-term profits to shareholders — their investment efforts are sighted on capitalizing on short-cycle developments, rather than longer-term developments. Amid ESG headwinds and supply chain disruptions, OFS companies have been more commonly tasked with supporting active rigs, supplying marginal equipment, and other services necessary for E&P companies to capitalize on this commodity upcycle.“In addition, I expect an important change in our customers behavior and priorities will provide structural support to oil prices throughout this upcycle. I believe supply dynamics have fundamentally changed due to investor return requirements, public ESG commitments and regulatory pressure, which make it more difficult for operators to commit to long-cycle hydrocarbon investments and instead drive investment flexibility through short-cycle barrels.” – Jeff Miller, Chairman, President & CEO, Halliburton“The shorter cycle [is] catching up, improving the situation around our very, very constrained supply chain challenges [and] meeting sort of the near-term demand of supporting rigs, frac fleets and stimulation equipment…both land and offshore, I think that's kind of the biggest near-term needle mover for NOV.” – Clay Williams, Chairman, President & CEO, NOV“There have been episodic supply chain disruptions with our customers, where we've been on location waiting for another service company to arrive or complete a job, and that's becoming, unfortunately, more frequent. I think that you're seeing a lot of marginal equipment being deployed and you're going to see a lot more marginal equipment being deployed as we pass through the 700 level in the U.S. rig count on the way to maybe just under 800 by year-end.” – Scott Bender, President, CEO & Director, Cactus Shifting Priority to Margin ExpansionThough the demand for oilfield services has particularly revolved around short-cycle projects to support production, executives note that total demand for these products and services has still increased across the board. Amid a plague of supply constraints and a tight market for their products and services, OFS companies have shifted their focus towards increasing margins, rather than gaining market share. Despite a surge in demand, margins face pushback as inflation and rising wages erode the pricing power of OFS companies.“It's probably fair to say that we're entering into a period of potential meaningful margin expansion. And I think that volume expansion in terms of shipments is going to be constrained. And unlike some of our peers, we have the capacity to manage increased volumes. So we could potentially benefit from [this].” – Scott Bender, President, CEO & Director, Cactus“We are seeing increasing demand across all services. And I'd say, particularly on the well servicing side just because for a lot of operators, some of their cheapest incremental barrels are workover barrels. So we are seeing that demand. As Brandon indicated, we're now running 157 rigs and we would expect through the year that, that number starts to kind of trend up.We are being pretty diligent in maintaining margins, but we do think we can deploy additional rigs and maintain margins.” – Stuart Bodden, President & CEO, Ranger Energy ServicesPrivate Companies Have an Increasing Role Within the Customer BaseA recurring theme, as mentioned in previous blog posts, is how private companies have been more active than public companies in ramping up production. As this relates to OFS, Q1 earnings calls have acknowledged that relationships with private operators are of greater importance than in the past. This shift comes in light of capital restraint from public operators. While perspectives differ about the future activity plans of the public E&P companies, OFS company executives commonly recognized increased activity from private operators, due to growth, consolidation, and greater capital freedom.“Our penetration of privates is undeniable. It's going to increase this year because I think the privates are becoming much more sophisticated. They're consolidating. And as they become more sophisticated and larger, then our product becomes far more attractive to them. They're not nearly restrained from a capital perspective. And we're doing our level best to call on those customers with whom it makes economic sense for us to pursue that business.” – Scott Bender, President, CEO & Director, Cactus “Today, as I look at a combination of customer activity and inflation, my outlook has improved, and I now expect North America spending to increase by over 35% this year. With respect to activity, over 60% of the US land rig count sits with private companies and they keep growing, while public E&Ps remain committed to their activity plans. Activity and demand for our services are increasing, both internationally and in North America.” – Jeff Miller, Chairman, President & CEO, Halliburton “As far as mix, I'd say it's twofold. We referred on the call that we are working for larger group of operators and I'd say the preponderance of that increase is probably in the private side ... so I think we will see growth in both sides, but two different dynamics driving this.” – Kyle Ramachandran, CFO & President, Solaris Oilfield Infrastructure Mercer Capital has its finger on the pulse of the minerals market. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the mineral aggregators with working and royalty interests in the underlying production. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.

Private Capital Better Than Public for the RIA Community?

It’s Not Supposed to Work That Way, But…

Last month I received an abrupt reminder of the roots of my career when the latest iteration of Shannon Pratt's "Valuing a Business" landed on my desk. At 1200 pages and weighing in at more than eight pounds, the current installment is the sixth edition of what has been the go-to resource for the business valuation community since Dr. Pratt published the first edition in 1981. Shannon didn't quite live to see VAB6 in print, but he was available to provide guidance and moral support to me and the other four members of the working group who saw the sixth edition through to completion, and I know he would be happy with the outcome.While working on VAB6 often felt like a distraction from my day job, it was a useful discipline to remember how the broader finance community views valuation issues outside of the echo chamber of the RIA community. BV still means "business valuation" to the RIA team at Mercer, but there are also "beyond valuation" moments where we're working on consulting engagements that take us far from our traditional "solve for X" profession. And, leafing through my printed copy of VAB6, I'm reminded of the many times long accepted valuation truths that seem to conflict with observed market behavior.Is Private Capital Better Than Public for the RIA Community?Valuation professionals generally accept that public market capital is cheaper and leads to higher valuations than can be achieved by closely-held businesses. The words and actions of market participants who invest in RIAs do not necessarily align with this belief.In a recent webinar, two heads of prominent private consolidators in the investment management space reflected, indirectly, on this dilemma, noting internal valuations with multiples double that of prominent publicly traded consolidators. One went so far as to say that the public markets weren't "ready" for the RIA consolidator model.Anyone can be accused of "talking their book," but that's not my point. These moguls are in a good position to understand this, and they are far from alone. The past decade has seen the ascent of more than a dozen privately funded acquirers of investment management firms, many of whom have prospered even while their public counterparts languished.The news suggests there is no “multiple-arbitrage” available to buy private RIAs with public funding.Public consolidators appear to be caught in a bind. The recent news that Focus Financial Partners was going to use cash to repurchase up to $200 million in stock (instead of using that same money to buy RIAs) and CI Financial's announcement that they were "slowing" (pausing?) acquisition activity to focus on integration got our attention.The news suggests no "multiple-arbitrage" is available to buy private RIAs with public funding. If the evolution of equity ownership can be described as a never-ending search for cheaper capital, the cheapest capital today is not necessarily from public markets.Why Is This Happening?In the valuation world, we use a simple diagram to illustrate the different financial perspectives of public and private investors. It's known as the "levels of value" chart, and while there are different versions, most generally look something like this:The "Levels of Value" Chart The general concept of the Levels of Value chart is the fair market value of equity securities corresponds to the public (or as-if-freely-traded) cost of capital (market risk, or beta), adjusted for idiosyncratic or non-systemic risks associated with a particular company (alpha). That exercise derives a valuation at the "marketable, minority" interest level of value (think public-share equivalent). Deviations from that anchor point are consequent from factors exogenous to the value of the enterprise. Some acquirers of controlling interests in a business might be able to pay more than the as-if-public price because of issues specific to them – usually operating synergies. Holders of minority interests in closely-held businesses might not be willing or able to pay as-if-freely-traded pricing because of the illiquidity inherent in the shares.PE relies on financial synergies (cheap capital and long time horizons) to fund their ambitionsThis chart is sacramental to the business valuation community, but the reality of the RIA industry suggests it's more of a tautology. Minority interests in RIAs often sell to institutional investors for multiples that rival control stakes, as the minority investors prize alignment with management control. And consolidators of control stakes in RIAs rarely have operating synergies available to pay premium valuations. Instead, PE relies on financial synergies (cheap capital and long time horizons) to fund their ambitions. Those financial synergies are fueling PE's competitive advantage when bidding for RIAs.Is Private Equity's Advantage in the RIA Space Durable?Ironically, recent public market volatility appears to be driving more retail investors to private equity from public markets, reinforcing this inversion of the levels of value chart. Will this last? It's hard to imagine the mass affluent providing a sustainable flow of funds to maintain PE behavior, especially if institutional investors reallocate elsewhere. And PE's current advantage may be their undoing.Private equity may be a permanent middle road between public and private ownership, but it’s still subject to the laws of financial gravity.Entry pricing is, after all, a highly reliable indicator of expected returns. Earning enough to justify premium acquisition multiples requires leverage (financial risk), value-added stewardship (operating risk), superior exit pricing (timing risk), or some combination of the three. Plenty of PE skeptics have already been "early," and they don't need me to pile on. But I was raised to profess that public market returns were the logos, the reference point of finance. Our founder, Chris Mercer, had me tape a Levels of Value chart above my desk when I was a junior analyst. Private equity may be a permanent middle road between public and private ownership, but it's still subject to the laws of financial gravity.In the summer of 2008, the head of a prominent community bank told me he was grateful his bank was closely-held so he could avoid all the unpleasantness going on in the stock market. That perspective wasn't durable.

Q1 2022 Earnings Calls

Large Dealer Groups Continue to Invest in the Franchise Dealer Model, Managing Their Dealerships as Portfolios

There continues to be no end in sight for new vehicle supply constraints. So much so that it's taken as a given, and there was less direct mention of inventory shortages in 2022's first quarter public auto dealer earnings calls. Despite this shift, scarce inventory remains the key theme underpinning the operating environment for auto dealers.Demand continues to exceed supply across all OEMs. For example, Lithia Motors noted it started a month with 13,000 vehicles and ended with 12,000 vehicles but was still able to sell over 24,000 vehicles. We've seen this with our auto dealer clients, and it really brings into focus what Days' Supply consistently under 30 looks like. When dealers are selling nearly double the inventory on their lots, it will take a long time before inventories can build back to pre-COVID levels. And with higher profits for dealers and OEMs, we may not ever reapproach those levels.Even more so than last quarter, there are a couple of interesting nuggets that don't quite fall into themes that were noteworthy. For example, much has been made about the future of electric vehicles and the impact on auto dealers. There have been concerns about a shift towards an agency model and conventional wisdom has been that EVs would generate less service work for dealers. Asbury's VP, Dan Clara, challenged that notion this quarter with the following:"My belief is the propensity or the frequency of [EVs] coming to the shop will be less. But the time in dollars will be greater, not just what they spend, but what we end up charging because of sophistication to work at it. And putting electric aside and not talking about autonomous, there are some technology features in cars today, braking where your car can break with someone in front of you, lane changing, the shifting and learning you. That's all technology that could have bugs in them. So while the cars really get heavy content with technology, not just the battery piece, it allows for more opportunity for things to go wrong. And when you talk about driving a 5,000-pound vehicle at 60 miles an hour down the road, there's a lot of liability in touching those cars. So you've really got to be thoughtful and think about what you're going to do over the [airwaves] that are nice to have and what you're going to do that may have a real liability issue in driving the vehicle."So, while he acknowledges there may be fewer ROs, dealers stand to potentially increase their pricing power for more complex work while also taking market share from less sophisticated body shops. As we've noted before, a significant amount of repair work is not performed by auto dealers at present, which provides an opportunity if the shift in powertrain steers more consumers back to the dealership. Fixed operations have generally improved as vehicle miles traveled increase and people continue to return to the roads. However, a depressed SAAR since 2020 has held back warranty work for many public auto dealers.While the themes presented below touch on M&A and large auto groups seeking to manage their investment in dealerships as a portfolio, Roger Penske discussed the benefits of open point locations, which are amplified in this low inventory environment:"On an open point, they have a plan that says this is the planning potential for a point, let's say, it's 1,500. And what they will do is preload you with those cars when you-- before you open and you get those for about, I think, probably about 90 to maybe 180 days, but then you're on a run rate based on your history. So it works out well. And I think -- after spending $15 million or $20 million on a facility, you certainly need the cars to start the business. I think it's certainly good for future allocation because you continue to meet the requirements of the planning potential and to give you the cars or trucks to be able to meet that early on. So it's up to you to drive it, and then maintain it."Here are the major themes from the Q1 2022 Public Auto Earnings Calls:Theme 1: CarMax kicked off earnings season by attributing a decline in its used car volumes to affordability issues. Affordability became a common question of the franchised dealerships due to this statement, particularly as interest rates rise. While Penske acknowledged that affordability likely had some impact, other companies tended to downplay any concerns."Inflation is never good for the consumer, but clearly, it's going to hit the lower demographic sectors of the market first. And there is such a massive gap and has been such a massive gap for the last 18 months between supply and demand. But first of all, demand would have to come down on new vehicles a long way before it got anywhere close to supply. […] And our core customers, while it may be not ideal, we just don't have data that shows that that we're seeing less activity in our stores yet." – Earl Hesterberg, President and CEO, Group 1 Automotive"What we're seeing from a macro perspective is there's not any material impact to the prime and near prime consumers. Are you starting to see a little bit of degradation in credit and portal in the lower income brackets, which is a very small part of both our franchise as well as our EchoPark consumers? So, that you're starting to see a little bit on the lower income, but on the upper tier that we're not seeing anything material." – Heath Byrd, CFO, Sonic Automotive"And then, there is some affordability issues there which are going to have some impact on margin. But from an overall standpoint, the demand is strong, we're selling into our pipeline from the standpoint of our new car business, and sequentially in our units are up from 101,000 to 114,000. If you look at Q4 to Q1, so we're not seeing it at the moment that we're having any impact negatively at this point. – Roger Penske, Chairman & CEO, Penske Automotive Group"The demand is there. I'd disagree with the comment made a few weeks ago. I don't think that's accurate. There's still plenty of demand. There'll be 37 million to 40 million cars sold in America this year in terms of pre-owned. So, the demand is there. The problem is, is that we're pushing $500 a month payments, and we used to pay $400 a month payments, and it's too close to the new car pricing. […] You really want your average used vehicle selling price to be one half that of your new vehicle selling price. And in my whole career, it's always run 50% to 55%, somewhere in there. It's at 70%. It's too close to the new vehicle pricing and prices are too high, $500 whatever, $525 a month payment. That's just not -- that's out of the norm and that's what's causing someone to maybe think that there's not a demand there. – Jeff Dyke, President, Sonic AutomotiveTheme 2: With the backdrop of framework agreements, large public auto groups are managing their stores as a portfolio, seeking to optimize by brand and geography. When certain OEMs only allow a certain number of stores per auto group, they are more selective about the markets in which they choose to operate their finite number of dealerships."We'll continue to monitor the M&A market as we believe there are potential opportunities that would enhance our already strong dealership portfolio. […] We have the ability through relationships today to go out and purchase another $5 billion if we wanted to today. Our goal is not to grow quickly. Our goal is to grow thoughtfully and be great capital allocators for our shareholders. So I think that the timing, cadence and pace is important. I think the states where you've seen us grow in our thought process of balancing the brands with the right states, you won't see us differ from that and acquisitions going forward will be accretive for us. The one thing I don't think our space gets a lot of look at is portfolio management. What do they buy? What do they sell? What did that do from an accretion standpoint? Not from a top line revenue, but what did that really do to them as a whole? And so I think you'll see us really manage the portfolio well. You'll see more divestitures over time, probably at some point in the future. And you'll certainly see more acquisitions as well. But that's just really maximizing the portfolio to generate the highest returns and create the most stable company for our employees and our shareholders." – David Hult, CEO, Asbury Automotive Group"I think most importantly, we always optimize our network to make sure that it's clean. We bought stores over the years that, that were in groups typically that weren't right for Lithia and it's a matter of divesting those. I believe it was annual run rate of about $90 million were sold in the quarter. And a number of those were assets that we just don't believe were to some extent salable okay and in this environment, everything is kind of salable. So we took advantage of that and divest of those stores. And you'll see, you'll probably see more of that in the next few quarters. You probably have a half a dozen stores that are typically smaller stores may be located in an area where it's not helping our network at all, meaning, it's a duplicate store, secondary store or it's into smaller market where you're utilizing a General Manager talent and you can reposition them in a better and bigger store." – Bryan DeBoer, President and CEO, Lithia Motors"We signed up for framework agreements probably, what, 10 year sago, there were some with some like Honda, Lexus had it, and we've lived with those over time. Now they are getting more active now when you look at BMW and other of these manufacturers are coming in now with probably not as much to try to curtail the growth but more to be sure that the dealerships that you already have are meeting the CSI requirements, and the CI and the market performance. And that's what they're looking at before they would allow you to grow. […] I don't think they're saying no. In fact, if you're a good dealer, and you've got a good track record, they [only] limit you to [a] number in a particular market, so you're not the only dealer in the marketplace. I think other than that, they're very appreciative when we come to them with an opportunity because they know we've got the capital, we've got a track record. We've got a management team that many of them know. And I've seen you've seen the growth just in the public, and they've been approved with big acquisitions. Now in some cases, you might have a market where you have to sell something off. But I think that is easy. I mean we made a move from Lexus in New Jersey to buying the two Lexus stores in Austin, and we had to divest the two to get two more. But obviously, I looked at the Jersey market versus the Austin market, and feel, on a longer-term basis, it would be a better opportunity for the Company." – Roger Penske, Chairman & CEO, Penske Automotive Group"We're in a cyclical business, right? So obviously for me I like the blend that we have in terms of brands. I think it's a really good blend particularly when I think through the plan for the individual OEMs are put in place, because ultimately the product that they are working on today really is going to dictate the success on the new car side of the business going forward. Firstly, I am encouraged by the level of investment has been made. And secondly, it doesn't really change my view on the balance that we have in our portfolio today. I think it just reinforces we have a good balance. – Michael Manley, CEO, AutoNation"It's a timing situation. We were competing to buy LHM. We didn't know who we're competing against and didn't know we were getting the deal. The Stevinson deal […] came together quick. We didn't want to pass on that opportunity not knowing if we're going to get the Miller organization. Then fast forward, we signed Stevinson and then we got the Miller one. So we knew we had an issue because the manufacturer has a limit to how many stores you can own and reach in. So we knew that we would have to sell some stores." – David Hult, CEO, Asbury Automotive GroupTheme 3: The franchise dealer model is alive and well. Multiple companies emphasized vehicle acquisition as the key to performance in used vehicles, and a primary driver is trade-ins when customers purchase new vehicles."We continue to focus on the acquisition of the inventory. We all know that is in used cars, where the return is generated. Close to 85%, 86% of our acquisition is coming through the consumer, whether it is in the form of our leased earnings, trades or buying cars through -- directly from the consumers." – Daniel Clara, SVP and CFO, Asbury Automotive Group"As we all know, success in the used car market is dictated by your ability to manufacture great quality, well priced desirable used cars and this clearly covers key elements of the business, including efficient and effective reconditioning for example, but it all starts fundamentally with your ability to competitively acquire used inventory and with strong consumer demand we continue to focus on our self-sourcing capabilities for used vehicles, which I think further strengthened both our franchise dealerships but also our AutoNation USA businesses." – Michael Manley, CEO, AutoNation"We're a different business than CarMax or Carvana and some of these used car retailers. Because, number one, we've got a large parts and service business, which covers 60% to 70% of our fixed costs. We also have OEMs that we're tied to would give us an area of market that we operate in. And they provide us with all the umbrella advertising to drive customers, both new and used to our stores, and then we have the relationship with the captive finance companies. And then, the lease returns that are coming in give us in the future when the cars are available for additional use. So looking at that, taking that as really a base to work from, we've got a short supply of new cars, which is driving used car prices up. And certainly, our acquisitions have been very tough at the moment when you think of about just looking at CarShop in the U.S., in the UK and the U.S. are our cost of sales up $8,500 [per unit] and the UK is up [$4,400 per unit]. And when you add that on to the existing number, it's really pricing us on the U.S. side, up into almost new car numbers." – Roger Penske, Chairman & CEO, Penske Automotive Group"As a top of funnel, new car dealer that gets to used vehicles coming in on-trade. We're making about $1,900 more on vehicles that come in from consumers than that we buy at auctions or from other dealers and we turn that much faster. So it's a huge advantage that we have […] a pipeline of inventory coming in quickly on the used car side." – Chris Holzshu, EVP & COO and CEO, Lithia MotorsConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

What Can We Make of All This Turnover in the RIA Space?

Some Thoughts on How RIA Principals Can Minimize or Even Capitalize on the Chaos

You’re not the only one dealing with turnover. The pandemic spawned the Great Resignation, and rising inflation means there’s probably a better salary (or signing bonus) out there for anyone that’s looking. The ensuing talent war has created more industry turnover than the end of broker protocol in 2017, and RIA principals are having to invest more time and resources into recruitment and retention than ever before.This trend actually started last year when the RIA industry was relatively healthy. Favorable market conditions and rising AUM levels meant that most investment management firms could easily afford to replenish departing staff members to service a growing revenue base. So far this year, the fixed income and equity markets have reversed course, and most RIAs are suddenly having to deal with declining assets under management and fee income. Add inflationary labor and overhead costs into the mix, and declining margins and profitability seem almost inevitable this year.This doesn’t necessarily have to be all bad for you and your firm. As Petyr ‘Littlefinger’ Baelish once proudly reassured Lord Varys during particularly turbulent times at King’s Landing in Season 3 of Game of Thrones, “Chaos isn’t a pit. Chaos is a ladder.” Fidelity Investments seems to agree and plans to make 28,000 hires in 2021 and 2022 to increase industry dominance as its competitors struggle with thinning margins and a fleeting workforce. James Lowell, editor-in-chief of Fidelity Investor, elaborates, “The discrepancy in the numbers of Fidelity hires suggests a new game is afoot: gaining market share of talent which will, in turn, better enable them to out-compete on service, not just products.”That’s probably easier for a firm like Fidelity which has $11 trillion under management and countless resources at its disposal. There are still ways for smaller RIAs to capitalize on this chaos or at least minimize the damage until normalcy is restored:Increase the payout percentage to leading advisors. In all likelihood, their compensation is falling with AUM and management fees. Increasing their payout will soften the blow and incentivize them to continue growing their book of business and servicing clients. If you don’t, there’s a good chance a competitor will.Offer some sort of equity compensation to key staffers. Our RIA contacts continue to tell us that an increasing number of tenured employees (and sometimes even prospective hires) are asking about ownership or some form of equity consideration as part of their total compensation package. In some cases, their inability to offer equity or a clear path to ownership has led to retention issues since many of their competitors can offer these benefits. Equity ownership is the best way to strengthen employees’ ties with the firm and align their interests with other RIA principals.Don’t offer the same raise to all staffers (in percentage or absolute terms). It’s highly unlikely any RIA’s employees are equally productive and deserving of the same bump in pay. Your revenue is likely declining with the markets, so an across-the-board increase in salary (at currently elevated rates of inflation) will compound the adverse effect on margins and profitability. Varying raises and shifting towards more performance-based forms of compensation should minimize undesired turnover and further declines in profitability.Consider establishing a bonus pool for key employees tied to firm profitability. Many RIAs have established a bonus pool that sets aside a certain percentage of pre-bonus operating income for its management team. This structure will incentivize them to run the business efficiently and maintain profitability when revenue hits.Articulate a plan on how the firm will weather the storm and potentially come out stronger. This probably isn’t the first market downturn that your firm has endured. Your AUM, revenue and earnings are still probably higher than the COVID bear market and almost certainly higher than the last Financial Crisis. The next few months (and maybe even quarters) will likely be rough, but there’s no reason to believe you can’t endure this cycle and be in a better position when the market recovers. Your staff needs to be reminded of that. Many of these suggestions may dampen your distribution or ownership in the short run, but it’s likely a worthy sacrifice to avoid losing key staffers in addition to AUM and management fees. It may not be a ladder, but it’s certainly a lifeline.

Have Reserve Reports Been Relegated To Investor Footnotes?

In the early part of my career, I vividly recall first learning about what was then arguably the most important document that an upstream company produced – the reserve report. Full of pertinent information, the reserve report struck at the heart of an oil and gas company’s economic relevance.The now discontinued Oil and Gas Financial Journal once described reserves as “a measurable value of a company’s worth and a basic measure of its life span.” Thus, understanding the fair market value of a company’s Proven Developed Producing (PDP), Proven Developed Non-Producing (PDNP), and Proven Undeveloped (PUD) reserves was key to understanding the fair market value of the company. Investors and analysts looked to the reserve report before reviewing the financials sometimes.Not these days.Consigned to back pages, footnotes, and appendices, the reserve report’s relevance has waned. Current investor presentations of four Permian-focused oil and gas companies (Pioneer, Centennial, Laredo, and Callon) exemplify this. What I found pertaining to reserve reports continues a years-long trend and was a far cry from what I saw for most of my career. Only one, Laredo, spent any meaningful discourse on their reserve report over the course of a few pages in their investor presentation. They were the smallest company of the group. As for the others: Centennial and Callon spent one whopping page each on their reserves; and the most valuable of them all, Pioneer, showed a single curt reserve figure just in front of their footnotes.Investor presentations are notable in that they represent a company’s current communication to investors, aspiring to highlight some of the most important information investors want to know. Under that argument, management believes investors don’t care to know much about reserve reports.For decades, an oil and gas company (all else being equal) often expected to have an enterprise value somewhat close to their PV-10 calculations in their annual reserve report.Not these days.The table below shows that current Permian valuations don’t track very close to their PV-10 figures at all. Remember, SEC pricing utilized in these PV-10 calculations below were $66.56 per barrel and $3.60 per Mcf. The enterprise values below reflect today’s prices of over $105 per barrel and over $7.50 per Mcf so price volatility is also a big factor considering that reserve reports reflect a snapshot in time, just like values. We also looked at the enterprise value relative to developed and oil reserve mixes. No clear pattern emerged there either. It begs the question: if Pioneer is lapping the others regarding this time-tested metric, why are they currently burying it next to the fine print? As of May 11, 2022 Source: S&P CAPIQ The answer is because investors are focused on other things – namely the types of themes that show up in the big bold print of these investor presentations: returns to shareholders, free cash flow and deleveraging. Looking through that lens, we noticed a clearer picture of why Pioneer is valued so highly. Let’s quickly analyze these other metrics in the table below: As of May 11, 2022 Source: S&P CAPIQ Immediately Pioneer’s dividend yield and Debt/EBITDA ratio stand out on this table. Pioneer is also the only company on this list with an investment grade credit rating. This appears to be what investors notice. It can’t be understated that the return of capital theme is emphasized for the first ten pages of Pioneer’s investor presentation. Laredo, Callon and Centennial all centered their presentations on these themes too, sans the dividend yield that they don’t have. Valuations appear to be driven by: (i) near term cash flows, (ii) returns on capital, (iii) well margins, and (iv) deleveraging. There are other ancillary things that analysts and management teams additionally reference frequently such as: held by production (margin related metric), cost per lateral foot drilled (margin related metric), and inventory (near term cash flow related metric). Reserve reports speak into some of those things, but certainly not all and not comprehensively. Stock prices suggest that investors are less concerned about having 15 years of reserves life, or what a company’s probable and possible reserves could be, but more about how profitable next years’ worth of wells will be. It’s also clear that investors do not want management teams beholden to their bankers for capital but prize the ability to operate more self-sufficiently going forward. It is not that reserve reports are obsolete. They have valuable information, and the core components of value are still found within the walls of a detailed reserve analysis. Reserve reports give investors an idea of the possible production management can reasonably be sure of getting. That’s critically important. It also shows investors what production profiles look like for a company’s current (and perhaps future) wells. It also endeavors to measure near term well drilling and production costs. Bankers still utilize reserve reports as an input to lending decisions (although there has not been much reserve lending happening lately with the deleveraging trend). Most of the elements I touched on above (near term cash flows, returns on capital, well margins) can be dug out of the details of a reserve report. What’s different now is that how production, costs, risk, and growth are analyzed have gotten more nuanced, detailed, and challenging. More layered analytical work needs be done in an increasingly complex, regulated, and integrated global oil and gas market. So, can an investor reliably breeze through a reserve report, look at proven reserves, an SEC pricing deck, and a 10% standardized discount rate to come up with the fair market value of an oil and gas company? Not these days. Originally appeared on Forbes.com.

Smart Connected Cars, OTAs, and Their Impact on Auto Dealers

The Future of Automobiles

Lost in all of the headlines surrounding electric vehicles is another trend that has emerged in automobiles over the last several years: Connected Cars.The presence of connected features transitions the car (or light-weight truck) from just a vehicle getting you from point A to point B to a computer-like device with customizable technology features, making the trip an experience. Just as mobile phones and appliances have gone from single-function devices to smart devices, so have cars.(Why the moniker "connected" cars, and not "smart" cars. With apologies to the discontinued venture between Swatch and Mercedes Benz, the term "smart" car has historically been synonymous with a compact, fuel-efficient design.)In a previous post, we discussed the future of auto dealerships and how they will be affected by inventory shortages and electric vehicles/direct selling.In this post, we examine the size and growth of the connected car segment and discuss the struggle between auto manufacturers/OEMs and auto dealers over servicing these features.Connected Cars and Size of the MarketConnected cars are vehicles with their own connection to the internet, usually through a wireless local area network (WLAN) that enables the vehicle to share data with other devices inside and outside the vehicle.Connected technology features can include satellite-navigation systems with traffic monitoring capabilities and remote features that utilize smartphone apps such as starting the engine, warming or cooling the car, or locking/unlocking the car. In theory, connected cars could also communicate with other smart products opening up a whole new world of possibilities.These features are not without limitations in the current automobile manufacturing environment. As we have discussed on this blog, automobile manufacturers have faced numerous production challenges including COVID-related plant shutdowns and, more recently, shortages of microchips due to supply chain issues. Modern automobiles continue to use more microchips for features such as emergency brakes, back-up cameras, and airbag deployment systems. Not to be overlooked, microchips are also used in connected features such as touchscreens and are present in engines to improve engine efficiency and lower emissions.There were 84 million connected cars on the road in 2021 compared to ~3 million electric cars. And the number of connected cars is estimated to grow to 305 million by 2035.What is the size of the connected car segment and how does that compare to the size of the electric vehicle (EV) market? According to estimates by Hedges Company, there were approximately 286.9 million cars registered in the U.S. in 2020. The figure was expected to climb to 289.5 million by the end of 2021. Most prognosticators estimate that the number of electric vehicles on the road in the U.S. is less than 1% of the total cars, SUVs, and light-duty trucks. Using these figures, total electric vehicles would top out at less than 2,895,000.By contrast, Statista estimates there were 84 million connected cars on the road in the U.S. in 2021. Based on the numbers and despite all of the headlines about electric vehicles, the majority of connected cars would be traditional ICE (internal combustion engine) vehicles. Over the last few years, all major OEMs have been introducing new models with connected features. According to projections by Statista, there will be over 305 million connected vehicles on the road by 2035 in the U.S. alone.Size of the Global Connected Car Fleet in 2021, With a Forecast for 2025, 2030, and 2035, by RegionSource: StatistaThis implies that while EVs are expected to be a growing percentage of future vehicles produced, the vast majority of vehicles being produced today are connected cars.OTAs and Service DepartmentsLike smart phones and smart appliances, the connectivity features of cars can be controlled and updated through a technology referred to as Over the Air updates (OTAs). An OTA is a software improvement or upgrade that is sent from an OEM or industry software company directly to the vehicle through a wireless internet connection.We are all familiar with technology updates sent to our phones that most of us initiate at night so we can wake up to their successful completion and implementation (if we remember to keep them on the charger). With connected features in automobiles, the technology is very similar. OEMs or product manufacturers can deliver updates or communicate directly with these features in times when the software is not working properly.Auto-related OTAs are usually grouped into two broader categories: infotainment and drive control. Infotainment refers to the touchscreen and features that combine information and entertainment to improve the in-vehicle experience. Examples of infotainment include maps/navigation, phone calls, and Bluetooth connection, music, and podcasts. Drive control refers to safety protocols to improve the performance of the vehicle such as system enhancements or corrections to powertrain systems, fuel efficiencies and engine emissions features, and advanced driver assistance systems.This spring, West Virginia became the first state to introduce a bill that would ban auto manufacturers from offering OTA updates directly to vehicle owners – forcing visits to dealerships. Will other states follow?Drive control features are typically less noticeable to the average driver. For perspective, MARKETSANDMARKETS estimates that the size of the global infotainment market is $20.8 billion and is expected to grow to $38.4 billion by 2027, at a compound annual growth rate (CAGR) of 10.8%. Another study by Acumen Research and Consulting estimates the entire global automotive OTA update market will grow by a CAGR of 18.1% through 2028.What are the advantages to OTA updates?Less or no in-person recalls – For software-related issues on connected features, an OTA could eliminate the need to visit the dealer.Cost Savings – Vehicle owners can save time and money without having to visit the dealer, and OTA updates could mean significant savings for automakers in labor costs.Additional Features – With OTA updates, certain features on the vehicle will continually be improved, potentially leading to a slower depreciation rate on aging vehicles.Safety/Compliance – As new legislation and standards are enacted, such as emissions standards or autonomous driving, OTA updates would be able to address changes in a timelier fashion. What are the disadvantages to OTA updates?Fewer visits to auto dealers – What can be an advantage to a vehicle owner can be a disadvantage to an auto dealer. Service departments in traditional auto dealers rely on service visits to assess and recommend other service items in addition to the primary reason for the visit, such as tire rotations, brake repair, oil changes, and other routine and scheduled maintenance. The service department allows the dealer to maintain an ongoing relationship with the customer through these frequent touchpoints. The service department is historically the most profitable department in the dealership in terms of margin. To spin this positively, happier consumers may lead to more brand stickiness for dealers.Cybersecurity – As with all technology and wireless internet connections, OTAs present risks of technology malware and theft or exposure of personal information. Who will seek to capture and monetize the OTA update market? Just as Tesla has been the poster child for innovation and technology in the electric vehicle market, they have also implemented OTA updates as part of their operating strategy and ongoing revenue. Will the traditional OEMs try to monetize and capture some of the market through a subscription model, and will it be at the expense of auto dealers? A few other key players in the automotive OTA updates industry are Airbiquity, Continental AG, Blackberry QNX Software, and Hitachi, among others. We recently attended the Spring Conference of the National Auto Dealer Counsel (NADC), and the topic of OTAs was discussed in a session presented by NADA. Specifically, Andrew Koblenz shared that the OEM's strategy regarding technology revolved around three premises: improving the overall customer experience through such measures as single price selling, driving efficiency and eliminating unneeded costs, and optimizing downstream revenue opportunities through OTAs. Perhaps the "right to repair" battle over OTAs is just beginning to intensify. This spring, West Virginia became the first state to introduce a bill that would ban auto manufacturers from offering OTA updates directly to vehicle owners – forcing visits to dealerships. The provision was later dropped as part of a larger bill. It will be interesting to see if other states will seek to address OTAs or whether OEMs and auto dealers can share the same vision for the increasing number of connected features in automobiles and how these features will be serviced and maintained.ConclusionConnected cars are here to stay. We will continue to monitor the issues presented by connected cars and their impact on auto dealerships. In the meantime, feel free to contact a member of the Mercer Capital auto dealer team today to discuss a valuation issue in confidence. Mercer Capital provides business valuation and financial advisory services, and our auto team assists dealers, their partners, and family members in understanding the value of their business.

Is a Slowdown in RIA M&A Imminent?

RIA M&A activity and multiples have trended upwards for more than a decade now, culminating in new high watermarks for both activity and multiples set late last year. Deal momentum continued strong into the first quarter, but we sense at least initial signs of slowing as the macroeconomic backdrop has deteriorated.What Does the Future Hold for RIA M&A?On CI Financial’s first quarter earnings call last week, CEO Kurt MacAlpine remarked that the company’s acquisition pace has “absolutely slowed down” relative to 2021 as they focus on integrating existing firms and delivering. We suspect that other serial acquirers will follow a similar path as CI this year, particularly in light of rising interest rates and declining fundamentals for existing firms. Add to that the challenges of negotiating a deal when equity markets are swinging as wildly as they have been, and it’s easy to imagine at least a temporary slowdown in the pace of M&A in the coming months.The driving force in recent years has been strong demand and low supply for investment management firmsWill we look back at 2021 as the year RIA transactions peaked, or is the current slowdown merely a blip on the radar amidst a longer-term trend of consolidation and rising valuations? To look forward, it’s helpful to first consider what shaped the RIA transactions landscape over the last decade. In short, the driving force in recent years has been strong demand and low supply for investment management firms. On the demand side, the amount of capital and number of acquirer models has increased rapidly in recent years as investors have sought out the high margins, strong growth profile, and low capital intensity that the fee-based business model offers.At the same time, the number of RIAs in the market for a third party acquirer has remained limited, despite the industry’s often cited lack of succession planning. As the ratio of buyers to sellers has increased, so too have multiples and transaction activity.We don’t see those long-term supply and demand dynamics changing with the current market environment. Certainly, some buyers (like CI) will be sidelined temporarily, but they’re still around. When markets eventually stabilize, it’s more than plausible that transaction activity will return to the long-term trendline.What About Multiples?Supply and demand dynamics have certainly played a role in the rising multiples we’ve seen over the last decade, but the macroeconomic backdrop has added fuel to the fire as well. The era of extremely low interest rates lowered the cost of capital for acquirors and enabled consolidators to finance RIA acquisitions with cheap debt. And a persistent bull market has made it easy for buyers to justify projections that look like something out of a SPAC deck.A persistent bull market has made it easy for buyers to justify projections that look like something out of a SPAC deckSo far this year, margins for RIAs have been attacked on two fronts: falling equity markets eroded the fee base, while high inflation and a tight labor market threatened to drive up personnel costs and other overhead. There’s a lot that goes in to pricing, but it’s safe to say that on many recent transactions, the buyer’s projection model likely looked very different than what’s actually transpired so far this year. While many of these deals may work out in the long term, chances are there are sellers out there who feel they timed things perfectly, and some buyers that feel they’ve been left holding the bag.With the cost of capital for aggregators rising rapidly and the growth outlook for RIAs declining, we expect to see some multiple contraction relative to the high watermarks seen last year. And while private transactions for wealth management firms have historically been priced very differently than public asset/wealth management firms, it’s equally likely that at least some of the decline we’ve seen in the public firms will translate to the private markets.There’s still much uncertainty about the duration of the current market environment and the ultimate impact it will have on RIA performance and transaction activity. As it stands, a near-term slowdown in transaction activity and multiples seems likely, but so too does a return to normal once markets stabilize.

Themes from Q1 2022 Earnings Calls

Part 1: Upstream

In Part 1 (E&P Operators) and Part 2 (Mineral Aggregators) reviews of Q4 Earnings Calls, prevalent themes among the E&P Operator calls included cost inflation, a shifting focus towards liquids, and policy headwinds towards the Oil & Gas industry. Among the mineral aggregators, common themes were capital discipline, flat production growth, and the strength in the position of aggregators amid the highly inflationary environment.This week, we take a holistic upstream perspective on the themes of both the E&P operator and mineral aggregator earnings calls for Q1.The Future Role of U.S. Production in the European MarketRussia invaded Ukraine on February 24, 2022. Global markets blinked, and commodity futures skyrocketed. In the weeks following the invasion, European nations discussed plans to phase out sourcing energy from Russia. With OPEC holding firm on its production plans, attention turned towards the U.S. — the world’s largest hydrocarbon producer and a vocal supporter of sanctions towards Russia. Upstream Oil & Gas companies recognize that their role in supplying European energy markets, and the global market generally will grow.“As the war in Ukraine and the resulting governmental sanctions continue, Russia's oil production is expected to be impacted by shut-ins, natural declines, storage limitations and lower exports, creating a global shortage of oil. Over the next few years, we will need to make up for this lost production, and we believe that the U.S. oil and gas industry is best suited to provide the low-cost environmentally-friendly barrels needed to ensure global energy supply. However, today, we are operating in a constrained environment with inflationary pressures continuing to increase across all facets of our business. Also labor and materials shortages are now present across the supply chain…[an] increase in activity now would result in capital efficiency degradation that would not meaningfully contribute to fixing the global supply and demand imbalance in the oil market today.” – Travis Stice, Chairman and CEO, Diamondback Energy “The reality is that energy markets were already tightening from supply and demand fundamentals before this Russian action, and the risk premium now embedded in commodities, including oil and gas has returned with a vengeance. Even in the unlikely event of a near-term resolution to this crisis, the die has been cast and actions, particularly by European countries are already underway to move away from Russian oil and gas and secure more reliable supply from the Middle East and the U.S. It has underscored the need for an orderly energy transition that includes oil and gas as part of all of the above strategy, and has recalibrated global views as to the current and ongoing role of U.S. oil and gas in the world economy.” – Lee Tillman, Chairman, President and CEO, Marathon Oil“On the supply side, the shift towards maintenance capital plans and supply chain constraints led to moderated global supply growth. Then during the first quarter of 2022, this bullish fundamental backdrop was further strengthened by the geopolitical events in Europe. Unlike prior commodity price spikes, these events had a large impact on the futures curve, where we saw the natural gas strip move up 45% throughout the curve all the way to calendar year 2026. As Europe looks to strengthen its energy security, it has become clear that there will be a significant call on U.S. shale gas in the coming decades.” – Paul Rady, Chairman, President and CEO, Antero Resources“Recent world events have highlighted the global strategic importance of U.S. gas reserves, and we believe the Haynesville shale is the best position play to benefit from continued growth in LNG export volumes over time.” – Tom Carter, Chairman and CEO, Black Stone MineralsConfidence of Continued Favorable PricingIn Part 1 (E&P Operators) of the Q4 earnings call themes, we noted upstream companies’ strong desire to reap the full benefits of the pricing environment. Executives focused on shorter-term deals, unhedged positions, and a more opportunistic approach when it came to derivatives contracts. With fewer hedges in place or shorter-term contracts, operators continue to pursue maximizing their upside from continued price appreciation or a prolonged favorable pricing environment.“We’re happy where we are right now on shorter-term deals, whether it’s selling on the day or on the month. We’re not interested in longer-term supply deals unless we receive significantly higher premiums. There is too much optionality today to get in prematurely. We are virtually unhedged on all commodities in 2023. This attribute will allow us to capture the upside to growing LNG and LPG export demand.” – Paul Rady, Chairman, President and CEO, Antero Resources“As we look to 2023, we have positioned the portfolio with a good base layer of hedges. With strength in the oil and natural gas, we’ll opportunistically add 2023 hedges over the remainder of this year. However, we expect to hedge less volumes, or said another way, a lower percentage of production than we have historically.” – Kevin Haggard, Senior Vice President and CFO, Callon Petroleum“If oil prices were to average $60 for the remainder of the year, Pioneer's shareholders would receive approximately $17 in dividends per share. At $120, approximately $31. Shareholders have significant upside on higher oil prices as we have zero 2022 oil hedges.” – Scott Sheffield, CEO and Director, Pioneer Natural Resources“While the Permian led all of the basins in terms of growth in rig count, we believe strong natural gas prices will compel improved activity in the Haynesville, Marcellus and Mid-Con as we continue through 2022.” – Bob Ravnaas, Chairman and CFO, Kimbell Royalty PartnersCompletions Trending UpUpstream operators commonly noted that their Q1 completion rates increased, with expectations that completions will continue to increase throughout 2022. This is an encouraging sign for aggregate production.“[Regarding] completions, our field team continues to see really good improvements and they’ve increased their overall completed lateral per foot per day by 10% compared to 2021.” – Jeff Leitzell, Executive Vice President-Exploration & Production, EOG Resources“As you mentioned, 11-wells went online earlier, and they are performing above the type curves. We still have six more to turn online, making 23 Eagle Ford for this quarter. And we have even more wells set to come online in the Eagle Ford through third quarter. It is very early, but we’re very excited about the wells coming online earlier and at higher results.” – Molly Smith, Vice President of Drilling and Completions, Murphy Oil“The decrease in oil volumes was primarily a result of lower suspended revenue volumes received in this quarter as compared to last quarter. Our staff successfully worked with producers in the second half of last year to release suspended production volumes across our mineral position… Given the temporary nature of these items and combined with the generally positive industry environment and the ramp up in activity, we expect to see the Haynesville and Austin formation shock through our organic growth programs. We expect that growth trajectory to resume throughout the year.” – Jeff Wood, President and CFO, Black Stone Minerals“Strong commodity prices during the quarter translated into increased activity on our acreage as evidenced by the 20% increase in the rig count actively drilling on our acreage at no cost to us. In addition, line of sight inventory from our major properties increased 6% sequentially to 5.03 net DUCs and permits. This is notable since we only need approximately 4.5 net wells completed each year to keep production flat.” – Bob Ravnaas, Chairman and CFO, Kimbell Royalty Partners “Looking ahead, our net activity well inventory, which represents the combination of our drilled but uncompleted locations, or DUCS, in our permits was 11.7 net locations at the end of the first quarter, our net DUCs and inventory at the end of the first quarter stayed roughly flat versus the fourth quarter, despite our extremely strong aforementioned DUC conversions. We anticipate that PDC, Chevron, Pioneer, Oxy, and Diamondback will convert the majority of our DUC inventory.” – Rob Roosa, CEO, Brigham MineralsConclusionMercer Capital has its finger on the pulse of the minerals market. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the E&P operators and mineral aggregators in the upstream space. For more targeted energy sector analysis to meet your valuation needs, please contact a Mercer Capital Oil & Gas Team member for further assistance.

Case Review: Observations From a Recent Auto Dealer Litigation

A recent Appellate Court decision was released from a case (Thomas A. Buckley v. Grover C. Carlock, Jr. et.al.) that we were directly involved in back in 2019. The case centered around a shareholder oppression issue involving a minority owner of an “ultra-high-line” auto dealership. Mercer Capital was hired by the Defendant to serve as the expert witness.The company at issue, TLC of Franklin, Inc. (“the Company”), was an official auto dealer for Aston Martin, Alfa Romeo, Lotus, Maserati, Rolls-Royce Motorcars and Bentley. The valuation aspect of the case required both experts to determine the fair value of the oppressed shareholder’s 20% interest in the Company as of January 31, 2017.The Appellate Court upheld and affirmed the Trial Court’s determination of value of the 20% interest. A summary of each expert’s valuation opinion and the Court’s conclusion of value is as follows: The nature of the Company’s underlying operations created several valuation challenges in this case. First, the unique set of the brands offered by TLC, that are referred to as “ultra-high-line,” is not as prevalent in auto dealerships across the country. Among the nearly 17,000 auto dealers in the U.S., there are very few that retail the premium brands offered by TLC of Franklin. Because of this, there is little published data on these franchises – from details of their historical profitability to market multiple representations of their value in transactions. The other challenge presented in this case was that the Company’s historical operations did not report consistent profitability during the reviewed period. In this post, we highlight the differences in the assumptions and conclusions of both valuation experts, as well as provide observations regarding some of the commentary provided by the Trial and Appellate Courts in arriving at the ultimate conclusion of value. We also touch on normalization adjustments, valuation methodologies, and the way in which the Court decided its determination of value.Normalization Adjustments to EarningsWhat Are Normalizing Adjustments?It is important in the valuation of an auto dealership to review the company’s financial statements to determine if any normalization adjustments should be made. Normalization adjustments take private company financials and adjust the balance sheet and income statement in order to view the company from the lens of a “public equivalent.” Typical normalizing adjustments to the income statement are made to non-recurring items, as well as discretionary expenses related to current management that would not necessarily be incurred by a hypothetical owner of that business. As mentioned previously, the actual historical operating performance of the Company was inconsistent during the reviewed period. In some years, the Company reported operating losses, making the determination of these adjustments difficult.The Experts’ Application of Normalizing AdjustmentsThe experts disagreed with respect to the magnitude of normalization adjustments, though they agreed such a normalization adjustment would be necessary. For example, after directly identifying several adjustments to earnings, Mercer Capital selected a 1.5% normalization factor of pre-tax earnings-to-revenue based on the Company’s actual operating performance, similarly sized auto dealerships, and our experience valuing luxury and ultra-high-line dealerships. The Plaintiff’s expert determined a normalization factor of 5% of pre-tax earnings-to-revenue based on their experience valuing ultra-high-line dealerships.The Trial Court’s DeterminationThe Trial Court selected a normalization factor of 2.8% - 2.9% of revenue based upon historical data for 2015 and 2016 as published by the National Auto Dealers Association (“NADA”). Specifically, the Court cited annual historical profitability for “Luxury” and “Import” brands noting they were the best comparison to TLC of Franklin. Until October 2021, NADA published monthly profitability data referred to as Dealership Financial Profiles for categories of auto dealerships, including average, domestic, import, mass market, and luxury, and the Trial Court relied heavily on this data.The Use of Industry Comparable DataThe use of comparable data to compare a subject company to industry averages can be important to the valuation process. While NADADealership Financial Profiles is more specific than general industry profitability data, such as the Annual Statement Studies provided by the Risk Management Association (“RMA”), no single comparison is perfect, and appraisers should be careful in applying average percentages to their subject company.The use of comparable data to compare a subject company to industry averages can be important to the valuation process.TLC’s ultra-high-line brands were not included in the descriptions of the NADA Dealership Financial Profiles classifications, even among luxury dealerships, despite connoting a similar type of consumer. In reality, the representative average data in these studies is comprised of many dealers performing at higher or lower levels than the ultimate average. A rigid comparison to the average could potentially ignore the fact that the subject company has been performing below average since its operation or in recent history.The other caution against a rigid normalization adjustment to an industry benchmark is the implied level of the resulting adjustment. In other words, by normalizing a company to a certain % of pre-tax earnings, what is the resulting dollar amount of the adjustment? Take, for example, a company with revenues of $35 million. To normalize earnings to a 5% pre-tax earnings level would imply that there are $1,750,000 of expenses to be normalized or added back.The Plaintiff’s expert offered no evidence or specific expenses that would rise to that level in their review of the historical financial statements. Mercer Capital determined several normalization adjustments to earnings after reviewing the Company’s financial statements and discussions with management before making an overall normalization adjustment of 1.5% of earnings based on our experience with similar dealerships to TLC.Valuation Methodologies UsedIncome ApproachThe income approach is a general way of determining the value indication of a business or ownership interest using one or more methods that convert anticipated economic benefits into a single present amount. The income approach allows for the consideration of characteristics specific to the subject business, such as anticipated earnings, level of risk, and growth prospects relative to the market.Mercer Capital ultimately determined the value of the subject interest through the use of a capitalization of earnings method. Historical earnings were adjusted through a combination of direct normalization adjustments and an industry adjustment to 1.5% of revenues. The resulting value under the income approach represents the overall value of the dealership, both tangible and intangible. The difference between the overall value of the dealership under the income approach and the value of the dealership’s net tangible assets represents the implied value of the dealership’s intangible or Blue Sky value. Therefore, Mercer Capital’s income approach included and quantified the Blue Sky value of TLC.The application of the income approach assumes that the company possesses the appropriate level of assets and liabilities to produce the level of anticipated earnings in the income approach. Only non-operating or excess assets are added to the value determined under the income approach. For example, some dealerships carry much more cash than needed for operations before eventually distributing it to owners. In such cases, the excess cash is added back on top of the indication of value under the income approach.Mercer Capital did not identify any non-operating or excess assets owned by TLC. Therefore, no assets were added to our conclusion of value under this approach.The Plaintiff’s expert did not employ an income approach in his determination of value.Market Approach – Recent TransactionsOne method under the market approach is to examine any transactions within the subject company's stock. Appraisers will often examine whether any transactions have occurred, when they occurred, and at what terms they occurred. There is no magic number, but as with most statistics and data points, more transactions closer to the date of valuation can often be considered better indicators of value than fewer transactions further from the date of valuation.Three transactions occurred within the stock of TLC in the three to five years prior to the date of valuation. A summary of those transactions and their indicated equity values are as follows: The Plaintiff’s expert used the internal transactions as one of his three valuation methods but only relied upon the first and third transaction in the figure above. All three transactions occurred in relatively similar proximity but obviously indicated materially different implications of overall value. Ironically, the second transaction that the expert excluded involved the plaintiff’s buy-in to the company. The third transaction involved a minority sale to a celebrity, and no evidence was provided as to the motivations of the buyer and seller in that transaction or whether any financial information or due diligence was performed by the buyer. As such, it may be reasonable to consider this transaction less reliable as an indication of value than the other two. The first transaction was for a 75% interest, which represents a controlling interest basis, which is a different level of value than the other two transactions. Since the subject interest is non-controlling, the level of value would be more comparable to the last two transactions in the table above.Motivations of buyer and seller in internal transactions can be critical to their consideration in the overall valuation process.Motivations of buyer and seller in internal transactions can be critical to their consideration in the overall valuation process. Motivations may not always be known, but it’s important for the financial expert to try to obtain that information. Suppose there have been multiple internal transactions, such as with TLC of Franklin. In that case, appraisers must determine the appropriateness of which transactions to include or exclude in their determination of value possibly. Without an understanding of the motivation of the parties and specific facts of the transactions, it becomes trickier to include some, but exclude others. The more logical conclusion would be to consider all of the transactions or exclude all of the transactions with a stated explanation.The Trial Court was critical of the Plaintiff’s expert’s exclusion of transaction #2 and noted the material impact it would have on concluded values.Mercer Capital observed the internal transactions of TLC but did not place any reliance on this method.Market Approach – Blue Sky MethodUnder the market approach, the Blue Sky method determines value by applying a brand-specific multiple to pre-tax earnings. This method estimates the intangible value or franchise rights of the specific brands they retail.Blue sky multiples are published quarterly by two sell-side advisory firms in the auto dealership industry: Haig Partners and Kerrigan Advisors. Specific multiples are calculated and presented for each represented brand by quarter based on observed transactions. It should be noted that neither Haig nor Kerrigan publishes any multiples for ultra-high-line dealerships or any of the brands retailed by TLC.The Plaintiff’s expert concluded a Blue Sky multiple of 8x based on reported multiples for luxury brands and applied that multiple to two different income streams. First, he applied the Blue Sky multiple to normalized earnings based on his 5% pre-tax figure described previously. Secondly, he applied the Blue Sky multiple to projected earnings based on figures from a management presentation.The Trial Court was especially critical of the use of projections for TLC since it was not a start-up entity. Projections are rarely used in the valuation of auto dealerships. It should also be noted that no evidence was provided as to where the management projections came from, who produced them, and for what purpose. Blind or rigid reliance on management forecasts should be avoided especially if they are not discussed with management. Projections should be viewed with caution, especially in instances where projected results greatly exceed historical operating results or if the company has historically performed below previous projections or budgets. If projections must be used, appraisers typically account for this by using more conservative multiples to balance these lofty projected earnings.To these approaches, the Plaintiff’s expert added back the net tangible assets of TLC since these methods estimate the intangible value or franchise rights of the brands represented by the dealership.Mercer Capital did not rely on a direct Blue Sky method to value TLC since no published multiples exist for the brands represented by TLC. When applicable, we employ the use of a similar methodology to value dealerships in conjunction with or to support the valuation determined under another method, such as the income approach. The transaction multiples reported by Haig and Kerrigan are derived from negotiations between buyers and sellers. The ultimate consideration paid is determined by the buyer’s assessment of expected cash flows, the growth potential of those cash flows, and the anticipated rate of return. The multiple reflects the price paid in relation to a financial metric, in this case pre-tax earnings.Courts’ Determination of ValueThe Trial Court ultimately determined value through several calculations. The Court utilized the profitability data provided by the NADA Dealership Financial Profiles for luxury and import dealerships for 2015 and 2016 and applied profitability factors of 2.9% and 2.8% to TLC’s historical revenue for those years.The Court concluded the use of an 8x multiple or factor to normalized pre-tax earnings to estimate value for TLC. The Court’s final conclusion of value for the subject 20% interest was $1,745,500. This conclusion included an average of those four calculations along with half of the adjusted net assets to reflect the inclusion of market and income methods. The Appellate Court affirmed the concluded value and methodology used by the Trial Court in this case.ConclusionAs evidenced by this litigation case, the valuation of auto dealerships can be very challenging and complex. The subject company, in this case, provided additional challenges given the unique specialty of the brands that they retail, combined with their inconsistent and lack of historical profitability.Mercer Capital provides valuation services to auto dealers and their advisors all over the country for litigation and non-litigation purposes. Contact a Mercer Capital professional today to learn more about the value of your dealership or if we can assist you in a litigation issue involving the value of your dealership.

April 2022 SAAR

The April 2022 SAAR was 14.3 million units, up 6.5% from 13.4 million in March but down 21.9% from the recent high April 2021 SAAR of 18.3 million units. The last three April SAAR figures (’20, ’21, and ’22) are interesting to compare to one another, as dynamic conditions resulted in three very different narratives surrounding the SAAR.In April 2020, the COVID-19 pandemic had taken its grip on the world economy, stifling the demand for vehicles as economic uncertainty pushed consumers to hold off on vehicle purchases. This pause in activity kept potential buyers off dealer lots despite adequate inventory levels across the entire industry. Cooled conditions resulted in very low sales and a relatively high inventory to sales ratio (3.93) compared to the all-time high of 4.64 in January 2009. It may be hard for some to remember, but dealers were turning as much inventory as they could even at lower GPUs in order to shore up their cash position.In April 2021, demand had more than recovered. Pent up demand from the pandemic was showing its face, resulting in the highest ever recorded level of April raw sales. Inventory balances would have been considered healthy but declining due to strong demand. Sales outpaced the rate of OEM vehicle production.In the current environment, the tables have now completely turned from the observed conditions in April 2020. Demand has continued to stay strong, but historically low balances of inventory have restricted raw sales numbers well below what was observed in April 2021. While there may be some signs or reasons to expect some pullback in demand, it is still overwhelming when compared to historically constrained supply.Thomas King, president of the data and analytics division at J.D. Power shared his takeaways from April: “The April sales pace may look disappointing compared with April 2021, but last April’s record sales pace was enabled by the combination of extremely strong consumer demand and enough inventory (nearly 1.7 million units) to turn that demand into actual sales. This April, demand remains strong, but with fewer than 900,000 units in inventory at dealerships, sales volumes will necessarily be well below year ago levels.” As the last three Aprils have shown us, striking a balance between the number of available vehicles on dealer lots and the demand that exists in the market has been difficult over the last two years and will likely continue to be difficult until the supply/demand dynamics of the auto market align more closely. During the valuation process of several engagements, many of our auto dealer clients have spoken about the sales pace on their lots compared to their limited stock of vehicles. We are seeing that most of these dealerships ended April with just about the same inventory balance as the start of the month while selling at almost a 1:1 relationship between inventory-in and inventory-out. This is due to a high number of pre-order sales, which brings lot-time for these vehicles close to essentially zero days. It is truly impressive that dealers can sell more vehicles in a month than they had sitting on their lots at the start of the month. A sign of the times.Keeping with the trend over the last year, year-over-year growth in profits has been observed as high as 20%, hammering home the fact that dealers continue to thrive in this high price environment. Many consumers may balk at transaction prices that continue to run up the charts, but it is worth noting that the demand for vehicles has seemed much less elastic (sensitive to price changes) than many previously thought. Speaking of transaction prices, the industry average remained elevated at $45,232 per unit, up 18.7% from this time last year and an April record. The all-time record was set last December and there have only been small incremental changes up and down since then.High transaction prices have come alongside decreasing incentive spending per vehicle. April’s incentive spending per unit came in at $1,034, an all-time low. See below for a comparison of the last seven April’s incentive spending per unit: The cost of financing a vehicle has also worsened for consumers as rising interest rates have pushed monthly payments up to an April high of $685. The Federal Reserve, after already having introduced a rate hike in the first quarter of 2021, opted to raise rates by half a percentage point on May 4. This increase is twice the size of a typical rate hike due to the Fed’s aggressive strategy against inflation. The Fed has also announced that it expects to raise rates further over the summer.Despite interest rates adding fuel to the fire, monthly payments are only up 15.6% from this time last year while transaction prices have increased 18.7% over the same period. This can be attributed to longer terms on loans, as 72 and 84 month terms become more commonplace. Lower and middle-income buyers will have to weigh the rising costs of financing a vehicle as affordability challenges limit the options that these buyers have available.May 2022 OutlookMercer Capital’s outlook for the May 2022 SAAR is consistent with the last several months. Industry supply chain conditions continue to stagnate. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Stay tuned for more updates on next month’s SAAR blog.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value.

Investment Management Confronts Stagflation and More

Malaise, Anyone?

Last week my colleague, Brooks Hamner, took us down the rabbit hole of the impact of higher interest rates on valuation in the RIA space. With the expansion of acquisition multiples over the past few years, it’s a healthy reminder that very low interest rates helped fuel those higher prices, and that cheap debt is a two-way street.There’s more to the story, but, unlike most things in finance, the other economic factors that accompany higher interest rates exacerbate the negative impact on RIAs, rather than mitigating them. The Fed is raising rates, after all, because inflation is higher. Investment management is a labor-intensive business and has an expense base that is, therefore, highly sensitive to inflation. Further, higher interest rates don’t just hit RIA valuation multiples – they also impact the valuations of the very securities that RIAs charge fees against to derive revenue.If you haven’t already (I imagine many of you have), this is an excellent time to stress-test your financial condition to see what impact weakened markets, higher inflation, and rising interest rates will have on your firm.Base Case: Successful Wealth ManagerAssume a successful wealth management firm with $5 billion in AUM that generates fee revenue at a blended rate of 75 basis points. On the expense side, salaries run about $15 million which, at 40% of revenue, is within norms. Variable – or bonus – compensation runs 20% of pre-bonus EBITDA, after consideration of non-personnel related expenses which total 20% of revenue. The net result of this is an EBITDA margin of 32% - very healthy for the sector. With strong margins and a variable compensation structure that buffers some of the impact of changes in profitability, this is the profile of a firm designed to weather most RIA operating environments.Base Case Plus DebtNow, let’s take our sample firm case one step further, and assume that part of this wealth manager’s business was acquired in recent years in leveraged purchases using covenant-light financing from a non-bank lender. Acquisition debt outstanding is $30 million, amortizing over 15 years at a base rate plus 550 basis points, or (until recently) 5.75%. This computes to annual debt service of about $3.0 million.Under the circumstances described in our base case, debt is well within conventional covenants, with debt to EBITDA of 2.5x and debt service coverage (EBITDA to debt service) of nearly 4x.Threat 1: Impact of Bear MarketAs I write this, major U.S. equity indices are down between 15% and 25%. Normally, a wealth manager could expect falling equity markets to be offset by a flight to quality. That market rotation would increase bond prices, or at enable help them to hold steady and offset the impact on AUM from falling stocks. As we all know too well, debt markets haven’t offered any shelter from the equity storm this year, such that it’s difficult to assume much help from fixed income to mitigate the downturn in equity markets. Higher rates appear to be repricing different classes in such a way that we’re seeing more correlation than usual – certainly more than we would prefer.A 20% drawdown in AUM has a corresponding impact on our sample firm’s revenue, but the only expense offset is to bonus compensation. With this one change, our sample firm’s EBITDA margin declines to 17.5%, and the leverage ratio doubles.Threat 2: InflationInterest rates are rising because inflation is well above the Fed’s target. Lots of expenses borne by RIAs are subject to inflation. The biggest expense for a wealth manager is, of course, labor – and especially so in this market because talent is scarce. The RIA industry may actually be experiencing negative unemployment, as the demand for skilled staff from client-facing to compliance positions exceeds the number of people employed in the industry. Peruse your LinkedIn and you’ll see investment management talent playing musical chairs, all of which threatens to increase costs for everyone at something exceeding inflation. In major markets, non-staff costs like rent are back on the rise, and other costs from tech to insurance are at least keeping pace.If we increase fixed costs at 10%, overall expenses grow considerably. Again, because of the hit to profitability, bonus compensation drops – at least in theory. Cuts in variable comp may prompt staff to look elsewhere, increasing talent replenishment costs and reducing the function of profit-sharing schemes in cushioning the blow of lower margins.Couple inflation with the drawdown in markets, and the EBITDA margin is cut even further. At this point, leverage ratios are beyond compliance levels even for non-bank lenders, and our sample company is at risk of not being able to service its debt.Threat 3: Higher Interest RatesIf EBITDA drops when interest rates are increasing, what does that do to our sample firm’s ability to service their debt. Well…it doesn’t help. If interest rates increase by 300 basis points, which seems to increasingly be the consensus, our highly diminished EBITDA barely covers principal and interest payments.Efforts to stave off default mostly include restructuring debt into longer amortization terms and cutting owner compensation. My stepfather often told me that you can always tell which one of a banker’s eyes is glass: it’s the one that shows sympathy.What About You?This illustration is overly simplistic, but useful nonetheless. Consider what this means for your own firm. If you’re interested, shoot me an email and I’ll send you the excel file behind this post that you can use to build your own stress test. Or hire us and we’ll do a more elegant version using your particular circumstances.I was reminded this week of a few comforting words from noted British economist Elroy Dimson: “Risk means more things can happen than will happen.” Given the possibilities I’ve presented here of things that can happen, we can all hope that other things will happen. Dimson probably didn’t intend to be quoted on this matter in the spirit of optimism, but right now it sounds better than President Jimmy Carter’s description of similar times: malaise.

May 2022

In this issue: Specialty Finance Acquisitions

U.S. LNG Exports

Part I: The Current State of U.S. LNG Export Terminal Facilities and Projected Export Capacity

Up To This Point…From 2010 to 2021, the Federal Energy Regulatory Commission (“FERC”) received approximately145 long-term applications for export facilities seeking to export liquified natural gas to countries both with and without free-trade agreements (“FTA”) with the U.S. Of these 145 applications, 93 (or 64%) have been approved, with approximately 80% of the approved applications coming from submissions made from 2011 through 2016.Up to this point, we have seen applications either submitted or reasonably anticipated to be submitted for approximately 25 export facilities. To be clear, a significant portion of these applications pertain to capacity expansions to either existing or proposed export terminals where the initial application for a proposed facility was approved, and another application for expanded output volume was later submitted prior to the actual construction of the facility. Additionally, there are separate applications for exporting to FTA and non-FTA countries; if a facility seeks to export to both types, there is one application for the FTA markets and one for the non-FTA markets. In other words, 145 applications received do not directly translate to 145 LNG export facilities. The number of submitted applications dropped in 2017 and has since remained far below the annual numbers seen in 2011 through 2016. This was primarily caused by the massive decline in LNG export prices starting in Q1 of 2015. The subsequent decline in the applications submitted, which was not very evident until 2016, was not as steep. This was most likely due to project sponsors either hedging against sustained lowered natural gas export prices, or playing into the sunk cost fallacy of submitting an application after already having expended the time and resources necessary to prepare it in the first place. Further expanding on the element of LNG export prices, the following chart presents the monthly prices of LNG exports from January 2005 through January 2022, with annual 2010-2016 average prices also presented over the time period. In light of the clear increase in LNG export prices during mid to late 2021, it may be slightly surprising that the number of applications in 2021 and in 2022 (so far) has not picked back up. However, a prior Energy Valuation Insights post noted that there were massive pullbacks in 2020 and 2021 capital expenditures throughout the oil and gas sector. Real growth projections for projected capital outlays in 2022 are modest as upstream operators remain focused on returning capital to shareholders, paired with maintenance level capital expenditures that will keep overall oil and gas production relatively flat or modestly higher. In addition, there are a number of outstanding final investment decisions (“FIDs”) to be made regarding the construction start for proposed facilities that have already received FERC approval. There are drilled but uncompleted (“DUC”) wells in the field – wells that are queued up to be put into action. Similarly, one may think of FERC-approved export terminal projects with outstanding FIDs as, “ready to roll”, relatively speaking, as compared to LNG export projects that still need regulatory approval. Approved LNG export terminal projects loom over potential new projects that may or would otherwise pursue FERC approval. In essence, the U.S. LNG export terminal market is relatively saturated with projects that could be started and put into operation fairly quickly as compared to new entrants still in the pre-application or pre-approval stages of project development. The development of already-approved projects would increase the capacity to supply global demand for U.S. LNG exports. This would likely tank the underlying economics supporting any new (yet-to-be-approved and pre-FID) projects; and not by virtue of poor planning on the part of project sponsors at the micro level or weak energy prices at the macro level, but rather due to the total timing of the approval process, an affirmative FID, and the construction and commissioning phases of project development. They would be showing up to register for the race right as everyone else was already taking off from the starting line. On that front, it’s worth taking a look at existing export capacity, total FERC-approved export capacity, and how that capacity may satisfy the demand for U.S. LNG exports. The Current State of AffairsHistorically, the U.S. has exported LNG to European markets, East Asian markets, and other markets, including within South America, the Caribbean, and within the past six years to parts of the Middle East, including Egypt, Israel, Jordan, and even Kuwait and the U.A.E. As presented in the following two charts, growth in export volumes to the Asian and European markets has far outpaced export volumes to the other markets. On a forward looking basis, projections of global natural trade by the EIA in its International Energy Outlook 2021 report indicate a natural gas deficit may be the norm over the next 30 years. (Negative values represent net exporters, with positive values representing net importers.) As it stands, total U.S. LNG export capacity is projected to grow approximately 13% from 14.0 Bcf/d at year-end 2021 to 15.9 Bcf/d by year-end 2022. LNG export volume at year-end 2021 was 9.8 Bcf/d (or 70% of capacity) and is projected to increase 17% to 11.5 Bcf/d by year-end 2022 (or 72% of projected export capacity). Regarding the export terminals themselves, eight were operational at year-end 2021, with one additional facility (Venture Global Calcasieu Pass) expected to be operational and delivering cargo by year-end 2022.Beyond 2022, export volume capacity is anticipated to increase rather sharply, reaching 38.5 Bcf/d (nearly 145% from year-end 2022) in 2027, indicating a compound annual growth rate of approximately 19% in export volume capacity over the prospective five-year period. These projected volumes only consider the 18 export facilities for which the project sponsors have provided an anticipated date of the projects’ operational status; they do not consider the incremental volumes stemming from a new terminals or capacity expansion projects for which it is unclear as to when the additional export capacity might come online. Clearly, the export capacity of U.S. LNG is primed to take off. But take off to where?As we saw in the chart above concerning global natural gas trade projections, with the U.S. presented clearly as a net exporter of natural gas, export volumes are anticipated to rise quickly to just over 18 Bcf/d by 2030, then slowly tick up annually, topping out at around 20 Bcf/d in 2045-2050.To put this in better context, the following chart summarizes the projected export capacity by region and year of anticipated operational status, as well as the projected annual LNG export volumes through 2031. Further detail regarding the export terminal facility and capacity expansion projects are provided in Appendices A and B. Based on the eye-ball test, it’s pretty clear that projected export capacity could far outstrip demand for U.S. LNG, based on the EIA’s export projections (as of early 2021), only if all that capacity were to come online. Free Market Economics 101 theory would indicate, rather decisively, that such excessive capacity would clearly not be worth building out given the export volumes projected as of early 2021. Then, on February 24, 2022, Russia – the largest supplier of LNG to Europe – invaded Ukraine. In Part 2 of our analysis on U.S. LNG Exports, we will take a closer look at the destination markets of U.S. LNG export cargoes, with a particular focus on Europe and its move away from Russian natural gas, and the commitment by the U.S. to help mitigate that transition while balancing its policies and goals aimed at addressing climate change. We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed. Appendix A – U.S. LNG Terminals – Existing, Approved Not Yet Built, and ProposedClick here to expand the chart aboveAppendix B – U.S. LNG Terminals – Existing, Approved Not Yet Built, and ProposedClick Here to Read Part 2 of This SeriesIn part 2 we take a closer look at the destination markets of U.S. LNG export cargoes, with a particular focus on Europe and its move away from Russian natural gas, and the commitment by the U.S. to help mitigate that transition while balancing its policies and goals aimed at addressing climate change.

Statutory Fair Value vs Fair Market Value (and Fair Value): Not So Subtle Differences

Over the past year we have seen an uptick in transactions (and contemplated transactions) in which boards seek to reduce the number of shareholders via reverse stock splits and cash out mergers. The central question for a board aside from fairness and process is: what price?While the terms “fair market value” and “fair value” appear to be similar, they are very different concepts.When seeking a business valuation, it is critical to ensure that the appraisal is performed according to the relevant and proper standards.Transactional ValueFair market value (“FMV”) and fair value as defined in Accounting Standards Codification (“ASC”) 820 define value in the context of a market clearing price. Statutory fair value (“FV”) is defined in state statutes and is interpreted through precedents established in case law over the year, most notably in Delaware.The accounting profession defines fair value in ASC 820 as:The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.The accounting profession defines fair value from the seller’s perspective with the indicated value used for a variety of purposes including disclosure in financial statements for Level 1, 2, and 3 assets and liabilities.In the business valuation community, FMV is the most widely recognized valuation standard. FMV is the primary standard used in valuations for estate tax, gifting, and tax compliance.The IRS defines fair market value in Revenue Ruling 59-60 as:The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.What brings hypothetical, willing buyers and sellers to the intersection point of fair market value is their respective assessments and negotiations regarding the expected cash flows, risk, and growth associated with the subject interest. Depending on the corporate governance of the specific interest, fair market value also may incorporate discounts to reflect a business interest’s lack of control or lack of marketability. 1, 2Expropriated ValueStatutory fair value is governed by state law and interpreted by state courts in which dissenting shareholders to certain corporate transactions (e.g., a merger approved by a shareholder vote) petition the court for the fair value of their shares.Most state statutes provide appraisal rights that allow shareholders to obtain payment of the FV of their shares in the event of various corporate actions, including amendments to the articles of incorporation that reduce the number shares owned to a fraction of a share if the corporation has the right or obligation to repurchase the fractional share.In 1950, the Delaware Supreme Court offered this interpretation of fair value:“The basic concept of (fair) value under the appraisal statutes is that the (dissenting) stockholder is entitled to be paid for that which had been taken from him viz. his proportionate interest in a going concern. By value of the stockholder’s proportionate interest in the corporate enterprise is meant the true intrinsic value of his stock which has been taken by merger.”In effect, the noncontrolling shareholder who is dissenting to a transaction is entitled to his or her pro rata share of value of the company as interpreted in most jurisdictions. As a result, the controlling shareholder cannot expropriate value from the minority shareholder who is being forced out. Therefore, some state statutes explicitly declare and most case law affirms the view that neither a discount for lack of control and/or an illiquidity discount should be considered in determining fair value. 3While there is no official valuation hierarchy in the Delaware Court of Chancery, based upon a review of recent cases a few observations can be made:Unaffected stock price immediately before the transaction announcement in an efficient market (with regards to both volume and information) is the best indication of valueDeal price is a reliable indicator if the analysis excludes the benefit of synergiesNo recognized valuation methods have been ruled outThe discounted cash flow method is generally one of the preferred valuation methods if unable to observe efficient transaction prices that occurred before the transactionThe observations from Delaware case law about the meaning of statutory FV are reflected in some states’ business corporation act. For instance, FV according to the Guam Business Corporation Act §281301(d) shall be determined:Immediately before the effectuation of the corporate action to which the shareholder objects excluding any appreciation or depreciation in anticipation of the corporate action objected to;Using customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal; andWithout discounting for lack of marketability or minority status except, if appropriate, for amendments to the articles pursuant to §281302 (a)(5).Shown below is a graphic detailing the different levels of value and how we at Mercer Capital think about them in relation to fair value and fair market value.Controlling interest basis refers to the value of the enterprise as a whole and may be analyzed from two perspectives:Strategic Control Value is best described as Investment Value, based on individual investment requirements and expectations. The strategic control level of value is not generally consistent with FMV, in that it considers the motivations of a specific buyer as opposed to a hypothetical buyer. In other words, the “strategic control premium” is often deemed to be outside both the fair market value and statutory fair value standards. Most bank M&A deals take place at this level of value given cost save assumptions that are common in the industry. In a statutory fair value appraisal, deal value generally may not include the benefit of synergies.Financial Control Value is most often consistent with the fair market value and statutory fair value standards because (i) the underlying premise is a going concern; (ii) it typically does not include any premiums that might be paid by a buyer with specific motivations and the ability to implement synergistic structural and financial changes; and (iii) no minority interest or marketability discounts are applied.Marketable minority interest basis refers to the value of a minority interest, lacking control, but enjoying the benefit of liquidity as if it were freely tradable in an active market. The marketable minority level of value also is an enterprise level of value that may align with the financial control value.Nonmarketable minority interest basis refers to the value of a minority interest, lacking both control and market liquidity. The standard of value for a nonmarketable minority interest valuation is usually fair market value and is seldom statutory fair value.ConclusionMercer Capital has decades of experience working with boards of directors regarding statutory fair value in the context of transactions that create appraisal rights and dissenters’ rights. While we sometimes are called to assist in such matters once a transaction has occurred, it is better to address the issue of fair value (and fairness) beforehand. Please call if we can assist your institution.1 Valuation of Noncontrolling Interests in Business Entities Electing to be Treated as S Corporations for Federal Tax Purposes, page 8, Accessed Online March 31, 2022 | https://www.irs.gov/pub/irs-utl/S%20Corporation%20Valuation%20Job%20Aid%20for%20IRS%20Valuation%20Professionals.pdf2 Statutory Fair Value, Accessed Online March 25, 2022, https://mercercapital.com/content/uploads/MerceCapital-Statutory-Fair-Value.pdf.3 Tri-Continental v. Battye, 74 A 2d 71, 72 (Delaware 1950)

What Happens to RIA EBITDA Multiples When Interest Rates Rise?

2021 may be remembered as both the busiest M&A year in history for the investment management industry, as well as the year in which valuation multiples in the space peaked. Transaction volume surged last year and carried into the first quarter, as deals negotiated during a period of cheap money, strong multiples, and the threat of changes in tax law drew both buyers and sellers to the negotiating table. Between Thanksgiving and New Year’s, however, we began to detect a change in the atmosphere for RIA valuations that, in hindsight, may prove to have been a turning point. It was around the same time that the topics of inflation and interest rates began to dominate the financial press, and it’s no coincidence. With the Fed in tightening mode, it’s time to question what impact the change in market conditions has for the investment management space.Many industry observers believe anticipated rate hikes will have little or no impact on the sector since most RIAs don’t have any debt on their balance sheets. While it’s true that most investment management firms do not employ leverage in their capital structure, rising rates will nonetheless have an impact on their cost of equity and, consequently, their valuations. We can illustrate this by way of a common decomposition of the most prevalent valuation metric in the RIA space, the EBITDA multiple.In the interest of simplicity, and to avoid trying to show side-by-side discounted cash flow models, we’ll use the EBITDA single period income capitalization method. We won’t dwell on every detail, but you can read more about it in a related article on our website.This method uses the capital asset pricing model (CAPM) to develop EBITDA multiples based on a company’s risk/growth profile, interest rate levels, and historical returns on publicly traded stocks. We’ve incorporated it here to determine what happens to EBITDA multiples when interest rates go up. This methodology is especially useful to the RIA industry because EBITDA is the most cited performance metric since AUM and revenue rules of thumb tend to vary with profitability. Further, EBITDA is usually a good proxy for cash flow when capital expenditures and interest payments are minimal.In the first example, we’ll demonstrate the impact of a 250 basis point increase in interest rates on EBITDA multiples for RIAs with no debt in their capital structure. We’ve assumed this increase based on an expected 2.5% increase in the Fed Funds Rate from the end of last year to the beginning of 2023 (year-ends depicted on the X-axis below). (Some are now anticipating a 300 bps increase.)A sample build-up in the cost of capital for an RIA might look something like the illustration below. The cost of equity is the sum of expected equity returns in excess of long-dated treasuries, plus a non-systemic, or company specific, risk premium. The cost of debt is typical of covenant-light loans from non-bank lenders to the space, set at a premium to some base rate, illustrated here as Libor. Most RIAs operate without debt, so the weighted average cost of capital, or WACC, is the same as the cost of equity. If you subtract expected growth in cash flow from the WACC, you’re left with a capitalization rate (the inverse of which is a multiple) applicable to debt-free net income. This can be grossed up by the firm’s effective tax rate to derive an EBIT multiple, and further adjusted for depreciation to derive an EBITDA multiple. In this case, the implied EBITDA multiple is one that would be familiar to many industry participants.Of course, this illustration derives an implied EBITDA multiple prior to expected increases in interest rates. As noted below, a 2.5% increase in the federal funds rate (which we’re using to approximate changes in the risk-free rate here) results in a 25% decrease in the EBITDA multiple (holding everything else constant) even though we’ve assumed no interest-bearing debt in the capital structure. The reason is higher interest rates raise an RIA’s cost of equity capital because investors in these businesses will require the same incremental return over riskless alternatives to induce investment, so a higher risk-free rate means a higher required return on RIA investments. Sellers will have to offer lower prices to satisfy a buyer’s need for an increased return, and the EBITDA multiple (assuming no changes in EBITDA) will fall with the transaction price.Last week we noted that RIA acquirers and aggregators now account for roughly half of the industry’s deal volume. Since these firms are responsible for a significant portion of the sector’s acquisitions, changes in their cost of capital will affect how much they’re willing to pay for RIAs and the resulting multiple for many industry transactions. In a rising interest rate (and cost of capital) environment, they’ll have to transact at lower prices to generate an ROI that justifies the investment.RIA consolidators typically use debt to purchase investment management firms, so their cost of capital can be viewed very differently than a pure-play RIA with little or no leverage. Aggregators employ debt financing because it’s cheaper (lower required rate of return) than equity capital, and interest rates have been hovering at historic lows until recently.The illustration above shows an 80/20 equity/debt capital ratio, which is more conservative than many consolidators have employed. Push the capital structure more toward the debt-side, and you’ll quickly get to the 20x or more multiples we’ve heard private consolidators use to describe their valuations.The higher the multiple, the greater the impact from rising interest rates. Unlike most investment management firms, rising interest rates adversely affects both debt and equity financing costs for RIA consolidators, so their cost of capital has likely gone up dramatically in recent months. If we illustrate that same 250 basis point increase in rates for a consolidator, the impact on EBITDA multiples increases proportionate to their leverage. In this instance, the two and half percentage point increase in rates cuts the EBITDA multiple by more than a third.A couple of weeks ago, we referenced that RIA aggregators had gotten off to a rough start in 2022. Our RIA aggregator index is off nearly 40% since November when the Fed first started signaling rate hikes to stave off inflationary pressures.Underlying EBITDA is also getting squeezed as labor costs rise and AUM falls with the fixed income and equity markets, and we’ll dive into that more next week.

E&P Capital Expenditures Set to Rise, but Remain Below Pre-Pandemic Levels

The upstream oil and gas sector is highly capital intensive; production requires expensive equipment and constant maintenance. Despite higher oil and gas prices, E&P operators have refrained from increasing capital investment and instead, are delivering cash to shareholders. This post explores recent capex trends in the oil & gas industry and the outlook for 2022 through 28 selected public companies.Historical and Projected Capital ExpendituresCapital expenditures, as measured by spending on property, plant, and equipment (PPE) has varied widely during the last five years. After the recent high in capital investment in 2019 of $138 billion, guideline group capex dropped 33.5% in 2020 to $91 billion. After minor growth from 2020 to 2021 on the order of 1.8%, capital expenditures are expected to ramp up investment to about $109 billion in 2022, representing a growth of 17.5% but still below pre-pandemic levels. Leading this growth, Exxon (XOM) is expected to increase capital expenditures by 44.0% to $17.4 billion in 2022, up from $12.1 billion in 2021. Chevron follows Exxon with an estimated $11 billion in capital spending for 2022, up 37.5% from 2021’s level of $8 billion. All in all, global integrated companies and E&P companies are expected to experience capex growth on the order of 26.3%, up from $71 billion in 2021 to $89 billion in 2022. The global guideline companies account for the lion’s share of total forecasted growth in capital spending, as summarized in the chart below. Appalachia Is Regional Leader in 2022 Capex Growth EstimatesThrough the lens of our company groups by region, the Appalachian Basin is expected to see the largest upswing in capital expenditures. This is by no means an exhaustive indication of growth by region, but it is indicative of the industry environment in Appalachia — capital expenditures are expected to total $5.4 billion in 2022 from the five major operators active in the area, up from $3.9 billion in 2021. As shown below, 2022 is set to be the first year of significant capital investment growth since 2018. Companies in the Eagle Ford are expected to increase capital spending modestly by about 12.6% to $5.1 billion, up from $4.5 billion in 2021. On the other hand, companies in the Bakken and Permian have lowered their capital plans after relatively high spending in 2021, representing a decrease of 52.8% and 15.0%, respectively. Cost Inflation Baked into 2022 Capex BudgetsWhile the expected rise in 2022 capital investment levels from 2021 is encouraging for the global supply of oil & gas, spectators need to acknowledge the effects of cost inflation in the estimates. According to the Bureau of Labor Statistics ' March Consumer Price Report, inflation has reached a four-decade high in March 2022 as the Consumer Price Index (“CPI”) rose 8.5% over the last 12 months. Cost inflation, by definition, will detract from operators’ “bang-for-the-buck,” and it is no secret that this is baked into 2022 capex estimates.“In this upcycle, investors have made it clear they wanted to see discipline from all players. So far, E&Ps for the most [part] are exhibiting capital discipline. A significant part of E&P capital spending growth this year (2022 versus 2021) will be consumed by cost inflation as the cost for all inputs continues to increase…” – Dallas Fed Respondent, Q1 Dallas Fed Energy SurveyMoreover, estimates are directly tied to operators’ budgets and management forecasts — which also commonly attribute rising capital expenditures levels within their budget to, among other things, inflation — a theme we covered in a previous blog post. This helps bridge the divide between rising capital investment budgets and the common industry theme of “capital discipline”.ConclusionCapital expenditures fluctuate as operators react to global marketplace demand for Oil & Gas commodities. After a recent low in 2020, capital investment is expected to pick up — rising by about 17.5% in 2022, after relatively stagnant growth in 2021. Rising capital expenditures are generally a precursor to increased production, which will likely help to alleviate the current imbalance of supply and demand of oil & gas in the global marketplace at some point. However, capital expenditures for 2022 are expected to trail pre-pandemic levels still, and rising inflation is eroding the value generated by those investment dollars.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss. your needs in confidence and learn more about how we can help you succeed.Appendix A – Selected Public Company Capital ExpendituresClick here to expand the chart above

RIA M&A Q1 2022 Transaction Update

RIA M&A activity continued to trend upward through the first quarter of 2022 even as potential macro headwinds for the industry emerged. Fidelity’s March 2022 Wealth Management M&A Transaction Report listed 58 deals in the first quarter, up 26% from the first quarter of 2021. These transactions represented $89.2 billion in AUM, down 2% from the prior year quarter.Deal volume continues to be led by serial acquirers and aggregators. Mariner, CAPTRUST, Beacon Pointe, Mercer Advisors, Creative Planning, Wealth Enhancement Group, Focus Financial, and CI Financial all completed multiple deals during the quarter. This group of companies, along with other strategic acquirers and consolidators, have continued to increase their share of industry deal volume and now account for about half of all deals. In addition to driving overall industry deal volume, the proliferation of strategic acquiror and aggregator models has led to increased competition for deals throughout the industry, which has contributed to multiple expansion and shifts to more favorable deal terms for sellers in recent years. While deal activity remained robust, the first quarter this year was dominated by macro headlines like inflation, rising interest rates, tight labor markets, and multiple contraction in equity markets—all of which are factors that have potential to impact RIA performance and M&A activity. Rising costs and interest rates coupled with a declining fee base could lead to strain on highly-leveraged consolidator models, and a potential downturn in performance could put some sellers on the sidelines until fundamentals improve. While the duration and extent to which these trends will ultimately impact RIA M&A are still uncertain, recent pricing trends for publicly traded consolidators suggest that investors aren’t particularly optimistic about these models in the current environment. On the other side of the equation, historically tight labor markets and rising costs could amplify certain acquisition rationales like talent acquisition and back-office synergies. Structural trends continue to support M&A activity as well: the RIA industry remains highly fragmented and growing with over 13,000 registered firms and more money managers and advisors who are capable of setting up independent shops. As advisors age, succession needs will likely continue to bring sellers to market. Whatever net impact the current market conditions have on RIA M&A, it may take several months before the impact becomes apparent in reported deal volume given the often multi-month lag between deal negotiation, signing, and closing. But at least through March, transaction activity has remained steady. The Fidelity report lists 19 deals in March, a record level for the month and in line with the levels reported in January and February.What Does This Mean for Your RIA?For RIAs planning to grow through strategic acquisitions: Pricing for RIAs has continued to trend upwards in recent years, leaving you more exposed to underperformance. While the impact of current macro conditions on RIA deal volume and multiples remains to be fully seen, structural developments in the industry and the proliferation of capital availability and acquiror models will likely continue to support higher multiples than the industry has been accustomed to in the past. That said, a long-term investment horizon is the greatest hedge against valuation risks. Short-term volatility aside, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth compared to broker-dealer counterparts and other diversified financial institutions. For RIAs considering internal transactions: We’re often engaged to address valuation issues in internal transaction scenarios. Naturally, valuation considerations are front of mind in internal transactions as they are in most transactions. But how the deal is financed is often an important secondary consideration in internal transactions where buyers (usually next-gen management) lack the ability or willingness to purchase a substantial portion of the business outright. As the RIA industry has grown, so too has the number of external capital providers who will finance internal transactions. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and in some instances may still be the best option), but there are also an increasing number of bank financing and other external capital options that can provide the selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs. If you are an RIA considering selling: After years of steadily increasing multiples and fundamental performance, RIA valuations are now at or near all-time highs. But whatever the market conditions when you go to sell, it is important to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. As the RIA industry has grown, a wide spectrum of buyer profiles has emerged to accommodate different seller motivations. A strategic buyer will likely be interested in acquiring a controlling position in your firm and integrating a significant portion of the business to create scale. At the other end of the spectrum, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Given the wide range of buyer models out there, picking the right buyer type to align with your goals and motivations is a critical decision, and one which can have a significant impact on personal and career satisfaction after the transaction closes.

Values Up, Valuations Flat?

As the Inventory Shortage Persists, Dealers Are Getting More Credit for Their Outperformance

Pre-COVID and chip shortage, it would be no surprise if Blue Sky multiples remained stable over numerous quarters for many brands. As seen in the charts later in this post, multiples normally don’t tend to shift dramatically on a quarterly basis. Multiples are dependent on numerous factors, though brand desirability is chief among them. This is usually tied to product lineup and the overall effectiveness of the OEM.In 2020, the economic shock to the economy borne by the COVID-19 pandemic caused Blue Sky multiples to oscillate in near lockstep, regardless of brand. While multiples changed on a quarterly basis throughout 2020, notably, so did the earnings stream to which buyers applied the Blue Sky multiples. As the chip shortage and lack of inventory have persisted into 2022, auto dealers are getting more credit for recent outperformance as earnings rise steadily.According to Haig Partners, buyers have historically focused on adjusted profits from the last twelve months, which has been viewed as the best indication of expectations for the following year. Since the onset of the pandemic, as expectations have been much more dynamic, the earnings stream to determine ongoing expectations has shifted.Throughout most of 2020, Haig’s Blue Sky multiples were applied to 2019 earnings as these were viewed as the best indication of a dealership’s “run rate” prior to any negative COVID impact. When profitability improved and uncertainty began to decline around June 2020, multiples applied on these 2019 earnings rebounded. Throughout the latter half of 2020, it became clear that the pandemic positively impacted earnings. Most dealers significantly outpaced pre-COVID results, despite a month or two of nearly stand-still operations.In late 2020 and into 2021, Haig reports that buyers were using a three-year average of adjusted profits from 2018, 2019, and LTM ’20 or ’21, or two years of pre-pandemic results and one year of outperformance. The prevailing thought was that the outperformance due to COVID would eventually normalize, and buyers didn’t want to overpay for dealerships that may not be able to repeat these earnings in the future.Now in 2022, Haig reports that buyers are ready to acknowledge that not only have earnings continuously increased, but the inventory shortages show no signs of abating. As we’ve noted for months, industry players have continuously said the situation should normalize in the next 6-9 months. But they’ve been saying that since about February 2021, or 14 months ago.If you only look at the Blue Sky multiples from the Haig reports, you’re missing the bigger picture because valuations (multiples) may be flat, but values are up.As we sit here today, the outlook is still uncertain, but I personally wouldn’t have extreme confidence to say operating conditions or earnings will normalize in 2022. The lead time to meaningfully increase microchip production is clearly long, and with record profits for dealers and manufacturers, OEMs aren’t necessarily incentivized to change the status quo. Demand for personal vehicles is certainly more inelastic than the market previously indicated.If you only look at the Blue Sky multiples from the Haig reports, you’re missing the bigger picture because valuations (multiples) may be flat, but values are up. With earnings steadily increasing, Blue Sky values have followed the same path. That’s why it’s important to understand what level of earnings are being applied to the multiple.Illustrative Example: HondaTo show the path of Blue Sky values since the onset of the pandemic, we’re going to take pre-tax earnings for average import dealerships as reported by NADA and apply them to the appropriate multiple. Last year, we did this analysis for Lexus, so we’re switching from Luxury to Mid-Line Import. We also thought earnings would normalize, yet it has gone the opposite direction in the past year. Unfortunately, due to licensing issues, NADA no longer posts monthly dealer financial data on its website, so our analysis is only based on what we had previously saved, and we must use some extrapolations.In Q4 2019, Haig Partners reported a Blue Sky multiple range of 5.5x to 6.5x for Honda dealerships (tied with Toyota for the highest multiple for import dealerships). With 2019 pre-tax earnings of $1.66 million for the average import dealership, the implied Blue Sky value for the average Honda franchise would range between $9.1 million and $10.8 million. In Q1 2020, the multiple declined by 0.50x on the top and bottom end, dropping implied Blue Sky values to a range of $8.3 million to $9.9 million.By year-end 2020, multiples and earnings each increased significantly, and Honda was up to a range of 6x-7x, or $11.1 million to $12.9 million based on a 3-year average pre-tax earnings of $1.84 million. Through a tumultuous year, the multiple landed a half-turn higher than Q4 2019, and earnings were up 39.9%. Even using the 3-year average, “ongoing” earnings at year-end 2020 were up 11.2% from 2019. As seen on the chart above, Honda’s reported Blue Sky multiples have been unchanged since Q3 2020 at a range of 6x-7x. But from Q3 2020 to Q3 2021, earnings more than doubled, and 3-year average earnings increased 51% from $1.67 million to $2.52 million. Multiplying by the mid-point of the range, Blue Sky values increased from $10.9 million to $16.4 million. In Haig’s Q4 2021 report, ongoing earnings are now expected to be based on 2019, 2020, and 2021 earnings. With 2021 performance more than double 2018 earnings for import dealerships, this change in methodology further increases ongoing earnings. Based on our estimate of 2021 earnings, the average Honda dealership would fetch $18.6 million in Blue Sky or double its value from Q1 2020. While the mid-point multiple has only increased from 5.5x to 6.5x, ongoing earnings increased from $1.66 million to $2.86 million.Even in what has been perceived as a seller’s market, buyers of auto dealerships have likely done pretty well in their first year of ownership.We consider a hypothetical transaction to further illustrate how Blue Sky values have exploded. If a Honda dealership was sold in January 2021 at the prevailing mid-point Blue Sky multiple of 6.5x applied to 3-year average earnings of 2018, 2019, and 2020, the seller would’ve received just under $12.0 million in Blue Sky. The buyer’s first year of earnings in 2021 would be an estimated $4.44 million, way above the “ongoing” expectation. While nobody expects 2021 performance to be earnings into perpetuity, the implied Blue Sky multiple of that transaction was only 2.7x, or lower than any reported Blue Sky multiple range. While few could predict what would happen in 2021, the hypothetical buyer above was a clear winner. While there are numerous doomsday scenarios for dealers these days about longer-term perspectives, I would think twice before selling my largest investment while at peak cash flows that I felt I had some control over if I wasn’t getting well compensated. Even in what has been perceived as a seller’s market, buyers of auto dealerships have likely done pretty well in their first year of ownership. Below, we observe how Blue Sky multiples have changed over the past five years. However, as we’ve illustrated above, the recent lack of movement is not indicative of stagnant Blue Sky values.Blue Sky Multiples: Luxury BrandsAfter three straight quarters of changes in 2020, not a single luxury dealership saw a change in its multiple range, though as highlighted above with imports, dealership values have taken off. After years of only reporting a value range due to a lack of profitability, Cadillac dealerships are now reported at a range of 3x-4x and will be included in future graphs. This multiple range is in line with Acura as the lowest for luxury dealerships. Despite being luxury brands, 3-4x is the lowest reported multiple range, in line with VW and Mazda, which have had their fair share of struggles in recent years.Blue Sky Multiples: Mid-Line Import BrandsFour of the eight Mid-Line Imports multiples improved in the second half of 2021. In Q3 2021, Kia and Hyundai multiples increased 0.5x to 3.75x-4.75x, further distancing these dealerships from the lower half of the mid-line imports (VW, Mazda, and Nissan) though as seen in the graph below, still well below Toyota, Honda, and Subaru. Nissan’s multiple also ticked up 0.25x in Q3 2021, making it slightly more desirable than VW and Mazda.Toyota was the only brand to see a change in its multiple in Q4 2021, modestly increasing its lead at the top of the group at 6.5x-7.5x. Toyota dealerships now fetch just higher valuations than Audi and Jaguar-Land Rover dealerships. While they don’t sell luxury vehicles, Toyotas are definitely viewed as dependable vehicles which consumers can appreciate. Toyota has also taken a balanced approach in terms of EV adoption, which makes sense for the company that really pioneered the hybrid approach with its Prius in the early 2000’s.Blue Sky Multiples: Domestic BrandsDomestic franchise multiples have not changed in the past year, all generally above the lackluster mid-line imports but well below other players. One would think that supply chain constraints would negatively impact import brands more than their domestic counterparts. However, the past year has demonstrated that even domestic brands rely heavily on the global supply chain for their inputs, particularly microchips.In the last five years, Stellantis dealerships have seen their multiples modestly improve, while Ford, Chevy, and Buick-GMC are all down. Only Audi shows a decline in the past five years while Acura, Honda, and Mazda are unchanged and everyone else has seen their multiples increase. While domestic dealerships have not received high Blue Sky multiples, they have been well positioned for the shift from cars to trucks, and heightened earnings across the board is likely to lead to greater return on investment for dealerships that trade at lower multiples.ConclusionBlue Sky multiples provide a useful way to understand the intangible value of a dealership. These multiples provide context for someone familiar with the auto dealer space but perhaps not the specific dealership in question. Buyers don’t directly determine the price they are willing to pay based on Blue Sky multiples; they analyze the dealership and determine their expectation for future earnings capacity (perhaps within the context of a pre-existing dealership where synergies may be present) as well as the risk and growth potential of said earnings stream. The resulting price they are willing to pay can then be communicated and evaluated through a Blue Sky multiple. If a dealer feels they are being reasonably compensated, they may choose to sell. As demonstrated in this post, earnings expectations can be significantly different from actual results.For dealers not yet looking to sell, Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze these key value drivers. We also help our dealer clients understand how their dealership may or may not fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to learn more about the value of your dealership.

Wealth Management Trend Lines May Be Rolling Over

After a Great Year, Higher Rates and Weaker Markets Threaten Continued Growth

While wealth management continues to benefit from demographic trends in the U.S. and the general accumulation of investible assets during the pandemic, 2022 is proving to be somewhat more difficult for the sector, and sentiment among investors in wealth management firms has dimmed.Public firms with substantial operations in the wealth management space have been underperforming alt asset managers and the broader market, and aggregator models like Focus Financial and CI Financial (whose share prices currently trade at 52-week lows) will need organic growth to overcome sluggish financial markets, fee pressure, and higher interest rates. Recent market activity is a strong contrast to the uptrend seen for much of 2021. Prices for aggregator models accelerated into December of last year, peaking as transaction activity in the space hit a fever pitch, fueled by higher multiples and the threat of changes in tax law that would make selling after year-end potentially disadvantageous. The annual Schwab survey of wealth management firms confirmed this bullish sentiment, with advisors generally more optimistic about industry growth prospects than they were a year earlier.Source: June 2021 Schwab Advisor Services Independent Advisor Outlook StudyIt’s noteworthy that the survey represents sentiment in mid-summer. In the nine months that have transpired since the survey was taken, the market has had to digest higher inflation, a new uptrend in global interest rates, the Federal Reserve shrinking its balance sheet, and the war in Ukraine. The survey to be taken in 2022 could prove less sanguine.Despite all of the media attention given to consolidation activity in the wealth management sector, it’s noteworthy that the advisors surveyed by Schwab saw ample opportunity to grow their firms organically, with less than 10% of expected growth coming from recruiting or M&A.Also noteworthy is a generally positive look back at the impact of the COVID pandemic on the wealth management industry, with most firms reporting better performance working remotely than expected. Many firms found opportunities for efficiency in video calls, better staff utilization by cutting staff community times, and expense saving opportunities by cuts in travel costs and office space.Technology investment is a continued theme in the wealth management space, as firms look to new resources for investment management, client management, and firm management to improve service and efficiency. Most firms expect technology spending to increase in 2022, and some view it as a way to overcome staffing challenges presented by tremendous growth in clients and lack of available talent.By the spring of 2022, many of the industry trends facing and favoring wealth managers started to shift, threatening margins and valuations.Higher interest rates are undermining valuations in both debt and equity markets, taking an unusually strong toll on everything from U.S. treasuries to tech stocks. This shift creates a downward gravitational pull on assets under management, and therefore revenue, for wealth management firms. At the same time, inflationary forces are pushing up on both labor and non-labor expenses for RIAs. The consequence could be challenging for margins in 2022 and could deflate some of the positive influences on profitability that have provided a tailwind to RIA valuations for several years.Valuations may ultimately suffer as well because of higher interest rates, as other income producing assets provide an alternative to investing in RIAs, and the cost of capital increases on both the equity and debt sides of the equation for leveraged consolidators of wealth management firms.

Oilfield Water Markets

Update, Trends, and the Future

The Oilfield Services (“OFS”) industry has long been known for its cyclicality, sharp changes in “direction” and demand-driven technological innovation. One segment of the OFS industry that is among those most subject to recent, rapid change is the Oilfield Water segment – including water supply, use, production, infrastructure, recycling and disposal. In this week’s Energy Valuation Insights blog, we look to key areas of the Oilfield Water segment – oilfield water disposal and oilfield water recycling – and address both recent trends and where the segment is going in the near-future.Oilfield Water DisposalThe oilfield water disposal (saltwater disposal) industry remains dynamic with numerous forces driving change. Key among those forces are volume demand, growth in water recycling and rising seismic activity in key shale basins. With the rebound in oil prices since 2020, demand for oilfield water disposal has rebounded as well. While oilfield water recycling continues to grow rapidly in volume, there remains a very significant imbalance between produced water and recycling volumes. The portion of produced water that is being recycled was estimated at 20%, per Dr. Chris Harich, Chief Operating Officer at XRI during his presentation at the recent Oilfield Water Markets Conference (“OWMC”).Additional recent factors impacting the saltwater disposal (“SWD”) industry, particularly in prominent U.S. shale plays in Oklahoma, Texas and New Mexico, is the distinct increase in seismic events that are attributed to oilfield production and waste disposal activity. In September 2021, the Texas Railroad Commission initiated added reporting, permitted volume reductions and even cessation of operations of certain SWDs near high seismic activity areas, referred to as seismic response areas (“SRA”). As a result of the rising demand for oilfield water disposal capacity and reduced disposal availability in certain areas, Kelly Bennett, CEO & Co-Founder of B3 Insight, expects (i) disposal capacity to remain far below produced water volume through 2026, (ii) increased demand for additional SWD facilities and a race for development of shallow SWDs, (iii) more produced water being transported outside of production areas for disposal, and (iv) a resulting rise in water management costs to producers.In regard to the use of shallow SWD wells, one OWMC panel (including Gauri Potdar, SVP Strategy Analytics at H2O Midstream; Laura Capper, President of Energy Makers Advisory; Max Harris, Director at EIV Capital; and Ken Nelson, President & Co-Founder of Blue Delta Energy) noted that shallow depth SWD activity can interfere with production activity in the immediate area, inherently leading area producers to push back against shallow SWD development projects.Finally, how to finance projects providing additional oilfield water disposal capacity comes with challenges not faced in many other industries. Bennett noted that as a dynamic industry that seems to be becoming even more dynamic, financing considerations are becoming even more complicated in recent years.Oilfield Water RecyclingOn the recycling side of oilfield water management, the complications aren’t any easier to deal with. While demand for oilfield water recycling is certainly on the rise, the headwinds to providing recycling services are many and naturally push upward on the cost of recycling services. However, as with most challenges in the oilfield services industry, new technology and innovation are expected to drive industry participants to overcome the inherent barriers.Notable among the oilfield water recycling headwinds are cost, lack of detailed information as to needed recycling volumes, the need for disposal of certain by-products of recycling, and landowners that are economically predisposed against recycling. The cost of recycling services likely needs no explanation; however, the logic as to the other headwinds may not be quite as obvious.The OWMC’s panel on the Mechanics of Recycling at Scale (including Jason Jennaro, CEO of Breakwater Energy Partners; Dr. Chris Harich; David Skodak, SVP Water Treatment at CarboNet; Ryan Hassler, Senior Analyst with Rystad Energy; and Joseph De Almeida, Director Water Strategy & Technology at Occidental Oil and Gas), noted that currently there are no oilfield water recycling reporting requirements. As such, potential recycling project developers have to deal with somewhat rough estimates as to demand volume, rather than a more concrete indication as to the recycled water volume potential in a particular production area. As with any potential investment, less specificity as to the potential market for services is “read” as greater risk, thereby providing greater uncertainty to project investment.As to byproducts of oilfield water recycling, one only has to go as far as the industry name for the liquid being recycled – saltwater. Yes, by volume, salt is logically one of the primary byproducts of saltwater recycling. In the Permian Basin, already known for its high produced water to oil cuts, salt content is higher than found in other basins resulting in higher recycling costs due to the sheer volume of salt byproduct and driving up the cost of capital for development.The last headwind referenced is the economic motivation of landowners in the production area. The OWMC’s panel on Engaging Landowners (including Rick McCurdy, VP-Innovation & Sustainability at Select Energy Services; Brian Bohm, Sustainability Manager with Apache Corp; Nate Alleman, HSE and Water Infrastructure Specialist at ALL Consulting; Matthias Bloennigen, Director – Consulting with Wood Mackenzie; and Jason Modglin, President of Texas Alliance of Energy Producers) noted that landowners are often compensated to supply water for oilfield exploration and/or production use, or for use of their property in the disposal of saltwater. As such, these landowners naturally aren’t in favor of the development of water recycling projects that are viewed as cutting into the fees they are being paid under existing contracts.Recycling SolutionsDespite the abundance of recycling headwinds, expectations are that all will be successfully addressed and overcome by the innovation of industry participants. Costs can be reduced by various means including the extraction of certain rare metals commonly found in produced water, use of flare gas as an inexpensive energy source for recycling operations, the development of recycling equipment that can be readily relocated, and greater cooperation in water management asset “sharing” between basin operators. In addition, increased recycling reporting requirements can assist in reducing some of the risk inherent in recycling projects and landowners can be educated as to recycling being a complementary service to existing water supply and disposal operations, thereby decreasing the natural resistance to recycling projects.ConclusionAs has always been true of the OFS industry, change brings challenges – and that is no different in the Oilfield Water segment. The dynamics of oilfield water disposal and oilfield water recycling continue to evolve, but the OFS industry has a long history of addressing and conquering its challenges, and there’s no reason to doubt the current challenges will also be conquered.Mercer Capital has significant experience valuing assets and companies in the energy industry. Our energy industry valuations have been reviewed and relied on by buyers, sellers, and Big 4 Auditors. These energy-related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed energy industry valuations domestically throughout the United States and in foreign countries.Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

March 2022 SAAR

The March 2022 SAAR was 13.3 million units, down 5.3% from 14.1 million in February and down 24.4% from March 2021's SAAR of 17.6 million units. This drop in the SAAR is a product of several factors, one being the low magnitude of the seasonal adjustment. The seasonal adjustment in this month's SAAR is minimal compared to adjustments made in January and February, as March is typically a bigger selling month in the automotive industry (See below for unadjusted total sales numbers).Also pulling the SAAR down is production stoppages, as the production of new cars and trucks continues to be limited in the wake of ongoing supply-chain issues and global shocks from the war in Ukraine. More detail on the specifics of auto supply-chain headlines is included later on in this post.Seasonal AdjustmentTotal unadjusted sales over the past month were certainly low compared to previous years, except March 2020 when the COVID-19 pandemic shook up the world economy. Declining sales are not due to a lack of consumer demand, which has been elevated since mid-2021. In fact, consistently heightened demand for vehicles has kept incentive spending low (all-time low of $1,044/Vehicle) and average transaction prices high (March record of $43,737) over the last month.High sticker prices have increased the average monthly vehicle payment to $658, up 12.4% from this month last year. Rising interest rates in the last several months have compounded the issue, making the purchase of a new vehicle that much more expensive for consumers. Vehicle payments have not increased at quite the rate of sticker prices due to higher trade-in equity values, up 81.3% per vehicle from March 2021.These conditions come as no surprise. When asked about the last month prior to the SAAR data release, Thomas King, president of the data and analytics division at J.D. Power, commented, "Typically, March is a high-volume sales month with elevated promotional activity because it marks the end of the fiscal year for some manufacturers and the close of the first quarter for others. In March 2021, consumers purchased almost 1.4 million new vehicles at retail. This year, with fewer than 900,000 units in inventory, it will be impossible for the sale pace to even approach last year's level. Given the strong demand and extremely constrained inventory situation, it should be no surprise that manufacturer discounts are at their lowest level ever, while prices and profitability set records for the month of March."Industry-wide inventory balances for February were released this month, and they revealed virtually no change from the status quo. The industry Inventory/Sales ratio saw a modest increase, but the uptick was primarily due to decreased sales rather than increased inventory. When looking into the individual components of auto inventory in the U.S., domestic auto production and the number of imported vehicles both decreased, making for an all-around lack of vehicles available to auto dealers and their customers.The War in Ukraine and the Auto Supply ChainRussia's invasion of Ukraine and the resulting economic sanctions and reverberations are the latest global events to rock supply chains. The United States government has talked of reeling back globalization in an effort to reduce dependencies on China and Russia in a number of strategically important industries. President Biden has also announced a release of 180 million barrels of oil from U.S. reserves in response to rising fuel prices, given Russia's place in the oil and gas industry. Furthermore, microchip facilities are under construction across the U.S. as the country makes a concerted effort to become less dependent on off-shore micro-chip producers, which pre-dates the Russian invasion of Ukraine but is certainly relevant. As we've discussed before, there is a long lead time to producing microchips, meaning it will still take a while to increase domestic production meaningfully.Some analysts are projecting around 1.5 million lost units in 2022 as a result of shutdowns, while others are projecting up to 3 million lost vehicles.To focus on the auto industry in particular, automakers are facing their third supply-chain crisis in the past three years. On a global scale, European auto manufacturers like Volkswagen are being forced to shut down facilities. The company released a statement saying that "With the extensive interruption of business activities in Russia, the executive board is reviewing the consequences of the overall situation during this period of great uncertainty and upheaval." The fallout is not limited to Europe either, as Toyota, Ford, and Hyundai shut down plants in response to the conflict and have echoed sentiments of uncertainty. According to the Wall Street Journal, some analysts are projecting around 1.5 million lost units in 2022 as a result of these shutdowns, while others are projecting up to 3 million lost vehicles. The point is that visibility is very low.European OEM facility shutdowns are not the only repercussion of the conflict in Ukraine. Dozens of auto parts makers shut down facilities in the country as well, setting up a ripple effect that could impact automotive plants in every corner of the globe. For example, Ukraine has become a key supplier of electrical wiring assemblies. Western Ukraine is an attractive location for making wiring harnesses and cable assemblies because of the local workforce's relatively high quality and low cost (it is a labor-intensive activity). It is also geographically situated as a hub between manufacturing plants in Germany and Asia. Likewise, many raw materials used in the production of vehicles are sourced from Ukraine. Oil (used in countless processes) and neon gas (used in the production of microchips) are the two most relevant newly restricted raw materials in the automotive industry.There is no reliable estimate as to when these supply lines will be re-opened, and the timetable seems long and uncertain to say the least.Logistical issues have also been magnified amid the invasion. Train, plane, and boating connections have been disrupted or halted in the region, adding additional costs to an already elevated logistics pricing environment. There is no reliable estimate as to when these supply lines will be re-opened, and the timetable seems long and uncertain to say the least.Another consideration relevant to the automotive industry has to do with trade policy and the global presence of automakers. Since the invasion began, several OEMs like General Motors have gotten out of Russia (financially and physically). The decision to back out of the country came as several corporations across many industries (seemingly) came together to sanction and exclude Russia from economic activity. Many of these companies probably viewed their Russian investments as losing bets once the war started. These actions by OEMs raise an important question: will the doctrine of globalization in auto finally decline after the dust has settled? If that turns out to be the case, will any automakers move back into Russia after the war is over to seize an opportunity?April 2022 OutlookMercer Capital's outlook for the April 2022 SAAR is pessimistic and consistent with the last several months. Industry supply chain conditions continue to worsen and are expected to decline before they get better. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arrival. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Stay tuned for more updates on next month's SAAR blog.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Private Oil Company Values Are Readying For Take Off: While Publics Remain On Runway

As the term “energy security” comes back into the public lexicon, the values of U.S. oil companies are rising. This comes at the delight of some and chagrin of others. Regardless, it represents a foreshadowing of a potential longer-term cycle; whereby U.S. oil production being able to meet energy demands will be increasingly important. Many believe the U.S. is now the world’s “swing” producer (although John Hess disagrees), and it is not due to government action (or inaction). Biden’s third SPR release in the last six months is largely symbolic and more of a political gesture than a meaningful macro-economic needle mover. Demand and supply were drifting apart before Russia’s invasion of Ukraine and this geopolitical dynamic has only widened that gap. The market participants best positioned to seize upon this unexpected gap are private U.S. operators.The current price expectations of oil make a lot of reserves economically attractive. The rate of return on capital deployed for drilling is going to (if not already) outstrip the demand for other capital deployment options such as dividends or debt repayment. However, most U.S. public companies are not shifting their strategies.Domestic Dynamics (Not Russia’s) Keeping Public Valuations Relatively GroundedAs I have written before, shareholders have demanded returns from oil companies for years now in forms other than production growth. Oil company valuation in its fundamental form is a function of the present value of future cash flows. Therefore, if capital available today is best served in drilling more wells tomorrow, then production growth is the most efficient path to a higher value. At historical prices from a year ago, the decision to return more capital to shareholders (as opposed to deploying it in capex) made sense. It doesn’t now. However, public companies have yet to change the courses they’ve been setting for the past several years. That’s partly why the public sector (using XOP as a proxy) only rose 62% in the past year while prices nearly doubled. Demand is strong with the anticipated depletion of Russian oil on world markets. U.S. capital budgets would have to quadruple by the end of 2024 for shale to replace Russian oil exports to continental Europe according to Wells Fargo. In addition, break even prices in most basins for new wells are still around where they were a year ago according to the Dallas Fed Survey. That cost is going up and will continue to, but there is still lots of room for profitability at over $100 per barrel. Also, as I have mentioned before as well, DUC wells continue to shrink. In summary, there are a lot of signals to public companies to “drill baby drill”, yet they aren’t. To be fair there are some caution signs on the horizon that should be considered and are baked into these public valuations. First, the futures curve is still backwardated, meaning that prices are anticipated to fall in the future (not rise). However, even the long-term NYMEX curveis still over $70 in four years, which is still profitable for a lot of reserve inventory. Second, new wells drilled today appear to be less productive. The EIA’s drilling productivity report shows that new well production per rig is going down (although they acknowledge that metric is “unstable” right now). Lastly oilfield services markets have become very tight: “ Labor and equipment shortages, along with inflation in oil country tubular goods and shortages of key equipment and materials, will limit growth in our business and U.S. oil production. In particular, truck drivers are in critical shortage, perhaps due to competition from delivery services.” – Dallas Fed Survey RespondentPrivate Companies Take To The FrontEnter the private oil companies. If forecasts suggest the U.S. can add between 600,000 and 800,000 barrels of oil by the end of the year (EIA says this can be 760,000) then the path to get there will be through the drill bits of private and private equity backed producers. According to an Enverus Report cited by Hart Energy, these types of operators have assumed the vast majority of new rig activity since the summer of 2020. With fewer external concerns, less ESG pressure, and lower regulatory costs, the private sector’s flexibility and nimbleness allow it to surge in front in search of the growth that the fundamental economics suggest is lurking.As an example, Mercer Capital’s latest merger and acquisition discussion focused on the Eagle Ford shale suggested that the market have signaled to potential buyers that the time was right to increase their footprint in southern Texas while conversely providing for an exit for sellers who could either capitalize on the prospect of a continued upswing in energy prices or redeploy capital elsewhere.Whatever the exact incentives may have been that drove the M&A activity, the result was ten deals closed, mostly by private buyers or small-cap producers such as SilverBow Resources.These implied valuation metrics in the table above suggest that there are outsized returns to be made on incremental new wells at the present time. Lots of eyes are turning to watch U.S. production, not only in the Permian, but South Texas, Oklahoma, and the Bakken as well. What they are seeing right now is public companies remaining grounded with their capital, while private companies could be leaving them behind - and quickly.Originally appeared on Forbes.com.

Alt Managers Best the Market and Other Types of RIAs During a Rocky Twelve Month Stretch for the Industry

Access to cheap financing and favorable market conditions spurred significant gains for private equity firms and hedge fund managers during 2021. These tailwinds reversed course in the first three months of this year, and now many of these businesses are in bear market territory. Such volatility is typical for the alt space, which often relies on leverage to enhance returns on its underlying fund investments.Other classes of RIAs didn’t fare so well as the market downturn in January and February erased all their gains over the prior nine months. A closer inspection of the first quarter shows all classes of RIAs down 20% or more at the end of February when the S&P was only off 8%. Investors are likely anticipating lower margins for the RIA industry as AUM and revenue falls with the market while labor costs continue to rise.RIA aggregators also had a rough start to the year. Because the aggregator model is levered to the performance of the wealth management industry generally, the recent downturn for RIA stocks has impaired consolidator valuations too. While the opportunity for continued consolidation in the RIA space is significant, investors in aggregator models have expressed mounting concern about rising interest rates and leverage ratios which may limit the ability of these firms to continue to source attractive deals. Performance for many of these public companies continues to be impacted by headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. These trends have especially impacted smaller publicly traded RIAs, while larger asset managers have generally fared better. For the largest players in the industry, increasing scale and cost efficiencies have allowed these companies to offset the negative impact of declining fees. Market performance over the last year has generally been better for larger firms, with firms managing more than $100B in assets outperforming their smaller counterparts. As valuation analysts, we’re often interested in how earnings multiples have evolved over time since these multiples can reflect market sentiment for the asset class. After steadily increasing over the second half of 2020 and first quarter of 2021, LTM earnings multiples for publicly traded asset and wealth managers declined modestly in the back of last year before dropping nearly 20% last quarter, reflecting investor anticipation of lower revenue and earnings as the market pulled back in the first two months of the year.Implications for Your RIAThe value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with closely held RIAs should be made with caution. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds such as fee pressure and asset outflows to passive products.In contrast to public asset/wealth managers, many smaller, private RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.Notably, the market for privately held RIAs remained strong in 2021 as investors flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer. Deal activity for these businesses continued to be significant in 2021, and multiples for privately held RIAs tested new highs due to buyer competition and shortage of firms on the market. As these dynamics continue into 2022, the outlook for continued multiple expansion and robust deal activity remains favorable assuming interest rates and market conditions stabilize in the near future.

FreightTech Update

Automated Trucks, VC Frenzy, and the Rise of Brokerages

The COVID-19 pandemic brought economic hardship to many. The second quarter of 2020 might go down as one of the quickest economic downturns ever recorded. However, in an effort to protect the economy, the Fed created an extremely hospitable environment for venture capital, and with the glaring supply chain issues, FreightTech became a cushy landing place for investor’s money. We have written about venture capital and FreightTech before, and it has only gotten bigger since then.

Meet The Team

Scott Womack, ASA, MAFF

In each “Meet the Team” segment, we highlight a different professional on our Auto Dealer Industry team. This week we highlight Scott Womack, Senior Vice President of Mercer Capital and the leader of the Auto Dealer industry team.While Scott has provided valuation services for clients in a wide variety of industries, he has significant experience in the auto dealership industry. He provides clients in the industry with valuation and financial advisory services for purposes including gift and estate tax valuation, litigation support, corporate valuation, ESOPs, and financial reporting.The experience and expertise of our professionals allow us to bring a full suite of valuation, transaction advisory, and litigation support services to our clients. We hope you enjoy getting to know us a bit better.What attracted you to a career in valuation?Scott Womack: Initially, I knew I wanted to be in a career involving numbers and problem solving. My introduction to the valuation profession came from my college roommate's father, who is a pioneer in the industry. Ironically, that college roommate and his father are now two of my colleagues at Mercer Capital, Bryce and Don Erickson. After 20+ years in the industry, I still enjoy the challenge of determining the qualitative and quantitative factors that impact the value of businesses.What attracted you to a career in litigation support?Scott Womack: I started doing divorce work about 13 years ago. Personally, I find this work to be very rewarding. Divorce clients are very appreciative and I believe I am making a difference as their Trusted Advisor throughout the process, but especially in mediation or during the trial. Often the non-business (or "out-spouse)" is not directly involved in the couple’s business and doesn’t know the value of the business or understand the process of valuation. These clients look to us to educate them and guide them through the process. Business owners (or the "in-spouse") also see us as a value-add to the process, as they may have not gone through the business valuation process during their ownership of their company.What type of cases gives rise to your involvement in litigation matters?Scott Womack: More often than not, I am involved in family law/divorce cases. The cases generally involve high-wealth individuals and those who own businesses or business interests. In addition to the valuation and forensic work, I also participate in mediation to assist the client in an attempted settlement. If mediation is not successful, I generally submit a formal report to the Court and do testimony work at trial. Other litigation projects include breach of contract or shareholder disputes.How has the valuation industry evolved since you started?Scott Womack: Early in my career, the industry was comprised mostly of valuation generalists. In the early 2000s, financial statement reporting and valuations took on a whole new life of their own with purchase price allocations and stock-based compensation. At this point, the valuation profession kind of exploded to become more specialized. We have people that now specialize in a specific service – be it, say, divorce or financial statement reporting – or a particular industry. So, the movement from generalization to specialization within the industry is the most pronounced change I have witnessed. Especially for growth in your career, specialization is a great avenue for advancement because you are able to become an industry or service line expert.What influenced your concentration in the Auto Dealership Industry?Scott Womack: I had a partner at a prior firm who had several auto clients and I often got to work on those engagements. Some of those engagements were related to divorce so I was able to see what litigation-related valuation is all about. The Auto Dealership industry has some unique characteristics in its financial statements and operations. After being exposed to these differences I saw an opportunity to make an impact in this industry. I am able specialize in this area in order to provide the best valuation services possible.What are a few unique characteristics of the Auto Dealership Industry?Scott Womack: The financial statements are pretty unique in the Auto Dealership industry. Dealers have to submit monthly financials to manufacturers, and each manufacturer statement looks a little different, almost like trying to solve a puzzle. Due to the specialization and profit centers of the various departments, these statements have a lot of detail. They are very informative pertaining to not only the major categories like assets, liabilities, and revenues, but you can also determine the size of the service department or how many used vehicles they sold, what they’re selling them for, or how much inventory they have on the lot. Not only do auto dealerships have to submit monthly statements, but some also report a thirteenth month statement. The thirteenth month takes the twelfth month with added year-end tax adjustments, normalization adjustments, etc. Furthermore, there is unique terminology in this industry. An example would be “Blue-Sky,” which is the goodwill value of the dealership. It can encompass a number of factors and the Blue Sky value is often very meaningful to a dealer requesting a valuation. There are also nuances in ownership and management that are important to know, as well as different valuation techniques and methodologies that are preferred. Someone specializing in this industry is better equipped to know what a client is looking for. My experience valuing auto dealerships has given me an advantage in knowing what to look for and what questions to ask.What types of Auto Dealership engagements do you work on?Scott Womack: Most privately owned auto dealerships are owned in a similar fashion – the operating dealership held in one entity, and the real estate utilized for the dealership location in another entity. I perform valuations of both types of entities for a variety of purposes including estate planning and litigation. We have performed valuations of auto dealerships in numerous states around the country and have been involved in litigation engagements in multiple jurisdictions.What is one thing about your job that gets you excited to go to work every day?Scott Womack: I have always enjoyed that the valuation and consulting business is project-based. On a project basis, you are able to work with different owners and different industries all across the board. One of my favorite parts of a project is conducting the management interviews and site visits. While the financial statements paint a picture and supply the quantitative results of operations, the management interviews provide much of the qualitative factors and allow you to gain an understanding of the company, the industry, and the risk factors that they face. I enjoy meeting different business owners and learning about their successful companies and history.

Modest Production Growth for Eagle Ford

With More on the Way

The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. In this post, we take a closer look at the Eagle Ford.Production and Activity LevelsEstimated Eagle Ford production (on a barrels of oil equivalent, or “boe,” basis) increased approximately 4% year-over-year through March. This is in line with the production increases seen in the Bakken and Appalachia (4% and 5%, respectively) but lags behind the Permian, where production increased 14% year-over-year. There were 56 rigs in the Eagle Ford as of March 25, up 75% from March 19, 2021. Bakken, Permian, and Appalachia rig counts were up 162%, 48%, and 21%, respectively, over the same period. One may wonder why the Eagle Ford has lagged the Permian in production growth despite a larger increase in rigs. The answer has to do with legacy production declines and new well production per rig. Based on data from the U.S. Energy Information Administration (“EIA”), the Eagle Ford needs ~40-45 rigs running to offset existing production declines, and only recently (starting in January) had more rigs running than this maintenance level. The Permian has generally been operating with more than the maintenance level of rigs, so it has seen a higher level of production growth despite a smaller increase in rigs. However, with 56 rigs now running in the Eagle Ford, more production growth should be on the way. Commodity Prices Rise Amid Geopolitical TensionOil prices generally rose through the first two months of the quarter as increased demand was met with continued producer restraint. While the shale revolution had largely put geopolitics in the back seat as a key driver of commodity prices, geopolitics once again became front and center as Russia launched its invasion of Ukraine. In response, Western nations launched a series of economic sanctions against Russia. While the sanctions generally included carve-outs for energy exports, issues with financing and insurance, as well as the exit of Western oil companies and oilfield service providers from Russia, have resulted in a substantial decline in oil exports from the country. Russia was the third-largest producer of petroleum and other liquids in 2020, according to data from the U.S. Energy Information Administration, behind the U.S. and just shy of Saudi Arabia. The potential for that much oil to no longer be available for global markets has led to a high degree of volatility in oil prices. West Texas Intermediate (WTI) front-month futures prices began the quarter at ~$75/bbl and reached $120/bbl in March. Prices have swung dramatically based on actions in Ukraine and the progress of peace talks. Natural gas prices did not exhibit the same level of volatility as oil prices, given the more localized nature of the commodity. However, natural gas is becoming more globalized as Europe grapples with how to replace Russian imports. One obvious source is the United States, as President Biden pledged to boost LNG exports to Europe, despite these same exports being demonized by Democratic Senator Elizabeth Warren just a few short months ago. Administration officials aim to increase European LNG exports to 50 billion cubic meters annually, up from 22 billion cubic meters exported to the E.U. last year. Financial PerformanceThe Eagle Ford public comp group saw relatively strong stock price performance over the past year (through March 28). The beneficial commodity price environment was a significant tailwind to smaller, more leveraged producers like SilverBow and Ranger, whose stock prices increased 326% and 147%, respectively, during the past year, outperforming the broader E&P sector (as proxied by XOP, which rose 62% during the same period). Larger, less leveraged EOG was a laggard, with its stock price rising 61%, slightly behind the broader E&P sector.Survey Says Eagle Ford Wells Among Most EconomicAccording to participants of the First Quarter 2022 Dallas Fed Energy Survey, Eagle Ford wells are among the most economic in the nation. Survey respondents indicated that the average WTI price needed to break even on existing Eagle Ford wells was $23/bbl. This is below the average breakeven in the Permian ($28-$29) and other parts of the U.S. ($30+). While the economic advantage diminishes somewhat for drilling new wells, the Eagle Ford also had the lowest average breakeven for new development, with producers needing WTI at $48/bbl to profitably drill new wells, besting the Permian ($50-51) and other parts of the country ($54-$69). The Eagle Ford’s economic advantage comes from both its geology and geography. The basin’s proximity to Gulf Coast refining and export markets gives it a leg up relative to more inland basins. ConclusionEagle Ford production growth was relatively muted over the past year as capital discipline led to producers running rigs largely at maintenance level. However, with the recent surge in commodity prices, producers are finally starting to bring more rigs online, which should lead to more production growth. However, this growth can’t fill the void left by Russian exports, so commodity prices will likely remain volatile until there is some sort of resolution in Ukraine.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

April 2022

In this issue: Statutory Fair Value vs Fair Market Value (and Fair Value): Not So Subtle Differences

Medtech and Device Industry Newsletter - Q2 2022

E&P Second Quarter 2022

Permian Basin

Permian Basin // Both oil and gas commodity prices rose in the second quarter of 2022, with WTI and Henry Hub front-month futures prices floating around $121/bbl and $9/mmbtu in mid-June, as Russia launched its invasion of Ukraine in late February.

Transportation & Logistics Newsletter

Second Quarter 2022

Purchase Price Allocations for Asset and Wealth Manager Transactions

In recent years, there’s been a great deal of interest in RIA acquisitions from a diverse group of buyers ranging from consolidators, other RIAs, banks, diversified financial services companies, and private equity. Due to the high margins, recurring revenue, low capital needs, and sticky client bases that RIAs often offer, these acquirers have been drawn to RIA acquisitions. Following these transactions, acquirors are generally required under accounting standards to perform what is known as a purchase price allocation, or PPA.A purchase price allocation is just that—the purchase price paid for the acquired business is allocated to the acquired tangible and separately-identifiable intangible assets. As noted in the following figure, the acquired assets are measured at fair value. The excess of the purchase price over the identified tangible and intangible assets is referred to as goodwill. Transaction structures involving RIAs can be complicated, often including deal term nuances and clauses that have significant impact on fair value. Purchase agreements may include balance sheet adjustments, client consent thresholds, earnouts, and specific requirements regarding the treatment of other existing documents like buy-sell agreements. Asset and wealth management firms are unique entities with value attributed to a number of different metrics (assets under management, management fee revenue, realized fees, profit margins, etc). It is important to understand how the characteristics of the asset management industry in general and those attributable to a specific firm influence the values of the assets acquired in these transactions. Because most investment managers are not asset intensive operations, the majority of value is typically allocated to intangible assets. Common intangible assets acquired in the purchase of private asset and wealth management firms include the existing customer relationships, tradename, non-competition agreements with executives, and the assembled workforce.Customer RelationshipsGenerally, the value of existing customer relationships is based on the revenue and profitability expected to be generated by the accounts, factoring in an expectation of annual account attrition. Attrition can be estimated using analysis of historical client data or prospective characteristics of the client base.Due to their long-term nature, relatively low attrition rates, and importance as a driver of revenue in the asset and wealth management industries, customer relationships often command a relatively high portion of the allocated value. We can see this in the public filings of RIA aggregator Focus Financial. Between 2017 and 2021, Focus completed 130 acquisitions of RIAs. Of the aggregate allocated consideration for these transactions, a full 51% was allocated to customer relationships. Most of the remainder (48%) was allocated to goodwill.TradenameThe deal terms we see employ a wide range of possible treatments for the tradename acquired in the transaction. The acquiror will need to decide whether to continue using the asset or wealth manager’s name into perpetuity or only use it during a transition period as the acquired firm’s services are brought under the acquirer’s name. This decision can depend on a number of factors, including the acquired firm’s reputation within a specific market, the acquirer’s desire to bring its services under a single name, and the ease of transitioning the asset/wealth manager’s existing client base. In any event, for most relatively successful small-to-medium sized RIAs, the tradename has some positive recognition among the customer base and in the local market, but typically lacks the “brand name” recognition that would give rise to significant tradename value.In general, the value of a tradename can be derived with reference to the royalty costs avoided through ownership of the name. A royalty rate is often estimated through comparison with comparable transactions and an analysis of the characteristics of the individual firm name. The present value of cost savings achieved by owning rather than licensing the name over the future period of use is a measure of the tradename value.Noncompetition AgreementsIn many asset and wealth management firms, a few top executives or portfolio managers account for a large portion of new client generation. Deals involving such firms will typically include non-competition and non-solicitation agreements that limit the potential damage to the company’s client and employee bases if such individuals were to leave.These agreements often prohibit the covered individuals from soliciting business from existing clients or recruiting current employees of the company. In the agreements we’ve observed, a restricted period of two to five years is common. In certain situations, the agreement may also restrict the individuals from starting or working for a competing firm within the same market. The value attributable to a non-competition agreement is derived from the expected impact competition from the covered individuals would have on the firm’s cash flow and the likelihood of those individuals competing absent the agreement. Factors driving the likelihood of competition include the age of the covered individual and whether or not the covered individual has other incentives not to compete aside from the legal agreement (for example, if the individual is a beneficiary of an earn-out agreement or received equity in the acquiror as part of the deal, the probability of competition may be significantly lessened).Assembled WorkforceIn general, the value of the assembled workforce is a function of the saved hiring and assembly costs associated with finding and training new talent. However, in relationship-based industries like asset and wealth management, getting a new portfolio manager or advisor up to speed can include months of networking and building a client base, in addition to learning the operations of the firm. The ability of employees to establish and maintain these client networks can be a key factor in a firm’s ability to find, retain, and grow its business. An existing employee base with market knowledge, strong client relationships, and an existing network may often command a higher value allocation to the assembled workforce. Unlike the intangible assets previously discussed, the value of a assembled workforce is valued as a component of valuing the other assets. Under current accounting standards, the assembled workforce value is not recognized or reported separately, but rather is included as an element of goodwill.GoodwillGoodwill arises in transactions as the difference between the price paid for a company and the value of its identifiable assets (tangible and intangible). Expectations of synergies, strategic market location, and access to a certain client group are common examples of goodwill value derived from the acquisition of an asset or wealth manager. The presence of these non-separable assets and characteristics in a transaction can contribute to the allocation of value to goodwill.EarnoutsIn the purchase price allocations we do for RIA acquirors, we frequently see earnouts structured into the deal as a mechanism for bridging the gap between the price the acquirer wants to pay and the price the seller wants to receive. Earnout payments can be based on asset retention, fee revenue growth, or generation of new revenue from additional clients, assets, or product offerings. Structuring a portion of the total purchase consideration as an earnout provides some downside protection for the acquirer, while rewarding the seller for meeting or exceeding growth expectations. Earnout arrangements represent a contingent liability for the acquiror that must be recorded at fair value on the acquisition date.ConclusionThe proper allocation of value to intangible assets and the calculation of asset fair values require both valuation expertise and knowledge of the subject industry. Mercer Capital brings these together in our extensive experience providing fair value and other valuation and transaction work for the investment management industry. If your company is involved in or is contemplating a transaction, call one of our professionals to discuss your valuation needs in confidence.

First Quarter 2022 Review: Volatility Resurfaces

The first quarter of 2022 marked the most volatile period since the first quarter of 2020.The quarter began with significant deterioration in the market’s outlook for growth stocks, particularly those lacking demonstrable earning power.Then, a geopolitical crisis, building for some time, intensified with the invasion of a European country, roiling markets ranging from commodities to equities.Last, the Federal Reserve announced, as expected, a 25 basis point change in its benchmark rate and telegraphed six more rate increases in 2022, taking the Federal Funds rate to nearly 2.00% by year-end 2022.In a speech on March 21, 2022, though, Chairman Powell suggested a greater likelihood that future Fed moves may occur in 50 basis point, rather than 25 basis point, increments to combat inflation, which mirrors the position taken by Governor Bullard in dissenting to the Fed’s 25 basis point rate change at the mid-March meeting.The following tables summarize key metrics we track regarding equities, fixed income, and commodity markets leading up to the invasion of Ukraine on February 23, 2022 and thereafter.Equity IndicesIndex data per S&P Capital IQ ProBroad market indices contracted through February 23, 2022, driven by valuation concerns for growth stocksBank stocks remained stable through February 23, 2022, as valuations remained reasonable relative to historical normsSince February 23, 2022 bank stocks have experienced modest pressure, primarily among larger banks that may have some exposure to RussiaWhile markets were volatile after the Ukraine invasion, broad market averages reported a robust recovery in the week of March 18, 2022 and continued gaining into last weekTreasury RatesTreasury yields per FRED, Federal Reserve Bank of St. LouisTreasury rates increased during 1Q22, with a greater share of the expansion occurring prior to February 23, 2022The yield curve flattened in 1Q22Yields on 3- and 10-year Treasuries were virtually identical as of March 24, 2022, relative to a 55 bps spread as of year-end 2021Debt SpreadsCorporate Credit Spreads per FRED, Federal Reserve Bank of St. Louis CMBS spreads per ICE Index PlatformCorporate debt and commercial MBS option-adjusted spreads widened in 1Q22Prior to the Ukraine invasion, high yield bond spreads widened to a similar degree, regardless of rating.However, since the invasion, BB-rated issuers have outperformed B- and CCC-rated issuers1Q22 spread widening in BBB-rated corporate bonds (40 bps) is the largest since 1Q20Although commercial real estate may appear somewhat more insulated from geopolitical considerations than the corporate bond market, CMBS spreads widened to a greater degree than corporate bond spreads in 1Q22CommoditiesOil price represents West Texas Intermediate; WTI prices per FRED, Federal Reserve Bank of St. Louis Corn & wheat prices per BloombergCommodities experienced higher price appreciation than other asset classes in 1Q22Wheat prices, already rising prior to the invasion, leapt after it.This reflects potential production disruptions in Ukraine, sanctions on Russia, and transportation issues in the Black SeaOil prices dropped in the weeks after the invasion of Ukraine but still notched a 49% increase in 1Q22Our agriculturally-oriented banks still expect U.S. farmers to fare well in 2022, despite higher input prices and difficulty obtaining some supplies like fertilizerResidential MortgagesThe 30-year mortgage rate, as reported by Freddie Mac, exceeded 4.00% in the week ended March 18, 2022.This is the first time the mortgage rate has exceeded 4% since May 2019.For the week ended March 25, 2022, the 30-year mortgage rate climbed higher to 4.42%Mortgage rates widened to a greater extent than long-term Treasury rates in 1Q22UWM Holdings, the largest wholesale mortgage lender, in its March 1, 2022 earnings release projected that 1Q22 originations would decline by 24% to 40% from 4Q21 originations.Mortgage rates have increased further after it provided this estimate

Public Auto Dealer Profiles: AutoNation

As we discussed in previous installments of this blog series, there are six primary publicly traded auto dealers that own approximately 923 new vehicle franchised dealerships as of year-end, or approximately 5.5% of the total number of dealerships in the U.S. The proportion of the total U.S. dealerships that these publics own demonstrates how fragmented the industry continues to be, despite recent consolidation. For example, in the back half of 2021, there were three significant acquisitions made by public dealers that captured headlines. (Check out our blog from October to explore how these acquisitions might matter to your dealership).Our goal with the Public Profiles blog series is to serve as a reference point for private dealers who may be less familiar with the public players, particularly if they don’t operate in the same market. Larger dealers may benefit from benchmarking to public players. Smaller or single point franchises may find better peers in the average information reported by NADA or more regional 20 Group reports. However, they might still value staying plugged into public auto dealers’ performance. Public auto dealers also give dealers insight into how the market prices their earnings, the environment for M&A, and trends in the industry.AutoNation OverviewAutoNation is the largest automotive retailer in the United States. As of December 31, 2021, the company owned 339 new vehicle franchises from 247 stores located in the U.S. At year-end, the company also owned and operated 57 AutoNation-branded collision centers, 9 AutoNation USA used vehicle stores, 4 AutoNation-branded automotive auction operations, and three parts distribution centers.LocationsAutoNation’s stores are primarily set in the Sunbelt region, but the company has a presence in 17 states. A map of all states that the company operates in with associated percentages of total revenue is included below:Source: AutoNation Investor Deck Fourth Quarter 2021 BrandsThe company sells 33 different new vehicle brands, with 90% of its revenue coming from Toyota (including Lexus), Honda, Ford, General Motors, FCA, Mercedes-Benz, BMW, and Volkswagen (including Audi and Porsche). Comprehensive brand selection is important to AutoNation, as it hopes to provide customers with a broad range of products to choose from. Profit amongst these brands has remained relatively stable over the company’s history. However, in recent years the company has seen a slightly greater profit mix towards selling and servicing higher-margin, luxury vehicles.The company is seemingly brand agnostic, which makes sense given its massive scale and complications with franchise agreements, where OEMs don’t want too many dealerships to be controlled by one company. A breakdown of income by brand from AutoNation’s Q4 2021 investor presentation can be seen below:Source: AutoNation Investor Deck Fourth Quarter 2021 Historical Financial PerformanceAs we’ve discussed frequently, there are numerous hurdles to clear when comparing a privately held dealership to a publicly traded retailer. Scale and access to capital make the business models different, even if the store and unit-level economics remain similar. Despite these fundamental differences, we should still take a look into some of the financial metrics and trends that AutoNation has observed in its operations over the past few months.There are numerous hurdles to clear when comparing a privately held dealership to a publicly traded retailer.In the fourth quarter of 2021, AutoNation observed a 13.8% increase in total revenue and a 34.3% increase in gross profit compared to the same period last year. This asymmetric growth can be attributed to margin expansion as rising vehicle prices have benefitted the company’s selling operations. Remarkably, while sales prices have increased faster than the cost of the vehicles, OEMs are also more profitable, which demonstrates why public players want some of the status quo to remain the same once the chip shortage abates. AutoNation’s net income and EPS margins have expanded as well, with net income increasing by 78.3% over the year and EPS increasing by 137%. Changes in the individual components of the company’s income statement are broken down below:Source: AutoNation Investor Deck Fourth Quarter 2021 Like most of its public and private counterparts, AutoNation has achieved an impressive financial performance in the midst of lower retail units sold and historically low numbers of units on lots. Day Sales Outstanding is an appropriate metric to show the magnitude of the inventory shortage’s effect on AutoNation. Throughout 2021, the company’s Days’ Supply dropped from 42 to 9, which is even more notable considering that sales volumes are also declining, which all else equal raises Days’ Supply. Used vehicles bridged some of the gap for AutoNation; as new retail units declined 20% due to manufacturer supply shortages, used vehicles increased by 21%.AutoNation’s finance and insurance department also performed well in 2021, as higher margins on service contracts and increased product penetration resulted in gross margin expansion in the business segment. Parts and Service also saw an increase in gross profit, primarily due to growth in customer pay, internal reconditioning services, and the sale of wholesale parts.Across AutoNation’s four revenue segments, margin structure differences allow for variability between each segment’s revenue contribution and gross profit contribution, as can be seen in the company’s investor presentation and below:Source: AutoNation 2021 10-K AutoNation USAIn 2021, AutoNation’s capital allocation focused on its rollout of AutoNation USA, an exclusively pre-owned sales venture that the company is launching to target additional market share in the used vehicle market. Unlike Lithia that is actively acquiring new vehicle franchises, AutoNation, like Sonic, is investing in a network of used-only stores to compete with Carvana, Vroom, Shift, and other online retailers. They have the built in benefit of sourcing trade-ins when customers come to AutoNation’s new vehicle franchises as well as the scale of their vast dealer network. AutoNation is targeting to have over 130 AutoNation USA stores in operation from coast-to-coast by the end of 2026, and has already launched 5 pilot stores, all of which were profitable. Of the 130 targeted openings, 12 stores are expected to open in 2022. Given they only have 9 currently, getting to 130 will take a significant investment in 2023-2026. If they stick to these plans, there may not be significant capital allocated to acquiring more new vehicle franchises.Implied Blue Sky MultipleIn prior blogs, we’ve discussed how blue sky multiples reported by Haig Partners and Kerrigan Advisors represent one way to consider the market for private dealerships. Below, we attempt to quantify the implied blue sky multiple investors place on AutoNation. If we assume that the difference between stock price and tangible book value per share is made up exclusively by franchise rights, then their Blue Sky value per share is approximately $109.55. Given recent outperformance, Haig Partners prescribes a 3-year average to determine ongoing pre-tax income. Using this methodology and applying the 24.1% effective tax rate implied by AutoNation’s financials, its ongoing pre-tax earnings per share would be $9.20 or 9.05x Blue Sky.Source: AutoNation Investor Deck Fourth Quarter 2021 While this is relatively in line with all of its public counterparts, it is relatively high compared to import or domestic dealerships likely due to its size and growth potential and its tilt towards luxury brands.ConclusionAutoNation is a good proxy for the entire auto dealer industry in many ways. While the company is regionally clustered in Florida, California, and Texas, it has a presence in and is a product of several unique markets across the entire United States. Its presence in these states also isn’t random; these are three of the four most populous states in the country. AutoNation also sells almost all of the major domestic, import, and luxury brands, further emphasizing the very broad nature of its operations. Financially, the recent historical performance of AutoNation follows many of the same trends that privately held dealerships have been seeing over the past year.At Mercer Capital, we follow the auto industry closely to stay current with trends in the marketplace. Surveying the operating performance, strategic investment initiatives, market pricing of the public new vehicle retailers gives us insight to the market that may exist for a private dealership. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Does RIA Consolidation Work?

Show Me the Money

RIA group-think has been pro-consolidation for the past decade, and increasingly so. You've read the headlines about the pace of deals reaching a fever pitch last year and continuing into this year. We've been skeptical of the believed necessity for RIA consolidation in this blog in the past, and have yet to be dissuaded from our position. But opinions are only opinions, and facts are facts. This seems like an opportune moment to check our feelings against reality. How is RIA consolidation performing so far? The verdict from the public markets isn't very encouraging. We look at three publicly traded consolidators of wealth management businesses, Silvercrest, CI Financial, and Focus. Over the past five years, Silvercrest Asset Management Group (SAMG) showed cumulative share price appreciation of less than 65%, underperforming the Russell 3000 by over 2200 basis points. To be fair, SAMG pays a reasonable dividend, and its wealth management clients are probably not 100% invested in equities. Nevertheless, we think of RIA returns as being leveraged to the market, and in an era of strong markets a wealth management firm with organic growth plus an acquisition strategy should – in theory - be able to outperform broad indices. SAMG didn't beat the market, but it outperformed a couple of rivals. Focus Financial Partners trades less than 25% above its IPO price from the summer of 2018, in spite of a tremendous number of acquisitions and sub-acquisitions. Focus doesn't pay a dividend so 22% cumulative return is the total return for FOCS shareholders since going public. CI Financial has fared even worse, as the Canadian shop revered for its willingness to pay top dollar hasn't posted a positive return over the past five years, even if you count dividends. Keep in mind, all of the above happened in an era of strong equity markets and low interest rates – what should be optimal conditions to consolidate the RIA space.Obligatory Car StoryThe business climate of the late 1990s was one in which consolidation was rife in nearly every industry. Rollup IPOs were the SPACs of the day, newly minted dot-coms were trading their highly inflated equity currency for other companies' highly inflated equity currencies, and old economy manufacturers were teaming up to share branding, technology, and overhead. Sometimes this worked very well, and sometimes it didn't.It's often said that most M&A results in failure. The free-wheeling, mass-market managers at Chrysler could never agree on expectations with the hierarchical, engineering-led team at Daimler-Benz. The loveless marriage resulted in unfortunate offspring like the Pacifica crossover and the R-class. Less than a decade after the 1998 merger, Daimler unloaded Chrysler to Cerberus for about 25% of the $36 billion it had originally paid.At the same time, a more unlikely pairing actually worked. The 1998 sale of Lamborghini to Volkswagen's Audi division turned out to be wildly successful. Italian styling and German build quality make a good combination, and today Lamborghini sells almost fifty times as many cars annually as it did before Audi bought it. It hasn't caught up with Ferrari yet, but it's close enough to make the guys in Modena pay attention.Investment ThesisLooking back on the two auto industry transactions sheds some light on the expected performance of RIA deals. One way to compare Daimler-Chrysler and Audi-Lamborghini is to consider why they happened in the first place.Daimler-Chrysler was a bulking-up, bigger-is-better, merger-of-equals. The logic was driven by internally-focused economies of scale, and it wasn't clear who was in charge. That left an environment that was unusually hospitable to culture clashes that undermined opportunities, synergies, and (ultimately) sales.Audi-Lamborghini was product-focused, and it was clear from the beginning who acquired who. Huge increases in Lambo sales and the opportunity to equal or surpass their old rival with the Prancing Horse kept internal dissent at bay.Which transaction looks most like the typical RIA deal? The investment thesis for investing in RIAs (whether asset management or wealth management) is straightforward: sticky revenue and operating leverage produce a sustainable coupon with market tailwinds. In an era of ultra-low yields, it's the best growth-and-income trade available, and it's become a crowded trade with a diverse array of institutional investors and family offices. As we've said many, many times in this blog, it's easy to see why one would invest in investment management.Consolidation ThesisInvesting in RIAs is one thing; consolidating them is quite another. Still, the themes that drive industry consolidation are equally well-rehearsed:Scale. With 15,000 or so RIAs in the United States alone, solving for fragmentation seems like an obvious play. Consolidation wonks tout the financial leverage that comes with economies of scale, enhancing margins, distributions, and value.Access. Larger firms theoretically are able to source more sophisticated investment products, technology stacks, and marketing programs.Problem Solving. Sellers have to have an impetus to give up control over their own destiny, and consolidation is often seen as the solution for aging leadership (or at least aging ownership) without a compelling succession path.Financial Engineering with Debt. Covenant-light debt at low rates has made capital widely available for public and private acquirers alike. Banks will typically lend at 3x and non-bank lenders at as much as 6x. With Libor near zero, even premiums on the order of 500 to 600 basis points make LBOs compelling.Financial Engineering with Equity. Multiple arbitrages has been the handmaid of cheap debt. At one point, it was "buy at five to six times, sell at eight to nine times." Then the spread was 9 to 12. Then it was 12 to 15. Then it went further. The whisper numbers usually outpace reality, but the logic is the same. All the above is widely accepted in the industry, and it's easy to see why. But if Fed activity stalls equity, while at the same time raising the cost of borrowing, things could change abruptly. This wouldn't just threaten industry consolidation for financial reasons, it might also expose some flaws in the consolidation thesis.Diseconomies of ScaleIf you put ten RIAs together that each makes $5 million in EBITDA, your combined operation will make $50 million in EBITDA. Your holding and management operation, however, will probably need an executive team with a C-suite, an accounting department, a marketing department, legal, compliance, investor relations, and a couple of pilots for your jet. They'll all need office space in a nice building, even if they mostly work from home. The subsidiary level profitability will inevitably be eroded by monitoring costs.Some of this expense may be replacing functions that would previously have happened at the subsidiary RIA level, but not all of them. Is there enough expense synergy in consolidation to cover the overhead costs of a consolidator? I doubt it.In the asset management space, there is an argument that AUM can be added faster than overhead, and margins can expand almost infinitely (we've seen some big ones). In wealth management, it's a tough slough. When Focus Financial went public, we thought that, even with massive growth, it would be hard to get their adjusted EBITDA margin above 25% - the level we're very accustomed to seeing on a reported basis at wealth management firms of more modest proportions. A publicly traded consolidator might have more than 100 souls on board at the management company level. That's a lot of payroll to cover with subsidiary-level synergies.AccessibilityAre small firms disadvantaged when it comes to necessary products and services? With custodians eager to accommodate all manner of investment products, outsourced compliance, subscription-based tech, and scalable marketing, it's easier than it has ever been to compete as a sub-billion dollar RIA. Scale enables firms to have positions to manage these functions, but it doesn't provide the functions themselves. We aren't experts in RIA operations, but we haven't yet seen a small firm struggle because it couldn't get what it needed (or wanted).Exit and SuccessionConsolidators offer exit capital for RIA founders. In that regard, they can resolve the standoff between generations of leadership and pay senior members a price that next-gen staff either cannot or will not pay. But a cheaper source of capital (or greater appetite for risk) is not a surrogate for succession.Since most of the consolidators in the industry are relatively new, we don't know a lot about whether these models are sustainable. RIAs are not capital intensive, but they are highly dependent on staff to manage both money and relationships. Often the staff who will generate returns for the consolidator in the future don't get a lot of equity consideration in the transaction. And will the founding generation work as hard for their new boss as they did for themselves?These conundrums have led many consolidators to structure earnouts or develop hybrid ownership models that share equity returns in some form or other with subsidiary RIAs. One touts promising to never turn "an entrepreneur into an employee" – which sounds reasonable. Ultimately, though, the staff at subsidiary operations are sharing equity returns with the parent company, and the principal/agent dilemma is less a dichotomy and more of a spectrum.As such, the consolidator will be paying for a firm run by highly motivated founders and getting a firm that will ultimately be run by differently motivated successors. RIA consolidation is the act of simultaneously acquiring the operating asset and accepting the succession liability.Financial De-EngineeringMost RIAs, by far, operate on a debt-free basis. Usually, this is for the obvious reason that there isn't much of an asset base to finance, so why bother. Consolidators, on the other hand, frequently rely on debt financing and, as deal prices have increased, so have leverage ratios. Financing a cash flow stream that is in many ways leveraged to Fed activity works very well in the era of declining and low interest rates – as we have seen.Rising rates and falling (or stagnant) markets lead to higher debt burdens and lower cash flows to service that debt. Add to that the threat of inflation increasing payroll burden. In normal times, there would be enough equity cushion to protect against default. With higher deal multiples – based on highly adjusted EBITDA measures - and the massive leverage available from non-bank financing, we could be in for some nasty surprises.If coverage starts tightening, deal activity will fall off, and multiples will drop. If multiples drop, acquirers won't be able to exit on satisfactory terms. Without equity compensation as a carrot, producers will find an exit for themselves. The unfortunate reality of leveraged RIAs is that their assets get on the elevator, but the liabilities never leave.Climate ChangeI'm not calling it the end of the RIA consolidation trend. For many reasons, it could continue for years to come. But the performance of publicly traded consolidators has been lackluster, in spite of very favorable conditions in which those business models should thrive. Now that we have the prospect of RIA stagflation, it could become very difficult to maintain a land-grab mentality that operates as if the acquirer is valued on the basis of price-per-press-release.

Eagle Ford M&A

Transaction Activity Over the Past 4 Quarters

Deal activity in the Eagle Ford increased over the past year as energy prices recovered from a tumultuous 2020. As we noted in June of last year, production in the Eagle Ford remained relatively flat over the prior year despite 146% growth in the regional rig count, suggesting the significant increase in drilling activity was just enough to offset the decline in already-producing wells, but not economical enough to spur production growth meaningfully. This may also have signaled to potential buyers that the time was right to increase their footprint in southern Texas while conversely providing for an exit for sellers who could either capitalize on the prospect of a continued upswing in energy prices or redeploy capital elsewhere. Whatever the exact incentives may have been that drove the M&A activity, the result was ten deals closed in the Eagle Ford over the past four quarters, up from eight transactions closed in the prior four quarters.Recent Transactions in the Eagle FordA table detailing E&P transaction activity in the Eagle Ford over the last twelve months is shown below. The median deal value in the past four quarters ($370 million) was approximately $282 million higher than the median deal value from Q2 2020 to Q1 2021, excluding Chevron’s acquisition of Noble Energy in July 2020. The average deal value over the past year ($573 million) was more than double the average value ($274 million) over the prior year (excluding the Chevron-Noble Energy deal). Also notable, larger positions were transacted over the past year, with a median size of 45,000 net acres as compared to 26,500 net acres in the prior year (excluding Chevron-Noble Energy), and an average deal acreage of nearly 80,000 net acres this past year which was more than double the average of 34,775 net acres in the prior year.SilverBow Resources Builds Up Its Eagle Ford AssetsOn October 4, 2021, SilverBow Resources announced the closing of its purchase to acquire oil and gas assets in the Eagle Ford from an undisclosed seller in an all-stock transaction. The aggregate purchase price for these assets was $33 million, with the transaction consisting of approximately 1.5 million shares of SilverBow’s common stock. In late November 2021, SilverBow announced another transaction closed with its purchase of oil and gas assets from an undisclosed seller for $75 million, including $45 million in cash and approximately 1.35 million shares of SilverBow’s common stock.Of this second transaction, Sean Woolverton, CEO of SilverBow, commented, “This is the third acquisition we have closed in the second half of this year. This transaction represents SilverBow’s largest to date. As we look to 2022, the Company is set to grow production by double digits in part from the incremental development locations and a full year’s worth of contribution from the acquired assets. With greater cash flow and liquidity, SilverBow remains well-positioned for strategic M&A and further de-levering.”Callon Petroleum Divests Non-Core Eagle Ford AssetsOn October 5, 2021, Callon Petroleum – one of the upstream companies we follow regularly in our quarterly review of earnings call themes from E&P operators – announced it had entered into an agreement to sell non-core acreage in the Eagle Ford as part of its acquisition of leasehold interests and related oil, gas, and infrastructure assets in the Permian basin from Primexx Energy Partners. Total cash proceeds from the divestiture were approximately $100 million. The Eagle Ford properties included approximately 22,000 net acres in northern LaSalle and Frio counties. Net daily production from the properties was approximately 1,900 Boe/d (66% oil) on average in the third quarter through month-end August. Callon noted in its press release that the sale would eliminate approximately $50 million in capital expenditures related to continuous drilling obligations over the next two years, allowing for redeployment of capital to higher return projects.ConclusionM&A activity in the Eagle Ford has picked up over the past year in terms of both deal count and the amount of acreage involved. The ten deals noted over the past year were split evenly between property/asset acquisitions and corporate transactions, such as the Desert Peak Minerals-Falcon Minerals Corporation merger announced in mid-January of this year. This signals a notable increase in corporate-level activity as only one of the eight transactions in the prior year involved a corporate transaction, possibly foreshadowing greater industry consolidation in the Eagle Ford moving forward.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

WHITEPAPER | Community Bank Valuation

Key Considerations in the Valuation of Banks and Bank Holding CompaniesThis whitepaper focuses on the two issues most central to our work with depository institutions at Mercer Capital:What drives value for a depository institution?How are these drivers distilled into a value for a given depository institution?In this whitepaper, we dive into the more technical valuation issues, but at its core, value is a function of the following:A specified financial metric or metricsGrowthRisk

Succession Planning for Auto Dealers

Sorting Through the Madness

March is one of the best months on the sports calendar for avid and casual sports fans. Last week, the NCAA College basketball tournament began. Most of us have been checking our brackets to see which games we picked correctly and which upsets have destroyed our brackets. There’s a reason they call it March Madness. Who would have predicted that St. Peter’s would beat Kentucky? The tournament and the bracket challenges are an opportunity to unite friends, co-workers, and family members in a spirited competition. But, they can also be a source of frustration with stumbling blocks at unexpected terms. In many ways, succession planning can leave auto dealers with the same fears and confusion over the process and some of the decisions made along the way.What is succession planning? Succession planning is the transfer of value or leadership in a company or organization. For auto dealers, the dealership can represent a lifetime of efforts and relationships with key employees and customers. Hopefully, the dealership has also provided the owner with wealth and income over the years. These factors make the discussion of succession more complicated for auto dealers because of the deep emotions tied to the legacy that they have created.This post discusses some of the key factors involved in the succession planning process and why they are so critical.Cost of a Business Valuation One of the first steps in the succession planning process is to determine the value of the auto dealership. Often there can be a difference in the expectation of value. In other words, there may be a perceived difference in value when assessed by a third party versus the owning dealer. The cost of obtaining a business valuation can also be a stumbling block to the succession planning process. Most valuation professionals will offer different levels of service based upon the strength of the conclusion, the level of procedures performed and the information analyzed, and the style of the report. While it may be more cost-beneficial to engage a business valuation professional to perform limited procedures, a formal valuation is the better course of action. If decisions are ultimately made to transfer the auto dealership in some estate planning tool, a formal valuation will help protect the integrity of that transaction or transfer. In other words, if the transfer was ever to be audited or challenged by the IRS, a formal business valuation serves to justify the indication of value used in the estate planning process. Besides the formal event requiring the valuation, a business valuation can also benefit auto dealers for other reasons. A formal business valuation can be useful to an auto dealer when examining internal operations. While the business valuation represents an estimate of value at a certain point in time, the value can also be examined relative to the business over time. An auto dealer may use additional valuations to evaluate the performance of the dealership over time to assess its performance relative to a budget or long-term plan. Valuations can also give auto dealers insight into the value drivers of their dealership. Auto dealers can continue focus on areas of strength that contribute to value, while also addressing other areas of weakness that may be detracting from value. Finally, a business valuation could serve to evaluate the dealership relative to its peers and competition.Who Should Perform the Business Valuation? The selection of the business appraiser is critical to the succession planning process. A quality business valuation will not only determine the value of the dealership, but also provide a well-reasoned report to explain the basis of value and the underlying assumptions. Further, the valuation assists the auto dealer and their advisors in an understanding of how the dealership is valued. As we’ve written in this space before, dealers and their advisors should select a business appraiser that is properly qualified and credentialed. Additionally, the auto dealer industry is unique from other industries due to its unique financial statements, terminology, and specific valuation methods. When selecting a business appraiser, you should also seek a firm or individual that has experience in the auto dealer industry.Timing of Decision-Making Auto dealers have to face many daily challenges and operational decisions. Chief among them in the current environment, what is my new vehicle inventory and where am I going to obtain additional new and used inventory? Decisions that can be made tomorrow, such as succession planning, may be shifted to the back burner. However, these decisions should be made sooner rather than later. First, unexpected events can impact the value of your auto dealership or the succession planning process. We have focused more on the value of the dealership in this blog post, but succession planning also refers to the transfer of leadership with key employees. A life-changing event to the owner or the departure or thinning of key leadership over time can also impact the value of the dealership.In the current environment, the profitability and implied values of auto dealerships are at record highs.In the current environment, the profitability and implied values of auto dealerships are at record highs. Most prognosticators believe those trends will continue in the short-term due to inventory constraints. For auto dealers that have seen the value of their dealership climb in recent years and the expectation that those values could climb even further, why not consider transferring some of that value to your family? With annual gifting amounts being fixed, auto dealers could transfer more ownership at lower values today than retaining those shares in an appreciating climate. While there has been a lot of talk about estate planning and tax law changes since the change in administration, no material changes have been enacted as of yet. Changes could still be on the horizon.In addition to annual gifting, the lifetime estate and gift tax exclusion is set to sunset in 2026. The current exclusion allows for individuals to transfer $12.06 million ($24.12 million for a married couple) without being subject to estate taxes. These levels are set to drop by almost 50% in 2026. Auto dealers can transfer considerably more value under the current exemption levels today, than if those levels are reduced in 2026.Ultimate Decision The current environment in the auto industry has placed many auto dealers at a crossroads in terms of their ultimate decision: should they consider transferring the dealership to the next generation or should they sell? High profitability and high blue sky multiples for most franchises translate to heightened valuations. The evolution and adoption of electric vehicles forces many dealers to contemplate the additional expenses and challenges that will come with retailing and servicing these vehicles. Further, consolidation in the industry by the public companies and larger private auto dealership groups forces the smaller auto dealer families to compete with companies that have much larger resources and economies of scale. What decision should auto dealers make? Some of the decision revolves around the expectation of value discussed previously in this Blog. Does the dealer’s perception of value equal reality? If the dealership is worth less than what a dealer expected, perhaps it makes sense to retain the dealership and improve operations and improve certain value drivers to eventually increase the value of the dealership. If the dealership is worth more than the dealer expected, perhaps it makes sense to consider selling the dealership at a time of heightened value.High profitability and high blue sky multiples for most franchises translate to heightened valuations.The other critical factor to succession planning, and in this case, transferring the ownership of the dealership to the next generation or key employee, is to assess the existing leadership talent in the business. Is there a second generation of the family that is currently involved in the dealership and familiar with the operating environment? If not, is there a key employee that could step in and continue the legacy of the dealership? In either case, an auto dealer must consider whether either of these individuals would be approved by the OEM. The OEM has to approve the dealer principal of an auto dealership. This consent is not always guaranteed and presents another unique element to the succession planning process for auto dealers.ConclusionAt Mercer Capital, we perform valuations of auto dealerships for owners and advisors all around the country for a variety of purposes. Additionally, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation engagements. If you are contemplating succession planning with your dealership, contact a professional at Mercer Capital to discuss your valuation needs in confidence.

What Market Volatility Means for Your RIA

Is Volatility the New Normal?

It’s de ja vu all over again. The volatility from the onset of the pandemic two years ago has been creeping back up as investors grapple with the global implications of the war in Ukraine. At the end of last year, most RIA owners were enjoying peak AUM and run-rate profitability. Since then, these measures have likely taken a substantial hit as the S&P 500 and NASDAQ are down 12% and 19%, respectively. When this happened two years ago, the market made a sharp recovery in the preceding quarters, but looking forward, we don’t know where the bottom lies. Most RIA principals are likely grappling with a sizable decline in management fees and earnings for the next billing cycle.The VIX, which calculates the expected volatility of the U.S. Stock market, hit a new all-time high on March 16,2020, of 82.69. It gradually declined until Russia invaded Ukraine several weeks ago and has ticked back up ever since. If one thing has become more clear, it’s that market volatility is likely here to stay – at least for a while. In this post, we explore what this volatility means for you and your RIA.AUM, aka Revenue Base, Is More VolatileFor RIAs that charge fees on a quarterly basis, the fees charged on March 31, 2022, will likely be significantly lower than the fees charged as of year-end (barring any major advances in the market over the next week or so – which is not out of the question). Many RIAs have quickly adjusted to this new normal. Rather than charging fees quarterly, which makes them more susceptible to the large swings in the market, they have switched to charging fees on a monthly basis to smoothen the impact from a swift correction.Active Managers May Be Able to Exploit Mispricing in the MarketDuring times of increased volatility, active managers are generally able to take advantage of the swings in stock valuations away from fair value, allowing them to realize increased returns for their clients. This may be more difficult in the current market as the volatility today is not just driven by increased “fear” in the market, but a lack of liquidity in our financial system.Over the last few months, bid-ask spreads have widened, and trading volumes have generally declined. A lack of liquidity in market structure is associated with increased risk. In a less liquid market, it is more likely that you could get stuck in a losing position. Additionally, in less liquid markets, prices tend to overreact, making market moves less informative. While there are more winning opportunities presented to active managers, there are also more losing ones.Sector-Specific Managers Are Missing Out or Killing ItMuch of the decline so far this year has been driven by tech stocks, which outperformed most other sectors of the economy over the last few years. Conversely, energy sector fund XLE is up 34% year-to-date after underperforming the broader market for several years. Mean reversion has been a major force so far this year to the benefit and detriment of sector-specific asset managers.Internal Transactions Have Been Temporarily SidelinedMany RIA principals are more reluctant to sell at the pricing implied by recent valuations that consider the impact from the market fallout. Additionally, the next generation of leadership may be less inclined to take on the additional risk if their compensation also took a hit. We haven’t seen any evidence of this so far, but it could work its way through the system if these conditions persist over the next few quarters.External Transactions Might DeclineSince many debt-fueled purchases of RIAs rely on variable rate financing, many prospective external buyers will also be sidelined if borrowing becomes more expensive. Lenders could also get spooked by rising volatility and waning profitability for many RIA firms.Planning Is More Important Than EverDuring this time when the outlook for global markets and the economy is uncertain, many RIA principals are working to nail down the unknowns associated with business ownership. RIA principals are devoting more time to working on their buy-sell agreements in an effort to protect the working relationships with their partners and ensure they and their families are protected financially in the event of a divorce, partner dispute, disablement, or death.The current environment is ripe with uncertainty. This presents both challenges and opportunities for principals of investment management firms. As we all know, this will eventually pass, so most of our clients are focused on positioning rather than acting.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of March 15, 2022

Q4 2021 Earnings Calls

Inventory Shortages Continue to Dominate the Auto Dealership Operating Environment

There continues to be no end in sight for new vehicle supply constraints. In past posts we have noted how executives keep kicking the can down the road, guessing things will normalize in 6 months or so, which they’ve been saying for the past twelve months. Group 1’s management team was refreshingly honest on the situation as detailed in the quote below.“I have been unable to predict on [when inventories normalize] with any accuracy at all. I continue to be shocked. And every month seems to delay the recovery another month. Clearly, no one is building inventory still. […] It seems that there are some issues beyond chips as well now with COVID interruptions and shipping interruptions […] I can’t even keep track of all the stated reasons. But it would certainly seem the first half of the year is going to remain with severe new vehicle inventory shortages. I don’t know what will happen in the second half of the year.” – Earl Hesterberg, CEO of Group 1 AutomotiveInventory shortages are at the forefront of many of this quarter’s themes. While dealers across the country are looking to increase their new vehicle inventories, used vehicles are in greater supply. Numerous executives noted they are carefully managing this inventory to avoid getting burned on currently elevated prices. All the publics (except Lithia) explicitly mentioned a hope that inventories would increase to a new normal, that is below pre-pandemic inventory levels. Executives also seem to generally believe that GPUs will normalize with inventories, though a push for market share by industry participants may further shrink GPUs once inventory is available.On February 15, Edmunds released research indicating 82% of car shoppers paid above sticker price in January. While there have been reports of dealers charging above the manufacturer’s suggested retail price (“MSRP”) since mid-2021, the practice has proliferated and analysts sought comment on the topic this quarter, which was generally denounced for various reasons, again with Lithia being the exception.M&A was not as big of a topic of conversation as in prior calls, though it does still come up. The current M&A market for dealerships is similar to the market for the vehicles they sell: values are elevated above historical norms. As a result, dealer principals may be more interested in testing the waters on what they could get for their dealership. Most executives and dealer principals acknowledge that recent strength in new vehicle grosses should normalize whenever inventories normalize (we’re still waiting). Still, if dealers think the price is right, they may be willing to sell if they can get anywhere near a “normal” multiple on these heightened profits.Private dealers testing the waters on the Blue Sky for their dealership reminds me of Zillow’s “Make Me Move” feature that they recently discontinued. Homeowners on the fence about selling used to be able to post a high price, and if they got traction, they may decide to sell, avoiding the potential penalty of having your home listed for a significant amount of time, which leads to price concessions or actually discourages would-be buyers assuming something “must be wrong” with the house. Bringing it back to vehicles, I recently tested what offer I’d get on my 11-year old vehicle and was pleasantly surprised as it was considerably above its pre-pandemic value.When it comes to M&A for the public automotive retailers, they continue to focus on brand and geographic fit. An interesting nugget came from Sonic that may be interesting to smaller market dealers. While 2021 was the year of the mega-deal, Sonic noted its large RFJ acquisition (which was one of the mega-deals) primarily operates in smaller markets. While the company previously would not have been interested in buying such dealerships, the success they’ve seen thus far means they are open to more tuck-in acquisitions of dealerships in smaller markets, a welcome development for such dealer principals.A couple of other interesting pieces didn’t quite make their own theme. Penske threw cold water on the adoption of EVs, noting that 98% of its sales have been ICE over the past three years, and while OEMs have committed to more EV models, Penske believes it will take “longer than people expect” for widespread adoption, largely due to costs of EVs. Regarding discussions about direct-to-consumer sales, he also called attention paid to startups like Rivian “overblown.” Penske also holds more used vehicle inventory than Asbury, AutoNation, Group 1, and Sonic.Lithia also holds more used vehicle inventories than its peers and as noted previously, and doesn’t have a problem with charging over MSRP. Curiously, its executives also began positioning the company for an environment without franchise laws as it suggests the industry could move towards an agency model with its manufacturers by 2035 (see page 18 of its investor presentation).Theme 1: While dealers are looking forward to more normal inventory levels, they believe there is something to be learned from the heightened profits in the last year: auto dealers are hoping “normalized” inventory levels will be considerably below pre-pandemic levels.“So we don't want 60-day supply inventory. We don't need more 45-day supply inventory. They could just get it back to the 20 and 30-day supply you got great demand, great margin, and it sets up '22 and really '23 for just to be fantastic years for the industry. – David Smith, CEO, Sonic Automotive“The OEMs have become more sophisticated in that regard. And they understand that too much inventory is bad for us and we're not going to take it. And it's bad for them too. And that lesson is really being driven home right now to the OEMs as to the cost of excess inventory. The distribution channels in both the US and UK have been overstuffed for a decade or more. And now that they get leaned out, you can see what it does for the OEM profits also. It's much better for them. And so I think we're going to be in a much better position going forward.” –Earl Hesterberg, President and CEO, Group 1 Automotive“I have to believe that given all the learning through the pandemic and supply and demand dynamics that we've recently seen and the clear messages coming from the manufacturers, we will not return to the excessively high inventory levels that depressed new vehicle margins for both the dealers and the OEMs. […] And the levels of profitability for both OEMs and dealers clearly show the benefits of selling vehicles at MSRP. And what a concept, right, selling at MSRP.” –Michael Manley, CEO, AutoNation“When you look at the floor plan support, you look at customer support, and you look at the incentives that are being paid over the traditional years where we had normal business, the OEMs are digging deep in their pocket. Now they’ve seen a real benefit by backing that off. In fact, I think that’s helping them look rationally down the road that will help them find the R&D that’s going to be necessary when we look at electrification. So hopefully, they got a taste of that. And that will be a slow return and they’ll keep the day supply in the 30 to 45 days and we won’t obviously be where we are today in single-digits. But I think we can manage that carefully brand by brand.” –Roger Penske, Chairman & CEO, Penske Automotive GroupTheme 2: Whenever vehicle inventories normalize, vehicle profitability is expected to normalize as well, though some executives cautioned an attempt to grab market share could further depress heightened GPUs. Notably, Lithia’s base case assumes vehicle profitability fully returns to pre-pandemic levels.“Well, I would hope no one would ever go over 50 days again. And, of course, historically the domestic has always had well over that because of these -- the big variation on the build combinations of full-size trucks and things like that. But for decades Toyota dealers have operated well below 30 days and never missed that much business as far as I could tell. So I think most brands can operate in 30 days to 40 days. And hopefully there will be a corporate memory that the OEMs also can see this benefit and try to manage that way as we go forward. However, any time these large auto companies start fighting for market share that's when the discipline can erode." – Earl Hesterberg, President and CEO, Group 1 Automotive“It's a competitive world and you never know what someone is going to do to try and gain market share and grow their business. I think everyone's learned from the concept that we can be effective with a lower days supply and everyone can benefit from that. Does that mean we'll stabilize at a 35, 40 days supply compared to a 65 or 70? I think it's too early to tell.” –David Hult, CEO, Asbury Automotive Group“Total vehicle GPUs returning to pre -pandemic levels. […] Every day it does seem like the window for increased elevated margins are probably there for longer than we all would like or our consumers would like, but it may be that they don't return to some normalized level” – Bryan DeBoer, President and CEO, Lithia MotorsTheme 3: Used vehicle prices have runup even as compared to the price increase of new vehicles. Public auto dealers are trying to avoid being left holding the bag as the company holding too much used vehicle inventory when the music stops."It's hard to tell but we see the values starting in November, December, have adjusted meaning that they're not growing exponentially as they were before. And until the inventory levels, our belief is until the inventory levels for new cars somewhat stabilize, the used car valuation is going to remain where it is right now. And I don't -- we don't believe that when there is a correction that it will be an immediate correction. It's going to be a gradual correction. So -- but we do believe that is going to be dependent on the new DSI.” – Daniel Clara, SVP and CFO, Asbury Automotive Group“We're sitting at a 36-days supply [on used vehicle inventory…] What you worry about is the rest of the market out there that might have a 60, 80, 90-day supply, they're still sitting on cars that they paid at the height of the market, they're going to have issues. […] It's the price point, right? That's pushing demand up for new cars really because the used car price points are so high and that's got to give. And it's going to give. I mean that's going to happen. Used cars are not -- like I said earlier, are not going to continue to appreciate. We do believe we're starting to see the depreciation cycle start, if the last six weeks are any indication of that.” –Jeff Dyke, President, Sonic Automotive“The used market obviously is super dynamic. We're able to keep the inventories at the level they are because of our -- we changed our sourcing model. And the good thing about the PRUs is, we manage our inventory very tightly. So, any changes in the pricing environment we can react very quickly. I don't know when it's going to change. I feel like it's going to change at some point this year, but I don't know when.” – Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 AutomotiveTheme 4: In the high-priced environment, more dealers are charging above MSRP or requiring customers to buy add-ons in order to get the vehicles they want. OEMs generally denounce the practice, as did some of the public auto dealers. Generally, the practice is viewed to leave consumers not trusting the dealer community.“We've seen a number of comments about vehicles being sold above MSRP, quoting the potential adverse impacts on brands and customers, which I understand. And by the way, last year, less than 2% of all the new vehicles sold by AutoNation were above MSRP. But this discussion on MSRP branded customers actually also adds to my optimism regarding new vehicle margins going forward. Because I think it's equally clear that significant discounting and high incentives can also damage a brand, which is another reason for our industry to balance appropriately supply and demand, and another reason why we may expect higher new vehicle margins than we have historically seen pre-COVID. […] I think where the issue is where you've got a short-term temporary disruption and your supply and demand curve in, what I would call, general market, mass market vehicles, where there is no history in these mass market vehicles of used prices going significantly above for a long period of time against new vehicles. And I think that is where you have to be incredibly careful.” – Michael Manley, CEO, AutoNation“We're pressing very hard for them not to bring inventory levels back to pre-pandemic levels. And so margins are going to stay high. The margins prior to the pandemic are low. We should be selling cars at MSRP. I mean this industry needs to get away from doing all the negotiating it’s a hell of a lot less complex, much easier, and it brings the right value for the vehicle. […] I just don't see margins coming back going back to pre-pandemic levels ever.” –Jeff Dyke, President, Sonic Automotive“However, our inventories are still tight and led to a majority of units being presold. As a reminder, our focus is on driving long-term relationships with our customers. We direct our stores to sell at MSRP. It helps to create the kind of sticky relationships that feeds our segment-leading aftersales performance. We realized it cost us some SG&A leverage in the short term. But for us, it's much more important to drive retention in the strongest part of our business which is aftersales.” –Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 Automotive“Our stores make those decisions in the field. And they do that based off their supply and what their competitors are doing. So yes, we do have some stores that are charging over MSRP. We don't have specific numbers because we don't specifically track it because we allow our network to make the decisions close as to what their customer base is and what the supply and demand is in that local market.” –Bryan DeBoer, President and CEO, Lithia MotorsConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Themes from Q4 Earnings Calls

Part 3: Oilfield Service Companies

Last month, we reviewed Q1 through Q3 2021 earnings call themes from oilfield service companies. Commentary regarding the progress of ESG efforts, whether initiated by the OFS companies themselves or in support of their customers' ESG programs, was prevalent throughout the year. OFS management teams also noted their anticipation of increased industry consolidation by way of M&A activity. Perhaps most poignantly over the first three quarters of 2021, OFS companies signaled increasing leverage in their ability to either start commanding higher prices of their customers, or the expectation they would be able to do so in the very near term.In Part 1 of our Themes from Q4 Earnings Calls, we examined key topics among E&P operators, including:Projections of moderate cost inflation, typically in the upper single digits;Shifting focus towards liquids, including crude oil and NGL streams; andIndustry headwinds stemming from macro energy policies in the U.S. In Part 2 of our Themes from Q4 Earnings Calls, key topics among mineral aggregators included:Greater scrutiny and discipline regarding the execution of M&A deals;Expectations of relatively stagnant production in the near-term; andGreater insulation from price inflation relative to the impact on E&P operators. With this background in mind, we focus this week on the key takeaways from the OFS operator Q4 2021 earnings calls.Macro HeadwindsLabor shortages and supply chain constraints have been a common topic in the daily news cycle regarding the macroeconomic environment in the U.S. Suffice it to say, the OFS industry has not been immune to these factors."You know the story of tubulars people are struggling to get the right tubulars on time. They are having to make substitutions. We are seeing some rig efficiencies begin to deteriorate, which is attributable to several factors. Part of that, of course, is the basins. Different basins have different efficiency profiles. But I think our view is activities at the rig side have slowed down, all things being equal, strictly because of problems with personnel breakdowns. I think the industry is a bit stressed right now." – Scott Bender, President & CEO, Cactus Wellhead"Beyond activity trends, we see a continuation of many of the same things from 2021. Operators will continue to look for ways to improve efficiency and sustainability. We see the current constraints in many critical areas such as labor, sand, and trucking also continuing for the near term." – William Zartler, CEO & Chairman, Solaris Oilfield Infrastructure"Productivity and efficiency was broadly encumbered by 2 significant factors. First, the tightening labor market we faced in the U.S. was exacerbated by COVID outbreaks in certain plants during the fourth quarter. As skilled workers recuperated safely at home, their work was performed by less experienced, less efficient crews or by other skilled workers working overtime. Labor shortages led to higher product costs and scheduling headaches. Second, our manufacturing scheduling headaches were compounded by component and raw material shortages and late deliveries from our vendors who are facing the same sort of challenges that we are. Some businesses report supply chain challenges are getting a little better, but mostly these disruptions are persisting or getting more challenging in the near-term." – Clay Williams, CEO, National Oilwell VarcoIndustry Consolidation through M&A ActivityIn our Q1 through Q3 2021 OFS earnings call themes post, we noted anticipation of greater M&A activity and industry consolidation in 2022. This continued in Q4, with the ongoing expectation of consolidation activity in the near future."We have not given up on industry consolidation. That's our number one priority. And importantly, I don't think the industry has given up on industry consolidation. Yes, the valuations are going to be higher today than they were this time last year, but our currency is also more valuable today than it was this time last year. I don't really consider that to be an impediment to getting a deal done. The impediment is finding the right deal. ... Private equity has decided maybe now is the time to monetize after they've probably given up hope over the last couple of years." – Scott Bender, President & CEO, Cactus Wellhead"As I've stated many times, I believe consolidation is very important for this industry. Through a combination of cash and stock consideration, we closed on the acquisitions of Complete Energy Services, Agua Libre Midstream, HB Rentals and UltRecovery during 2021. Additionally, we are set to close on the acquisition of Nuverra Environmental Solutions. In doing so, we've added nearly $300 million of run rate revenues to an already growing base business and acquired strategic portfolio of infrastructure assets, including gathering and distribution pipelines, disposal facilities, and landfill operations." – John Schmitz, President & CEO, Select EnergyESG ActivityThe Q4 OFS earnings calls were peppered with commentary regarding ESG, including recognition of OFS operator initiatives from outside the industry, the mitigation of environmental impacts on local communities at present, and projections of continued demand for ESG-focused services."We announced our science-based emission reduction targets, added 11 new participating companies to Halliburton Labs and were named to the Dow Jones Sustainability Index, which highlights the top 10% most sustainable companies in each industry." – Jeff Miller, CEO, Halliburton"Overall in 2021, we recycled 25 million barrels that produced water through our fixed facilities, and we expect to continue driving these volumes higher. This recycling alleviates demand for freshwater sources in water stress regions, while also limiting waste disposal which is particularly important in areas of seismicity concerns." – Nick Swyka, CFO, Select Energy"On the technology and sustainability front, we continue to advance our water recycling efforts. We've invested in six facilities during 2021 which are backed by long-term contracts. This sets the stage for a significant growth in our recycled volumes for 2022." – John Schmitz, President & CEO, Select Energy"We're busy upgrading Tier 2 fleets to Tier 4 dual fuel fleets that can utilize up to 85% natural gas. And we expect the pursuit of ESG-friendly operations, efficiency gains and the industry's existing tired fleet of equipment will lead to continued demand for such rebuilds." – Jose Bayardo, CFO, National Oilwell Varco Mercer Capital has its finger on the pulse of the OFS operator space. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the ancillary service companies that help start and keep the stream flowing. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.

Hot Inflation and Cold Markets: RIAs Hit With a New Storm Front

So much for transitory: February's CPI growth came in at 7.9% year-over-year (the highest level in recent memory), and the ongoing Ukraine conflict portends further supply chain challenges that could drive prices even higher. The front-end of the yield curve has shifted higher as market participants reason that rising inflation will force the Fed to raise rates sooner and by a greater magnitude than had been previously anticipated.Historically, a flattening yield curve has signaled an end to a growth cycle, and so far in 2022 that certainly seems plausible. Markets are down and valuation multiples have declined significantly, particularly in high-flying tech stocks. So, what does all of that mean for the RIA industry?Revenue Impact on RIAsAlmost all wealth management and asset management firms employ a revenue model where fees are based on a percentage of AUM. Such a model is unique in that it’s not directly linked to the cost of doing business. In many other industries, there is a far more direct link between pricing and the cost of doing business. If a widget manufacturer’s cost of making a widget goes up, it raises prices to compensate. If a bank’s cost of borrowing goes up, it raises interest rates. And so on.For RIAs, revenue changes with the value of client assets, not the cost of doing business. While larger accounts are often more complicated (and costly) to manage than smaller accounts, the relationship between the cost to manage an account and the value of an account is not linear. If, for example, a $20 million account decreases to $10 million, the cost of managing that account is unlikely to drop by half. The consequence is margin pressure.The percentage of AUM revenue model works well for the RIA industry because it aligns interests between clients and advisors (fees increase when the value of a client’s assets increases). In times of rising markets, the percentage of AUM revenue model is an enviable one: market growth can drive revenue growth that is largely decoupled from the cost of doing business, which has allowed significant margin expansion and profit growth in the industry.This operating leverage is the secret sauce of RIA margin expansion. In recent years, market growth alone has contributed to 10-15% annual revenue growth at many firms—far outpacing formerly modest inflation effects. Even many firms with negative organic growth have seen growing revenues and profitability as market growth has more than offset client outflows.Current market conditions, however, demonstrate the downside of the “percentage of AUM” revenue model. Through March 8th, the Russell 3000 index was down over 14% year-to-date. For all but the most rapidly growing RIAs, organic growth will have done little to offset the market decline this year. Tiered fee structures may help mitigate the impact (the first dollar of AUM lost is often at a lower fee rate than the firm’s overall rate), but run-rate revenue for many RIAs has likely still taken a significant hit so far this year. RIAs often bill on a quarterly schedule, so the impact of the current market downturn may not have been felt yet, but it will soon absent a significant turnaround. Operating leverage works both ways.While RIAs have little control over market movement, they do have control over their fee schedules and fee discipline. If there were ever a time to increase fees, now would (theoretically) be the time. Everyone is experiencing rising costs across nearly every aspect of their lives, so price increases are to be expected. But RIAs are in an awkward spot when seeking to raise their fees—the whole point of the “percentage of AUM” revenue model is that the fees paid scale with the value of the account.Informing clients of increasing fee schedules at a time when their account value is down significantly is unlikely to be well received despite the familiarity of price increases elsewhere. When you combine that with the secular trend of declining fees in the investment management industry, we think that the ability of firms to raise their fee schedules is somewhat limited. For new clients, there may be more flexibility to remain disciplined on stated fee schedules in order to more closely align the price of investment advice with the cost of delivering it.Cost Structure ImpactAt the same time that revenue is declining, the fixed cost base for RIAs is facing significant upward pressure. Tech and software vendors, landlords, professional service firms, and the like are all raising prices at the fastest pace in decades to reflect their own higher costs of doing business and strong demand. While it takes time for these price increases to make their way to an RIA’s P&L, rising costs seem unavoidable for many RIAs unless inflation retreats significantly. With rising costs and declining revenue, the potential for margin compression if the current environment continues is very real.Most significantly, compensation costs (the largest component of an RIA’s cost structure) are under pressure given the extremely tight labor market and record turnover. RIAs will need to balance increasing compensation costs in order to retain key employees with firm profitability. We’ve said it often in the past, but compensation mechanisms that directly link employee pay to firm profitability (e.g., through a variable bonus pool or equity compensation) not only help to attract and retain key employees, but also help to preserve margins when revenue declines. How to best structure compensation packages to weather environments like today’s is a topic for another blog post, but it suffices to say here that we see firms with well-structured compensation packages that balance short term (salary), medium term (bonus), and long term (equity) incentives as having a competitive advantage in tight labor markets and volatile financial markets alike.M&A and Deal ActivityM&A activity and consolidation in the RIA industry is driven largely by long-term, secular trends like aging founders, lack of succession planning, and gaining access to the benefits of scale and broader service capabilities. As such, the longer-term trends in deal activity are likely to continue. In the short run, however, we could see an impact on M&A deal volume and pricing depending on the duration of continued inflation and the current market downturn. If revenue declines and margin contraction persists, we may see sellers delay going to market in order to wait for performance to rebound. For deals that do occur, multiples at the top-end of the current range may come under pressure without the backdrop of a market updrift to rationalize premium pricing.Further, there is the potential for RIA aggregator models (which account for a significant portion of total industry deal activity) to come under pressure if the current market environment continues. These firms typically rely on floating rate debt and high leverage to acquire RIAs, leaving them particularly exposed if the performance of the underlying firms deteriorates or if interest rates increase.So far, we haven’t seen any downturn in deal activity. Fidelity’s monthly Wealth Management M&A Transaction Report listed 13 transactions in February, a record level for the month. But, as we saw in 2020, there can be a lag between market activity and a noticeable impact on deal volume due to the multi-month process between deal negotiations, signing, and close. Recent market pricing of public RIA aggregators isn’t terribly encouraging; their cost of capital is going up rapidly – but that too is a topic for another post.There’s still much uncertainty about the duration of the current market environment and the ultimate impact it will have on RIA performance. The upshot to all of this is that revenue growth in recent years has far outpaced the cost of doing business for most firms, allowing margins to expand to healthy levels. As a result, many firms today are well positioned for a potential downturn given their robust margins and ample cushion to absorb possible revenue declines while remaining profitable.

February 2022 SAAR

The February SAAR was 14.1 million units, down 6.4% from last month and 11.7% below this time last year. After last month’s SAAR of 15.0 million, the 2022 Q1 SAAR is expected to be the highest since Q2 2021 when the vehicle inventory shortage started to fully take hold. While the seasonally adjusted annual rate has certainly improved from the lows of late 2021, raw sales numbers tell a different story. Raw sales volumes in February were much lower than in previous years, as shown in the chart below. Seasonal adjustments in the early months of the year typically account for lower expectations in those months after lofty sales expectations in December, explaining the discrepancy between raw sales and the SAAR metric. Unadjusted figures show just how constrained inventories are.Source: Bureau of Economic AnalysisIn February, the new vehicles that were available to sell continued to fly off the lot. According to J.D. Power, the average time a new vehicle sat on dealer’s lots was 20 days, down from 54 a year ago but up from the record low of 17 days in December 2021. In response to this persistently high demand, OEMs are expected to reduce incentive spending even more in February to a per unit average of $1,246. To give some perspective, when shown as a percentage of MSRP, incentive spending is at an all time low of just 2.8%. Average transaction prices on new vehicles are expected to reach $44,460 this month, an all-time February record and an increase of 18.5% from a year ago.Used vehicles continued to appreciate throughout February. While the intrinsic value of these vehicles might be unchanged or lower than months prior, constricted inventories continue to prop up price increases. According to J.D. Power, the average amount of trade-in equity that consumers were able to cash in on was up 93% compared to this time last year.Source: Bureau of Economic AnalysisComing as no surprise to dealers, new and used vehicle inventories remained scarce over the last month. The industry’s inventory to sales ratio was 0.171 in February, the lowest recorded value since the Bureau of Economic Analysis started tracking the metric in 1993. Inventory shortages have been present for almost a year now, and the supply chain issues that have perpetuated the shortage are here to stay until 2023 at the earliest. For more discussion on production issues, check out our January SAAR blog.Parts and Service Outlook – Manufacturers, Competitors, and TrendsAuto dealerships have several sources of revenue, including sales of new and used vehicles, financing revenue from internal F&I departments, and parts and service revenue from on-site vehicle repairs. While all of these revenue streams are essential to a successful dealership, the margin structures of each department fundamentally differ. Most important for this blog, parts and service departments have the healthiest margins at an auto dealership, making these departments essential to profitability.Higher fixed operations margins combined with increasingly aged vehicle populations have made parts and service departments more and more important over the last year and into the early months of 2022. Check out our recent blog for an in-depth look into the importance of fixed operations for your dealership. In this blog, we seek to provide an update on the auto parts industry, including manufacturers, competitors, and expected ramifications on dealers’ fixed operations.Raw material increases and rising labor costs have soared for parts manufacturers around the country, leaving many operators asking themselves how they will offset increasing costs without getting price relief from OEMs.Auto Parts Manufacturers – There are Always LosersLately, auto parts supply chains have been the target of headlines. While most of the discussions in our weekly blogs have focused on supply chain disruptions’ impact on the production of new vehicles, these same issues also apply to individual parts. Namely, auto parts manufacturers have been experiencing cost issues over the last year. They must feel like they are getting left out of one of the most profitable periods in the auto industry’s history.Raw material increases and rising labor costs have soared for parts manufacturers around the country, leaving many operators asking themselves how they will offset increasing costs without getting price relief from OEMs. This relief has not materialized due to the contract structure that the industry has in place, as explained in further detail below.Contractual agreements between OEMs and parts manufacturers set prices for the entire length of a vehicle’s production cycle and are difficult to renegotiate without both parties’ goals aligning. In the past, OEMs have not always benefitted from the fixed nature of these contracts and are now hesitant to renegotiate terms, especially when they are on the winning end of the deal. General Motors President, Mark Ruess, recently said that “passing things through is not the way to create value for customers.” While this may be true, the statement would also make sense if dealers and OEMs replaced customers.Auto Parts Retailers – Direct CompetitionAuto dealers are obligated to purchase parts for their service departments directly from OEMs. This relationship ensures that standardized replacement parts are offered to consumers and that OEMs can control the prices paid for these parts. In this framework, however, auto parts retailers like O’Reilly Auto Parts and AutoZone become direct competitors of auto dealers’ parts and service departments. The key question is: “Can these retailers get generic replacement parts cheaper than OEMs?” and “Can auto parts retailers effectively siphon off market share from parts and service departments?”Auto parts are getting pricier, and demand for those parts is increasing, but well below the rate of vehicle prices themselves. As shown in the chart below, motor vehicle parts and equipment were 12.6% more expensive in January compared to a year earlier, while used-car prices increased 40.5% in that same time frame. With consumer demand for parts and services high, auto parts retailers have been able to capture success. For example, in 2021, Advance Auto Parts increased its operating margin for the fourth consecutive year. Likewise, O’Reilly Auto Parts and AutoZone also experienced margin growth. As 2022 gets into full swing, parts and service departments as well as auto parts retailers are both expected to get bigger slices of the growing auto industry pie. When it comes to your dealership’s parts and service department, it is unlikely that future competition between auto parts retailers and parts and service departments reaches the point where significant market share is at stake. However, further margin improvement is expected across the board as high auto prices keep existing vehicles on the road for longer, requiring more replacement parts with favorable margins priced in.As 2022 gets into full swing, parts and service departments as well as auto parts retailers are both expected to get bigger slices of the growing auto industry pie.Trends – Expectations in 2022Like new and used vehicle departments, auto dealers’ parts and service departments are poised to thrive in 2022. Increased mileage on an aging vehicle population is expected to keep the demand for auto parts high and dealerships fixed operations are expected to remain strong enough to prevent lost market share to retailers. Increased automation, digitization, and electrification may represent a tailwind as professionals are more likely to handle increasingly difficult repairs. Also, margins should remain healthy as parts manufacturers struggle to enforce desired price increases.On the other hand, some factors could be a drag on parts and service departments’ success over the next year. For example, increased vehicle leasing could encourage consumers to put off repairs on cars and trucks that they do not personally own. More reliable models also tend to need less work overtime, as procedures like oil changes happen less often. Electric vehicles, a growing segment, raise issues for dealerships in the short and long term as dealerships are experiencing a shortage of qualified technicians and equipment to conduct repairs on these types of vehicles.March 2022 OutlookMercer Capital’s outlook for the March 2022 SAAR is pessimistic. January and February are the two months that require the largest seasonal adjustment to the SAAR metric, hiding low volumes behind low expectations that accompany any year’s first two months. Vehicle sales in March are typically higher than January and February, meaning that continued record low inventory and sales volumes are likely to rear their head in next month’s seasonally adjusted annual rate.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Do RIA Investors Prefer Growth Over Value?

What Public Company and Transaction Data Multiples May Tell Us About RIA Investor Preferences

As valuation experts, we watch trading multiples closely in both the public and private markets. We diligently follow handpicked investment manager indexes, and we monitor publicly disclosed transactions as well as our own proprietary data collected through our hundreds of valuation engagements. In a valuation context, market pricing is often viewed as a test of reasonableness as to an appraiser’s conclusion of intrinsic value. As any investment management professional knows, the reason may elude public pricing from time to time, but in the long run, market pricing is the only true proxy for intrinsic worth. Studying how multiples change over time helps us contextualize industry trends and pervading sentiments.In recent years, market sentiment for publicly traded investment managers has lagged the optimism seen in the robust private markets for RIAs and other investment managers. This should sound counterintuitive. In most cases, publicly traded companies are priced at a premium to their typically smaller, less liquid peers. Theoretically, public companies enjoy the benefits of liquidity and heightened access to capital which in turn spurs growth. Additionally, publicly traded companies are typically larger and have demonstrated the aptitude to amass scale, institutional backing, and brand necessary for an IPO. To some degree, these trends do bolster public market valuations, which makes it all the more striking that public multiples should trail private market competitors.*Table represents Mercer Capital’s index of U.S. publicly traded investment management firms with under $100 billion in AUM, excluding those specializing in alternative investmentsWhile public companies traditionally warrant outsized multiples, transaction data to is often biased upwards. In most cases, and especially in the investment management industry, deals are made for the purpose of unlocking “transaction value.” This may arise from increasing profitability, growth, or reducing risk. For instance, in joining two firms, advisors may be able to increase margins by sharing overhead and management costs or by streamlining cost-effective operational platforms. In other instances, advisors may be able to tack on new service offerings or expand into more strategic geographies. Any value identified in a transaction above fair market value is referred to as a transaction premium and is often shared between the buyer and seller upon negotiated terms.Transaction premiums vary widely and are difficult if not impossible to quantify without already having determined a specific buyer. In the context of “fair market value” – the most common standard of value used in appraisals — we try to decouple any transaction premiums when relying upon transaction data. In many instances, however, transaction premiums cannot be identified in private transactions due to the inability of a third party to ascertain the value a unique buyer sees in their purchase. For this reason, appraisers are often cautious when using guideline transactions data. A common proxy for a transaction premium, albeit a rudimentary one, is an earnout. Earnouts are contingent money paid out to the seller over time based on future performance. The purpose of an earnout is to align the incentives of the buyer and seller after any transaction is closed. If we consider earnouts to be a decent proxy for a transaction premium, transaction multiples observed from private market data still indicate a premium of 6.4% enterprise value to revenue and 27.4% enterprise value to EBITDA (see table below). We believe there are multiple reasons for this discrepancy in pricing among public and private buyers. First, most publicly traded investment management firms can be categorized as asset managers, specializing in investment products and seeking to generate alpha, while the typical RIA often focuses on wealth management, specializing in a range of services to protect and grow client wealth. Over the past decade or so, asset managers have faced fee compression as passive investment products such as ETFs and index funds have outperformed actively managed funds in both fund flow and return. Wealth managers, on the other hand, have demonstrated exceptional client retention independent of market performance. Consequently, wealth managers are often valued at a premium to asset managers in the current market environment. This may explain to some extent why smaller transactions are trading at multiples above publicly-traded competitors, but probably not entirely. For instance, consider Silvercrest Asset Management Group, Inc. Despite its name, Silvercrest can be considered, for all intents and purposes, a wealth manager. According to Silvercrest’s most recent 10-k, the RIA boasts 98% client retention and promotes itself as a financial advisor offering family office services to ultra-high net worth individuals (net worth above $10 million) along with investment services to institutional investors. While investment research, portfolio construction, and implementation are performed in-house, Silvercrest benefits from the same higher margin, higher retention model of any wealth management firm. Despite the similarities to smaller wealth managers, Silvercrest was trading more or less in line with the median multiples observed among publicly traded asset management firms with assets under management below $100 billion. Compared to our proprietary transaction data, excluding contingent consideration, Silvercrest is valued well below private market indications. So, Who Is Correct?To understand the pricing discrepancy between public and private markets, it is helpful to look to the publicly traded RIA consolidators for perspective.The aggregator value proposition to investors can more or less be summed up as enhanced growth through RIA (typically wealth management) acquisitions done at multiples below the aggregator’s multiple (multiple arbitrages) and financed with cheap (for now) debt. RIA multiples have expanded significantly in recent years, which leaves growth as the primary driver of shareholder return. While the aggregator model may advertise streamlined platforms or expansive service offerings, the business model is more or less the same as those wealth managers they look to acquire. Multiples, however, tell a different story. As seen in the table above, median revenue and EBITDA multiples are well above those observed in our transactions data, suggesting a significant premium on growth in the RIA market.The premium investors place on growth in the RIA industry helps explain the discrepancy in multiples between the private and public markets. The private RIA market is dominated by a handful of aggregators, and the need to achieve growth to appease shareholders may be a primary reason for outsized valuations within the smaller, private markets. Additionally, smaller RIAs, like any smaller company, are able to achieve superior growth during the beginning of their life cycle, better attracting buyers and higher valuations. While in most industries the premium placed on outsized growth for smaller companies is typically offset by higher discount rates attributable to company specific risk, the RIA industry may place a higher premium on growth opportunities than other industries.As independent appraisers, our objective is to render an unbiased conclusion of value that is both aware of while also independent of general market sentiments. This is why it is essential to hire an appraiser with both deep industry knowledge and expertise in business valuation. If you are considering a valuation or a transaction, please contact a Mercer Capital professional.

Price vs. Value

How Can the Conclusion of Value for the Same Auto Dealership Be Different?

Do you first see a man playing the saxophone or the face of a woman? How can different folks viewing the same image see different things? These types of images are fun and there are the reasons that we see what we see which involve human psychology and how the brain works. In terms of a business valuation, how can the conclusion of value for the same auto dealership be different?Arriving at Different Conclusions of ValueWe have heard it said that if you have ten different business appraisers perform a valuation of the same auto dealership, they might arrive at ten different conclusions of value. That doesn't sound comforting. How is this possible? In the previous two-part blog series on Levels of Value (here and here), we discussed a few potential reasons.Values can differ due to the appropriate level of value for the intended valuation or due to the purpose of the valuation. Values can also differ because the valuation process is both an art and a science. The science of valuation includes the three valuation approaches (asset, income, and market) as well as the valuation process (due diligence and financial modeling). The artful part of valuation incorporates all of the underlying assumptions including the appraiser’s understanding, interpretation, and support for each.Valuations can also differ depending on the Standard of Value used in the valuation. The three most common standards of value are fair market value, fair value, and strategic/investment value. A brief definition of each is as follows:Fair Market Value – The price exchanged between a willing buyer and a willing seller, both being informed of the relevant facts, and neither being under compulsion to buy or sell (generally includes the application of discounts for lack of control and marketability where applicable)Fair Value – Generally assumed to be fair market value without consideration of discounts for lack of control and marketabilityStrategic/Investment Value – The value to a particular investor or buyer based on their individual requirements and expectations. Because certain investors are able to generate higher returns from the same assets due to strategic opportunities, they can pay a higher price than other potential buyers and achieve the same level of returnThe Difference Between Value and PriceThe difference can also be explained by the difference between price and value. For a public company, these terms are supposed to be synonymous. In other words, the value of a share of Apple stock is equal to the market price of the equivalent share on a given day. Then again, if the price of every public stock was exactly what it was worth, would Warren Buffet be a billionaire?While the terms price and value are often used interchangeably, their meaning may not be synonymous in the context of a private business, or in this case an auto dealership. In this post, we examine the differences between price and value.The Price of an Asset or BusinessConversely, the price of an asset or business is governed by the supply and demand for that asset. As demand for an asset increases, the price will increase. As supply for an asset decreases, the price will increase. We are seeing the negative impact when both conditions exist in our daily lives with the prices of new and used automobiles, along with most consumer goods. This is also true for auto dealerships themselves. In an increasingly digital world, some of the large public auto retailers are acquiring dealerships in order to increase their scale. This added demand has boosted the Blue Sky values of dealerships. And while there are plenty of headlines about large deals and high valuations, the environment has persisted because strong earnings have made some dealers reticent to let go of their primary asset during a period of record performance.The price of a dealership may also be impacted by circumstances unique to the dealer principal. Selling the dealership may mean the loss of a salary in addition to the residual earnings of the dealership. Given the stage of life and other considerations, some dealers may not be willing to give up the golden goose, meaning it would take a much higher price to compensate them to exit the investment, perhaps exceeding the “value” of the dealership.Price, particularly in the stock market can also be affected by mood, momentum, and sometimes irrational forces. These factors are often referred to as Behavioral Economics. A classic example is “loss aversion” when a person refuses to sell a declining investment to avoid recognizing a loss. In such cases, the person is hoping for a recovery in the price before selling, even if their capital could be better deployed somewhere else. With the GameStop craze last year, plenty of investors piled into the stock wanting to be part of the crowd, being overconfident, or not properly assessing potential risk and return with the investment. While this undoubtedly plays a role in the elevated price, the vast majority of people buying acknowledged the stock price was not in line with the Company’s intrinsic value.The Value of an Asset or BusinessThe value of an auto dealership, or any asset, is generally based on its fundamentals. Under an asset approach, the value of an asset is typically based on the condition, age, and creator of that asset. For an auto dealership, the adjusted balance sheet indicates the fair market value of the tangible assets of the dealership. When combined with the Blue Sky value for the franchise rights, the resulting indication represents the total fair market value of the dealership. Under the income approach, the value of the business is determined by three primary factors: earnings/cash flow, risk, and growth. As cash flow/earnings or growth increases, the resulting value increases. As risk decreases, the resulting value will also increase all other things held constant.While a valuation considers the asset, income, and market approach, the difference between price and value might best be understood through the lens of these approaches. The asset approach is the price of all the Company’s assets, minus the price of its liabilities. The market approach is the price someone else might be willing to pay, based on prices paid for similar dealerships. The income approach however is more of a value perspective. It is based on an expectation of future earnings, weighed against a required rate of return. The value indication is primarily driven by these return expectations, rather than a price an investor would be willing or able to pay.Price or Value in Auto Dealership Valuations?After analyzing the differences between price and value, let’s revisit some of the purposes and data points for an auto dealership valuation to determine whether the conclusion represents price or value.Wealth Transfer/Gift and Estate – VALUEThe valuations of auto dealerships for these purposes are compliance-based and serve to protect the integrity of the transaction or transfer. The valuations are based on the classical valuation models and the conclusions will generally illustrate value.Valuation for Strategic Planning for Dealer to Contemplate a Sale – PRICEIn this instance, the appraiser might consider specific factors of the investment or buyer in addition to the classical valuation models. The conclusion might consider cost savings to the eventual buyer or improvements that a larger or more sophisticated buyer could implement to improve current operations.General Litigation or Divorce – VALUEIn the context of most ligation settings, the appraiser is asked to determine the value of the auto dealership for the trier of fact. Likewise, these valuations are based on classical valuation models and the conclusion will generally illustrate value.Internal Transactions within the Company’s Stock – VALUE and PRICEIn the course of a valuation of an auto dealership, the appraiser will ask management if any recent transactions have occurred in the stock of the Company. Transactions typically consist of an owner buying into the Company or the Company or owner redeeming another owner. These transactions can serve as data points to the valuation. Often, the sophistication and motivation of the buyer and seller are unknown. Further, many of these transactions occur without a formal valuation. In many cases, these transactions will reflect price (how much the buyer can afford to pay) and not necessarily value (what a hypothetical disinterested third party might be willing to pay). Typically, an appraiser would seek to investigate the motivation of the parties and evaluate the conclusion in the context of other classical valuation models to determine if they are an appropriate indication of value.ConclusionAs we have discussed, price and value are terms that are often used interchangeably. In the context of privately held auto dealerships, the terms can represent different conclusions of value. Some define price as what you pay for an asset, while value is what you receive or what something is worth.Understanding the purpose for a valuation and the appropriate level of value can dictate whether the conclusion represents price or value. Understanding these terms and the other factors discussed in this post can also explain some of the differences in concluded values for the same auto dealership.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Acquire or Be Acquired (AOBA) 2022: Review & Recap

After going virtual in 2021, the Omicron waved peaked just in time for the Acquire or Be Acquired (AOBA) conference to resume its normal physical presence in Phoenix, Arizona during late January.The virtual sessions in 2021 lacked their normal impact, given the inability, through face-to-face communications, to delve deeper into emerging strategies and industry trends with peers and subject matter experts.The most common sentiment expressed this year was simply the gratitude that we could gather once again, connecting with existing industry contacts and establishing new relationships.AOBA’s emphasis has evolved.When we first attended the conference, the sessions emphasized acquisitions of failed banks to such a degree that presenters struggled to avoid overlapping content.Then, the conference shifted to emerging from the Great Financial Crisis and the transition to unassisted M&A transactions.We still remember the years that distressed debt buyers roamed the halls looking for unsuspecting bankers with loans to sell.More recently, the traditional financial services industry structure—with separate, and somewhat inviolable, silos for banking, insurance, wealth management—has been fractured by new challengers from the FinTech sector.Armed with venture capital funding, a willingness to tolerate near-term losses, and a mindset not shackled by traditional operating strategies, the FinTech challengers have sought product lines prone to automation and homogeneity, like consumer checking accounts and small business lending.However, while seeking to disrupt the banking industry, FinTech companies also need the banking industry for compliance expertise, funding, access to payment rails, and the ability to conduct business across state lines.AOBA 2022 sought to unify several discordant themes.The first theme is fracturing and convergence.While FinTech companies seek to challenge the traditional banking industry, they rely on the industry and, indeed, have entered into M&A transactions to acquire banks.The second theme is threat and opportunity.Banks face challenges from FinTech companies for certain customer segments, but FinTech products and partnerships offer access to new products, new markets, and more efficient operations.For fans of price/tangible book value multiples, though, AOBA 2022 still offered plenty of perspective on recent bank M&A trends.We’ll cover four themes from AOBA 2022.1. FinTech Competitors/Partners & the Nature of CompetitionFinTech’s presence continued to increase at AOBA, both in terms of conference sponsors and mentions throughout the conference.The most popular breakout session we attended was entitled “Crypto/Digital Assets – A Threat or Opportunity for Your Bank,” although it is difficult to ascertain whether the attendance reflects mere curiosity or a leading indicator that more banks will enter the Crypto space.One common thread of FinTech-related presentations is that bankers should take a more expansive view of their competitors.Three FinTech-related companies would rank among the twenty largest U.S. banks, as measured by market capitalization, including Paypal Holdings (#4), Square (#9), and Chime (#12, based on the value implied by its last funding round).One speaker encouraged banks to adopt an “ecosystem” strategy instead of an “industry” strategy, noting that families often have 30 to 40 relationships with financial services providers, defined broadly.1Thus, banks’ strategies should not be defined by traditional boundaries but rather embrace the entire financial “ecosystem” in which a range of competitors seek to displace banks from their traditional roles.In this view, banks compete for customers from the “inside out,” while FinTech companies challenge from the “outside in.”It remains difficult to quantify the direct impact on community banks from the current crop of non-bank competitors.Nevertheless, banks’ strategic plans should evolve to reflect the growing population of well-financed non-traditional competitors, for which the pandemic has in some cases accelerated customer adoption.The last FinTech theme related to “partnerships.”This term has evolved towards a somewhat expansive definition this millennium, with seemingly any relationship (even as a customer/vendor) deemed a “partnership.”Certainly, many banks are evaluating FinTech products, with an eye on both expanding revenues and increasing efficiencies.Others are becoming more intertwined with FinTech companies, either as investors or as the banking platform used by the FinTech company itself.There is some evidence that banks more closely allied with FinTech companies are being warmly received by the market, given their potential revenue upside.When evaluating “partnerships,” we suggest deploying a risk/reward framework like banks use in evaluating other traditional banking products.The lower risk/lower reward end of the spectrum would entail limiting the “partnership” to a particular FinTech product or service, such as for opening consumer checking accounts or automating a lending process.The higher risk/higher reward part of spectrum would include equity investments or facilitating the FinTech’s business strategy using the bank’s balance sheet, compliance expertise, and access to payment rails.Like with any bank product, different banks will fall in different places along this spectrum, given their histories, management and board expertise, shareholder risk tolerance, regulatory relationships, and the like.2. Traditional Bank M&A:Tailwinds & HeadwindsMercer Capital provided its outlook for bank M&A in the December 2021 Bank Watch.Naturally, the investment bankers at AOBA are bullish on bank M&A in 2022.This optimism derives from several sources, including the pressure on revenue from a low interest rate environment and the technological investments needed to keep up with the Joneses.Several headwinds to activity exist though:Some transactions initiated prior to the COVID-19 pandemic in March 2020 were placed on hold throughout 2020, but negotiations resumed in 2021.These transactions likely enhanced the reported level of deal activity in 2021, but this deal backlog now has likely cleared.With the banking industry consolidating, fewer potential buyers exist.Smaller banks or banks in more rural areas may face a dwindling number of potential acquirers.Meanwhile, the remaining acquirers may seek to focus on larger transactions in strategic markets.This could lead to a supply/demand imbalance, although non-traditional buyers—read credit unions—could fill the void.After the drama over the FDIC’s leadership, many observers are expecting a more rigorous regulatory review of merger applications, such as around competition issues or fair lending compliance.In the near term, navigating the regulatory thicket would appear most fraught for larger buyers.Another trend to watch is M&A activity involving non-traditional buyers.Mercer Capital’s Jay Wilson presented a session on credit union acquisitions of banks, focusing on the perspective credit unions take when evaluating potential acquisition targets.In a reversal of roles, FinTech companies now have entered the scene as acquirers.In February 2022, SoFi completed its acquisition of Golden Pacific Bancorp, and several other precedent transactions exist.3. Subordinated Debt:Act Now?The subordinated debt market has been quite active, with bank holding companies issuing debt typically with a ten-year term, a fixed rate for the first five years and a variable rate tied to SOFR for the second five years, and a call option in favor of the issuer after five years.Pricing tightened throughout 2021.Through early 2022, pricing of newly-issued subordinated debt has remained stable in the 3.50% range, despite rising Treasury rates.This implies that the spread between the fixed rate on the subordinated debt and five-year swap rates has tightened, falling to levels even below those observed in 2021.Subordinated debt counts as Tier 2 capital at the bank holding company level but can be injected into the bank subsidiary as Tier 1 capital.If bankers expect rising loan volume as the economy continues to recover from the pandemic, then it may behoove institutions to issue subordinated debt now and lock in a low cost source of capital.4. The Regulatory Wild CardSome attendees expect greater regulatory enforcement and rule making activity in certain areas, with the most likely suspect being fair lending.However, leadership at some regulatory agencies remains in flux, such as at the OCC where President Biden’s nominee was withdrawn in the face of Senate opposition.This would not be a constraint, though, at the CFPB, which has a Senate confirmed director who appears ready to take a more active stance on fair lending matters.Interestingly, many larger banks have moved to limit overdraft and insufficient funds charges, even absent any actual (as opposed to hinted at) regulatory changes.Tightening practices around overdrafts appears to be another risk to community banks, which may lack the revenue diversification that permits larger banks to absorb a loss of consumer banking fee revenue.ConclusionWe sense that AOBA is moving into a new era, as it did when the Great Financial Crisis passed.Attendees and sponsors are, to an ever greater extent, coming from outside the traditional banking industry.This mirrors the banking industry itself, with its widening set of non-traditional competitors targeting different customer niches.Future conferences will reveal the extent to which traditional and non-traditional competitors converge.Regardless of what happens with the intersection of banks and FinTech companies, we can only hope that we’ve attended our last virtual conference.1 See Ronald Adner, Winning the Right Game, How to Disrupt, Defend, and Deliver in a Changing World, The MIT Press, 2021.

Themes From Q4 Earnings Calls

Part 1: E&P Operators

InPart I of our Themes from Q3 Earnings, topics included increased global demand for U.S. LNG exports and the divergence in the value proposition of E&P operators. Some opted to focus on using free cash flow to either pursue share repurchase programs and/or increase dividends instead of seeking out acquisition opportunities.On the other end of the spectrum, Continental Resources announced an agreement to purchase Delaware basin assets from PioneerResources to the tune of $3.25 billion. Technically, this acquisition was announced in Q4 (on November 3rd), but Continental’s management team made a point of mentioning it in the Q3 earnings call. Still, some companies, like EOG Resources, signaled setting their sights on pursuing more organic, exploration-driven growth and footprint expansion.In the last round of earnings calls for 2021, cost inflation was discussed with a bit more granularity than in recent quarterly calls, strengthening oil prices sparked a shift in focus towards the liquid hydrocarbon streams, and commentary regarding macro policies targeting hydrocarbons were prevalent in E&P management discussions.Cost InflationIn our Q1-Q3 2021 Themes From Oilfield Service Company Earnings Calls post from late January, we noted that OFS operators were likely hitting an inflection point in mid- to late-2021, with greater command of the prices they charged their E&P customers than in recent history. While service cost inflation was certainly on the minds of some E&P operators, costs for various industry inputs were mentioned in the Q4 earnings calls.“On the service side, on the rig and the frac crew side, because the way that we've contracted those services we've been somewhat isolated so far, in any kind of cost inflation along those lines. Where we've seen the bulk of the inflation so far in our business has been materials, particularly with respect to steel related material. Probably half of the inflation that we’ve baked into our '22 forecast [5% to 10%, year over year] is almost entirely in either steel or tubular. The rest of it, would it be spread across the multitude of materials that we use in our business." – Chad Griffith, Chief Operating Officer, CNX Resources“Our drilling and completion capital budget of $675 million to $700 million reflects an impact of approximately 5% from service cost inflation. This inflation includes the net benefit of expected sand savings from our regional sand mine.” – Paul Rady, President & CEO, Antero Resources“On the cost side, structural operating efficiency gains in 2021 continue to drive our average cost per foot down by approximately 7% on average, year-over-year. In our 2022 budget, we expect modest cost inflation.” – Jack Stark, President, Continental ResourcesShifting Focus Towards LiquidsIt is not newsworthy at this point to say energy prices bounced back over the course of 2021 as compared to the subdued levels seen over 2020. However, despite the significant increase in U.S. natural gas production (with no countering decrease in gas prices), several E&P management teams noted a shift back towards liquids in the latest earnings calls.“While our 2022 lease operating cost per barrel-oil equivalent guidance is modestly above our 2021 level, this reflects our pivoting towards greater oil activity…” – John Hart, CFO, Continental Resources“My comments today will focus on our current view of the liquids markets, more important than ever given we are fully unhedged on all oil and NGL production as of the start of 2022. The past few months, we have seen crude prices reaching their highest levels since 2014, with Brent and WTI touching these 7-year highs supported by global supply concerns and geopolitical tensions across several key regions. At the same time, demand has surprised to the upside and market demand forecasts have been revised upward, primarily due to the more muted impact of Omicron on global consumption compared to previous COVID variants. NGL prices have also benefited in the current bullish price environment.” – David Cannelongo, Vice President – Liquids Marketing & Transportation, Antero ResourcesPolicy HeadwindsIn our Energy Valuation Insights coverage of Appalachia, we noted a strongly worded letter sent from Massachusetts Senator Elizabeth Warren to natural gas E&P operators for the purpose of “turning up the heat on big energy companies who are gaming the system by raising natural gas prices for consumers to boost profits and line the pockets of executives and investors.” Controversy regarding the perception, whether real or imagined, that the U.S. E&P industry holds enough power to materially or unilaterally guide global energy prices is nothing new. However, several comments made in the Q4 earnings calls suggested a deeper underlying sentiment from E&P management teams that certain industry headwinds are the direct result of certain national policies.“We are proud to play our role in supporting U.S. energy security, which protects the U.S. consumer and serves as a powerful tool of foreign policy providing options for both the U.S. and our allies. We must take on the dual challenge of meeting the world's growing energy needs while also prioritizing all elements of our ESG performance, including efforts to address climate change. This is not an either/or proposition and failure on either front is not acceptable. However, our approach must be pragmatic and grounded in the free market, innovation and an ‘all of the above energy’ approach. We are unfortunately experiencing firsthand the impacts of misguided energy policy and the dramatic role it can play on energy affordability as well as geopolitical stability.” – Lee Tillman, President & CEO, Marathon Oil“I may add one other thing that I know you would have seen some of the comments from the Federal Reserve, if I can, this morning about, ‘Do you want to go and target industries?’ [We note that the referenced comments from the Fed could not be readily verified], and so I think that's why you're seeing us and probably the industry at large being very focused on getting that net debt down, because there is potentially a targeting of this industry to not be friendly toward lending money term.” – Bill Berry, CEO, Continental Resources“What you've got right now, not just within Appalachia, but nationally, is a policy that is designed basically to not have a natural sort of [pipeline] investment occur to match something like the supply of natural gas to the demand centers. I don't know if, at last, we're starting to see some problems manifest with respect to that type of policy.” – Nick Deluliis, CEO, CNX Resources Mercer Capital has its finger on the pulse of the E&P operator space. As the Oil & Gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.

Value Adrift?

If You Don’t Know What’s in Your Buy-Sell Agreement, You Don’t Know What You Own

A couple of weeks ago, the crew of a ship known as The Felicity Ace noticed smoke coming from the cargo hold. Below deck were 4,000 cars being ferried from Europe to Rhode Island, including at least 2,000 Volkswagens, 1,100 Porsches, and nearly 200 Bentleys. The fire spread quickly and the 23 members of the crew were evacuated by a Portuguese military helicopter. The ship was left to drift several hundred miles off the coast of the Azores; bad weather has made it difficult to reach The Felicity Ace and tow it to port. The ultimate fate of the ship and its cargo are still unknown, but it’s certain to be a mess.I was reading about The Felicity Ace while we were publishing our recent blog series on buy-sell agreements (here, here, and here). The former is a decent metaphor for the latter. When RIAs are formed, they often enter into some kind of shareholder agreement whereby the parties agree upon rules to buy or sell ownership interests under given circumstances. No one thinks much about it because the expectation of a terminal event – like the sale of the business or the retirement of a member – is so far off in the future. It’s like loading 4,000 cars on a ship and sending it out to sea, assuming that, at the end of the journey, the cargo will be reliably delivered and offloaded in good condition. No one thinks about the ship while it’s on the way from one destination to another until a fire breaks out.Our consistent experience is that few RIA owners review their buy-sell agreements until something UN-expected happens. The partners argue over the future of the business. Someone gets divorced. Someone gets in trouble with the SEC. Someone dies suddenly. At that point, the buy-sell agreement goes from being a forgotten afterthought to the only thing on everyone’s mind. And, unfortunately, that one thing may be subject to interpretation.Our consistent experience is that few RIA owners review their buy-sell agreements until something UN-expected happens.The biggest problem we see in shareholder agreements: pricing mechanisms.If a buy-sell is triggered and a 25% shareholder is to be redeemed, what’s the transaction price?I probably don’t have to tell you what we think of formula pricing. Is the formula a multiple of trailing, current, or forward earnings? Are appropriate multiples reflective of long term averages, current market pricing, good times, bad times? Meant to represent a change of control multiple? To a financial buyer or a strategic buyer? Rational buyer looking for ROI or irrational buyer making a land grab? Pricing reflective of highly synergistic deal terms (use our vendors, sell our products, adopt our brand) or on a stand-alone basis? Sale of actual equity interests or a hybrid instrument that asymmetrically shares upside but protects the buyer against downside?We had one situation where the agreement called for pricing an interest based on “prevailing market value.” What does that mean? Current prevailing market conditions work something like this: RIA with reported EBITDA of $5 million and adjusted EBITDA of $7 million at the time of negotiating the LOI, and reported EBITDA of $6 million and adjusted EBITDA of $8 million at the time of closing, sells for upfront consideration of $40 million plus the potential to get an additional $20 million in earnout if profits grow by 25% in three years. What’s the multiple? Is it:5x (upfront consideration as a multiple of adjusted EBITDA at closing)?6x (total possible consideration as a multiple of hurdle EBITDA at the time the earnout is paid)?7x (upfront consideration as a multiple of reported EBITDA at closing)?5x (total possible consideration as a multiple of adjusted EBITDA at closing)?8x (upfront consideration as a multiple of reported EBITDA at negotiation)?9x (total possible consideration as a multiple of adjusted EBITDA at negotiation)?10x (total possible consideration as a multiple of reported EBITDA at closing)?12x (total possible consideration relative to reported EBITDA when negotiated)? Naturally, the seller wants to believe they sold for 12x, and the buyer wants to tell his capital providers he paid 5x. It does no good to ask parties what multiple was paid. We find that when people whisper deal multiples they tend to go for the highest number possible – in most cases the maximum transaction proceeds possible as compared to a trailing measure of reported earnings. This makes more than a bit of sense, because it’s also self-serving. The seller gets to brag about what he was paid – and we all value psychological rewards. The investment banker brags about what a good job she did – and she probably did do a good job. And the buyer gets a reputation for paying up so the potential sellers will return his call. All of this is good for the deal industry, but not especially revealing as to valuation.We find that when people whisper deal multiples they tend to go for the highest number possibleAbsent some reliance on formula pricing or headline metrics, you can hire an appraiser…like us…but even that’s complicated. Do you pick a valuation specialist or an industry expert? Valuation people characteristically rely on DCFs that might be more expressive of intrinsic value than market. That’s not me engaging in professional self-loathing – it’s just how my tribe is wired. Then there are industry experts – usually investment bankers – who’s perspective leans heavily on the best deal they’ve heard of recently with a highly-motivated and over-capitalized buyer and a pristine target company with strategic relevance.If you hire a valuation expert with ample amounts of relevant industry experience (like us), you should get a balanced approach to the pricing of your transaction. But even the best resources out there (like us) have to deal with pricing expectations set long before we are involved. A buyer who wants something akin to intrinsic value and a seller who wants the high bid from a strategic buyer in a competitive auction are going to have a hard time coming to terms with the result of any valuation exercise. That situation is more common than not.I’ll offer two closing pieces of advice on crafting the valuation mechanism in your buy-sell agreement:Get your RIA valued on some kind of regular basis. If you have a smaller firm, a valuation every few years may suffice. If you have a larger firm, you might need it more than once per year. What this manages, more than anything, is expectations. The psychological bid/ask spread I describe above is much more narrow when the parties to an agreement are accustomed to seeing particular numbers, methodologies, and metrics used to determine the value of their interest. This is the main function of regular valuations. Buy-sell valuations are five-figure exercises. Buy-sell disputes are seven-figure catastrophes.Don’t draft your pricing mechanism to intentionally privilege either the buyer or seller at the expense of the other. We’ve seen estate situations where the company was compelled to redeem a 25% stake for about 45% of the value of the business. The resulting dilution to the remaining shareholders put a huge strain on the business model, ownership transition, and sustainability of the company. We’ve seen shareholder squeeze-outs where a group of shareholders were entitled to kick out a partner for minimal consideration. There’s no virtue in democracy when two lions and one lamb vote on what to have for dinner. Regardless of what you think your RIA is worth, if you aren’t intimately familiar with the terms of your buy-sell agreement, you don’t know what your interest in your RIA will net you in a transaction. Pull your agreement out, and read it. If it seems at all confusing as to how it will function when the buy-sell mechanism is triggered, it will be worse than you expect. There has been considerable speculation as to what sort of cars are in the hold of The Felicity Ace. Are they all conventional internal combustion engine cars with a minimal amount of gasoline in their tanks, or are some of them EVs carrying highly combustible lithium-ion batteries? Whichever the case, it’s too late now to do anything about it. Don’t wait until your ship is adrift and on fire to check your buy-sell. If business is good and your partners are happy – consider this your opportunity.

A Primer on a Growing Breed of Bank Acquirers

Credit Unions & FinTech CompaniesWhile still making up a small proportion of overall deal activity (<10% of total deal volume in 2021), acquisitions of banks by both Credit Unions and FinTechs have been increasing in recent years.The first credit union to acquire a bank occurred in 2011/12.Since then, approximately ~55 whole bank transactions have been announced with the peaks occurring in 2019 (14 transactions) and 2021 (13 transactions announced).The first announced FinTech acquisition of a bank was Green Dot’s purchase of a small bank back in 2010 for $15 million. There were also several online brokers that acquired banks from the late 90s to mid-2000s. In 2021, there was a marked increase with six announced transactions whereby FinTechs announced acquisitions of banks.This emerging breed of bank acquirers (CUs and FinTechs) provides bank sellers with an additional pool of potential buyers to consider when evaluating strategic options and liquidity events.Mercer Capital's Jay D. Wilson and Honigman's Michael M. Bell presented this session at the 2022 Acquire or Be Acquired Conference sponsored by Bank Director.

WHITEPAPER | Understand the Value of Your InsurTech Company

InsurTech companies are an emerging and fast-growing sector of the financial services industry. Against a backdrop of robust fundraising numbers and high profile exits via SPAC or IPO, many of these companies begin as start-ups and a few exciting years later, are able to raise millions of dollars in hopes of becoming the next “unicorn”. While this business trajectory may seem simple and attractive, these companies usually have a highly complex ownership structure made up of many investors of different origins, including venture, corporate, and/or private equity, all with different preferences and capital structures.Valuing an InsurTech company can be complicated and difficult, but carries important significance for employees, investors, and stakeholders for the company. While all InsurTech companies have differences, including what niche (distribution, claims, benefits, etc.) they operate in or what stage of development the company is in, understanding the value of the business is critically important.

LOV(E): Why Getting the Level of Value Right Is So Important to Auto Dealers

Part II

In this two-part series (the first post dropped on Valentine’s Day), we are covering a topic near and dear to the hearts of business valuation analysts. LOV – or the “Levels of value” – refers to the idea that while “price” and “value” may be synonymous, they don’t quite mean the same thing. A nonmarketable minority interest level of value is very different from a strategic control interest level of value.Last week's post and this week's post were adapted from a piece written for Mercer Capital’sFamily Business Director Blog.Part I of this two-part series described the Levels of Value and why the concept is so important to auto dealers. We present the Levels of Value chart below for reference. This week, we discuss four potential transactions in which selecting the appropriate level of value is critical and explain why: 1) estate planning, 2) corporate development, 3) divestitures, and 4) shareholder redemptions. Engagement administration and engagement planning are two steps in the valuation process that don’t garner much of the spotlight. However, defining the scope of the engagement is critical to the success of a valuation project. The scope and eventual engagement letter are often described as a road map for the project to follow. One of the great strengths of a family business is the ability to take the long view. Unburdened by the quarterly reporting cycles of publicly traded companies, family businesses can make investing and operating decisions for long-term benefit without worrying about the effect on the next quarter’s earnings. One of the foundations of this long-term perspective is the stability of ownership within the family. With an indefinite holding period, why does the value of the family business even matter? While the family may have an indefinite holding period, the fact of mortality means that individual shareholders do not. So, even for committed families, transactions will occur and valuations will matter. Let's consider four potential transactions in which selecting the appropriate level of value is critical.1. Estate PlanningMany family shareholders determine that transferring wealth to heirs while still living is advantageous. Regardless of the specific technique used, the value of shares in the family business is a cornerstone of the estate planning process. Under the IRS’ definition of fair market value, the appropriate level of value depends on the attributes of the block of shares being transferred. Since estate planning almost always involves transactions of minority interests in the family business, the nonmarketable minority interest level of value is relevant.There are also elements of estate planning that are unique to auto dealers. All dealerships must be operated by a Dealer Principal approved by the OEM. Any succession plan must consider whether the next generation would be approved as a Dealer Principal by the OEM. This approval is not always guaranteed. When desiring to transfer ownership to the next generation, dealers would be wise to consider a family choice that has been active in the dealership or has industry experience.Any succession plan must consider whether the next generation would be approved as a Dealer Principal by the OEM.Measuring the value of shares in the family business at the nonmarketable minority interest level of value is a two-step process. First, we consider what the shares would be worth if they were traded on an exchange (i.e., the marketable minority level of value). Second, we determine an appropriate discount to apply to that value to reflect the unfortunate side effects of owning a minority interest in a private company. The magnitude of that discount depends on factors like the expected duration of the holding period until a liquidity event, the level of interim distributions, and the expected pace of capital appreciation. When combined with an assessment of the risks facing the investor, these factors determine the marketability discount, which, in turn, defines the fair market value of the shares on a nonmarketable minority interest basis.2. Corporate DevelopmentFamily businesses have two basic pathways for growth: organic growth through capital expenditures (“build”) or non-organic growth through acquisitions (“buy”). The pathways are not mutually exclusive. Some families are culturally averse to acquisitions, while for others a disciplined acquisition strategy is part of the family’s business DNA. As we have discussed in this space in prior blogs, the prospects for organic growth for dealers are somewhat constrained. While dealers can improve Fixed Operations and Used Vehicle Operations, they are limited to selling more vehicles from their OEM on the new vehicle side of operations. Those growth opportunities have been more constrained over the last two years due to inventory shortages and the microchip crisis. For more desired growth, dealers must consider adding additional rooftops or acquiring other dealerships.For more desired growth, dealers must consider adding additional rooftops or acquiring other dealerships.For family business acquirers, developing an appropriate valuation of the target is essential. As one of our colleagues is fond of saying: “Bought right, half right.” Regardless of the strategic merits of a proposed acquisition, the overpayment will weigh on the returns available to future generations of the family. When formulating a bid price for a potential target, acquirers should seek to answer two questions.What is the business worth to the existing owners? Selling their business to you means that the existing owners will be giving up the future cash flows they expect the business to generate under their stewardship. This reflects the financial control level of value, which as we noted in last week’s post, is probably not much different from the marketable minority value.What is the business worth to us? To answer this question, acquirers need to carefully evaluate how the target “fits” with their existing business. Will the combination of the two businesses generate revenue synergies (i.e., 2 + 2 = 5)? Or are there duplicative costs that can be eliminated as a means of generating higher margins for the combined entity? Perhaps the combination will reduce the risk of the family business, or perhaps the family has access to lower-cost capital than the existing owners. In any event, family business acquirers should develop forecasts for the pro forma combined entity using well-supported inputs that reflect the strategic case for the acquisition to determine what the business is worth to them. Forecasts are less seldomly used in the valuation of auto dealerships, but the concept of determining the anticipated future earnings is the same. Auto dealers will generally evaluate the last two to four years of operations to arrive at that conclusion. Due to heightened profitability over the last two years, this exercise can be more difficult. We are seeing many dealers consider an average of several years of operations as an indicator of expected future operations. The difference between these two values defines the “space” over which negotiations will center. The ultimate purchase price will reflect the relative bargaining power of the two parties. As illustrated in Exhibit 1, bargaining power is a function of the number of likely buyers for the target, and whether the target represents a generic or unique opportunity for buyers.To avoid overpaying, savvy family business acquirers focus not just on what the target could be worth to them, but also what the target is worth to its current owners, along with a careful assessment of the factors that influence the relative bargaining power of the parties.3. DivestituresAt some point, many families transition to being enterprising families. In other words, they are defined by the fact that they pursue economic opportunities together, rather than by continued ownership of the legacy family business. In pursuit of broader portfolio management objectives, enterprising families may sell businesses from time to time. In this case, the dynamics described in the preceding section are reversed.In the auto dealer space, we generally see divestitures occurring for one of two reasons in recent times. First, smaller single-point dealers are facing more pressures to compete against larger auto groups in terms of online platforms, imaging requirements, and the fear/threat of electric vehicles being introduced into their models. Secondly, dealers that do not have an identified succession plan or successor Dealer Principal candidates are apt to consider selling. Heightened profits and heightened blue sky valuation multiples are also making the decision to sell more attractive in the current environment.As the seller, you won’t have direct access to what your business could be worth to the buyer. However, knowing how your industry is structured and how your business operates, you should be able to estimate potential revenue synergies and cost-saving opportunities available to the buyer.In order to achieve a sales price closer to the value of your business to the buyer, it is important to identify the attributes of your business that differentiate it from other potential acquisition targets available to buyers. Further, generating interest from a larger pool of buyers is essential to reaping greater proceeds from a divestiture.4. Shareholder RedemptionsA shareholder redemption is a purchase by the family business of shares from a family shareholder. As with our corporate development and divestiture examples from last week’s post, shareholder redemptions reflect an inherent tension between buyers and sellers, as illustrated in Exhibit 2. Unfortunately, we often see these events occur in litigation because of the differing perspectives described below. It’s common for dealers to incentivize key employees and management with an ownership stake as part of an employment agreement. These ownership interests become the subject of redemption if the employee resigns or is terminated from the dealership. In a shareholder redemption transaction, the buyer and seller do not share the same perspective.The selling shareholder owns an illiquid minority interest in a private business. As a result, the fair market value – the amount that a hypothetical willing buyer would pay – reflects a marketability discount. In other words, the nonmarketable minority level is relevant.However, in a shareholder redemption transaction, the buyer is not a hypothetical party, but the company that issued the shares in the first place. The family business is not burdened by the illiquidity of the shares in the same way a shareholder is. As a result, the value of the shares to the family business is consistent with the marketable minority level of value. It strikes us as a bit perverse to evaluate transactions between family shareholders and family businesses in terms of relative negotiating leverage. Instead, we prefer to frame the decision in terms of family business objectives: What is the purpose of the redemption? The “correct” price at which to conduct a shareholder redemption transaction is always a bit ambiguous. Consider the alternatives:Nonmarketable Minority Level. This seems straightforward – after all, that is the fair market value of what the shareholder owns. Why should the family business pay any more than that?Marketable Minority Level. On the other hand, this is the value of what the redeeming company is acquiring. Why should the departing shareholder accept any less than that? From an economic perspective, redemption at the nonmarketable minority level is accretive to the non-selling shareholders. Redeeming at the marketable minority level provides a windfall to the selling shareholder relative to the fair market value of their shares. There is no simple escape from this dilemma. The ambiguity around the level of value in these instances generally exists for engagements for internal and strategic planning purposes. If these events result in litigation, the levels of value are typically defined in the applicable standard of value or case laws of the jurisdiction governing the matter.If the family business wants to discourage redemption requests, the nonmarketable minority level of value may be preferable.If the family business is designing a shareholder liquidity program with a view to promoting positive shareholder engagement, it may be desirable to conduct redemptions at the marketable minority level of value. However, in such cases it is essential to set limits on the amount of redemption requests the family business will honor in a given period; otherwise, the liquidity program could trigger a “run on the bank,” crowding out corporate investments critical to the long-term sustainability of the family business.If the objective of the redemption is to “prune” the family tree of unwanted branches, it may be necessary to pay a redemption price at the marketable minority / financial control level of value. Depending on state statute, it may be a legal necessity. In any event, the departing shareholders are likely to demand such pricing to exit the family business.ConclusionYour family business has a different value at each level of value because of differences in expected cash flows and risk factors. Considering four common corporate transactions, we have illustrated why the level of value matters to family businesses:When transferring minority interests among family members in furtherance of estate planning objectives, the fair market value of the interests transferred is properly measured at the nonmarketable minority level.When considering a potential acquisition, family businesses should evaluate both the marketable minority / financial control level of value (what the target is worth to the existing owners) and the potential strategic control level of value (what the target is worth to the family business). These two values for the target define the relevant range for negotiating a transaction price.When divesting a business, the dynamics are reversed. The relevant negotiating range is set by the difference between the marketable minority / financial control level of value (in this case, what the business is worth to the family) and the strategic control level of value (what the business is potentially worth to the buyer). The family can improve its negotiating leverage in these situations by differentiating the business from other available targets and exposing the business to multiple motivated buyers.Finally, shareholder redemptions can occur at either the nonmarketable minority or marketable minority /financial control levels of value. The appropriate level for a given transaction should be selected with a view to the objectives of the redemption for the family business. These transactions can have profound and long-lasting economic implications for the family business and its shareholders. When the stakes are high, it’s a good idea to measure twice and cut once. When your dealership is preparing for any of these transactions, give one of our valuation professionals a call.

Oilfield Services 2022

The Rise of the OFS Bulls

In our Energy Valuation Insights post from last week, Bryce Erickson focused on Oilfield Services (OFS) company valuations. This week we follow the same OFS theme, but with a focus on OFS “expectations” and the question: “Has the OFS industry turned the corner to a more prosperous outlook?”Enthusiasm Among ExpertsOne can’t come away from a review of current OFS industry musings without feeling that, in the endless battle between OFS Bulls and OFS Bears, the Bulls have gained the advantage and are on the rise.From Bloomberg Intelligence – and under the noteworthy heading of OFS Recovery to Reach Cruising Altitude in 2022 – we find that oilfield services industry revenues are expected to grow by ten to fifteen percent in 2022, compared to nearly flat revenue growth in 2021. North American OFS is expected to lead the way with likely 20% revenue gains.Representatives of investment banking firm Evercore’s E&P and OFS groups noted in a recent Natural Gas Intelligence piece that the E&P and OFS groups’ expectations for 2022 remain bullish as they believe we are in the early stages of a long, strong, multi-year E&P spending upcycle.In its recent industry outlook, Zacks noted that the OFS industry is bright again and that the business environment for E&P activities has shown drastic improvement. That improvement is reflective of oil prices having returned to the “glorious days,” thereby leading drillers to return to the oil patch, resulting in significantly improved demand for oilfield services.Many more significantly optimistic references are available, but suffice it to say that expectations for the OFS industry (due to E&P industry activity) have changed a lot, for the better, in the last year.Basis for OptimismSo, what are the industry experts seeing that is leading to this optimism? In short:oil demand rising as the Covid pandemic recedes and the world begins the return to normal levels of activities that require energy use,significant potential for an oil supply shortage, andrecent under-investment in the new production needed to sustain supply. In light of the factors above, industry analysts are detailing some very positive expectations for the OFS industry. Such as: The Energy Information Administration (EIA) forecasts that global consumption of petroleum and liquid fuels will average 100.6 million b/d for all of 2022, which is up 3.5 million b/d from 2021 and more than the 2019 average of 100.3 million b/d. On top of which the EIA forecasts that global consumption of petroleum and liquid fuels will increase by 1.9 million b/d in 2023. So, for the first time since Covid reared its head in early 2020, global oil consumption is expected to rise to a level materially higher than pre-Covid consumption. Mizuho Securities USA LLC indicates in a January 2022 NGI article (U.S. E&Ps, OFS Players Expected to Reset in 2022, with Eyes on Inflation, Supply Chains) that in order to generate sustainable oil volumes through 2022 based on current production volumes, the rig count across the five major U.S. oil basins would have to increase by 100 rigs, compared to a 178 rig increase since January 2021. Mizuho further indicated that the rate of completions in the major U.S. basins is probably sufficient to support growth. However, the drilled but uncompleted (DUC) inventory is at a historically low level, so more drilling activity will be required. Otherwise, the needed 2022 growth in the U.S. supply could be materially held-back. Early Indications Favoring the BullsAs to early evidence supporting those expectations, Baker Hughes’ most recent North American rig count is at 854, a level not seen since the onset of the Covid pandemic in March 2020.According to Bank of America, due to the draw-down in global oil inventories in 2021, the oil market is anticipated to move from a steep deficit to a more balanced market. With that in mind, BofA is predicting that WTI and Brent will average $82 and $85 over the course of this year.Other industry analysts, including Goldman Sachs Group, are indicating that oil prices could reach $100 during 2022, while forecasting average 2022 oil prices at $85. Employment in the U.S. oilfield services and equipment sector rose by an estimated 7,450 jobs in December, according to the Houston-based Energy Workforce & Technology Council. Zacks Equity Research summarized how all this ties in to the OFS outlook: “The price of West Texas Intermediate (WTI) crude is trading higher than $89 per barrel, marking a massive improvement of more than 50% in the past year. Strong fuel demand across the world and ongoing tensions in Eastern Europe are aiding the rally in oil prices. The massive improvement in oil price is aiding exploration, production and drilling activities. This, in turn, will boost demand for oilfield service since oilfield service players assist drillers in efficiently setting up oil wells.” Potential HeadwindsOf course, there are also headwinds for the OFS sector that will have to be dealt with, including inflation being a key consideration. As detailed in our January 14, 2022 Energy Valuation Insights post, industry analysts are projecting over 30% average OFS revenue growth in 2022, although average EBITDA margins are expected to edge downward from 13% toward 12%. Inflationary factors are pushing up OFS costs, but such increased costs are expected to only partly be passed through to their E&P clients.In addition, the Biden Administration is clearly adamant about getting the country moving rapidly away from hydrocarbon-based energy, despite the public already complaining mightily about fast-rising energy prices and more general inflationary pressures. Where those political winds will carry the matter is anyone’s guess.In SummaryAs indicated, the companies that comprise the OFS segment – at least those that survived 2020 – experienced some stabilization in 2021, and are now facing what appears to be a market that has the industry analysts feeling fairly bullish. Influenced by rising oil demand, an existing shortage, and recent E&P investment well below the sustainable level, expectations have moved from OFS stabilization to strong multi-year OFS growth in 2022 and likely beyond.Mercer Capital has significant experience valuing assets and companies in the energy industry. Our energy industry valuations have been reviewed and relied on by buyers, sellers, and Big 4 Auditors. These energy-related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed energy industry valuations domestically throughout the United States and in foreign countries.Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Additional Considerations for Your Buy-Sell Agreement

Following up on last week’s post (Three Considerations for Your RIA’s Buy-Sell Agreement), we offer four additional considerations that you should be addressing in your firm’s buy-sell agreement. We’ve seen each of these issues neglected before, which usually doesn’t end well for at least one of the parties involved. A well-crafted buy-sell should clearly acknowledge these considerations to avoid shareholder disputes and costly litigation down the road. We highly recommend taking another look at your buy-sell agreement to see if these issues are addressed before something comes up.1. Formula Pricing, Rules-Of-Thumb, and Internally Generated Valuation Metrics Don’t Withstand TimeSince valuation is usually the most time consuming and expensive part of administering a buy-sell agreement, there is a substantial incentive to try to shortcut that part of the process. However, non-professional valuation methods, such as formula pricing, rules-of-thumb, and internally generated valuation metrics are often key reasons for costly disputes or disruptions down the road. The investment management space is particularly fraught, and not too long ago, investment manager valuations were thought to gravitate toward about 2% of AUM.We have written extensively about the fallacy of formula pricing. No multiple of AUM, revenue, or cash flow can consistently estimate the value of an interest in an investment management firm. A multiple of AUM (typically expressed in percentage terms) does not consider relative differences in stated or realized fee schedules, client demographics, trends in operating performance, current market conditions, compensation arrangements, profit margins, growth expectations, regulatory compliance issues, and a host of other issues which have helped keep our valuation practice gainfully employed for decades.The example below demonstrates the problematic nature of this particular rule of thumb for two investment management firms of similar size, but widely divergent fee structures and profit margins.Both Firm A and Firm B have the same AUM. However, Firm A has a higher realized fee than Firm B (100 bps vs 40 bps) and also operates more efficiently (25% EBITDA margin vs 10% EBITDA margin). The result is that Firm A generates $2.5 million in EBITDA versus Firm B’s $400 thousand despite both firms having the same AUM. The “2% of AUM” rule of thumb implies an EBITDA multiple of 8.0x for Firm A—a multiple that may or may not be reasonable for Firm A given current market conditions and Firm A’s risk and growth profile – but which is nevertheless within the historical range of what might be considered reasonable. The same “2% of AUM” rule of thumb applied to Firm B implies an EBITDA multiple of 50.0x – a multiple which is unlikely to be considered reasonable in any market conditions.Flawed ownership models eventually disrupt operations which works to the disservice of owners, employees, and clients.We’ve seen rules of thumb like the one above appear in buy/sell agreements and operating agreements as methods for determining the price for future transactions among shareholders or between shareholders and the company. The issue, of course, is that rules of thumb do not have a long shelf life, even if they made perfect sense at the time the document was drafted. If value is a function of company performance and market pricing, then both of those factors have to remain static for any rule-of-thumb to remain appropriate. This circumstance, obviously, is highly unlikely.But the real problem with short cutting the valuation process is credibility. If the parties to a shareholder’s agreement think the pricing mechanism in the agreement isn’t robust, then the ownership model at the firm is flawed. Flawed ownership models eventually disrupt operations which works to the disservice of owners, employees, and clients.2. Don’t Forget to Specify the “As Of” Date for ValuationThis seems obvious, but the date appropriate for the valuation matters. If the buy-sell agreement specifies that value is established on an annual basis (something we highly recommend to manage expectations and avoid confusion), then the date might be the calendar year end. If, instead of having annual valuations performed, you opt for an event-based trigger mechanism in your buy-sell, there is a little more to think about.Consider whether you want the event precipitating the transaction to factor into the value. If so, prescribe that the valuation date is some period of time after the event giving rise to the subject transaction. This can be helpful if a key shareholder passes away or leaves the firm, and there is concern about losing clients as a result of the departure. After an adequate amount of time, the impact on firm cash flows of the triggering event becomes apparent. If, instead, there is a desire to not consider the impact of a particular event on valuation, make the as-of date the day prior to the event, as is common in statutory fair value matters.3. Appraiser Qualifications: Who Will Perform the Valuation?Once you decide to engage a professional to value your firm, you’ll need reasonable criteria to decide whom to work with. Often, partners in investment management firms feel they are equipped to value their own business as investment management firms (unlike many other closely held businesses) have ownership groups with ample training in relevant areas of finance that enable them to understand financial statement analysis, cash flow forecasting, and market pricing data.What insiders lack, however, is the arms’ length perspective to use their technical skills to determine an unbiased result. Many business owners suffer from familiarity bias and the so-called “endowment effect” of ascribing more value to their business than what it is actually worth simply because it is well-known to them or because it is already in their possession. On the opposite end of the spectrum, some owners are prone to forecast extreme mean reversion such that they discount the outperformance of their business and anticipate only the worst.Partners with a strong grounding in securities analysis and portfolio management have a bias to seeing their business from the perspective of intrinsic value, which can limit their acceptance of certain market realities necessary to price the business at a given time. In any event, just as physicians are cautioned not to self-medicate and attorneys not to represent themselves, so too should professional investment advisors avoid trying to be their own appraiser.Over time, we have reviewed a wide variety of work product from different types of service providers - but have generally observed that there are two types of experts available to the ownership of investment management firms: Valuation Experts and Industry Experts. These two types of experts are often seen as mutually exclusive, but you’re better off not hiring one to the exclusion of the other.Valuation experts can do better work for clients if they specialize in a type of valuation or a particular industry.There are plenty of valuation experts who have the appropriate training and professional designations, understand the valuation standards and concepts, and see the market in a hypothetical buyer-seller framework. The two primary credentialing bodies for business valuation are the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA). The former awards the Accredited Senior Appraiser designation, or ASA, and the latter the Accredited in Business Valuation, or ABV, designation. Both require extensive education and testing to become credentialed, along with continuing education. Also well known in the securities industry is the Chartered Financial Analyst designation issued by the CFA Institute. While it is not directly focused on valuation, it is a rigorous program in securities analysis.There are also a number of industry experts who are long-time observers and analysts of the industry, who understand industry trends, and who have experience providing advisory services to investment management firms.However, business valuation practitioners are often guilty of shoehorning RIAs into generic templates, resulting in flawed valuation conclusions that don’t square with market realities. By contrast, industry experts are frequently guilty of a lack of awareness concerning the use and verification of unreported market data, the misapplication of valuation models, and not understanding the reporting requirements of valuation practice.We think it is most beneficial to be both industry specialists and valuation specialists. The valuation profession is still, for the most part, populated with generalists. But as the profession matures, an increasing number of analysts are realizing that it isn’t possible to be good at everything. Valuation experts can do better work for clients if they specialize in a type of valuation or a particular industry. Because our firm has specialized in valuing financial institutions since the day we opened for business in 1982, it was easy to pursue this to its logical conclusion. Ultimately, you want an expert with both professional standards and practical experience.4. Manage Expectations by Testing Your AgreementNo matter how well written your agreement is or how many factors you consider, no one really knows what will happen until you have your firm valued. If you are having a regular valuation prepared by a qualified expert, then you can manage everyone’s expectations such that, when a transaction situation presents itself, parties to the transaction have a reasonably good idea in advance of what to expect. Managing expectations is the first step to avoiding arguments, strategic disputes, failed partnerships, and litigation.Annual valuations do require some commitment of time and expense, of course, but these annual commitments to test the buy-sell agreement usually pale in comparison to the time and expense required to resolve one major buy-sell disagreement. If you don’t plan to have annual valuations prepared, have your company valued anyway. Doing so when nothing is at stake will make a huge difference if you get to a situation where everything is at stake.Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled. Going ahead and having a valuation prepared will help to center, or reconcile, those expectations and might even lead to some productive revisions to your buy-sell agreement.

LOV(E): What Are the “Levels of Value" and Why Does It Matter to Auto Dealers?

Part I

In the spirit of Valentine’s Day, we are covering a topic near and dear to the hearts of business valuation analysts. LOV – or “Levels of value” – refers to the idea that while “price” and “value” may be synonymous, they don’t quite mean the same thing. In this week’s post, we adapt a piece written for Mercer Capital’sFamily Business Director Blog, and how it specifically relates to auto dealers. This will be the first part of a two-part blog series.Levels of Value OverviewShareholders are occasionally perplexed by the fact that their shares can have more than one value. This multiplicity of values is not a conjuring trick on the part of business valuation experts but simply reflects the economic fact that different markets, different investors, and different expectations necessarily lead to different values.Business valuation experts use the term “level of value” to refer to these differing perspectives. As shown in Exhibit 1, there are three basic “levels” of value for a family business. Each of the basic levels of value corresponds to different perspectives on the value of the business. Let's explore the relevant characteristics of each level.Marketable Minority Level of ValueThe marketable minority value is a proxy for the value of your family business if its shares were publicly traded. In other words, if your family business joined the public ranks of Lithia, Sonic, Asbury, etc. through an IPO, what price would the shares trade at? To answer this question, we need to think about expectations for future cash flows and risk.The marketable minority value is a proxy for the value of your family business if its shares were publicly traded.Expected cash flows. Investors in public companies are focused on the future cash flows that companies will generate. In other words, investors are constantly assessing how developments in the broader economy, the industry, and the company itself will influence the company’s ability to generate cash flow from its operations in the future.Public company investors have a lot of investment choices. There are thousands of different public companies, not to mention potential investments in bonds (government, municipal, or corporate), real estate, or other private investments. Public company investors are risk-averse, which just means that – when choosing between two investments having the same expected future cash flow – they will pay more today for the investment that is more certain. As a result, public company investors continuously evaluate the riskiness of a given public company against its peers and other alternative investments. When they perceive that the riskiness of an investment is increasing, the price will go down, and vice versa. So, when a business appraiser estimates the value of your family business at the marketable minority level of value, they are focused on expected future cash flows and risk. They will estimate this value in two different ways.When a business appraiser estimates the value of your business at the marketable minority level of value, they are focused on expected future cash flows and risk.Using an income approach, they create a forecast of future cash flows, and based on the perceived risk of the business, convert those cash flows to present value, or the value today of cash flows that will be received in the future.Using a market approach, they identify other public companies that are similar in some way to your family business. By observing how investors are valuing those “comps,” they estimate the value of the shares in your family business. Many novice investors are aware of Price-to-Earnings ratios, and there are plenty of valuation multiples that can be gleaned from public auto dealers. While these are two distinct approaches, at the heart of each is an emphasis on the cash flow generating ability and risk of your family business. We start with the marketable minority level of value because it is the traditional starting point for analyzing the other levels of value.Control (Strategic) Level of ValueIn contrast to public investors who buy small minority interests in companies, acquirers buy entire companies (or at least a large enough stake to exert control). Acquirers are often classified as either financial or strategic.Financially motivated acquirers often have cash flow expectations and risk assessments similar to those of public market investors. As a result, the control (financial) level of value is often not much different from the marketable minority level of value, as depicted in Exhibit 1. Imagine a private equity buyer with no other auto dealership investments. They’ll pay for the right to earn the cash flows you’ve been generating, but other than some creative financing, they may not be able to meaningfully increase cash flows above what the current dealer principal can achieve.Strategic acquirers, on the other hand, have existing operations in the same, or an adjacent industry. These acquirers typically plan to make operational changes to increase the expected cash flows of the business relative to stand-alone expectations (as if the company were publicly traded). For example, two adjacent auto dealers can likely run with a leaner management team.Strategic acquirers may be willing to pay a premium to the marketable minority value if they can achieve revenue synergies but, given relationships with OEMs, there may be fewer synergies in automotive retail than some other industries.The ability to reap cost savings or achieve revenue synergies by combining your family business with their existing operations means that strategic acquirers may be willing to pay a premium to the marketable minority value. However, given relationships with OEMs, there may be fewer synergies in automotive retail than some other industries.Of course, selling your family business to a strategic acquirer means that your family business effectively ceases to exist. The name and branding may change, employees may be downsized, and production facilities may be closed. It also reduces a significant source of cash flow, as future earnings are accelerated to a lump sum payment up front. Many auto dealers have looked to exit with blue sky values high, but it’s also hard to walk away during a time of record profits in a business that can operate throughout the business cycle.Nonmarketable Minority Level of ValueWhile strategic acquirers may be willing to pay a premium, the buyer of a minority interest in a family business that is not publicly traded will generally demand a discount to the marketable minority value. All else equal, investors prefer to have liquidity; when there is no ready market for an asset, the value is lower than it would be if an active market existed.The buyer of a minority interest in a family business that is not publicly traded will generally demand a discount to the marketable minority value.What factors are investors at the nonmarketable minority level of value most interested in? First, they care about the same factors as marketable minority investors: the cash-flow generating ability and risk profile of the family business. But nonmarketable investors have an additional set of concerns that influence the size of the discount from the marketable minority value.Expected holding period. Once an investor buys a minority interest in your family business, how long will they have to wait to sell the interest? The holding period for the investment will extend until (1) the shares are sold to another investor or (2) the shares are redeemed by the family business, or (3) the family business is sold. The longer an investor expects the holding period to be, the larger the discount to the marketable minority value. Imagine you own a 5% interest in a dealership that you’re looking to sell. If a potential buyer knows the dealer will “never sell to one of the big guys,” that will impact how much they’ll pay you for your interest.Expected capital appreciation. For most family businesses, there is an expectation that the value of the business will grow over time. Capital appreciation is ultimately a function of the investments made by the family business. Public company investors can generally assume that investments will be limited to projects that offer a sufficiently high risk-adjusted return. Family business shareholders, on the other hand, occasionally have to contend with management teams that hoard capital in low-yielding or non-operating assets, which reduces the expected capital appreciation for the shares. All else equal, the lower the expected capital appreciation, the larger the discount to the marketable minority value. Auto dealerships tend to have pretty strong cash flows, and relatively limited opportunities to reinvest in the business. While the OEM has imaging requirements every so often, the opportunity to meaningfully expand operations tends to be tied to adding on more rooftops.Interim distributions. Does your family business pay dividends? Interim distributions can be an important source of return during the expected holding period of uncertain duration. Interim distributions mitigate the marketability discount that would otherwise be applicable. High levels of distributions may be common for minority investors in auto dealerships. However, minority investors cannot compel these distributions themselves, and we’ve seen many cases where the cash simply builds on the balance sheet. As noted above, this can drag on returns.Holding period risk. Beyond the risks of the business itself, investors in minority shares of public companies bear additional risks reflecting the uncertainty of the factors noted above. As a result, they demand a premium return relative to the marketable minority level. The greater the perceived risk, the larger the marketability discount. A strong capacity for distributions and opportunities to be sold to a strategic buyer can push down marketability discounts for auto dealerships. Conversely, sporadic distributions and cash buildup can lower expected returns. And while dealerships must send monthly factory statements to the OEM, these don’t commonly get shared on a regular basis with minority investors who may not have a good pulse for how their dealerships are performing.ConclusionYour family business has a different value at each level of value because of differences in expected cash flows and risk factors. Hopefully, we’ve illustrated the “why” behind the various levels of value. In our next post, we’ll cover why getting the Level of Value correct is so important, and we’ll discuss numerous instances where a dealer may encounter the value of their store from different levels.

Oilfield Service Valuations: Dawn Is Coming

Most people who know me know that I have loved movies most of my life. One favorite is 2008’s The Dark Knight, where Harvey Dent proclaims hope to a skeptical media, “The night is darkest just before the dawn. And I promise you, the dawn is coming!” This comes to mind as I observe valuations and prospects for oilfield service companies. It has been tough sledding for OFS companies during COVID. Many shuttered their doors, equipment, or people. At the end of 2020, rig counts were around 350 and DUC counts were high.However, as we’ve been talking about for the past several weeks, things have changed for the positive as far as the industry is concerned, and it’s going to get better according to people like Marshall Adkins of Raymond James, who spoke at the NAPE Global Business Conference in Houston. The current U.S. rig count is now at 613 and, according to Mr. Adkins, may be heading to 800 this year if OFS companies can fill a real labor shortage gap.However, when it comes to valuations, assuming oilfield service companies will join the recovery has not always been true in the shale era. That said – this time may be different.What’s Old Is New: Cycle Could Be PivotingOFS is well documented to be one of the most cyclical industries. Financial performance tends to lag customers in the E&P sector. As an example, despite the expectation for strong revenue growth in 2022, analysts project that EBITDA margins are expected to actually decline slightly from a year-end 2020 median forecast of 12.8%, to a current figure of 12.2%. However, what if that growth continued beyond 2022 and into the following years? Many think this will be the case as global demand for oil and gas continues to grow amid the surge in renewables. Industry research analysts at IBISWorld project growth of 2.4% compounded for the entire $85.4 billion revenue industry (that’s over $2 billion of revenue growth every year for the next five years). Adkins sees this as the beginning of a multi-year bull run for energy on the tail of sector underinvestment, low supply, inflation, and demand growth rising to pre-COVID levels.Past Oilfield Service PerformanceOilfield service providers, drillers, pumpers, and equipment providers enabled E&P companies to ramp back up. So, where do they stand today? One lens through which to view things is the OSX index–a popular metric to track sector performance. Since the end of 2020, the OSX index has bounced around but has generally moved back up as demand has risen. In addition, this will almost certainly go higher if rig counts go back up to 800, which hasn’t been the case since 2019. From Adkins’ perspective, his question is: will the OFS industry be able to handle getting back up to 800 rigs? This is particularly acute from a labor perspective. The oilpatch has long been challenged to attract workers because of seasonality, remote operations, camp life, and the expectation that you will continue working regardless of the weather. It compensated with high wages, interesting and challenging work, and endless opportunities for advancement in a growing industry. But that’s not the case in 2022. The young generation that the industry has always managed to attract is increasingly urban, pampered, and has grown up in a society that has a negative impression of fossil fuels and is produced by an industry that some perceive to have no future. All the while the demand grows. Part of the reason for this growing demand is the steady depletion of drilled but uncompleted (DUC) well inventory in the past year or so. DUCs will eventually deplete to the point that more new wells must be drilled, thus increasing demand for OFS. E&P companies will, out of necessity, rediscover great respect for their suppliers. And the service sector will enjoy rewards for surviving the past seven years – perhaps not bigger, but certainly much better. Current Oilfield Service PerformanceHigher oil prices, coupled with competitive breakeven costs for producers, are making drillers, completers and a host of other servicers busy. Capex budgets for E&P companies, known as lead indicators for drillers and contractors, have cautiously been increasing, even amid the capital discipline drumbeat over the past several years.IHS Markit released a report early this month titled, “The Great Supply Chain Disruption: Why It Continues in 2022.” In the introduction, Vice-Chairman Daniel Yergin wrote, “There is no recent historical precedent for the current disruption in the modern highly integrated global supply chain system that has developed over the last three decades … [resulting in] delays and disruptions for manufacturers and deliveries on a scale never recorded in our 30 years of PMIs (Purchasing Managers’ Index).”In the meantime, the oil patch will need its supply chain to be working. According to Rystad Energy, the average productivity of new wells in the Permian Basin is set to hit a record high in 2022, breaching past 1,000 BOED due to a surge in lateral well length. The only way that this can be done is with more OFS services.Valuation TurnaroundNow that utilization rates and day rates are both trending upward, valuations should logically respond and by certain aspects, they are.Take, for example, a selection of guideline company groups: onshore drillers and pressure pumpers (fracking companies). One way to observe the degree of relative value changes is to look at enterprise value (sans cash) relative to total book value of net invested capital (debt and equity) held by the company or “BVIC”. Any multiple over 1.0x indicates valuations above what net capital investors have placed into the firm, which for drillers and pumpers is a notable threshold. In 2019-2020, with a multiple well below 1.0x, investors didn’t expect to get an adequate return on the capital deployed at these companies. However, in 2021 and continuing in early 2022, that trend has reversed. This suggests that the market is recognizing intangible value again for assets such as developed technology, customer relationships, trade names and goodwill. For pressure pumping and fracking concentrated businesses, which are more directly tied to DUCs, the trend is clear. Intangible asset valuations have grown even faster, more heavily weighted towards pumpers’ developed technology that is driving demand for these companies’ services. ConclusionOverall rig counts have shifted downward since 2014 and are currently nowhere near levels back then, however, this cycle may resemble pre-shale eras when fundamentals like inflation, supply issues, and related factors pushed commodity prices upward for extended periods. Oil and gas are fundamental economic building blocks in the world economy. If the longer-term cycles are pivoting towards the direction they appear, values of OFS companies may be increasing for a longer cycle this time.

Three Considerations for Your RIA’s Buy-Sell Agreement

Working on your RIA’s buy-sell agreement may seem like an inconvenience, but the distraction is minor compared to the disputes that can occur if your agreement isn’t structured appropriately. Crafting an agreement that functions well is a relatively easy step to promote the long-term continuity of ownership of your firm, which ultimately provides the best economic opportunity for you and your partners, employees, and clients. If you haven’t looked at your RIA’s buy-sell agreement in a while, we recommend dusting it off and reading it in conjunction with the discussion below.Decide What’s FairA standard refrain from clients crafting a buy-sell agreement is that they “just want to be fair” to all the parties in the agreement. That’s easier said than done because fairness means different things to different people. The stakeholders in a buy-sell scenario at an investment management firm typically include the founding partners, subsequent generations of ownership, the business itself, non-owner employees of the business, and the clients of the firm. It is nearly impossible to be “fair” to that many different parties, considering their different motivations and perspectives.Clients. Client relationships are often the single most valuable asset that an asset or wealth management firm possesses, and avoiding internal disputes is crucial to maintaining these relationships. Beyond investment advice, clients pay for an enduring and trusting relationship with their investment manager. As the profession ages and ownership transitions to a new generation of management, we see a well-functioning buy-sell agreement and broader succession planning as either a competitive advantage (if done well) or a competitive disadvantage (if disregarded).Founding owners. Aside from wanting the highest possible price for their interest in the firm, founding partners usually want to have the flexibility to work as much or as little as they want to, for as many years as they so choose. These motivations may be in conflict with each other, as winding down one’s workload into a state of partial retirement and preserving the founding generation’s imprint on the company requires a healthy business, which in turn requires consideration of the other stakeholders in the firm.Subsequent generation owners. The economics of a successful investment management firm can set up a scenario where buying into the firm can be very expensive, and new partners naturally want to buy as cheaply as possible. Eventually, however, there is a symmetry of economic interests for all shareholders, and buyers will eventually become sellers. Untimely events can cause younger partners to need to sell their stock, and they don’t want to be in a position of having to give it up too cheaply.The firm itself. The company is at the hub of all the different stakeholder interests and is best served if ownership is a minimal distraction to the operation of the business. Since handwringing over ownership rarely generates revenue, having a functional shareholders’ agreement that reasonably provides for the interests of all stakeholders is the best-case scenario for the firm. If firm leadership understands how ownership is going to be handled now and in the future, they can be free to focus on maximizing the performance of the company while at the same time avoiding costly disputes over ownership.Non-owner employees. Not everyone in an investment management firm qualifies for ownership or even wants it, but all RIAs are economic eco-systems in which all employees depend on the presence of stable and predictable ownership. The point of all this is to consider whether or not you want your buy-sell agreement to create winners and losers, and if so, be deliberate about defining who wins and who loses. Ultimately, economic interests which advantage one stakeholder will disadvantage some or all of the other stakeholders. If the pricing mechanism in the agreement favors a relatively higher valuation, then whoever sells first gets the biggest benefit of that at the expense of the other partners and anyone buying into the firm. If pricing is too high, internal buyers may not be available, and the firm may need to be sold to perfect the agreement. At relatively low valuations, the internal transition is easier, and business continuity is more certain, but the founding generation of ownership may be perversely encouraged not to bring in new partners, stay past their optimal retirement age, or push more cash flow into the compensation instead of shareholder returns as the importance of ownership is diminished. Recognizing and ranking the needs of the various stakeholders in an investment management firm is always a balancing act, but one which is typically best done intentionally.Define the Standard of ValueStandard of value is an abstraction of the circumstances giving rise to a particular transaction. It imagines the type of buyer, the type of seller, their relative knowledge of the subject asset, and their motivations or compulsions. Identifying and clearly defining the standard of value in your buy-sell agreements will save time and money when triggering events occur.Portfolio managers are familiar with certain perspectives on value, such as market value (the price at which a company’s stock trades) and intrinsic value (what they think the security is worth, based on their own valuation model). None of these standards of value are particularly applicable to buy-sell agreements, even though technically they could be. Instead, valuation professionals such as our group look at the value of a given company or interest in a company according to standards of value such as fair market value or fair value, among others.Identifying and clearly defining the standard of value in your buy-sell agreements will save time and money when triggering events occur.In our world, the most common standard of value is fair market value, which applies to virtually all federal and estate tax valuation matters, including charitable gifts, estate tax issues, ad valorem taxes, and other tax-related issues. It is also commonly applied in bankruptcy matters.Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60. It is defined in the International Glossary of Business Valuation Terms as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.The benefit of the fair market value standard is familiarity in the appraisal community and the court system. It is arguably the most widely adopted standard of value, and for a myriad of buy-sell transaction scenarios, the perspective of disinterested parties engaging in an exchange of cash and securities for rational financial reasons fairly considers the interests of everyone involved.For most buy-sell agreements, we would recommend one of the more common definitions of fair market value.The standard of value is critical to defining the parameters of a valuation. We would suggest buy-sell agreements should name the standard and cite specifically which definition is applicable. The downsides of an ambiguous or home-brewed definition can be severe. For most buy-sell agreements, we would recommend one of the more common definitions of fair market value.The advantage of naming fair market value as the standard of value is that doing so invokes a lengthy history of court interpretation and professional discussion on the implications of the standard, which makes application to a given buy-sell scenario clearer.Define the Level of ValueValuation theory suggests that there are various “levels” of value applicable to a business or business ownership interest. From a practical perspective, the “level of value” determines whether any discounts or premiums are applied to a baseline marketable minority level of value. Given the potential for valuation disputes regarding the appropriate level of value, buy-sell agreements function best when they memorialize the parties’ understanding of what level of value will be used in advance of a triggering event occurring.Most portfolio managers and financial advisors will already be familiar with the concept of “levels of value,” but they may be unfamiliar with the terminology used in the valuation profession to describe these levels. A minority position in a public company with active trading typically transacts as a pro rata participant in the cash flows of the enterprise because the present value of those cash flows is readily accessible via an organized exchange. This is known as the “marketable minority” level of value in the appraisal world. Portfolio managers usually think of value in this context until one of their positions becomes subject to acquisition in a takeover by a strategic buyer. In a change of control transaction, there is often a cash flow enhancement to the buyer and/or seller via combination, such that the buyer can offer more value to the shareholders of the target company than the market grants on a stand-alone basis. The difference between the publicly traded price of the independent company and the value achieved in a strategic acquisition is commonly referred to as a control premium.Closely held securities, like common stock interests in RIAs, don’t have active markets trading their stocks, so a given interest might be worth less than a pro rata portion of the overall enterprise. In the appraisal world, we would express that difference as a discount for lack of marketability. Sellers will, of course, want to be bought out pursuant to a buy-sell agreement at their pro rata enterprise value. Buyers might want to purchase at a discount (until they consider the level of value at which they will ultimately be bought out). In any event, the buy-sell agreement should consider the economic implications to the investment management firm and specify what level of value is appropriate for the buy-sell agreement. Fairness is a consideration here, as is the sustainability of the firm. If a transaction occurs at a premium or a discount to pro rata enterprise value, there will be “winners” and “losers” in the transaction. This may be appropriate in some circumstances, but in most investment management firms, the owners joined together at arms’ length to create and operate the enterprise and want to be paid based on their pro rata ownership in that enterprise. That works well for the founders’ generation, but often the transition to a younger and less economically secure group of employees is difficult at a full enterprise-level valuation.In any event, the buy-sell agreement should consider the economic implications to the investment management firm and specify what level of value is appropriate for the buy-sell agreement.Further, younger employees may not be able to get comfortable with buying a minority interest in a closely held business at a valuation that approaches change of control pricing. Typically, there is often a bid/ask spread between generations of ownership that has to be bridged in the buy-sell agreement, but how best to do it is situation-specific. Whatever the case, the shareholder agreement needs to be very specific as to the level of value.Does the pricing mechanism create winners and losers? Should value be exchanged based on a control level valuation that considers buyer-seller specific synergies, or not? Should the pricing mechanism be based on a value that considers valuation discounts for lack of control or impaired marketability? Exiting shareholders want to be paid more and continuing shareholders want to pay less, obviously. What’s not obvious at the time of drafting a buy-sell agreement is who will be exiting and who will be continuing.There may be a legitimate argument to having a pricing mechanism that discounts shares redeemed from exiting shareholders, as this reduces the burden on the firm or remaining partners and thus promotes the firm's continuity. If exit pricing is depressed to the point of being punitive, the other shareholders have a perverse incentive to retain their ownership longer and force out other shareholders artificially. As for buying out shareholders at a premium value, the only argument for “paying too much” is to provide a windfall for former shareholders, which is even more difficult to defend operationally. Still, all buyers eventually become sellers, so the pricing mechanism has to be durable for the life of the firm.ConclusionKeeping the above considerations in mind when drafting or updating your buy-sell agreement will help create a document that promotes the sustainability and orderly ownership transition of the firm while balancing the interests of the firm’s various stakeholders and the firm itself. However, this is far from an exhaustive list of things to consider when constructing your buy-sell agreement. In next week’s post, we’ll discuss additional parameters that should be addressed when constructing your buy-sell agreement.

January 2022 SAAR

SAAR reached a seven month high in January, totaling 15.0 million units on an annualized basis. SAAR was up 20.0% from last month but down 10.4% from January 2021. While the SAAR certainly improved, raw sales volume in January was the lowest since April 2020. January is typically the lowest selling month for dealers each year, so the seasonally adjusted nature of the metric can make it difficult to compare with other months; it puts a lot of faith in the math required to annualize sales. The bar chart below shows raw sales numbers in January 2022 compared with raw numbers in January since 2015.Source: Bureau of Economic Analysis Unsurprisingly, many of the same trends that have dominated over the last year have persisted into early 2022. Auto manufacturers continue to prioritize retail deliveries over fleet deliveries. Sales continue to be held back by limited inventories. Light trucks continue to dominate, reaching 79.8% of all light vehicle sales over the last month. Within this popular category of vehicles, pickups and SUVs gained market share while the popular crossover segment’s market share remained flat from December. Vehicle sales prices and profitability remained high. After reaching an all-time high of $45,743 in December, the average transaction price of a new vehicle is expected to cool slightly to $44,905 while still notching an all-time January high.Due to these persistently high prices, trade-in equity also remains high for consumers, with average trade-in equity up 88% from this time last year. Incentive spending continues to fall. In January, average incentive spending per unit was $1,319, down from $1,598 last month and $2,163 a year ago, down more than 50%.Source: Bureau of Economic Analysis Reported beginning-of-month January inventory balances remained low but showed a marginal improvement from last month. Improvements aside, the industry’s inventory to sales ratio remained well below its long-run average of 2.45x, emphasizing the fact that supply chain and production recoveries still have a long way to go.Production Update – Stumbling Out of the Gate in 2022After inventory shortages constricted sales volumes throughout 2021, the biggest question for auto dealers and manufacturers going into 2022 has been “when is the production process going to recover?”. Optimists have been predicting that recovery would come in the second half of the new year, but marginal inventory decrements in November and December did not encourage those following the industry that a full recovery is likely in 2022. Over the last month, a couple of manufacturers have released production updates that emphasize the magnitude of these struggles, at least in the short run.January started off well, with no reports of any auto manufacturing plants experiencing problems in the early days after the holiday break. However, it didn’t take long before Ford reduced scheduled production at its Flat Rock, Michigan, Oakville, and Ontario plants due to chip shortages. Toyota Motor Corp. followed suit by cutting its worldwide February output forecast by 150,000 vehicles. In February, Toyota North America alone was reported to lose 25,000-35,000 vehicles to production cuts.Domestic chip-manufacturing plants are not set to produce chips until 2023 at the earliest.These types of announcements from manufacturers are not going away anytime soon, as domestic chip-manufacturing plants are not set to produce chips until 2023 at the earliest. While it seems the chip issue has been going on forever, we note it takes even longer to meaningfully increase chip production. Until that time comes, domestic manufacturers are going to have to continue to rely on international supplies of microchips, likely making for choppy conditions over the next year.The Biden administration announced its intention to take action on the current microchip shortage in October, releasing a statement:“As you know, we’ve been working on the semiconductor shortage since day one of the president’s administration and it’s time to get more aggressive. […] There are bottlenecks across the economy, mostly due to COVID. There’s a disruption in the supply chain. Some of it will work itself out naturally but others like semiconductors will require investments so we make chips in America again. We have to make investments now so that never happens again.”Furthermore, at a September convening of semiconductor industry participants, the Commerce Department announced the launch of a Request for Information (RFI) that asked all parts of the supply chain – producers, consumers, and intermediaries – to voluntarily share information about inventories, demand, and delivery dynamics. The results of this RFI, which included 150 companies across several industries, were released on January 25th.The Commerce Department concluded that "there is a significant, persistent mismatch in supply and demand for chips, and respondents did not see the problem going away in the next six months." The report also said that median inventory for consumers for key chips has fallen from 40 days in 2019 to less than 5 days in 2021. The hope is that this report will give legislators a more informed view as they consider taking action. For those that have lived through these daily struggles, the conclusions of this report are unsurprising, so hopefully, nobody was holding their breath.It is projected that several chip manufacturing facilities abroad will come online by the summer of 2022.It is projected that several chip manufacturing facilities abroad will come online by the summer of 2022 and take some pressure off of existing facilities to meet the current level of demand. An uptick in supply would certainly be welcome and perhaps the latter half of 2022 will bring some inventory relief. In either case, LMC Automotive forecasts 86 million chips will be manufactured in 2022, an improvement of 6.2% from the 81 million estimated to have been produced in 2021. It remains to be seen how those will be allocated to vehicle manufacturing, but multiplying the anticipated increase in chip production by 2021 volumes, vehicle sales in 2020 would only be 15.8 million.Auto Forecast Solutions has aggregated vehicle production data following the chip shortage and its impact on auto manufacturing throughout the last month. The chart below shows the number of vehicles cut from production so far this year next to the full-year 2022 production cut projection: From an auto dealer’s perspective, not much has changed. Promises of structural changes to where microchips are produced and how many are available to auto manufacturers will take some time to follow through on, with the summer seeming like the absolute earliest that significant inventory relief might come. More updates should surface as the first quarter of the year is now in full swing.February 2022 OutlookOur outlook for February 2022 is that vehicle inventories will remain low and demand will remain high. Incremental inventory improvements are expected to accumulate eventually, but many of those improvements are not expected in the next several months. Also, the persistent Omicron variant of the COVID-19 pandemic could continue to affect supply chains and production facilities in the coming months as well, adding to the uncertainty.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Meet The Team

Bryce Erickson, ASA, MRICS

In each “Meet the Team” segment, we highlight a different professional on our Energy team. This week we highlight Bryce Erickson, Senior Vice President of Mercer Capital and the leader of the oil and gas industry team. The experience and expertise of our professionals allow us to bring a full suite of valuation, transaction advisory, and litigation support services to our clients. We hope you enjoy getting to know us a bit better.What attracted you to a career in valuation?Bryce Erickson: There are a lot of things appealing about valuation, and I feel fortunate to have been a part of it for over 20 years. Looking back, for me, three things stand out. First, I sort of grew up in the profession. My dad entered valuation in 1972, and I would hear the conversations at the dinner table about the cost of capital, customer lists, and comparables. Secondly, the economic and analytical disciplines at the center of what I do align well with how my brain functions and how I approach problem solving. That’s fun. Lastly, it allows me to serve clients in a way that, if done well, will lead to a long career whereby I have a lot of ability to chart my own course. That’s a great incentive.What does your personal practice consist of?Bryce Erickson: Sort of like the Generation X member that I am, my practice is a mix of a lot of things. When I started in valuation in the late ’90s, most firms and groups had not specialized (that has changed). I got exposed to a lot of industries and service lines as a result. I have touched a bit of everything in my career and still do in many respects. However, as my career has progressed, I have developed a few specializations. One is in energy, particularly upstream oil & gas, as well as minerals. That has been a big part of my career in the past 10+ years. Another has been professional sports (NFL, NBA, MLB, NHL), where I have had the opportunity to value teams I grew up watching or rooting for as a kid. That has been a real thrill. Again, I touch them all as far as service lines, but the two areas I have spent the most time on have been tax-driven and litigation-driven work. In addition to valuation, I have done a lot of economic damage-driven work and have testified nearly two dozen times now. Litigation is intense by its nature, and that intensity is useful in other areas of my practice, helping me give the best service I can to all clients.What types of oil & gas engagements do you work on?Bryce Erickson: As I’ve already mentioned, in addition to exploration and production company valuations, I do fairness opinions and quite a bit of mineral and royalty interest valuations. These come in many different scenarios, from tax to financial reporting to litigation. At this point, we have probably worked in just about every major oil & gas basin in the U.S. and several international projects as well. I also do some work with oilfield service clients.What is unique about Mercer Capital’s oil & gas industry services compared to your competitors?Bryce Erickson: I believe what is unique about our oil & gas group is our blend of industry expertise that we have gained over the years alongside the depth and knowledge of the valuation space. It is a powerful combination for our clients and they like it a lot. On the industry side, we are able to connect with clients and speak their language as far as reserves, basins, structures, and economics are concerned. On the valuation side, we speak the language of the audiences we are addressing as well, whether that’s a judge in a courtroom, an IRS engineer in a tax matter, or an auditor for a financial reporting issue. Our competitors may have one or the other of those two skill sets, but rarely both.As a Forbes.com contributor, what types of issues do you cover in your column?Bryce Erickson: I address industry developments, economic trends, and the impact on valuation for companies operating in the Permian, Eagle Ford, Bakken, and Marcellus & Utica regions, among others. Additionally, I cover these issues as they pertain to mineral rights and royalty owners. It is a fun column to write. It also allows me to stay tied into the industry as well as keep current.What is the one thing about your job that gets you excited to work every day?Bryce Erickson: That’s simple. Solving problems and serving clients. It scratches itches and is so satisfying for me. I am excited I get to utilize so much of my education and experience on each engagement so that Mercer Capital can do excellent work for our excellent clients.

February 2022

In this issue: Acquire or Be Acquired (AOBA) 2022: Review & Recap

March 2022

In this issue: First Quarter 2022 Review: Volatility Resurfaces

Buy-Sell Agreement Basics for Wealth Managers

The Importance of Buy-Sell Agreements for Wealth Management Firms, and Why It Might Be Time To Revisit Yours

Over the next several weeks, we will be publishing a series of blog posts discussing the importance of buy-sell agreements and other adjacent topics for RIA owners. Ownership is perhaps the single greatest distraction for advisors looking to grow with their firm, but it can also be an opportunity to align interests and ensure continuity of the firm in a way that is accretive for the firm’s founders, next generation management, and clients. As highlighted in the Charles Schwab 2021 RIA Benchmarking Study, planning for a successful transition of ownership — whether through internal succession or a strategic sale – continues to be a key differentiator among top RIA performers.Most wealth management firms are closely held, so the value of the firm is not set by an active market. They are typically owned by unrelated parties, whereas closely held businesses in other industries are often owned by members of the same family. In recent years, the profitability and value of many wealth management firms have increased substantially as assets under management have risen with the markets and a proliferation of capital aimed at the wealth management sector has bid up multiples. As a result of these dynamics, there is usually more than enough cash flow to fund the animosity when disputes arise, and what might be a five-figure settlement in some industries is a seven-figure trial for an RIA.Avoiding expensive litigation is one reason to focus on your buy-sell agreement, but for most firms, the more compelling reasons revolve around transitioning ownership to perpetuate the firm and provide liquidity for retiring partners. Clients increasingly seem to ask us about business continuity planning—and for good reason. In times of succession, tensions can run high. Having a clear and effective buy-sell agreement is imperative to minimizing costly and emotional drama that may ensue in times of planned or unplanned transition.Buy-Sell Agreement BasicsSimply put, a buy-sell agreement establishes a process by which shares of a private company transact. Ideally, it defines the conditions when the buy-sell agreement is triggered, describes the mechanism by which the shares are priced, addresses the funding of the transaction, and satisfies all applicable laws and regulations.A buy-sell agreement establishes a process by which shares of a private company transact.These agreements aren’t necessarily static. In wealth management firms, buy-sell agreements may evolve over time with changes in the scale of the business and breadth of ownership. When firms are new and more “practice” than “business,” these agreements may serve more to assign who gets what if the partners decide to go separate ways.As the business becomes more institutionalized, and thus, more valuable, a buy-sell agreement – properly rendered – is a key document to protect the shareholders and the business (not to mention the firm’s clients) in the event of a dispute or other unexpected changes in ownership. Ideally, the agreement also serves to provide for more orderly ownership succession, as well as a degree of certainty for shareholders that allows them to focus on serving clients and running the business instead of worrying about who gets what benefit of ownership.The irony of buy-sell agreements is that they are usually drafted and signed when all the shareholders think similarly about their firm, the value of their interest, and how they would treat each other at the point they transact their stock. The agreement is drafted, signed, filed, and forgotten. Then an event occurs that invokes the buy-sell agreement, and the document is pulled from the drawer and read carefully. Every word is parsed, and every term scrutinized because now they are not simply co-owners with aligned interests but rather buyers and sellers with diametrically opposed interests.Triggering EventsBuy-sell agreements govern the process and terms of a transaction if certain defined events occur. These “triggering events” can stem from voluntary or involuntary circumstances. Many buy-sell agreements call for an independent appraisal upon a triggering event to establish the price at which shares will transact. In cases where ownership is more fluid, some agreements require an annual appraisal to establish the price at which all transactions will take place.Voluntary CircumstancesAt any point in time, one generation of business owners is preparing for retirement, having planned (or frequently not planned) for a successful ownership transition from one generation of business leaders to the next. A buy-sell agreement is one of the most important steps to ensure a successful, planned transition of ownership, and as such, it should complement your succession plan.A buy-sell agreement is one of the most important steps to ensure a successful, planned transition of ownership.An effective succession plan could call for the sale of the retiring partner’s stake to current management or an outside investor group or may require the sale of the entire firm to a strategic buyer.If your exit strategy includes a sale to an insider, it should specify the terms and define the process for determining the price that shares are transacted at as an owner exits to retire. This is often a point of contention as young partners and retiring partners have inherently opposed objectives. A retiring partner will want to exit at the highest share price possible while the continuing partners are ultimately financing this repurchase.Because many wealth management firms are highly valuable, successors are often financially stretched to take over the founder’s interest in the firm. By establishing the process through which price is determined and the terms at which the shares will be transacted, a buy-sell agreement mitigates any potential drama. As such, a buy-sell agreement is foundational for your firm’s succession plan.If your exit strategy is to sell your firm to an outside buyer, you should be aware of your opportunities and make it explicitly known to your firm that this is your intention. For example, you should know the different incentives of potential buyers and what options exist with financial or strategic buyers.You should make sure that your buy sell agreement makes sense in the context of your other operating agreements. A buy-sell agreement should specify the process by which a sale to an outside investor group is agreed to. We once worked with a client whose operating documents required unanimous consent to bring on a minority partner, as this required an amendment to the operating agreement, while the sale of a majority of the Company just required the consent of a super majority.Knowing your exit strategy options will help clarify what is needed from your succession plan and your buy-sell agreement going forward.Involuntary CircumstancesBuy-sell agreements guard against undesirable transitions in ownership from a potential partner to an unaffiliated party; they also define a set price per share to ensure a fair transaction. In the case of death, disability, divorce, and bankruptcy, current partners will ultimately need to redeem the shares of their colleague.For instance, in the event of the death of a shareholder, a buy-sell agreement can protect the deceased’s family, ensuring such shares are bought at a fair price and in a timely manner. It can also protect your company from the inheritors of a deceased owner, who may want to benefit from the firm’s earnings but are not able to contribute to the growth of the business. Life insurance policies for owners are advised to protect your firm in case of an untimely death or a disabling scenario. A life insurance policy will secure your firm’s ability to repurchase shares in the case of the death or disability of an owner.A buy-sell agreement will outline the process through which a price is set and the transaction is financed.Additionally, if an owner files bankruptcy, the firm will need to repurchase his or her stake to avoid the shares being acquired by the owner’s creditors. In the case of a divorce, an owner’s shares may legally transfer to his or her spouse, in which case ownership would be seeded to the ex-spouse. A buy-sell agreement will outline the process through which a price is set and the transaction is financed.Our RecommendationWe recommend revisiting your buy-sell agreement to ensure that it makes sense in the context of your firm’s vision and in partnership with its other governing documents. If you do not currently have a buy-sell agreement in place, we highly encourage you to draft one with the help of legal counsel and an independent valuation expert. Doing so will help ensure the continuity of you firm, align incentives, and may even help avoid costly litigation down the road. If you plan on reviewing your buy sell agreement and other governance matters, please give us a call.

Don’t Turn a Blind Eye to Fixed Operations

A Look at the Importance and Stability of Fixed Operations

The phrase, “don’t turn a blind eye,” refers to the idea that one should not ignore something they know to be real and significant. The phrase is said to originate from an 1801 English naval battle – the Siege of Copenhagen – where two admirals disagreed over battle plans. Legend has it that the second admiral in charge, Horatio Nelson, was ordered to withdraw but pretended not to see the flagship signals of the ranking admiral because he put his looking glass up to his eye that had been blinded in an earlier battle.As auto dealer headlines continue to be dominated by shortages of new and used inventory and record profitability, it’s easy to focus on the variable side of operations, including the sale of new and used vehicles. But, auto dealers and their trusted advisors should not turn a blind eye to the fixed operations of the dealership, which generally includes service, parts, and the body shop.While fixed operations may not be grabbing any of the current headlines, auto dealers should remain focused on their importance and stability to the overall success and profitability of a dealership. In this blog post, we analyze the recent historical contribution of fixed operations to overall dealership metrics, analyze several key indicators of future performance, and explore several myths and the changing landscape of the service department and customer relationship.Recent Historical Performance of Fixed OperationsLike all aspects and departments of an auto dealership, fixed operations or “fixed ops” have been impacted by COVID-19 and the initial lockdowns, plant shutdowns, chip shortages, and changing consumer behavior. Nonetheless, fixed operations have always provided a high margin portion of the business to an auto dealer while also connecting the customer to that particular dealership over the life of the existing vehicle and hopefully future vehicles to come.To gain a historical and current perspective on the impact of fixed operations on the total dealership operations, we have analyzed the Dealership Financial Profiles for an Average Dealership historically published by NADA. Specifically, we have analyzed year-end data from 2019 and 2020, along with the most recently published data from October 2021. This time period provides some insight into the impact and trends caused by the pandemic and indicates signs of recovery.In 2020, the average dealership had approximately $7.06 million in fixed ops sales, down 7.8% from the $7.65 million achieved in 2019. Through the first ten months of 2021, this figure was $6.41 million, which, if we annualize to twelve months, would be about $7.70 million, or just above 2019 levels. While this appears to be a full recovery, fixed operations pales compared to the performance dealers have achieved in variable operations as new and used vehicle sales, and margins have exploded despite/due to inventory shortages.As seen in the graph below, the gross profit margin on fixed operations has steadily improved, from 46.6% of fixed operations sales in 2019 to 47.0% in 2020 and 47.2% in the first ten months of 2021. Over this same time period, fixed operations sales as a percentage of average total dealership sales have steadily declined from 12.4% to 12.0% to 10.9%.Gross Profit Margin on Fixed OperationsSource: NADADespite modestly improving pricing power in fixed operations (orange line in the graph above), it appears to be declining modestly in importance to dealerships from a revenue standpoint (blue line). While fixed operations have always contributed less revenue to dealerships than variable operations (due to the high sticker price of vehicles), fixed operations have typically contributed a significant portion of total dealership gross profit. In 2019, fixed operations contributed 12.4% of sales but 50.5% of total dealership gross profit. This is because gross profit margins on new and used vehicles were 5.5% and 11.3%, respectively, compared to the previously noted 46.6% gross margin on fixed ops sales.In 2020 and 2021, this historical norm has been flipped on its head. In 2020, fixed operations only contributed 46.1% of total dealership gross profit. Through the first ten months of 2021, fixed ops contribution to total gross profit declined all the way to 36.5%.Fixed Ops Contribution to Total Gross ProfitSource:NADATwo of the primary causes of these trends are the huge increase in margins from variable operations and the lack of vehicle miles driven, which we have covered in a prior blog and will re-examine later in this blog. What may not be clear from these figures: fixed operations provide consistent, high margins to the dealership as evidenced by the departmental gross profit margin steadily, albeit modestly improving over this period. While it may not get all the headlines of variable operations, fixed operations continue to support dealerships and will continue to do so once vehicle margins normalize.Key Indicators of Future PerformanceVehicle miles traveled (“VMT”) is defined as the number of miles driven and has been tracked since 1971. The rolling 12-month average identifies the current run rate of this metric at any given point in time. An increase in VMT indicates more cars are on the road logging more miles, which eventually will require parts and service and eventually purchase a new vehicle either from new or used vehicle inventory. The rolling 12-month VMT drastically reduced at the start and during the early months of the pandemic due to temporary lockdowns and staying at home. In fact, the VMT dropped below 3.2 trillion miles in March 2020, and the rolling 12-month VMT declined every month before finally starting to rebound in March 2021.VMT has enjoyed a gradual monthly increase and returned above the 3.2 trillion figure for the first time in November 2021. It will be interesting to monitor whether the rolling 12-month VMT will continue to rise each month, just as it did pre-pandemic. The metric and the graph below indicate that consumers are traveling by car at rates not seen since before the pandemic.Moving 12-Month Total Vehicle Miles TraveledSource: FRED Economic Data A second metric that serves as a key indicator for the future performance of fixed operations is the average age of a car on the road in the United States. Like VMT, as the average age of a car increases, the need for service and eventually the purchase of a new vehicle alternative increases. According to IHS Markit and the Bureau of Transportation Statistics, the average age of cars on the road has generally increased from 1995 until 2021. Specifically, the average age of a car on the road has climbed from 8.4 years to 12.1 years.Average Age of Cars on the Road - U.S.Source: IHS Markit and Bureau of Transportation Statistics Coupled with the actual age, the average mileage of these cars is much higher than in prior years. While it wasn’t that uncommon for cars to have over 100,000 miles in years past, now many cars in service have 200,000 miles or greater. Based on a survey performed by iSeeCars, nearly 16% of Toyota Land Cruisers on the road have at least 200,000 miles on them.Fixed Operations Myths and Changing landscapeMyth 1: Auto Dealers make more money in Variable Operations than Fixed OperationsIn order to assess the validity of this statement, we must clarify a few parameters. Variable operations have always generated more gross or raw sales dollars than fixed operations for most dealers. The adage of making money usually centers around the profitability or margins provided by certain segments of the total auto dealership. Prior to the conditions of the last twelve months caused by inventory and chip shortages, fixed operations have provided a greater, or at least equal, contribution to total gross margin for a dealership as detailed earlier in the blog. Further, the specific gross margin on fixed operation sales has always been greater than the gross margins on new and used vehicles. While the transitory conditions have shifted more of the overall contribution of total gross margin to variable operations, fixed operations remain a vital, high-margin component of dealership operations.Myth 2: There is not much value in a service customer to my DealershipAs we just examined, the service customer is certainly valuable to a dealership if merely analyzed for the financial impact of their existing service requirements. In reality, fixed operations allow for ongoing touchpoints between a dealership and a customer. Touchpoints have been a common term used by executives of publicly-traded auto dealerships. Not only does that customer relationship have value during the life of the current vehicle, but the hope is that there will be future loyalty to that dealership in the decision to purchase the next vehicle. For these reasons, dealers should improve the overall customer experience, including efficiency and technology.2 out of every 3 service visits do not occur at a dealership.We have demonstrated both the financial and behavioral benefits of fixed operations to the dealership. Despite these gains, dealers have ample opportunities to improve the focus and market share of this element of the dealership. According to a 2021 survey conducted by Cox Automotive, only 34% of consumers prefer dealership service centers to general repair shops. While this figure represents a 1% gain in market share by auto dealers over the last three years of the survey, it still leaves 2 out of every 3 service visits that do not occur at a dealership. These overall figures mask the early years of a new vehicle's lifespan, where most service visits that fall underneath the warranty almost certainly occur at the dealership where the vehicle was purchased.The survey cites several reasons why consumers choose general service centers over dealership service departments: costs and location. Dealers must fight against the perception that dealership service costs are overpriced compared to similar services at a general service center. Additionally, consumers choose service centers closer to home than the original dealership. As we’ve discussed in prior posts, the future of the auto retailing landscape is changing. If fewer vehicles are kept on lots for the long-term, this may enable dealers to invest in real estate that is more proximate to consumers, which could increase market share for fixed operations.An additional component for the service department to monitor in the future will be the ability to service electric vehicles.An additional component for the service department to monitor in the future will be the ability to service electric vehicles (EVs). In last week’s blog, we discussed the future of auto dealerships and the impact of EVs on shaping the future of automotive retail. The Cox Automotive Survey cited that 66% of their current survey responders offer some level of EV service work. Additionally, 30% of responders plan to service EVs within the next year.ConclusionFixed operations have always provided stable, and high margin returns to an auto dealership's overall profitability and success. Particularly for single-point dealers with only one brand, dealers can see lagging sales if product offerings from the OEM don’t engage consumers, oftentimes for numerous years. However, fixed operations can get these dealers through the ebbs and flows of the business or product cycle.While recent trends have shifted the contribution and focus to variable operations, fixed operations continue to benefit dealers in the form of financial performance and bolster the customer relationship and loyalty to the dealership. Auto dealers must stay focused and adapt to these trends regarding their fixed operations despite persisting obstacles of consumer behavior and retail preferences. While 2022 may result in declining trends to the high wave of variable operations over the last twelve months, the future looks bright for the fixed operations of auto dealers. With fewer vehicles being put on the road than in years past, the average age of vehicles should increase and lead to more service work. Now it’s up to the dealers to pull in their share of these opportunities.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Q1-Q3 2021 Themes From Oilfield Service Company Earnings Calls

Nuances of the Upstream PerspectiveAs our readers are well aware, Mercer Capital tracks and reviews themes from the quarterly earnings calls ofE&P operatorsand mineral aggregators, providing key insights into the upstream perspective on U.S. oil and gas. In this post, we look at oilfield service (OFS) company earnings calls for the first three quarters of 2021. Looking forward, we will likely incorporate OFS earnings calls in our quarterly survey of themes from the public oil and gas sector, using this post as a reference point for the upcoming round of Q4 2021 calls.We typically review earnings calls for 3 to 8 companies among the E&P operators and mineral aggregators each. Likewise, we look forward to reviewing calls for a roster of approximately 7 OFS companies that operate in the primary onshore U.S. basins covered by Mercer Capital. In this inaugural survey, however, we focus on Q1 through Q3 earnings calls for just two OFS companies – Halliburton and Ranger Energy Services. We follow the earnings call themes for these two companies, who represent some of the largest and smallest (by market cap) public OFS companies, through the first three quarters of 2021 to get a sense of how OFS industry dynamics have evolved over the past year.Promoting ESG InitiativesIn our review of Q1 2021 earnings call themes among E&P Operators, we saw a continued trend (from Q4 and Q3 2020 E&P operator earnings call themes) of emphasizing and discussing the progress of various ESG initiatives. This theme was absent in the Q2 2021 E&P earnings calls, and not a significant theme in the Q3 2021 E&P earnings calls. However, OFS operators were clear to point out their contribution towards various ESG initiatives throughout the first three quarters of 2021.“We're excited about the progress of Halliburton Labs, our clean-energy accelerator. In the first quarter, we announced Halliburton Labs' inaugural group of participating companies. They are working on solutions for transforming organic and plastic waste to renewable power; recycling of lithium-ion batteries; and converting carbon dioxide, water, and renewable electricity into a hydrogen-rich platform chemical.” – Jeff Miller, President & CEO, Halliburton [Q1]“We have successfully completed gas processing jobs for both dual fuel and e-frac fleet and anticipate more to come. There are several rewarding attributes to this transition. We are tangibly contributing to the ESG efforts of our industry.” – Darron Anderson, CEO, Ranger Energy Services [Q1]“On the Processing Solutions side, we continue to expect our customers' ESG mandate to drive an uptick in both the traditional flare gas capture use and newer fracturing dual-fuel and e-fleet generation fuel supply. We continue to have pilot program success on fuel supply projects, but have yet to sign that elusive long-term contract. Stay tuned here as stronger commodity pricing, incremental flare gas, emission regulation and the build-out and adoption of dual fuel and electric frac fleet are all tailwinds for our Processing Solutions segment.” – Bill Austin, Interim CEO & Chairman, Ranger Energy Services [Q2]“In the third quarter, Halliburton completed an all-electric pad operation on a multi-year contract with Chesapeake Energy in the Marcellus Shale.” – Jeff Miller, President & CEO, Halliburton [Q3]Opportunistic Acquisitions & Increased Consolidation of Smaller OperatorsWhile mineral aggregators were active on the M&A front in Q3 2021, with a favorable sentiment towards expanding their holdings since Q1, E&P operators were relatively quiet in the Eagle Ford and Appalachian basins, a bit more active in the Bakken, and chomping at the bit in the Permian. OFS operators, particularly those for whom incremental expansions carry more weight, kept their eyes on the horizon over 2021.“Our acquisition strategy has been fixed and simple. We are focusing on potential counterparties with top-tier assets, who have a reputation for best-in-class service quality. We are looking at both bolt-ons to our existing service lines and complementary service lines that extend our current core service offerings. Tactically, we believe in being opportunistic.” – Darron Anderson, CEO, Ranger Energy Services [Q1]“As we said in the prepared remarks, many of these small operators, frankly, we believe, lived and died on the PPP. They priced things that keep them alive and trade dollars. We think by signaling, and more than signaling that there's consolidation, and we think there'll be other players that will try to consolidate.” – Bill Austin, Interim CEO & Chairman, Ranger Energy Services [Q2]Leverage to Increase Service PricingThe greatest theme of 2021 from the perspective of E&P operators and mineral aggregators was the upward trajectory out of the crude abyssfrom 2020. What a difference a year makes, both in hindsight and for the road ahead. This was probably most present with OFS operators, which likely hit an inflection point from riding the wave as price-takers to potentially commanding the wave as price-makers in the near-term or at least being able to take more than what they can just get.“Service pricing improvement is the final step. We're not there yet, but we see positive signs of market rebalancing that should drive future pricing improvements. Total fracturing equipment capacity has limited room to grow in the current pricing environment.” – Jeff Miller, President & CEO, Halliburton [Q1]“I believe equipment availability will tighten much faster than most people think. In multiple product lines, we believe that equipment supply will fall behind anticipated demand. Today, both drilling and completions equipment are nearing tightness in North America.” – Jeff Miller, President & CEO, Halliburton [Q2]“Our primary near-term objective is driving margin expansion. Our largest near-term lever here is pricing.” – Bill Austin, Interim CEO & Chairman, Ranger Energy Services [Q2]“I'll give you two anecdotes. One customer was a smaller customer, that we went and said that these need to be the new rig rates for us to continue, working beyond what we had committed to. They were pretty upset. Used some pretty colorful language. And we said, we're going to okay, well, we will finish up our jobs that we committed to, and we'll walk away. Half an hour, they call back and agreed to it, right? So clearly, our view is that they got on the phone, called around, and realized that there wasn't anything available. And another one with a much bigger customer said that they wanted to add additional rigs. They were trying to use that as a bargaining chip for basically a volume discount. We very quickly said we'll talk about additional rigs only, until we get our first pricing, basically the first wave of price increases. It's been a multiple conversation event, but I think we’re getting there.” – Stuart Bodden, President & CEO, Ranger Energy Services [Q3]ConclusionMercer Capital has its finger on the pulse of the oil and gas sector. As upstream operators, mineral aggregators, and the OFS operators that support them regain their footing, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the hydrocarbon stream. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team.

WHITEPAPER | Understand the Value of Your Logistics Company

There are many reasons why a logistics company can be worth more or less than a standard rule of thumb might imply, and many reasons why a particular interest in a logistics company can be worth more or less than the pro rata value implied by that rule of thumb.This whitepaper provides useful information as to how logistics companies are valued and what impact that might have on their owners.The whitepaper breaks down basic concepts that must be defined in every valuation and goes into depth about three commonly accepted approaches to value. Financial and market considerations are discussed as are the differences between public and private companies as well as public and private logistics companies.

The Future of Auto Dealerships

How Inventory Shortages and Electric Vehicles May Shape the Future of Automotive Retail

Just as December is a good time to look back and reflect, January is a good time to look forward, to 2022 and beyond. When we value auto dealerships, we look back at performance in prior years because this helps to inform reasonable expectations for future performance. Prior to the pandemic, the directly preceding twelve months of performance may have been a reasonable proxy for ongoing expectations. However, throughout 2020 and 2021, discussions about when things will return to “normal” or whether we’re in the “new normal” have taken center stage.In order to look forward, we must also consider the past, or as Shakespeare’s Antonio would say, “What is past is prologue.” In this post, we look at two key trends in 2021 (inventory shortages and electric vehicles/direct selling) and how they may inform how automotive retailing will look in the future.Inventory ShortagesIn case you’ve been living under a rock (or working from home and refusing to turn on the news), new vehicle inventory has been tight, reducing availability and raising prices. While a lack of necessary microchips has stolen headlines, general supply chain issues are also at play (labor shortages, plant shutdowns due to COVID, etc.). From Econ 101, we know low supply leads to higher prices. And even though operating expenses have increased 16.3% for the average auto dealership in the U.S., pre-tax profits more than doubled in the first nine months of 2021.This inelasticity of demand affords greater pricing power to dealers and manufacturers than they’ve previously achieved.For years, retail has been obsessed with discounts. Think 10% for signing up for a mailing list, free shipping for orders over $25, or straight to the point: Black Friday/Cyber Monday. Automotive retailing is no exception, with incentives reaching above $4,500 per vehicle prior to the pandemic. As discussed last week, incentives have plummeted in the low inventory environment. Unlike knick-knacks bought in the Christmas season, many car buyers don’t have a reasonable substitute. When their car breaks down, they need a vehicle and can’t wait months for inventory levels to normalize. This inelasticity of demand affords greater pricing power to dealers and manufacturers than they’ve previously achieved.Auto dealers and their manufacturers are much more profitable under the current operating environment while producing fewer vehicles, reducing execution risk. It’s easy to chalk up these good times to temporary dislocations caused by COVID that will eventually normalize. But in a capitalist society, economic downturns tend to bring back the phrase attributed to Winston Churchill around World War II, “never let a good crisis go to waste.” OEMs will look at how they’ve adapted since March 2020 and look to keep profits higher with more efficient operations.Once the pandemic is finally in the rear view mirror, we think the level of inventories held on lots will be lower than pre-pandemic levels. While there is still a value to testing out the product before purchasing, we’ve seen other retail industries that hadn’t yet succumbed to ecommerce where certain buyers are now willing to buy sight unseen (see mattresses in a box). This shift in auto will reduce floor plan costs for dealers who can also downsize their real estate holdings or convert it to more service areas if they can find the technicians to fill the bays they already have. Smaller real estate requirements may enable dealerships to move to more cost-effective locations.But the main concern from dealers we’ve talked to is this: what if prevailing supply conditions fundamentally change the franchised dealer model?History of Dealer FranchisingTo understand the status quo of automotive retailing, we start at the beginning, when automotive manufacturer franchising of dealerships began in 1898. Back then, there were numerous methods of selling vehicles, including franchise locations, direct sales from factory-owned stores, traveling salesmen, wholesalers, retail department stores, and consignment arrangements. As automobiles proliferated, manufacturers preferred outsourcing sales to the franchise model, so they could focus on their core competency of manufacturing vehicles. They would rely on entrepreneurs to understand their local market in terms of which models were popular and where best to situate the dealership within the market. This also lowered investment for the manufacturers who could instead plow those resources back into product development.The franchise agreements were perceived as shifting risk downward to dealers and rewarding upwards to the manufacturers.Once this investment was made by numerous “mom and pop” shops throughout the country, dealers lobbied to protect their investment. It was deemed unfair for the Big Three (Ford, GM, Chrysler) to be able to sell directly to consumers in lieu of through its dealers. Manufacturers already operate from a position of power as the sole provider of new vehicles to its franchisees, a risk known in valuation as “supplier concentration.” OEMs can unilaterally determine production levels, and according to a 1956 Senate Committee report, franchise agreements of the 1950s typically did not require the manufacturer to supply the dealer with any inventory and allowed the manufacturer to terminate the franchise relationship at will without any showing of cause. Manufacturers could overproduce and force dealerships to accept the cars with the threat of no inventory in the future. This occurred with Ford during the Depression. Thus, the franchise agreements were perceived as shifting risk downward to dealers and rewarding upwards to the manufacturers.For perspective, restaurants don’t have similar franchise protections. For example, McDonald’s has both corporate owned and operated locations as well as franchise locations (approximately 93% of locations are franchisees). In this industry, there is heavy competition and franchisors often test out new products in their own locations before rolling them out to franchisees. This is quality assurance and also gives franchisors the ability to point to the success of a product so franchisees don’t feel like they’re being forced into something that may not appeal to their customers.While dealers made numerous lobbying efforts at the Federal level in the 1930s to 1950s, they made little headway. In fact, a 1939 Federal Trade Commission report found that manufacturers pitting dealers against each other actually led to an intense retail competition which ultimately benefitted consumers. To get the protections they sought, dealers turned to state legislatures, which is why franchise laws are largely handled at the state level. Today, all 50 states have laws that protect dealers, though the strength and terms of these laws varies by state. Common terms include the prohibition of forcing dealers to accept unwanted cars, protection against termination of franchise agreements, and restrictions on granting additional franchises in a dealer’s geographic market area. As many dealers today know, the OEMs still have significant bargaining power in these latter two areas.Direct SellingThe current market dynamic has prevailed for generations through numerous business cycles. Today, dealers are concerned that manufacturers may use electric vehicles (“EV”) as a means to skirt dealer franchise laws. Tesla has been very successful, particularly if you look at their share price, with its direct-to-consumer electric vehicle sales. OEMs naturally would like a piece of this (or anywhere near their valuation multiple).While Tesla has encountered legal troubles with its direct selling model, it’s important to note the difference between Tesla and other manufacturers. Tesla never pursued a franchise dealer model. Therefore, direct selling cannot disadvantage dealers of its vehicles since they don’t exist. Tesla offers a luxury product and has yet to reach a meaningful scale. Unlike OEMs of the early to mid-1900s, their product has not garnered mainstream demand, and they can therefore be competitive in their niche by keeping few parties in between the manufacturer and the consumer. While the below graphic is instructive, the OEM tends to play the role of plant, distributor, and wholesaler, meaning there’s really only one extra layer between manufacturer and consumer in this industry. Dealers naturally contend that direct-to-consumer EV sales should not be allowed as it could be a slippery slope to allowing the sale of all vehicles directly. There is nothing inherently different about the manufacturing and selling process as it relates to the powertrain of the vehicle. Tesla’s exception is not electric; it’s the lack of an existing dealer network. However, one of the benefits of the current dealership model is that consumers can return to the dealership to service their vehicle. If EVs deliver on their promise to require less maintenance than internal combustion engine (“ICE”) vehicles, maybe the need for this dealer network will be diminished in some regard. For now, electric vehicles are too expensive to be mainstream, but significant progress has been made on lithium batteries which have lowered costs. Still, massive investments in infrastructure will be necessary to make EVs practical. Electric vehicles are only 2.9% of the market, though combined with hybrids, alternative powertrains amount to 9.5%, with the remaining being internal combustion engines. While this is a relatively small piece of the market, it will likely grow over time.Source: NADA Market Beat December 2021ConclusionGiven the complexity of manufacturing automobiles and the heterogeneous preferences of consumers, we don’t think the recent shift to “just-in-time” delivery out of necessity will last. We believe electric vehicles will compose a much more meaningful market share, though we are less certain on the timing. While there are various proclamations of carbon-neutral by 2050 and the like, we think the market will determine when and how much electric vehicles hit the mainstream. If improved technology reduces costs and fears of range anxiety, EVs could be on the same playing field or even advantaged over ICE vehicles with higher upkeep costs (service and gas).We don’t believe electric vehicles will meaningfully change dealer franchise laws. However, we believe the trends we’ve seen of smaller stores being gobbled up by increasingly larger auto groups will continue, which is partially due to the threat of direct selling. However, smaller dealers are also getting out with valuations peaking, tax policy uncertainty, and increasing capital requirements to invest in digital platforms, automated systems, and the infrastructure to support electric vehicles rather than the direct selling of these vehicles.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

A B2B Fintech in the RIA Space Races to Market

Dynasty IPO Ticks a Lot of Boxes, and Begs a Few Questions

Two economists are walking along, and one of them says, “Look, there’s a hundred dollar bill on the sidewalk.” The second economist says, “It can’t be a hundred dollar bill; if it was, somebody would have picked it up by now.”Most economists believe in market efficiency. This belief requires a healthy dose of skepticism, which some see as cynicism. That characterization is unfair.Real Versus RareMy family was staying at the Grove Park Inn a few years ago when we spotted what looked exactly like a Porsche 904 GTS in the motor court (photograph above). It looked just like the mid-60s racing legend, with a short wheelbase, a very low roofline, and a detachable steering wheel (to assist getting in and out of the driver’s seat). Convincing, but I knew it couldn’t be real; highly unlikely that anyone would drive such a rarity to dinner (about 100 were built), even on a beautiful day in the mountains of North Carolina. A little research revealed it to be a kit car made by Chuck Beck – also rare but considerably more accessible than the original.Last week we were surprised by an equally rare sighting, an S-1 filed by a prominent player in the RIA community. Dynasty Financial Partners seeks to raise $100 million in a public offering. The mercifully terse prospectus is less than 250 pages, and is recommended reading for anyone who swims (or fishes) in this pond.The mercifully terse prospectus is less than 250 pages, and is recommended reading for anyone who swims (or fishes) in this pond.As most of the readers of this blog know, DFP is the ten-year-old brainchild of Shirl Penney, Edward Swenson, and Todd Thomson. The company provides a variety of services to both foundling and established RIAs, but principally engineered a plug-and-play back office for RIAs, sifting through the myriad of technology vendors needed for wealth management and organizing them on a proprietary platform called the Dynasty Desktop.The pitch for potential clients is self-evident: RIAs of any scale can access the tech stack of a big firm on a subscription basis. Dynasty stays on top of tech developments better than (most) in-house teams.Complementing this is a TAMP and access to growth capital. Being a Dynasty Network firm situates wealth management shops in a broader community of firms with similar interests, needs, and requirements. Client firms get to focus on what wealth managers do best: stay at the front of the house, developing their business, while Dynasty manages the back of the house, supporting their business.Great narrative. DFP’s financials are promising, if lighter than expected. Dynasty’s PR group is to be commended: the firm has developed an outsized prominence in the industry relative to its actual size.Dynasty has a recurring revenue stream (most of its services are priced as basis points on AUA) and the scale of the business has more than quadrupled in the past five years. Nevertheless, in the nine months ended September 30, 2021, Dynasty reported a bit less than $50 million in revenue and only $12 million in adjusted EBITDA. While adjusted financial metrics sometimes warrant criticism, Dynasty’s reported EBITDA was only off $750K or so for the same period.While full year financials aren’t yet available, we estimate run rate revenues of $75 million or more, with adjusted EBITDA approaching $20 million. Dynasty’s unit economics are enviable, with a growth-plus-margin metric, so often cited by SaaS investors, of nearly 75% (period-over-period revenue growth of 50% plus an EBITDA margin of 24%).What’s Not to Like?As available investment opportunities go, Dynasty looks great except for one thing: it’s available. Why is this hundred dollar bill on the sidewalk? More specifically, why is a firm with this story and size not being funded by private equity?There’s no shortage of private equity investors in the B2B, fintech, or RIA space; Dynasty should appeal to them. As a B2B, Dynasty has a track record of attracting and retaining demanding RIA clients with their platform. As fintechs go, DFP is certainly more interesting than the myriad of buy-now, pay-later startups that seem to attract nearly limitless capital these days. Compared to the many PE-backed serial acquirers in the RIA space, this is an actual business…with products. Surely, selling picks and shovels to RIAs is less speculative than being an RIA.Surely, selling picks and shovels to RIAs is less speculative than being an RIA.Why would management want to go public? Running a public company is no walk in the park, and most management teams don’t choose that path instead of PE backing, especially with less than $100 million in revenue. As such, we have a few questions:Is the Dynasty Desktop a comprehensive, proprietary technology solution for RIAs, or middleware that is easily replicable? The answer may depend on the client, but if it’s the latter, Dynasty is at risk of being exposed to more competition if the market for their platform becomes more visible. Their offerings could be featurized by custodians or custom-engineered by developers. The more success they achieve, the more competition they’ll attract.Is Dynasty’s fee schedule sustainable?We don’t have enough information to infer what Dynasty has been able to charge for their services over time, but current returns suggest a realized fee across all of their segments (tech stack, TAMP, etc.) of about 11 basis points. The S-1 suggests that fees are negotiable, and larger RIAs probably pay fewer bps than small ones. At the same time, Dynasty probably earns most of its profits from larger clients, because the base cost of service won’t be that different for a $200 million RIA and a $2 billion RIA.If the wealth management industry experiences fee compression, what does that mean for Dynasty? RIAs have the option of paying a consultant a one-time or infrequent fee to build a tech stack instead of regular subscription fees. Smaller RIAs have an obvious incentive to get someone like Dynasty to handle the back-of-the-house stuff so they can focus on wealth management. Larger RIAs can disintermediate and build their own margin with direct vendor relationships.What is normalized profitability for this company? Under the right circumstances, SaaS can throw off huge margins. Here, the margin opportunity is hard to assess, although the potential for operating leverage is obvious. Dynasty currently serves 46 firms with 75 employees. How much additional headcount would it take to service 80 firms, and how specialized would those additional staff be? We suspect that DFP’s move to Florida was part of an effort to right-size its cost structure. While many rue the outflow of financial businesses from New York, we see it as both prudent and inevitable. Being public, on the other hand, has costs of its own, and DFP will have to outgrow those costs to make the IPO worthwhile.What is the cost of remaining relevant in this space? It’s easy for in-house tech specialists to fall behind the competence curve. When they do, companies lose opportunities, fall victim to malware, and profits suffer from inefficiency. Outside tech providers can offer the latest and greatest and are pros at keeping themselves and their clients current. But remaining current is expensive, and one wonders if a company the size of Dynasty can handle the tradeoff between the margin they make from today’s products and services and the cost of developing tomorrow’s products and services. Dominant technology companies are either very niched or very large. The Dynasty S-1 is mostly routine, except for one section outlining their efforts to remedy problems with their internal controls. It’s probably nothing, but we’re surprised by this, as competent management of back-office issues is what DFP is supposed to be selling to RIAs. If Dynasty could have waited a bit on their IPO, they could have cleaned up and avoided the disclosure.Price Versus ValueSo what’s the verdict? It all comes down to price. We know Dynasty wants to raise $100 million, and we estimate they have nearly $20 million in EBITDA. How much of that EBITDA will $100 million buy? We’ll soon find out.It all comes down to price.The Beck 904 is faster, more comfortable, and more drivable than an original Porsche 904. It’s not “real,” but it’s real cool. And the Beck is much cheaper than the original, priced at less than 5% of the auction value of the Porsche. At $75K for a fully outfitted Beck and $2 million for the Porsche, each priced to reflect the underlying value of the car.

Desert Peak to Go Public via Merger With Falcon After IPO Attempt

Desert Peak Minerals and Falcon Minerals Corporationrecently announced an all-stock merger, forming a pro form a ~$1.9 billion mineral aggregator company. This comes in the wake of Desert Peak’s attempted IPO in late 2021. In this post, we look at the transaction terms and rationale, the implied valuation for Desert Peak, and implications for the mineral/royalties space.Transaction OverviewThe merger will combine Falcon’s ~34,000 Eagle Ford and Appalachia net royalty acres with Desert Peak’s ~105,000 acre Delaware and Midland position, resulting in a combined company with ~139,000 net royalty acres. Approximately 76% of the company’s acreage position will be in the Permian, with 15% in the Eagle Ford and 9% in Appalachia. Pro forma Q3 2021 production was 13.5 mboe/d, which moves Falcon from the smallest (by production) publicly traded mineral aggregator in Mercer Capital’s coverage to number four, leapfrogging Dorchester and Brigham.The transaction is expected to close during the second quarter of 2022, at which time legacy Falcon shareholders would own ~27% of the company, while legacy Desert Peak shareholders would own ~73%. The combined company will be managed by the Desert Peak team and headquartered in Denver.Going forward, one of the key strategies of the company appears to be M&A. The company seeks “to become a consolidator of choice for large-scale, high-quality mineral and royalty positions” and touted its “strategic, disciplined, and opportunistic acquisition approach” in presentation materials.The company also highlighted its ESG credentials, noting the diversity of its workforce and structural economic disincentives for flaring gas. However, most ESG discussions focused on the often-neglected G – governance. Management incentive compensation is expected to be 100% in the form of equity with an emphasis on total shareholder returns, rather than relative returns or growth metrics.Desert Peak Implied ValuationDesert Peak was pursuing an IPO in late 2021, looking to raise $200 to $230 million at an implied enterprise value of $1.2 to $1.4 billion, based on Mercer Capital’s analysis of Desert Peak’s S-1 filing. However, the deal was postponedin November and ultimately withdrawn in January.Based on Falcon’s stock price immediately preceding the announcement, the merger terms imply an enterprise value of $1.4 billion for Desert Peak, slightly higher than the valuation implied by the top-end of the IPO range. However, Falcon’s stock price has slid since then, bringing Desert Peak’s implied valuation back in line with the mid-point of the IPO range.Implied valuations and relevant multiples are shown in the following table.IPO stock price reflects midpoint of $20 to $23 range indicated in Desert Peak’s S-1. Merger stock price reflects Falcon's closing stock price as of 1/11/2022 (immediately preceding merger announcement). Current stock price reflects Falcon's closing stock price as of 1/19/2022.IPO shares pro forma for anticipated IPO offering. Other figures reflect the number of Falcon shares to be issued to Desert Peak.IPO net debt pro forma for anticipated transaction proceeds, as indicated in Desert Peak’s S-1. Other figures reflect net debt as disclosed in the transaction press release.Metric per transaction press release (as of 9/30/2021).Metric per transaction presentation (as of 9/30/2021). Multiple calculated on a dollar per flowing barrel equivalent basis ($/boe/d).Metric per Desert Peak S-1 (pro forma as of 12/31/2020). Multiple calculated on a dollar per barrel equivalent basis ($/boe).Metric per Desert Peak S-1 (pro forma as of 12/31/2020).Metric per transaction presentation.ImplicationsDesert Peak's inability to complete its IPO highlights the lack of appeal of oil & gas assets among generalist investors, which is not welcome news for an industry facing capital headwinds and a dearth of IPO activity. However, Desert Peak was able to structure a new deal at essentially the same valuation should give mineral and royalty owners confidence that logical buyers can be found.ConclusionWe have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

Auto Industry Trends to Monitor in 2022

Less Is More?

With the start of NFL playoffs and our third accumulating snowfall in three weeks, we are once again reminded that the calendar has flipped over to a new year. No doubt if you watched any games from Super Wild Card weekend, you were also reminded that the auto manufacturers and beer producers are two industries that have become synonymous with advertising in the NFL. One such beer producer had a longtime advertising campaign where they debated whether their beer “tastes great” or is “less filling.” While consumers continue to weigh that debate, that same beer producer ended some of their commercials with the line “everything you always wanted in a beer. And less.”That slogan could easily have described the state of the auto industry in 2021. Some industry experts have referred to it as “less is more,” others as “the new abnormal.” There is no debate that the auto industry faced numerous challenges but was able to adapt and turn in one of its most profitable years on record in 2021.What trends can we expect to see in 2022 for the auto industry? What trends will we see “less” of? What trends will we see “more” of?In this blog post, we examine some of these trends and offer some predictions for industry conditions in 2022.Less: Incentives from the ManufacturerHistorically, OEMs have offered incentives to auto dealers on certain makes and models for stocking the companies’ products and promoting sales. As the supply of new units was diminished since the onset of the pandemic due to plant shutdowns and then ultimately a shortage in microchips, the demand to buy the limited number of units outweighed supplies and incentives have diminished for most makes and models. The following chart from JD Power/LMC Automotive displays the average incentive spending per unit and the percentage of incentives to the average Manufacturers’ Suggested Retail Price (MSRP) from December 2019 through December 2021. Specifically, average incentive spending per unit has declined by approximately $3,000 per unit from December 2019 to December 2021, representing a 65.3% decline. Incentives as a percentage of average MSRP has also declined from 11.0% to 3.5%. With continued inventory supply challenges expected to persist for most of 2022, expect OEM/Dealer incentives to continue to be lower than historical levels. Quite simply, the demand for inventory will outpace supply in the continuing months.More: SAAR/Total Retail Units SoldAs we reported in last week’s blog, the December SAAR totaled just 12.44 million units. The total number of units retailed for the year has been estimated at 14,926,900. Volumes were negatively impacted by the same conditions that impacted manufacturer incentives – plant shutdowns, chip shortages, and supply chain issues. Despite the success achieved by auto dealers over the past two years, the total number of retail units sold has lagged behind the prior five-year average. Many analysts that cover the industry would estimate that demand for the annual SAAR should hover around 17 million units. In fact, the average SAAR for the period from 2015 through 2019 averaged 17.24 million units. As seen in the graph below, the decline in sales for the last two years has created a deficit of approximately 5.08 million units. Some of this deficit may get offset or replaced by consumers that have either delayed their next purchase or shifted to purchasing a newer used vehicle rather than a new vehicle. With fewer vehicular miles driven, some of these retail volumes may be permanently “lost.” In any event, there is pent-up demand from consumers due to the inventory shortages over the last two years. The market will need to absorb this pent-up demand as more inventory becomes available. Several industry experts have weighed in on their SAAR estimates for 2022:Kevin Roberts – Car Gurus: 15-16 millionJonathan Smoke – Cox Automotive: 16 millionPatrick Manzi – NADA: 15.4 million SAAR will most certainly increase in 2022 out of necessity from demand from the prior two years. Full recovery to the 17 million unit historical levels will continue to be challenged by the inventory conditions from the OEMs. If the OEMs are able to produce more units in 2022, auto dealers will be able to increase the number of units sold from the prior two years.Less: Number of Models AvailableGiven the challenging industry conditions, OEMs have been forced to prioritize which models they produce. Most OEMs have had a difficult time producing their full lineup of vehicles. Specifically, two segments that are among the hardest hit are the luxury market and cars (as opposed to crossovers and pickup trucks). In normal production years, luxury cars are more limited in supply than other brands, but those are being more impacted in 2021 and are being the hardest hit with seller markups. Cars and sedans are also seeing a reduction in the number of units produced. Consumer behavior, in addition to inventory shortages, is to blame for this phenomenon. According to a recent article in Newsweek, trucks and SUVs compromise nearly 81% of the total vehicles manufactured.OEMs will continue to prioritize the production of models based upon:units dealers are selling the most frequentlyunits for which necessary parts and microchips are availableunits achieving the highest margins. Like many industry experts, we anticipate the number of models from each OEM will continue to be limited in 2022.Less: Features on VehiclesAs we all learned in 2021, many of the accessories and features on our vehicles are powered through microchips. The microchip shortage has caused production delays and shortages. Some analysts have estimated that the global microchip shortage has cost the auto industry millions of lost vehicles and billions in lost revenue in 2021. How long are conditions expected to persist?Most automobiles can be built in 15 to 30 hours, while a microchip takes nearly five months to be produced.Most auto manufacturer plants can operate two production shifts five days a week or a total of 10 shifts per week. In times of high production needs, auto manufacturers can increase the total number of shifts to 21 shifts per week. In contrast, semiconductor plants are expensive, slow to build, and more complex to operate. For example, most microchip plants operate 24 hours per day, 365 days per year, so there is no room to increase production in existing plants to make up for any shortfalls. Further, the life cycle of a microchip plant from breaking ground on the facility to the start of production can take up to five years, compared to the six-month lead time at an auto manufacturing plant. Most automobiles can be built in 15 to 30 hours, while a microchip takes nearly five months to be produced, packaged, and shipped to an OEM for installation on a vehicle.So while companies such as Taiwan Semiconductor Manufacturing Company (TSMC) and others are making the investment to build new chip factories, it’s going to take considerable time to meet current demands. TSMC began building a new factory in Arizona in June, and Samsung is planning a new chip plant in Texas.Given supply constraints, OEMs can either produce fewer vehicles with the same number of features, the same number of vehicles with fewer features, or a combination of the two (smaller reduction of both vehicle volumes and features). As we saw in 2021 and anticipate into 2022, the auto industry will continue to suffer from the microchip shortage. Consumers will see the impact materialize in fewer accessories and features on the new vehicles produced in 2022.Less: Number of Electric Vehicles (EVs) on the MarketIn last week’s blog, we also commented on the OEMs participation and activity in the electric pickup truck race. The activity isn’t just limited to Ford, Chevrolet, and Tesla as newer manufacturers such as Lordstown Motors, Bollinger, and Atlis Motors are also entering the market.The demand for battery-electric vehicles doubled during the first half of 2021.While EVs only account for a fraction of the new vehicle sales in the United States, the demand for battery-electric vehicles doubled during the first half of 2021. Just last week, representatives from NADA, General Motors, and the United Auto Workers testified in a House hearing on the impact of EVs on rural communities. Many dealers indicate the desire and energy to participate in the direct sale of EVs once they are rolled out from production from the OEMs. Auto dealers wish for traditional state franchise laws to be upheld that govern the licensing and regulation of distribution and the sale and service of EVs. Specifically, auto dealers in rural or non-metropolitan areas want to make sure they are not excluded from participation due to a lack of technological innovations. Similar to other advancements such as electrification, broadband, and telephone service, rural area auto dealers want to ensure that they will be given the same priority and attention as their urban dealer counterparts.Consumer behavior and preference may also play a key role in the increased number of EVs on the road. According to a 2022 State of the American Driver Report from Jerry, 47% of millennials are interested in buying an EV as their next vehicle. Gen Z and Gen X also show strong interest in EVs at 41% and 38%, respectively.ConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation and litigation support engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Alt Managers Best the Market Along with Other Types of RIAs During a Strong Year for Investment Management Firms

Alternative asset managers fared particularly well during favorable market conditions for the RIA sector. Access to cheap financing and heightened market volatility spurred significant gains for private equity firms and hedge fund managers during 2021. Other types of investment management firms also benefited from another solid year in the equity markets as traditional asset managers and RIA aggregators outperformed the S&P 500 with 30% to 40% gains on average. Drilling down into the most recent quarter, we see more mixed results with positive gains for all sectors, but traditional asset managers and aggregators lagged the market as investors weighed the impact of the omicron variant and rising inflation on the sector’s prospects. Alt managers continued to benefit from higher allocations to risky assets despite some weakness across all sectors during the back half of the quarter. RIA aggregators exhibited outsized volatility during the quarter but ended on a positive note with the stock market in the last week of the year. Because the aggregator model is levered to the performance of the RIA industry generally, recent volatility for RIA stocks has triggered mixed investor sentiment towards the RIA aggregator model. While the opportunity for consolidation in the RIA space is significant, investors in aggregator models have expressed mounting concern about rising competition for deals and high leverage at many aggregators which may limit the ability of these firms to continue to source attractive deals. Performance for many of these public companies continues to be impacted by headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. These trends have especially impacted smaller publicly traded RIAs, while larger asset managers have generally fared better. For the largest players in the industry, increasing scale and cost efficiencies have allowed these companies to offset the negative impact of declining fees. Market performance over the last year has generally been better for larger firms, with firms managing more than $100B in assets outperforming their smaller counterparts. As valuation analysts, we’re often interested in how earnings multiples have evolved over time since these multiples can reflect market sentiment for the asset class. After steadily increasing over the second half of 2020 and first half of 2021, LTM earnings multiples for publicly traded asset and wealth managers declined moderately during the most recent quarter, reflecting the market’s anticipation of lower or flat revenue and earnings as the market pulled back modestly in September and November. Implications for Your RIAThe value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with privately-held RIAs should be made with caution. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds such as fee pressure and asset outflows to passive products.In contrast to public asset/wealth managers, many smaller, privately-held RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.Notably, the market for privately held RIAs remained strong in 2021 as investors flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer. Deal activity for these businesses continued to be significant in 2021, and multiples for privately held RIAs tested new highs due to buyer competition and the shortage of firms on the market. As these dynamics continue into 2022, the outlook for continued multiple expansion and robust deal activity remains favorable.

What a Difference a Year Makes: Part II

Analyst Projections

In our prior Energy Valuation Insights post – What a Difference a Year Makes – Mercer Capital’s Bryce Erickson dug into the key aspects of the energy industry during 2021, including oil and gas pricing, stock price performance, rig counts, production levels, capital spending, and LNG facility development. It’s well worth a read!In today’s post, we continue the “what a difference a year makes” theme, but now with a focus on analyst projections, then-and-now (then being as of year-end 2020, and now being as of year-end 2021) and energy stock valuation multiples.For the purpose of our analysis, we utilized the Capital IQ system and identified publicly traded energy companies, trading on the NYSE and NASDAQ exchanges, and operating in three broad areas – exploration and production (E&P), oilfield services (OFS), and midstream.The resulting pool included 44 E&P, 32 OFS, and 29 midstream companies1,227 forward (i.e., for the next year) revenue estimates were included in the analysis – 666 as of year-end 2020, and 561 as of year-end 20211,735 forward EBITDA (earnings before interest, taxes depreciation and amortization) estimates were included in the analysis – 854 as of year-end 2020, and 881 as of year-end 2021Potential survivor bias was eliminated by including the same set of companies as of both year-end 2020 and 2021So, What Are the Analysts Expecting?Exploration & ProductionWe’ll start at the drill bit end of the industry – the E&P companies. Revenue growth expectations (233 and 201 analyst estimates as of year-end 2020 and 2021, respectively) actually didn’t change significantly. As of year-end 2020 the median estimated 1-year revenue growth was 25.8%, with only a small increase to 29.7% as of year-end 2021. An improvement certainly, but by no means earth-shaking. A bit more significant for the E&Ps was a 7.5 percentage point increase in the median estimated EBITDA margin, from 57.7% to 65.2%. The real “move” in E&P estimates came from the combination of slightly improved revenue growth estimates and EBITDA margin estimates, buoyed by the rise in commodity prices. Those two estimates “teamed-up” for a mere 17.0% median EBITDA growth estimate at year-end 2020, but a very significant 119.8% median EBITDA growth estimate at year-end 2021.Oilfield ServicesNext up we look to the service and machinery providers to the E&Ps – where we find a much more positive outlook today relative to a year ago. Last year’s median revenue growth estimates sat in negative territory at -6.3%. Sentiment was much improved at year-end 2021 with a median revenue growth estimate at 23.9%. However, OFS EBITDA margins paint a different picture. Despite the expectation for strong revenue growth, EBITDA margins are expected to actually decline slightly from a year-end 2020 median forecast of 12.8%,d to a current figure of 12.2%. This implies that while demand and utilization will be strong, pricing power for oilfield service companies will slip somewhat. The combination of revenue growth and EBITDA margin estimates, though, show a strong improvement in EBITDA growth expectations, from a median expected decline of 5.3% at year-end 2020 to a median expected growth of 34.0% at year-end 2021. This is not as strong as EBITDA growth expectations among the E&Ps, but a very welcome increase all the same. MidstreamMidstream operators of course are the “Steady Eddies” of the energy industry – that in large part is due to the very nature of the services provided and the more contractual/commitment orientation of the midstream business. As one would expect, the difference between 2020 and 2021 median analyst estimates are much less material for midstream companies. Median revenue growth estimates were quite low at only 1.0% at year-end 2020, but improved to a median growth estimate of 7.5% as of year-end 2021. EBITDA margin estimates actually declined a bit more than those for OFS companies, with a 3.3 percentage point dip from 42.5% at December 2020 to a 39.2% median at December 2021. In combination, the revenue growth and EBITDA margin estimates result in the median EBITDA growth estimate of 2.1% in December 2020 and a median estimated growth of 9.0% as of December 2021. Valuation MultiplesLastly, in our comparison of year-end 2020 and year-end 2021 within the energy industry we look to valuation multiples across the three energy sectors. Here we see how the combination of uncertainty of future operating results (risk) and growth expectations combine in the form of enterprise value multiples of EBITDA, on both a trailing (latest twelve months – LTM) and 1-year forward EBITDA basis. Starting with the midstream companies, we see that modest improvement in revenue expectations and slight reduction in EBITDA margins combine with risk perceptions for fairly modest changes from 2020 to 2021 LTM and forward valuation multiples. LTM midstream multiples edged up from 9.0x to 10.0x, while the Forward multiples showed an even more modest increase from 8.7x to 9.0x.The negative 2020 EBITDA growth expectations and much larger (than Midstream) 2021 EBITDA growth expectations result in a very different combination of 2020 to 2021 and LTM to forward OFS multiples. Here we see the median LTM multiple jumping 34% from 2020 to 2021, while the forward multiple decreased by 24%. That with 2020 forward multiples 32% greater than 2020 LTM multiples, and 2021 forward multiples 50% below 2021 LTM multiples.By far the largest swing in 2020 to 2021 and LTM to forward multiples comes from the E&P companies. With only modest EBITDA growth expectations as of 2020, the E&P LTM and forward multiples are quite similar at 5.8x and 5.2x, respectively. However, the 119.8% median estimated EBITDA growth at year-end 2021 results in a much larger LTM to forward differential of 6.7x – 9.7x LTM compared to 3.7x forward. That high level of EBITDA growth expectations in 2021, compared to the much more modest growth expectation as of 2020 results in a 3.1x differential between 2020 LTM multiples and 2021 LTM multiples (5.8x versus 9.7x). As with OFS forward multiples, the E&P forward multiples decreased markedly from 2020 to 2021, from 5.2x to 3.7x. In SummaryThe energy industry that was hammered in 2020 by the combined OPEC+ induced oil glut and COVID related oil demand decline showed a mixed bag of marginal and tepid operating result growth expectations at year-end 2020, but is showing much greater expectations as analysts look ahead into 2022. However, it is the energy industry – so, be ready for the next cycle shift.Mercer Capital has significant experience valuing assets and companies in the energy industry. Our energy industry valuations have been reviewed and relied on by buyers, sellers, and Big 4 Auditors. These energy-related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed energy industry valuations domestically throughout the United States and in foreign countries.Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

What a Difference a Year Makes: Part I

Key Aspects of the Energy Industry in 2021

The close of 2021 marked the end of a long upward march for the energy sector. With oil closing up the year at $75 (compared to $48 at the end of 2020) and gas at nearly $4 per mmbtu (compared to $2.36 at the end of 2020), the commodity markets driving the energy sector were much more economically attractive to producers. Stock indices such as the XLE, which primarily tracks the broader energy sector, was up over 50% for 2021 and was by far the best performing sector. Rig counts, although with more cautious deployment than in the past, rose along with prices and increased by 235 for the year (586 at year-end 2021 vs. 351 at year-end 2020). Crude production rose to 11.7 million bbls/day with room to grow as inventories were about 7% below the five-year average. OPEC+ also has signaled it will continue its scheduled output growth.All of this growth is coming alongside the ascent of wind and solar. The Omicron variant raises uncertainty about the markets and took a cut into prices in December. However, while COVID may dampen demand growth, most analysts believe it won’t stop it.Prices & Production“We expect Brent prices will average $71/b in December and $73/b in the first quarter of 2022 (1Q22). For 2022 as a whole, we expect that growth in production from OPEC+, of U.S. tight oil, and from other non-OPEC countries will outpace slowing growth in global oil consumption, especially in light of renewed concerns about COVID-19 variants. We expect Brent prices will remain near current levels in 2022, averaging $70/b.” – EIA – December 7, 2021 The steady climb of prices in 2021 reflected a rebound in demand that exceeded earlier expectations. It also reflected a more cautious approach to bringing more production online and the curtailed capital environment as well. However, that may not last much longer as more estimates accumulate that suggest capital spending for upstream producers will pick up in 2022. Perhaps even more impactful for upstream producers has been the rise of natural gas prices in 2021 as well. After languishing for so long, prices not only exceeded $3.00 per mmbtu they rose to over $5.00 for a brief period. These price levels have been unseen for many years and are anticipated to remain near $4.00 mmbtu in 2022, however, volatility is expected to be higher as well. Production has increased, particularly in Appalachia and has now reached pre-pandemic levels. Perhaps in 2022 the restraint will come off on production efforts more than the past few years. According to the Dallas Fed Energy Survey 75% of companies surveyed plan to spend more in 2022 vs. 49% in the same survey given at the end of 2020. Cowen & Co. says the E&P companies it tracks plan to spend 13% more in 2022 vs. 2021 after significant drops of 48% in 2020 and 12% in 2019. Much of this growth vigor is fueled by smaller E&P companies that have struggled so much in recent years. However, there is still a lot of uncertainty with inflation and other issues which are keeping larger companies more conservative with their capital as reflected in comments like this: “Supply-chain issues continue to create logistical challenges, and it is difficult to plan and/or coordinate upstream operational activity. Labor shortages have contributed to this issue as well. Pandemic worries are definitely impacting the oil demand side, with resultant uncertainty with respect to commodity pricing and supply forecasting.” – Dallas Fed Respondent For larger companies, debt reduction and quality asset acquisitions are a higher priority as opposed to riding the drill bit. LNG Delays - But Rest Assured, It Is ComingOne of the outlets for production growth has been the development of LNG facilities along the Gulf Coast. At the end of 2020, there were five (5) facilities under construction. Unfortunately, as of the end of 2021, only one of those terminals got finished. There are still four (4) terminals under construction and no other approved terminals (there are 13 of those) have gotten going as well. This has inhibited production growth for natural gas as LNG is a major global demand growth outlet for U.S. production. The pandemic has delayed bringing online over eight (8) Bcfd of processing capacity. The Biden administration has also not made it any easier either. However, more should come online in 2022 which should help continue the growth trend for gas in the U.S.Regulatory PrognosticationsSpeaking of the Biden administration, last year around the election we were discussing some potential policy and impacts of a Biden administration. Several of those potentials have come to pass such as permit rejections, the stoppage of the Dakota Access Pipeline, and a decline in drilling on federal lands.One thing that has not borne out is the projection by some of a decline in oil production of as much as two million b/d by 2025. Production has held strong so far as prices increased in 2021. Considering the volatility in both regulation and markets, that’s pretty good in the prediction department.

WHITEPAPER | Understand the Value of Your Payment Company

When it comes to emerging sectors of the economy, FinTech companies remain in the spotlight. FinTech companies seek to improve inefficiencies in the financial services industry. COVID-19 accelerated these efforts as legacy problems became impossible to circumvent in the environment that the pandemic created.Valuing FinTech companies can be a complex exercise as their market opportunities can be evolving, and their cap tables are often complex.This complexity can be a result of venture capital, corporate, and private equity investors being cobbled together across a number of funding rounds.Throughout this whitepaper, we look into the payment industry’s place in the larger FinTech ecosystem, macroeconomic factors driving the industry, microeconomic factors pertaining to specific companies, and what valuation methods are most prudent when determining the fair market value of a payments company.

Asset Management Firms See Strong Performance in 2021

The asset management industry fared well in 2021 against a backdrop of rising markets and improved net inflows. Strong performance in equity markets was a major contributor to this performance. The S&P 500 index was up nearly 30% during the year, suggesting that many asset management firms saw significant increases in AUM driven by market movement and ended the year with assets (and run rate revenue) at or near all-time highs.As asset management firms are generally leveraged to the market, market movements tend to have an amplified effect on asset management firm fundamentals. Our index of publicly traded asset/wealth management firms reflected this in 2021, with the index generally outperforming the S&P 500 throughout the year and ending the year up just over 30%. While multiples saw modest improvement over this period, much of this outperformance was driven by rising fundamentals.Our index of asset/wealth management aggregators also improved significantly during 2021, ending the year up nearly 40% driven by strong performance in the underlying businesses in which aggregators invest. Alternative asset managers led the way, however, with this index increasing nearly 90% during 2021 driven by strong net inflows due to increasing investor demand for alternative assets.Return of Organic GrowthWhile market movement is often the dominant contributor to changes in AUM over a particular time period, it affects all asset managers in a particular asset class more or less equally and is (to some extent) outside of a manager’s control. Organic growth, on the other hand, can be influenced by the quality of a firm’s marketing and distribution efforts and can be a real differentiator between asset management firms over longer time periods.Many asset managers have struggled with organic growth in recent years, in part due to rising fee sensitivity and the influence of passively-managed investment products. Despite these headwinds, organic growth for our index of publicly traded asset/wealth management companies improved modestly during the nine months ending September 30, 2021 relative to the same period in 2020 (see chart below).In aggregate, these firms saw net outflows of $75 billion during the first three quarters of 2020, compared to aggregate net inflows of $49 billion during the first three quarters of 2021. While this improvement in organic growth is modest in absolute terms, the switch from net outflows to net inflows is a positive sign for the industry, indicating that these firms were able to grow AUM on an aggregate basis even in the absence of market movement.Fund Flows by SectorWhile overall organic growth improved in 2021, there were significant variances by asset class. Fund flow data from Morningstar (table below) shows that total inflows across active funds for the year ended November 30, 2021 were approximately $287 billion (relative to aggregate outflows of $188 billion in 2020). The aggregate inflows in 2021 were concentrated in fixed income, alternative assets, and international equity funds, while US equity funds shed nearly $200 billion in assets over the period. For perspective, all categories of actively managed funds except taxable bonds and municipal bonds saw net outflows in 2020.Notably, passively managed funds continued to outpace active funds in terms of net new assets in 2021. This trend will likely continue to pose a challenge for many types of active asset managers in attracting new assets.Improving OutlookThe outlook for asset managers depends on several factors. Investor demand for a particular manager’s asset class, recent relative performance, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing and on the performance of the underlying businesses.On balance, the outlook for asset managers has generally improved with market conditions over the last year. AUM has risen with the market over this time, and it’s likely that industry-wide revenue and earnings have as well. Modest improvements in organic growth are also a positive sign for active asset managers that bodes well for continued strong performance in 2022.

December 2021 SAAR

The December SAAR totaled just 12.44 million units, down 3.5% from last month and 23.7% from December 2020. Inventory shortages, supply chain issues, and consistently high demand have been commonplace in the auto industry since the summer. That being the case, December’s low SAAR should not surprise many.Several trends that have been observed in the industry over the last six months have continued to persist. For example, dealers continued to sell out inventories. According to J.D Power, the number of days that a new vehicle sat on the lot fell to a record low of 17 days, beating last month’s record of 19 days and even further down from 49 days a year ago.Transaction prices continued to climb over the last month as well. The average transaction price reached its own record of $45,743 in December, up from $44,000 last month and the metric’s first time above $45,000. Light trucks continue to dominate sales, accounting for 77.6% of all new light vehicle sales in 2021. This vehicle class includes crossovers, which accounted for 44.9% of all new light vehicle sales over the past year. Dealer incentives also remained low, falling to just $1,598 of incentive spending per vehicle, an all-time December low. All told, this past month was more of the same for auto dealers and manufacturers.According to J.D Power, the number of days that a new vehicle sat on the lot fell to a record low of 17 days.December inventory levels remained low. As a result, the industry’s inventory to sales ratio took another step down from 0.39 in October to 0.24 in November. There should be some incremental gains in inventory levels throughout 2022, but the exact point at which the supply chain tide will turn is still unknown. As far as auto sales are concerned, the pace remained red hot. High consumer demand for vehicles continued to empty lots around the country in December. In fact, in spite of the last six month’s conditions, 2021 new light sales totaled 14.93 million units, up 3.1% from 2020’s 14.47 million. When looking back at the past year in auto, it seems likely that 2021 sales of new light vehicles could have easily climbed to 17 million units in an unrestricted environment given the strong demand.Electric Pickup Truck Race Heats UpThe long-fought war between auto manufacturer’s pickup trucks has finally been pushed into the electric vehicle spotlight. As many manufacturers unveil their spin on an electric pickup, there are many questions that dealers and consumers have about brand loyalty and availability for these types of vehicles. The definitive answers to those questions won’t come for some time, but the conversation among consumers and those covering the industry has certainly started to heat up.Many major auto manufacturers have already announced plans to roll out electric pickup models. In December, General Motors released a video teasing an electric version of its GMC Sierra. This came one day after Toyota revealed its plans for an electric pickup in its near future. Nissan Motor Company showed off an electric pickup prototype in November called the Surf-Out, and newly publicly minted automaker Rivian, is taking preorders on its R1T and R1S electric truck and SUV.Ford announced that it has logged about 200,000 non-binding reservations for its F-150 Lightning, a battery powered truck that goes on sale this spring. The automaker has also announced its investment in a West Tennessee F-150 Lightning facility. Tesla announced its Cyber Truck in late 2019 but has recently removed information about production timelines from its website, implying a slower start to its electric pickup rollout than expected but perhaps still ahead of its competitors. There are several other manufacturers seeking to enter the market, including Lordstown Motors, Bollinger, and Atlis Motors.Moving on from the manufacturers and onto their customers, brand loyalty has always been more tangible in the market for pickup trucks than for any other class of vehicle. In years past, convincing a [insert name here] truck enthusiast to switch to another brand would have been harder than pulling teeth. However, the age of pickup loyalty may be on its way out due to high and rising sticker prices.A survey in 2019 conducted by used-vehicle shopping site CarGurus, found rising price sensitivity among truck owners, with more than two-thirds of respondents calling today’s pickups overpriced. We note price sensitivity is more likely to be apparent in used vehicle buyers, but brand loyalty was also found to be surprisingly fluid, with more than a third of Ford and Chevy buyers saying that they would consider the rival brand for their next pickup purchase. While these results may be true for gas powered pickups exclusively, the presence of deteriorating pickup loyalty makes for a blurry entrance into the electric market for dealers and manufacturers alike.The age of pickup loyalty may be on its way out due to high and rising sticker prices.With all these new models on the horizon, auto makers are hoping to gain an edge in a key battleground for the industry. Pickups are among the industry’s most profitable units, especially for U.S. automakers like GM and Ford where they account for a large share of global profit. If consumers embrace the shift to electric trucks, the segment’s early performance should inform dealers on how to respond and what works best on their lots. It will be interesting to see how OEMs are able to meaningfully scale production of these EVs in 2022 in light of tight inventories.January 2022 OutlookOur outlook for the first month of 2022 shows vehicle inventories remain low, and demand remains high. Incremental inventory improvements are expected to accumulate throughout the year, but many of those improvements are not expected in the next several months. Also, the persistent COVID-19 pandemic could further affect supply chains and production facilities in the coming months as well, adding to the uncertainty.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

RIA M&A Q4 Transaction Update

Aggregators Continue to Drive Deal Volume in 2021

Deal count is projected to reach new highs in the fourth quarter of 2021 as market activity continues to gain momentum, likely rounding out another record-breaking year for the RIA industry. In keeping with the rest of 2021, deal volume was driven by secular trends and supportive capital markets. As market activity remains robust, competition for deals continues to favor RIA aggregators such as Mercer Advisors, Mariner Wealth Advisors, Wealth Enhancement Group, and Focus Financial Partners (FOCS), to name a few. The RIA aggregator model largely developed in the wake of the RIA boom after the Great Recession and has since culminated into nearly a dozen firms, each with their own vision of how to marry the independence and client experience of an RIA with a national brand. Over the past couple of years, aggregators have gained private equity sponsors which have fueled their dealmaking capabilities. As we discussed in last quarter’s RIA M&A Transaction Update, this trend has only gained momentum in 2021, with private equity capital infusions at all-time highs. Aside from branding, industry consensus suggests some legitimate tailwinds encouraging consolidation in the RIA industry, which likewise supports the aggregator model. One such trend is a lack of succession planning by RIA founders, which we have written about extensively in prior posts. With immense experience and resources, aggregators offer a streamlined deal process and post deal integration, making many aggregators a convenient solution for principles looking to exit. While all aggregators offer liquidity solutions, each aggregator offers a slightly different value proposition to potential sellers. Consolidators such as Mercer Advisors, Wealth Enhancement Group, Mariner Wealth Advisors, and Goldman Sachs would largely be considered strategic buyers. Strategic buyers acquire firms in order to unlock value through synergy. Systemic issues such as fee compression in the asset management space or the growing cost of operational platforms and overhead in the wealth management space are solved by scale. Integrating with any one of the aforementioned firms should theoretically unlock value for buyers through higher profit margins and growth, but a strategic buyer may be a poor fit for a seller looking for a clean exit. Firms such as Focus Financial Partners lean towards the financial acquirer category in which acquisitions are primarily financially motivated investments. However, even aggregators like Focus provide many in-house back-office solutions and additional service offerings to their partners.Leading RIA AggregatorsBelow are a handful of RIA aggregators that have led M&A activity in 2021.Mercer Advisors. Mercer Advisors was founded in 1985 as a planning-focused RIA and in the last ten years has become an industry leader in the trend towards consolidation, acquiring a total of 45 firms and nine in 2021 alone. Mercer Advisors looks to integrate partnering firms intimately within the Mercer Advisors ecosystem to provide a homogeneous wealth management platform to clients. The Mercer Advisors deal team is led by David Barton, JD – former CEO and current Vice Chairman. Mr. Barton’s transition in 2017 highlights the firm’s aggressive M&A strategy and has since culminated in the majority of the firm’s acquisitions to date. The firm’s sale to private equity group, Oak Hill Capital, in 2019 has further bolstered the firm’s dealmaking activity.Mariner Wealth Advisors. In April 2021, Mariner sold a minority stake to private equity group, Leonard Green & Partners, which has since propelled the firm into 11 acquisitions. Similar to Mercer Advisors, Mariner seeks to integrate investment teams within a larger ecosystem, potentially allowing partners to exit entirely over time. In 2020, CEO Marty Bicknell announced a partnership with Dynasty Financial Partners creating Mariner Platform Solutions which looks to onboard advisors seeking independence from wirehouses and larger RIAs as well as partner with existing wealth management firms. Back-office services such as marketing, technology, compliance, and administrative support are handled by Dynasty Partners.Wealth Enhancement Group. On July 31, 2019, Wealth Enhancement Group was acquired by private equity firm, TA Associates, which has resulted in 13 acquisitions in 2021 alone. Wealth Enhancement Group offers a full suite of wealth management services across a single platform, much like Mariner and Mercer Advisors.Goldman Sachs Personal Financial Management (PFM). While Goldman Sachs did not make any direct RIA acquisitions in 2021, speculation remains high regarding the investment bank’s intentions to move into the wealth management market at scale. The purchase of United Capital in 2019, an RIA aggregator with 34 direct acquisitions to date, marked Goldman’s interest to become a leading RIA acquirer. Since the acquisition, Goldman Sachs has not leaned into the aggregator model as many had anticipated, but speculation rebounded in 2021 when Goldman hired former TD Ameritrade executive, Craig Cintron. The move suggests further development of Goldman’s burgeoning custodian services. Goldman Sachs’ historic brand and scale would make the firm a formidable competitor if it should choose to enter the RIA M&A ecosystem.Focus Financial Partners (NASDAQ: FOCS). The Focus umbrella includes over 80 partner firms (550+ principals) and over $300 billion in assets under management, making it the largest RIA aggregator by any metric. Focus self-proclaims to “preserve the autonomy of every partner firm who joins the Focus team,” and as such, would likely be a poor fit for principals looking for a clean exit. For those looking to remain post-acquisition, Focus provides a pay-out along with an operational scale for partners seeking to grow their firm or perhaps make acquisitions of their own. Accordingly, more partners who have joined Focus have made an acquisition than those who have not.In 2021 alone, Focus Financial Partners made 21 acquisitions, nearly double its deal count in 2020. Looking forward, Focus’s future is seemingly tied to its ability to continue to make deals upon more favorable or convenient terms than anyone else, and its prospects are tied to the backdrop of continued deal availability, pricing improvement, or entry into international markets.Implications for Growing Consolidation in the RIA M&A MarketThe arms race for deals, catalyzed and perpetuated by RIA aggregators, favors experienced buyers who have dedicated deal teams and capital backing. For perspective, the typical advisor operates with eight employees and approximately $341 million in AUM compared to Focus’s +$300 billion in AUM and staff of +4,000. Focus currently staffs a team of about 80 transaction-related professionals responsible for fielding acquisition targets and for integrating RIAs within the Focus Financial Partners ecosystem. Nearly all aggregators have extensive capital backing, either through private equity sponsorship, public capital markets, or both.As aggregators continue to bid up multiples, the sustainability of current M&A trends remains in question. While scale might favor a buyer’s ability to make deals, the verdict is still out on whether the RIA industry benefits from economies of scale. Despite consistent increases in M&A activity over the past decade, the number of RIA firms continues to grow, a fact that perhaps generally contradicts the aggregator investment thesis. However, the ever-increasing number of RIAs may continue to add fuel to current deal volume over the near future.

January 2022

In this issue: Net Interest Margin Trends and Expectations

E&P First Quarter 2022

Eagle Ford

Eagle Ford // Oil prices rose through the quarter as increased demand was met with continued producer restraint.

Transportation & Logistics Newsletter

First Quarter 2022

Demand for services in the logistics industry is tied to the level of domestic industrial production.

The Best of 2021

Energy Valuation Insights’ Top Blog Posts

After an extraordinarily challenging 2020, 2021 gave Oil & Gas companies some respite and (perhaps most importantly) some optimism going into 2022. As we enter the new year, we look back at to see what was popular with you – our readers. Below is a list of some of our top posts of 2021.Solvency Opinions: Oil & Gas ConsiderationsIn this post,David Smith covers key aspects of solvency opinions. Regardless of whether a company files for Chapter 11, is party to an M&A transaction, or executes some other form of capital restructuring – such as new equity funding rounds or dividend recaps – one fundamental question takes center stage: Will the company remain solvent?Recent SPAC Boom Largely Leaves Out Oil & Gas CompaniesWhile the mania around SPACs (special purpose acquisition companies) has subsided since its peak in early 2021, SPACs continue to be a key driver of capital markets activity. Alex Barry looks at oil & gas companies that were early adopters of the SPAC structure, the recent pivot of SPACs towards energy transition companies, and looks forward to see what the future might hold for the few remaining oil & gas-focused SPACs.Mineral Aggregator Valuation MultiplesAn important trend in the mineral and royalty ownership space has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership. Due to a variety of corporate structures and complex capital structures, mineral aggregator values pulled from databases are often missing meaningful components, leading to skewed valuation multiples. Mercer Capital has thoughtfully analyzed the corporate and capital structures of publicly traded mineral aggregators to derive meaningful valuation multiples on a historical and forward-looking basis. Look back at data fromMarch, May, August, andNovemberof 2021.The Evolution of E&P ESG ScoresWhile oil & gas and ESG (environmental, social, and governance) investing may seem at odds with each other, operators have increasingly included ESG talking points in their management commentary, signaling a proactive initiative rather than reactive response. Justin Ramirez discusses ESG criteria among E&P operators and looks at trends from 2016 to 2020.Upstream Producers Are Not Gouging–They’re Tentative. Here Are Three Reasons WhyAs commodity prices have risen and profits have rolled in, so have accusations of price gouging by oil & gas companies. Despite higher prices, producers haven’t materially increased production or announced aggressive drilling plans. Bryce Erickson identifies some of the reasons why, including supply and demand dynamics, rising costs, and capital headwinds.ConclusionWe look forward to 2022 and appreciate your interest in this blog. May you and your family enjoy a happy and prosperous year!

Bank M&A 2022 | Gaining Altitude

At this time last year, bank M&A could be described as “on the runway” as economic activity accelerated following the short, but deep recession in the spring. Next year, activity should gain altitude. Most community banks face intense earnings pressure as PPP fees end, operating expenses rise with inflation, and core NIMs remain under pressure unless the Fed can hike short-term policy rates more than a couple of times. Good credit quality is supportive of activity, too.Should and will are two different verbs, however.One wildcard that will impact activity and pricing is the public market multiples of would be acquirers. Consideration for all but the smallest sellers often includes the issuance of common shares by the buyer. When bank stocks trade at high multiples, sellers obtain “high” prices though less value than when public market multiples are low and sellers receive low(er) prices though more value.If bank stock prices perform reasonably well in 2022, after a fabulous 2021 in which the NASDAQ Bank Index increased 40% through December 28, then activity probably will trend higher as more community banks look to sell. MOEs may be easier to negotiate, too. If bank stocks are weak for whatever reason, then activity probably will slow.A Recap of 2021As of December 17, 2021, there have been 206 announced bank and thrift deals compared to 117 in 2020. During the halcyon pre-COVID years, about 270 transactions were announced each year during 2017-2019.As a percent of charters, acquisition activity in 2021 accounted for about 4% of the number of banks and thrifts as of January 1.Since 1990, the range is about 2% to 4%, although during 2014 to 2019 the number of banks absorbed each year exceeded 4% and topped 5% in 2019. As of September 30, there were 4,914 bank and thrift charters compared to 9,904 as of year-end 2000 and about 18,000 charters in 1985 when a ruling from the U.S. Supreme Court paved the way for national consolidation.Pricing—as measured by the average price/tangible book value (P/TBV) multiple—improved in 2021. As always, color is required to explain the price/earnings (P/E) multiple based upon reported earnings.The national average P/TBV multiple increased to 155% from 135% in 2020, although deal activity was light in 2020. As shown in Figure 1, the average transaction multiple since the Great Financial Crisis (GFC) peaked in 2018 at 174% then declined to 158% in 2019 as the Fed was forced to cut short-term policy rates three times during 3Q19 in an acknowledgment that the December and probably September 2018 hikes were ill-advised.Earnings—rather than tangible book value — drive pricing as do public market valuations of acquirers who issue shares as part of the seller consideration. Nonetheless, drawing conclusions based upon unadjusted reported earnings sometimes can be misleading.As an example, the national median P/E for banks that agreed to be acquired in 2018 approximated 25x, in part, because many banks that are taxed as C corporations wrote down deferred tax assets at year-end 2017 following the enactment of corporate tax reform. Plus, forward earnings reflected a reduction in the maximum federal tax rate to 21% from 35%.Also, the median P/E in 2021 fell to about 15x from 17x in 2019 and 2020 in part because the earnings of many sellers included substantial PPP-related income that will largely evaporate after this year.Buyers focus on the pro forma earnings multiple with all expense savings in addition to EPS accretion and the amount of time it takes to recoup dilution to tangible BVPS. Our take is that most deals entail a P/E based upon pro forma earnings with fully phased-in expense saves of 7x to 10x unless there are unusual circumstances.Public Market Multiples vs Acquisition MultiplesClick here to expand the image aboveFigure 2 compares the annual average P/TBV and P/E for banks that were acquired for $50 million to $250 million since 1997 with the SNL Small Cap Bank Index average daily multiple for each year. Among the takeaways are the following:Acquisition pricing as measured by the P/TBV multiple peaked in 1998 (when pooling-of-interest was the predominant accounting method) then bottomed in 2009 (as the GFC ended) and trended higher until 2018.Since pooling ended in 2001, the “pay-to-trade” multiple as measured by the average acquisition P/TBV multiple relative to the average index P/TBV multiple, has remained in a relatively narrow range of roughly 0.9 to 1.15 other than during 2009 and 2010.The reduction in both the public and acquisition P/TBV multiples since the GFC corresponds to the adoption of a zero interest rate policy (ZIRP) by the Fed during 2008 that has been in place ever since other than 2017-2019.P/E multiples based upon LTM earnings have shown little trend with a central tendency around 20x other than 1998 (1990s peak), 2018 (tax reform implementation) and 2020-2021 (COVID distortions).Acquisition P/Es have tended to reflect a pay-to-trade multiple of 1.25 since the GFC but as noted what really matters is the P/E based upon pro forma earnings with expense saves. To the extent the pro forma earnings multiple is 7-10x, the pay-to-trade earnings multiples typically are below 1.0 to the extent buyers are trading above 10x forward earnings.Click here to expand the image aboveClick here to expand the image abovePremium Trends SubduedPublic market investors often focus on what can be referred to as icing vs the cake in the form of acquisition premiums relative to the pre-announcement prices. Investors tend to talk about acquisition premiums as an alpha generator, but long-term performance (or lack thereof) of the target is what drives shareholder returns. Sometimes the market is suprised by acquisitions with an outsized premium, but in recent years premiums often have been modest.As shown in Figure 4, the average one-day premium for transactions announced in 2021 that exceeded $100 million in which the buyer and seller were publicly traded was about 9%, a level that was comparable to the prior few years excluding 2020. For buyers, the average day one reduction in price was less than 1%, though there are exceptions when investors question the pricing (actually, the exchange ratio). For instance, First Interstate (NASDAQ: FIBK) saw its shares drop 7.4% after it announced it would acquire Great Western for about $2 billion on September 16, 2021.About Mercer CapitalM&A entails a lot of moving parts of which “price” is only one. It is especially important for would be sellers to have a level-headed assessment of the investment attributes of the acquirer’s shares to the extent merger consideration will include the buyer’s common shares. Mercer Capital has roughly 40 years of experience in assessing mergers, the investment merits of the buyer’s shares, and the like. Please call if we can help your board in 2022 assess a potential strategic transaction.

Mercer Capital's 2021 Energy Purchase Price Allocation Study

2021: The Year of the Used Car

What Does This Mean for Dealers and Consumers?

2021 was an interesting year for many businesses, and it was certainly interesting for auto dealers. While automotive retailing may be an attractive space for purely financial investors, many dealerships are owned by the same folks that run the business. So while inventory shortages and other headwinds played a role in heightened profits in 2021, the return on investment achieved came with many operational headaches.Just about everyone we’ve talked to acknowledges that current performance is not indicative of ongoing expectations. The question has largely been focused on when we’ll revert to the mean, but this post touches on what things will look like when we return to a more “normal” operating environment. Specifically, what negative equity from used car buyers in 2021 may mean for dealerships.Used Car PricesIn a recent whitepaper, KPMG warned that used vehicle prices could fall abruptly and raise negative equity issues once new vehicle supply rebounds. Negative equity occurs when consumers owe more on their auto loan than the vehicle is worth. We’ve all heard about a vehicle losing value once you drive it off the lot and it's true. Compounding this problem is the expectation that values today will materially decline in a year or two which increases the likelihood of negative equity.Negative equity occurs when consumers owe more on their auto loan than the vehicle is worth.In April 2020, during the depths of the pandemic, 44% of trade-ins carried negative equity – more than double the amount seen a decade earlier. The average negative equity then was $5,571. A year later, vehicle prices increased significantly, but average negative equity only declined by a little more than $1,000. More importantly, the proportion of trade-ins with negative equity was relatively constant, meaning nearly half of buyers were looking at their trade-ins adding to the price of the vehicle they were looking to buy.According to our analysis of NADA data from 2011 to 2020, used vehicle retail prices increased at a compound annual rate of 2.7%, just above the 2.6% increase for new vehicles. In 2021, used vehicle prices lurched forward faster than new vehicles. New vehicle prices increased 7.5% in the last twelve months due in part to supply shortages. Consumers who couldn’t get the new vehicle they wanted or realized they needed a car, but prices were too high, may have turned to used vehicles, whose prices increased 19.1% due to increased demand.The ratio of used-to-new vehicle prices was 62.5% through October 2021, notably higher than the 56.5% observed in October 2020 and above the long-term average (2011 to 2020) of 57.1%. Used-to-new retail volumes were also 91.9% for the first ten months of 2021, higher than any full-year since at least 2011. Used vehicles have become increasingly important to dealers, as this figure has steadily increased from a recent low of 73.9% in 2015.What will happen if new vehicle supply is restored and used vehicle prices crater?As KPMG warns, what will happen if new vehicle supply is restored and used vehicle prices crater? Applying the long-term average used vehicle price appreciation of 2.7% to the $22,027 average used vehicle retail price in 2020, it would take until 2027 to reach $26,000. As of October 2021, the average retailed used vehicles cost $25,904. If used car prices revert to the long-term relationship of new car pricing (57.1% of $41,421 for new vehicles as of October ‘21), we would see a decline of 8.7%. KPMG indicated “a 20-30% plunge in used vehicles costs is within the playing cards.” This would almost certainly wipe out any consumer's equity who elected to finance their purchase.Consumers are able to buy more expensive cars when they get what they perceive to be a good deal on their trade-in, and higher used vehicle prices mean trade-ins are more valuable. However, this important source of cash for buyers will evaporate if used vehicle prices plunge, and negative equity just adds on to the price of a vehicle, putting pressure on how much consumers can pay up for a new vehicle. As noted previously, through April 2021, a significant number of buyers still had negative equity despite advantageous pricing on used vehicles. This could spike if prices crater.What It Means For DealersGiven the long life cycles of vehicles, dealership performance tends to ebb and flow with the economy. Executives of public retailers harp on the importance of touchpoints with the consumer, meaning they return to the dealership to get their car serviced. Dealers also hope customers return to their showrooms when it’s time for another vehicle, and the experience from the last purchase will likely play a big role.If consumers are unsatisfied with their purchase because prices were elevated when they bought in 2021 and decline significantly thereafter, they may feel aggrieved and choose to go with another dealership. While this situation is largely unavoidable for most dealerships, it could have negative ramifications down the line. Consumers may also choose to hold onto their vehicles longer to not recognize the loss by trading in. While it’s unclear how this will shake out down the road, dealers will need to prepare themselves for difficult conversations.Through the first ten months of 2021, the average dealership has already made nearly $3.4 million.As we alluded to previously, profits are up for dealerships in 2021. According to the NADA, the average dealership earned average pre-tax profits of $1.4 million from 2011 to 2020. Average pre-tax profits reached above $2.1 million in 2020, which was the first time above $1.5 million since 2015. Through the first ten months of 2021, the average dealership has already made nearly $3.4 million with two more months to add to these totals.The value of auto dealerships is communicated through Blue Sky values, which are based on a multiple of pre-tax earnings. While dealers aren’t likely to get a high multiple on peak earnings, we note both Blue Sky values and multiples are up since before the pandemic. However, once performance normalizes, dealerships may not be worth as much as they are now, much like the vehicles they sell. This would likely explain the record amount of M&A activity seen in 2021 with some of the largest dealer groups opting to sell.According to the Q3 2021 Haig Report, the average franchise has a Blue Sky multiple of 5.24x and adjusted pre-tax earnings of $2.08 million for a Blue Sky value of about $10.9 million, up 61% from year-end 2019 to all-time highs. At these prices, buyers must be optimistic that the good times will continue, multiples won’t crater, and/or the new normal of profits will be higher than historical levels.Source: Haig Partners Haig’s estimated pre-tax earnings of $2.08 million as an ongoing figure today is about 46% below current levels based on our calculations of NADA figures. However, according to NADA, it coincidentally represents a 46% increase over the 2011-2020 average for the average dealership. While that makes the ongoing figure appear reasonable, the chip shortage universally viewed as a temporary problem is far from “normal.” Suppose current estimates of ongoing earnings end up being overly optimistic, with an increased focus on recent outperformance. In that case, the values of dealerships, like the vehicles they sell, are likely to decline.ConclusionMercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

‘Twas the Blog Before Christmas…

2021 Mercer Capital RIA Holiday Quiz

‘Twas the blog before Christmas, when all through the house Every laptop was purring, every keyboard and mouse; The stockings were hung by the chimney with care, So that backgrounds on Zoom calls wouldn’t look quite so bare;When out on the squawk there arose such a clatter, I refreshed my Bloomberg to check on the matter. Then what to my wondering eyes did appear, But a global growth manager outperforming its peer.With a ghostly old PM so lively and quick, I listened, engaged, to his every stock pick. More rapid than eagles his recommends came, And he whistled, and shouted, and called them by name:“Buy Bitcoin! Buy Apple! Buy Tesla and Google! ’Cause shorting the future will always prove futile! To the top of the charts, for the big money haul, Go long like you’ve never had a bad margin call!”As I drew down my cash, and was turning around, Down the chimney John Templeton came with a bound. He was dressed like he owned just a few private jets, Which compared favorably to my “work at home” sweats.A bundle of hundreds he had flung on his back, Like an entrepreneur with a new public SPAC. He spoke not a word, but went straight to his work, And filled all my orders, then added a perk:His eyes - how they twinkled! His dimples, how merry! As he talked a new strat that would guarantee carry! And out-money calls bought to cover the shorts, Bringing untold riches to long-only sorts.A wink of his eye and a twist of his head, Made me want to get all of his thoughts on the Fed – And vaccines and rates and bullion and more, But he rose and I followed him out my front door.A magical Gulfstream waited there in my yard, And up the air-stairs sprang the RIA bard. But I heard Sir John claim, as he flew out of sight - "Let your best winners run, and all will be right!"...How much do you know about the RIA industry? Put your knowledge to the test with our RIA Holiday Quiz. Fill out your contact information and if you get a perfect score you will win a prize. Good luck!(function(t,e,s,n){var o,a,c;t.SMCX=t.SMCX||[],e.getElementById(n)||(o=e.getElementsByTagName(s),a=o[o.length-1],c=e.createElement(s),c.type="text/javascript",c.async=!0,c.id=n,c.src="https://widget.surveymonkey.com/collect/website/js/tRaiETqnLgj758hTBazgd_2BAEZcRHJHwtJp1wzgq96QNl8Vvqh42MIevvuINzlilE.js",a.parentNode.insertBefore(c,a))})(window,document,"script","smcx-sdk"); Create your own user feedback survey

Appalachian Production Stable Despite Price Volatility

The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. In this post we take a closer look at the trends in the Marcellus and Utica.Production and Activity LevelsEstimated Appalachian production (on barrels of oil equivalent, or “boe,” basis) decreased approximately 1% year-over-year through December. Production in the Permian and Eagle Ford increased 14% and 4% year-over-year, respectively, while the Bakken’s production declined 1%. Despite a much-improved commodity price environment, Appalachian production was very stable, driven by producers’ capital discipline and the fact that the region was largely unaffected by Winter Storm Uri that disrupted power supplies throughout Texas in February 2021. There were 41 rigs in the Marcellus and Utica as of December 10th, up 37% from December 4th, 2020. Bakken, Eagle Ford, and Permian rig counts were up 145%, 91%, and 74%, respectively, over the same period. One may wonder why Appalachia production has been relatively flat while the region’s rig count has increased. The answer has to do with legacy production declines and new well production per rig. Based on the U.S. Energy Information Administration (“EIA”) data, the Marcellus and Utica need roughly 37 rigs running to offset existing production declines. Relative to last year, most of Appalachia’s additional rigs came online in January and February. Since then, the total rig count has generally ranged between 36 and 40 (in line with the maintenance level). As such, production growth will likely be modest without additional rigs. Commodity Price Volatility ReturnsOil prices slowly and steadily rose through the first two quarters of the year as the vaccine rollout, and lower COVID case counts spurred economic activity. Oil prices were more volatile in the third quarter as the Delta variant caused an increase in COVID cases and concerns regarding the economic recovery. U.S. COVID cases peaked in early September, giving oil prices a boost during the latter part of the quarter. The net result is that WTI front-month futures prices began and ended Q3 at about the same place – approximately $75/bbl. In October, the upward price momentum continued in the fourth quarter as WTI futures prices nearly reached $85/bbl.This optimism was short-lived as the discovery of the new Omicron variant sent oil prices plunging in November. Prices rebounded in December as research has shown that, while highly transmissible, the Omicron variant typically results in less severe illness relative to previous variants. As of December 14th, WTI front-month futures price settled at $70.52/bbl. Going forward, the EIA expects prices to be flat to down in the near term as “growth in production from OPEC+, of U.S. tight oil, and from other non-OPEC countries will outpace slowing growth in global oil consumption, especially in light of renewed concerns about COVID-19 variants.” Natural gas prices steadily increased during the first three quarters of the year, which the EIA primarily attributes to “growth in liquefied natural gas (LNG) exports, rising domestic natural gas consumption for sectors other than electric power, and relatively flat natural gas production.” So far in the fourth quarter, natural gas prices have been relatively volatile as inventories are lower than recent averages. However, recent mild weather has resulted in less gas used for heating. Financial PerformanceThe Appalachia public comp group saw relatively strong stock price performance over the past year (through December 14th). The beneficial commodity price environment was a significant tailwind to smaller, more leveraged producers like Antero Resources and Range Resources, whose stock prices increased 230% and 155%, respectively, during the past year, outperforming the broader E&P sector (as proxied by XOP, which rose 59% during the same period). Larger, less leveraged players like EQT and Coterra (formerly Cabot) were laggards, with their stock prices increasing by 53% and 16%, respectively.Senator Warren Lashes Out Over High Natural Gas PricesMassachusetts Senator Elizabeth Warren wrote a strongly worded letter to eleven natural gas producers, including Appalachia E&Ps EQT, Coterra, Antero Resources, Ascent Resources, Southwestern, and Range Resources. According to Senator Warren’s press release, the purpose of the letter was to “[turn] up the heat on big energy companies’ greed as they jack up natural gas prices, exporting record amounts to boost profits while Americans foot the bill” despite the fact that natural gas producers are simply price-takers, selling a commodity into a competitive market with essentially no control over prices.It is true that LNG exports from the United States have increased dramatically over the past several years. However, that has been driven by the construction and completion of LNG export facilities, resulting in part by continued resistance to pipelines that would connect the Marcellus and Utica regions to East Coast population centers. And while Senator Warren criticized producers for their greed, “putting their massive profits, share prices and dividends for investors … ahead of the needs of American consumers,” she did not thank E&P companies for their previous largesse (or lack of capital discipline) in which natural gas prices were often below $2/mmbtu and numerous natural gas producers went bankrupt.EQT publicly responded to Senator Warren’s letter. Despite the recent run-up in natural gas prices “as the economic engines of the world have reignited,” the company cited that current prices are “significantly below the 20-year average of approximately $5.70 per Mcf.” As a result of the shale revolution, “the United States consumer has benefited from, and continues to benefit from, some of the lowest natural gas prices in the world.” The remainder of EQT’s response was primarily focused on natural gas’s green credentials. Toby Rice, EQT’s CEO, wrote that the United States led the world in CO2 emissions reduction from 2005 to 2020 largely as a result of replacing coal power plants with natural gas power plants. If the world wants to reduce emissions, there are no alternatives with the scale and speed of switching power generation from coal to gas. But with 91% of coal-fired power generation located outside the United States, the transition will require exports of U.S. natural gas to countries without their supply.ConclusionAppalachia production was largely unaffected by the wild commodity price ride we’ve experienced, driven by investor emphasis on capital discipline, the current rig count, and uncertainty. However, with higher natural gas prices, global demand for a lower-carbon alternative to coal, and political pressure, it will be interesting to see if Appalachia producers maintain their restraint.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America and worldwide. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

RIA Margins – How Does Your Firm’s Margin Affect Its Value?

An RIA’s margin is a simple, easily observable figure that encompasses a range of underlying considerations about a firm that are more difficult to measure, resulting in a convenient shorthand for how well the firm is doing. Does a firm have the right people in the right roles? Is the firm charging enough for the services it is providing? Does the firm have enough–but not too much—overhead for its size? The answers to all these questions (and more) are condensed into the firm’s margin.What Is a “Typical Margin”?We’ve seen a wide range of margins for RIAs. Smaller firms with too much overhead and not enough scale might see no profitability or even negative margins. On the other hand, an asset manager with rapidly growing AUM and largely fixed compensation expenses might see margins of 50% or more. The “typical” margin for RIAs depends on the context. As the chart below illustrates, different segments of the investment management industry typically have different margins based on the risk of the business model (among other factors). At one end of the spectrum are hedge funds, venture capital firms, and private equity managers. The high fees these companies generate per dollar invested can support very high margins, but the risks of client concentrations, underperformance, and key staff dependence are significant. Traditional institutional asset managers are somewhere in the middle of the spectrum. When these companies get it right, institutional money can pour in rapidly. A successful institutional asset manager may find themselves managing billions more in assets while staffing remains virtually unchanged. The additional fees flow straight to the bottom line, and margins can be robust as a result. But the risks are significant. Institutional money can leave just as quickly as it came if the manager’s asset class falls out of favor or if performance suffers. At the lower end of the margin spectrum are more labor-intensive disciplines like wealth management and independent trust companies. For these businesses, bringing on additional clients translates directly into increased workload for staff, which will ultimately translate into higher staffing levels and compensation expense as the business grows. While margins are lower, the risk is less. Key person risk is also less, because an individual’s impact is generally limited to the clients they manage, and not the entire firm’s investment strategy. Client concentration is less of a problem, because wealth management firms tend to have a large number of HNW clients rather than a few large institutional clients. Performance risk is generally less of a concern as well. Does a Firm’s Margin Affect What It’s Worth?A high margin conveys that a firm is doing something right. But what really matters from a buyer’s perspective is not what the margin is now, but what it will sustainably be in the future. Consider the three scenarios below. In Scenario A, the EBITDA margin starts relatively low (15%), but improves over time. In Scenario B, the margin starts at a higher level (25%) but remains constant. In Scenario C, the margin starts at 35% but declines over time. The sensitivity table below shows the buyer’s IRR in each scenario as a function of the multiple paid. For a given multiple, the IRR is highest in Scenario A (margins low but expanding) and lowest in Scenario C (margins high but declining). In Scenario A, the buyer can afford to pay a higher multiple and still generate an attractive rate of return (a 9.0x multiple results in an IRR of 32.8%). In Scenarios B and C, however, the buyer must pay a lower multiple in order to generate the same IRR, even though the initial margin is higher. The implication of the analysis above is that the prospect for future margins is much more important than the current margin when determining the appropriate multiple for an RIA. The market for different segments of the investment management industry tends to reflect this. Institutional asset managers – while they can have very high margins – tend to command lower multiples than HNW wealth managers, which often have lower margins. The reasons for this are many: asset managers are more exposed to fee pressure, trends towards passive investing, and client concentrations, among other factors. These factors suggest an increased likelihood for lower margins in the future for asset managers. HNW wealth managers, on the other hand, often have lower but more robust margins due to their relatively sticky client base, growing client demographic (HNW individuals), and insulation from fee pressure that has affected other areas of the industry. Margin and ValueHigh margins are great, but what really matters to a buyer is how durable those margins are. A variety of factors that affect this, some of which are within the firm’s control and some of which or not. Where the firm operates within the investment management industry (asset manager, HNW wealth manager, PE fund, etc.) is one factor that can affect revenue and margin variability.While a firm can’t easily change which segment of the industry it operates in, there are other steps that these businesses can take to protect their margins. For example, designing the firm’s compensation structure such that it varies with revenue/profitability is one way to protect margins in the event that revenue declines. See How Growing RIAs Should Structure Their Income Statement (Part I and Part II).Firms can also critically evaluate their growth efforts to ensure that additional infrastructure and overhead investments don’t outweigh gains in revenue. By structuring the expense base in a way that protects the firm’s margin if revenue falls and developing growth initiatives designed to support profitable growth, many RIAs can generate stable to improving margins in most market environments—and realize higher multiples when the firm is eventually sold.

November 2021 SAAR

The November 2021 SAAR was 12.9 million units, down 0.7% from October and 19% from November 2020. This month’s SAAR came in below expectations as the industry experienced only slight inventory improvement from the historic lows of September and October. This seems like old news, as persistently limited inventory on dealer lots has affected the industry for months now and has been the principal issue concerning auto dealers. In this environment, vehicle prices remain elevated, with the average transaction price paid for a new vehicle reaching a November record of $44,000 this month. Light trucks continue to be red hot, representing more than 80% of all new vehicles sold and leaving dealer lots at a record pace. The average number of days a vehicle stays on the lot fell to a record low of 19 days in November, down from 48 days in November 2020. It is no secret that inventory issues at the dealer level are a consequence of production stoppages and supply shortages by OEMs. OEMs have all been subject to supply chain disruptions for some time, and these challenges have been met with a wide range of responses. Jeff Schuster, president of J.D Power’s Americas operations and global forecasts recently addressed these responses by saying: “The supply shortage is being managed in very creative ways, from building vehicles without certain content, to bringing chip development and production in-house for better supply chain visibility. However, the improvements in vehicle production are inconsistent around the world. China and India both saw stronger vehicle production in October, but North America and Europe remain constrained. Even as plants restart after being down for several weeks, they are not running near-normal levels. While the solutions are intended to minimize the disruption now or in the future, consumers will continue to find it difficult to purchase the exact vehicle they want for several months to come."At least partially as a result of these “inconsistent” conditions across countries, the market shares of certain manufacturers have fluctuated a bit over the last month. Toyota, Hyundai-Kia, Honda, Nissan, and Mazda are among the manufacturers that experienced market share growth in November, while American manufacturers Ford, Stellantis, and General Motors all saw market share losses. This trend in auto public equities has been around for a few months now, but it shouldn’t take long for American and European manufacturers to catch up with their counterparts in other parts of the world by establishing in-house microchip development and securing a consistent pace of production going forward.What Could 2021 Mean to the Industry’s Future?For the last SAAR blog of 2021, we thought it might be valuable to reflect on the unique year that auto dealers and manufacturers have had. This is not a comprehensive recap of a year, but instead a commentary on what seemed to work well in 2021 and what changes might be around for a while.2021 defied nearly everyone’s expectations.While 2020 presented its own set of challenges and opportunities, 2021 defied nearly everyone’s expectations. Analysts following the industry watched as OEMs and dealers reacted to unprecedented conditions in almost every phase of their businesses. We saw dealer principals shepherd their auto dealerships through a choppy market environment and thrive in the current pricing and inventory environments. As the second half of the year wound down, new records were being set every month relating to low stocks of vehicles, elevated, and persistently rising gross profits, and consumer demand for autos of all classes. We also saw a red hot M&A market, with elevated Blue Sky multiples and record-high earnings driving mass amounts of industry consolidation by the public auto dealers like Asbury, AutoNation, Group 1, and Sonic Automotive.The motivation behind a chunk of the sales volume in 2021 seems unique to the times.On the other side of vehicle-buying transactions, vehicle scarcity and inflated sticker prices have left many consumers feeling uncertain about the future of car-buying and when they may choose to make that big purchase. Prospective buyers on the margins may have decided to hold off on buying their next vehicle in the hopes that prices will fall as inventory levels normalize. Others have chosen to take the opportunity to cash in on high trade-in values for their used vehicles that won’t stick around for long. In either case, the motivation behind a chunk of the sales volume in 2021 seems unique to the times we are living through. Many consumers are under the assumption that when things “get back to normal” the car-buying experience will closely resemble what it was pre-pandemic. While that will surely be true for many aspects of the sales process, auto dealers and manufacturers would be remiss not to take the lessons learned in 2021 and make some of the changes permanent in how they do business going forward.We aren’t likely to see high margins on vehicle sales persist.Could pre-orders on many models become more commonplace as dealers find the perfect inventory balance on their lots? Absolutely. Could record low dealer incentives persist in an effort to assist dealers in competitively pricing their vehicles when sticker prices inevitably fall off? Perhaps. But for changes like these to stick, factors like test drive availability and matching model-specific production volumes with the pent-up demand that exists will have to be addressed. It is also important to note that many local, full-service dealerships seek to gain loyalty through providing as great a personal experience for the buyer as possible. Repeat customers and parts and service revenues are very important to these dealers, and making customers feel like they are getting gouged is not in anyone’s best interest. For that reason, we aren’t likely to see high margins on vehicle sales persist. However, dealers and OEMs certainly learned there’s been money left on the table in the past due to the relative inelasticity of demand for vehicles.ForecastWhile December is typically a big selling month for dealers, we don’t see much changing the supply issues in the next couple of weeks to close out 2021. From a dealer’s standpoint, inventories will most likely continue to be sold within days of arriving on the lot.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact a member of the Mercer Capital auto team.

Insurance Valuation Services for Financial Sponsors

In recent years, financial sponsors such as private equity, venture capital firms, investment companies, and family offices have taken a more prominent role in funding and growing firms in the insurance industry. From insurance brokerage/distribution to underwriting to InsurTech start-ups, there are many opportunities for investment in the insurance sector and transaction activity in the space has steadily been increasing.Mercer Capital has worked with financial sponsors in the insurance industry for years and we understand both the dynamics of the industry as well as the accounting and valuation issues that are likely to be encountered.Key areas where Mercer Capital can help include:Valuations of Shares/Units for 409A / ASC 718 Compliance - If you anticipate granting equity to founders or key management at acquired companies, using rollover equity as part of a growth strategy, or issuing options or RSUs as part of your employee compensation plans, supportable and defensible valuations are critically important.Valuations for Financial Reporting – Acquisitive growth strategies will likely necessitate ASC 805 purchase price allocations, earn-out liability measurements, and goodwill impairment testing.Financial Due Diligence – We provide financial due diligence and quality of earnings reports on target companies, including analysis/trending of the pro forma P&L, potential earnings adjustments, working capital assessments, unit economics analysis, and other areas of financial analysis.Financial Opinions (Fairness and Solvency Opinions) – Certain types of transactions, related-party issues, or fiduciary concerns can lead a board to seek an independent opinion of fairness or solvency as it pertains to a transaction involving the subject company. These situations might include going-private transactions, special dividends, and leveraged recapitalizations.Portfolio Valuation for ASC 820 Compliance – We provide a range of services to assist fund managers with the preparation and/or review of periodic fair value marks. These services are cost-effective and include a series of established procedures designed to provide both internal and investor confidence in the fair value determinations. To discuss any of these services in confidence, please contact a Mercer Capital professional today.

M&A in Marcellus & Utica Basins

Activity in 2021 Was Muted Relative to 2020

The three transactions in the Marcellus & Utica basins over the past year were just a trickle compared to the 16 transactions reported in the prior year for the Appalachian basins. The number of transactions in 2020 was more than double the seven transactions in 2019, driven in part by the relative price stability of natural gas as compared to oil which would naturally tend to favor M&A activity in these gas-heavy basins. One key observation of the transactions in 2020 was that companies were making critical decisions regarding where to operate on a forward-looking basis. Companies, such as Shell, took the position of divesting their Appalachia assets, while other companies, such as EQT, chose to augment their Appalachian footprint. The following table summarizes transaction activity in the Marcellus & Utica in 2020: Appalachia transactions announced so far in 2021 are shown in the following table: The decline in transaction activity in 2021 most likely indicates that anyone looking to get into or out of the Appalachian basins effectively did so in 2020, or was concerned with natural gas price volatility, which increased sharply in 2021 after several years of relative calm. However, that is not to say that the activity in 2021 was any less interesting. Notable changes in the statistics between the transactions in 2020 and 2021 include a sizable increase in the median and average deal values, price per acre, and price per production unit. Based on the much smaller sample size of 2021, the magnitude of these differences probably doesn’t mean too much. But one metric, production per acre (or MMcf/Acre), on an annualized basis, could be indicative of a greater focus on obtaining more productive assets in 2021 than the transactions observed in 2020. The following table summarizes the estimated annualized production per acre, including the median and average values, for the transactions in 2020 and 2021: Buyers in 2021 seemed to target producing rather than prospective, assets, as indicated by, as indicated by the median and average annualized MMcf/Acre metrics. Irrespective of the smaller transaction count (sample size) in recent history, the minimum production density metric in 2021 (0.71 MMcf/Acre) was nearly 9% greater than the maximum metric observed in the 2020 transactions (0.65 MMcf/Acre), and 52% and 82% higher than the median (0.47 MMcf/Acre) and average ( 0.39 MMcf/Acre) metrics, respectively, observed among the transactions in 2020. Again, this back-of-the-napkin statistical analysis may fall far short of being arguably significant, technically speaking, but it’s pretty interesting as far as an eyeball test is concerned. EQT Corporation Adds to Core Marcellus Asset BaseOn May 6, EQT Corporation (NYSE: EQT)announced that it entered into a purchase agreement with Alta Resources Development, LLC (“Alta”), pursuant to which EQT would acquire all of the membership interests in Alta's upstream and midstream subsidiaries for approximately $2.93 billion. EQT intended to finance the acquisition with $1.0 billion in cash, drawing upon its revolving credit facility and/or through one of more debt capital market transactions, and stock consideration consisting of approximately 105 million EQT common shares, representing $1.93 billion. The asset was comprised of approximately 300,000 core acres positioned in the northeast Marcellus region. Net production as of the transaction date was approximately 1.0 Bcfe per day, comprised of 100% dry gas. The transaction also included 300-miles of owned and operated midstream gathering systems and a 100-mile freshwater system with 255 million gallons of storage capacity. Toby Rice, President and CEO of EQT, stated that the acquisition represents an attractive entry into the northeast Marcellus while accelerating the company’s deleveraging path, providing attractive free cash flow per share accretion for EQT shareholders and adding highly economic inventory to the company’s robust portfolio. Mr. Rice also noted the transaction increases the company’s long-term optionality, and should accelerate its path back to investment grade metrics while simultaneously achieving its shareholder return initiatives.Northern Oil and Gas, Inc. Acquires Non-Operated Appalachian AssetsOn February 3, Northern Oil and Gas (NYSEAM: NOG) agreed to acquire certain non-operated natural gas assets in the Appalachian basin from Reliance Marcellus, LLC (“Reliance”), a subsidiary of Reliance Industries, Ltd., for total consideration of $175 million in cash and approximately 3.25 million warrants to purchase shares of NOG common stock at an exercise price of $14.00 per share. The transaction was expected to be funded through a combination of equity and debt financings and anticipated to be leverage neutral on a trailing basis and leverage accretive on a forward basis. At the effective date of July 1, 2020, the acquired assets were producing approximately 120 MMcfe/d of natural gas equivalents, net to Northern Oil and Gas. The assets were expected to produce approximately 100?110 MMcfe/d (or approximately 19,000 Boe/d) in 2021, net to Northern Oil and Gas, and consisted of approximately 64,000 net acres containing approximately 102.2 net producing wells, approximately 22.6 net wells in process, and approximately 231.1 net undrilled locations in the core of the Marcellus and Utica plays. Furthermore, an inventory of 94 gross highly-economic, work-in-progress (“WIP”) wells was slated for completion over the following five years by EQT. As of the transaction announcement, approximately $50 million of net development capital had already been deployed on the WIP wells, which was not subject to reimbursement by Northern Oil and Gas. The acquisition complemented Northern Oil and Gas’s then-existing approximate 183,000 net acreage portfolio in the Williston and Permian basins. As of year-end 2020, the acquired assets held an estimated 493 Bcf of proved reserves, of which approximately 55% were comprised of PDP reserves, with PV-10 of $269 million (at strip pricing as of January 20, 2021).Nick O’Grady, Northern Oil and Gas’s CEO, commented, “This transaction furthers our goal of becoming a national non-operated franchise with low leverage, strong free cash flow and a path towards returning capital to shareholders. With this transaction, we expect increased opportunities to efficiently allocate capital and diversify risk, our commodity mix and geographic footprint.”ConclusionM&A transaction activity in the Marcellus & Utica shrank in number in 2021 relative to 2020. However, the relatively greater magnitude of production density represented by the transactions in 2021 could prove to be a bellwether of more “transformational” transactions to come in 2022 as companies stake their claim in the gas and gas liquids rich basins of Appalachia.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Q3 2021 Earnings Calls

Third quarter earnings calls across the group of public auto dealers began with similar themes from the prior two quarters: record profits and earnings, record Gross Profits Per Unit (GPU) on new and used vehicles, and tightening inventory conditions. Additionally, the public franchised dealers continue to post large scale improvements in SG&A expense as a percentage of gross profit or revenues.Supply chain disruptions caused by the microchip shortages continue to impact inventory levels on new and used vehicles for all auto dealers. The public auto dealers are not immune from these conditions as well. Average days’ supply for new and used vehicles for the six public auto dealers as of September 30 are as follows: We have focused previous blogs on the conditions impacting new and used vehicles and their contribution to overall profitability. While those themes still existed for the Q3 earnings calls, we will focus on other areas of profitability for the public auto dealers, including Fixed Operations and Finance and Insurance (F&I). Additionally, the M&A market for the entire industry continues to accumulate transaction volumes at record levels. While much has been discussed regarding the pricing of those transactions in terms of multiples paid and which historical earnings to consider for ongoing performance, we will discuss some of the other factors public executives consider when making acquisitions. Will inflation be the next disruptive force to impact the auto dealer industry as we close out 2021 and head into 2022? Find out how public executives view inflation to the auto consumer and how that might affect new and used vehicle transactions. Finally, we will examine some of the themes and performance enhancements that public auto dealers continue to experience from the digital and omnichannel platforms outside the obvious digital transactions of new and used vehicles. Theme 1: Public auto dealers report improvements in Fixed Operations and Service stemming from recovery in vehicle miles driven post-pandemic. Customer pay has continued to improve while collision work has lagged. “Consumers are approving more work than they had in years past, and they’re spending more dollars per order […] We do see more opportunity to be more digital and be more engaged and transparent with the consumer […] and mainly our source is text messaging. We’re communicating through text message.” – David Hult, President & CEO, Asbury Automotive Group“The strong areas, obviously being areas of customer pay have continued to perform well versus both 2020 and 2019. The one area that continues to be a little bit of a laggard is collision, we do anticipate as miles continue to improve that will fully recover.” – Joe Lower, Chief Financial Officer, AutoNation“Our customer pay continues to ramp -up following a very strong first half of the year with 19% same-store dealership gross profit growth compared to the third quarter of 2019 […] despite continued headwinds in warranty and collision, both of which we believe will reverse in time.” – Daryl Kenningham, President U.S. and Brazilian Operations, Group 1 Automotive“Our service and parts […] it’s a huge tailwind for us. Our warranty was only off 9% […] our customer pay was up 21%” – Jeff Dyke, President, Sonic AutomotiveTheme 2: Public executives report strong results in the F&I department fueled by escalating transaction prices and low-interest rates. The lower volume of new vehicle units retailed is also affecting the mix of F&I revenue as penetration from product sales is outpacing warranty and reserve components.“Our strong, consistent and sustainable growth in F&I delivered an increase of $155 to $1,955 per vehicle retail from the prior quarter […] We like the fact that 70% of our F&I number is product sales and only 30% is reserve […] [regarding our recent acquisition] Larry Miller group has better penetration numbers than we do. So we’re certainly excited to learn from them and grow as well.” – Dana Clara, SVP of Operations, and David Hult, President & CEO, Asbury Automotive Group“The real driver for us [on F&I] has been increased penetration […] about two-thirds of F&I for us comes out of product versus financing.” – Joe Lower, Chief Financial Officer, AutoNation “22% increase in F&I income […] The adjacency that we are furthest along with is Driveway Finance or DFC […] Driveway Finance earns three times the amount earned than when we arrange financing with a third-party lender […] Driveway Finance can penetrate 20% of our financed retail sales.” – Bryan DeBoer, President & Chief Executive Officer, Lithia MotorsTheme 3: Supply chain disruptions have affected all industries including the auto dealer industry. Executives are watching how inflation and rising interest rates might impact the purchase of new or used vehicles in the coming months.“We’re watching inflation and the CPI […] what they’ve missed is the consumers are very happy with that pre-owned valuation that they own, that the 275 million vehicles on the road in America are worth more. That has made the consumer happy, not unhappy […] so once you see the other side of the coin, that consumers are not unhappy with this, they don’t consider it inflation [….] [consumers say] oh I made a pretty good investment […] it’s worth more. And if I want to sell it, I can get a nice check. And if I want to trade it, I have a reasonable difference. As soon as you realize that the consumer doesn’t view that as inflation, but as a win for them, then you understand our optimism and our confidence about the future of automotive.” – Mike Jackson,Chief Executive Officer, AutoNation“I don’t think there’s any doubt that inflation is a business factor […] I don’t think we can call it transitory or anything like that […] the costs are going to go up on everything, but the affordability of vehicles is more dictated by retail financing and leasing. And with high used car values, and low interest rates, I don’t see this inflation raining on the vehicle sales parade in the foreseeable future." – Earl Hesterberg, Chief Executive Officer, Group 1 AutomotiveTheme 4: M&A continues to dominate headlines. 2021 will see more transactions than any year in recent history. “I think fragmentation provides an opportunity for consolidation. With the investment required today, I think there’s a number of smaller dealerships that will become available. I think the deals that we see, the bigger deals are expensive. And many of them require CapEx and also then would provide some input from the standpoint of framework agreements with the manufacturers.” – Roger Penske, Chairman and Chief Executive Officer, Penske Automotive Group“So we visited all of the RFJ stores […] the entire management team is coming along for the ride […] we kind of walk into one of their stores and if feels like a Sonic store, they run their playbooks very similar to us. […] They are a fantastic leadership team. […] This is a perfect fit for us.” – Jeff Dyke, President, Sonic Automotive“[Regarding the Greeley Subaru, Kahlo CDJR, and Arapahoe Hyundai announced transactions] The brand mix is about 50% luxury and then mostly, import with one domestic store as well. It’s a really a very strong group with the right brand mix in a market that we’ve been trying to grow.” – David Hult, President & Chief Executive Officer, Asbury Automotive GroupTheme 5: Digital/omnichannel advancements are happening to meet consumer demands and enhance the retail experience. Improvements consisted of more than just unique digital visitors and increased online transactions. Improvements include average deal time, used vehicle procurement, headcount efficiency, and the ability to serve consumers with all credit scores.“I think the reason you are seeing higher credit scores and higher down payments on the tool [Clicklane] is it’s simplistically someone with a 750-Beacon score understands that they’re not worried about financing and understands that they can get what they want […] [we] certainly see [sic] lower credit scores as well on there […] there’s a broad mix, but again, the score average is certainly higher.” – David Hult, President & Chief Executive Officer, Asbury Automotive Group“We’ve demonstrated that we can operate the business at a lower relative cost than was done historically in large part by the deployment of digital tools that are making our sales and service associates far more effective […] we’ve been able to continue to operate with 3,000 plus fewer heads within the store environment on a same-store basis year-over-year.” – Joe Lower, Chief Financial Officer, AutoNation“We’ve increased the productivity of our salespeople by 30%, pre-Covid versus today […] selling 13 or more units a month instead of 10 […] nearly 40% of our customers are scheduling appointments online these days” – Earl Hesterberg, Chief Executive Officer, and Daryl Kenningham, President of U.S. and Brazilian Operations, Group 1 Automotive“The average Driveway consumer is averaging exactly 50 points lower on their FICO scores. So there are 671 versus 721 in Lithia […] We did finance a higher percentage of customers in Driveway at 75% and only financed 67% of Lithia customers.” – Bryan DeBoer, President & Chief Executive Officer, Lithia Motors“Omni-channel is just not selling vehicles. You think about service appointments, online payments – that is key.” – Roger Penske, Chairman and Chief Executive Officer, Penske Automotive Group“EchoPark is all about buy the car, transport the car, recon the car, merchandise the car and moving like 12 days to getting on the frontline, it’s gone […] EchoPark model is a one-to-five year old model under 60,000 miles” – Jeff Dyke, President, Sonic AutomotiveConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation and litigation support engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Five Thoughts on Turning Your RIA’s Success Into Momentum

Knowing why you’re successful is a key to sustaining success. Porsche made its mark in auto racing in the 1950s by turning the race for better power-to-weight ratios on its head. While most automakers focused on the numerator, building bigger cars with more powerful engines, Porsche worked to keep the car's light - not only to improve acceleration, but also braking and handling. The formula worked both on the track and in the showroom, and Dr. Ferry Porsche never lost sight of what made his cars competitive and sought after. On roads that are a monotonous sea of SUVs, the 8th generation 911 Carrera stays true to an identity that Porsche established in the 1950s with the 550 Spyder and the model 356. Although the weight has crept up over the years, power increased even faster. Engineering advances have added double-clutch gearboxes, all-wheel drive, four-wheel steering, ceramic-disc brakes, and (to the horror of the Porsche faithful) water-cooling to Porsches. However, the core identity of the product has remained intact and forms the intangible that Porsche has monetized for over 70 years. Today, the waiting list for a new one is impressive.Despite the recent volatility, it’s been another very good year for the RIA community. Markets, on the whole, are strong, tax rates didn’t skyrocket, margins are thick, and transaction activity continues unabated.Success, alas, can be fleeting. While some in the industry are focused on continued opportunities and upside in the years ahead, it’s hard to ignore calls that corporate earnings growth is slowing, the yield curve is flattening, commodity prices are worrisome, emerging markets are uneven, fee pressure is growing, and the world is bracing for another round of COVID. Whatever brings about the rollover in industry trend lines, we all know it’s coming at some point.So if, indeed, 2021 is the peak of the cycle for the investment management industry, what will you one day wish you had done now?1. Know What Got You HereThere’s an old proverb that says something to the effect of every ship has a good captain in calm waters. If your RIA has grown in AUM, revenue, and profitability over the past decade, you’re not alone. Think about why your firm grew. Did you add productive financial advisors to your wealth management practice? Did you add attractive asset management strategies? Did your assets under management increase because you broadened your appeal to a larger range of clients? Did you develop deeper relationships with existing clients? Did you grow organically or was most of your growth the result of acquisitions? Are your effective fees charged steady or increasing?Most revealing is to look at whether or not your AUM grew because of market tailwinds or because of new clients. Bull markets come and go, of course, so building the fundamental value of your investment management firm is really contingent on having an asset acquisition strategy (i.e. marketing) to bring in new clients and new client assets net of terminations and client withdrawals. You will always face some client terminations – you don’t want to do business with everyone anyway. Even good wealth management clients will eventually spend their money, and institutional asset management clients will reward your outperformance by rebalancing their commitment to you. We all know that some attrition is unavoidable and, ultimately, healthy. You just can’t rely on favorable markets to keep your revenue base stable or growing.2. What Will Your Firm Look Like in Five Years?Corporations can be perpetual, but the people who work at them eventually leave. Because investment management is necessarily labor-intensive, your firm is a function of the career cycles of your staff. Five years from now, everyone who is still at your firm will be five years older. Stop for a minute and think about what that looks like. The RIA industry is, as a whole, facing demographic challenges, and by some measures, there are more financial advisors in the career wind-down stage than there are in the career development stage.So what will your staff look like in five years? Will any of them have retired? Will any have new skills and/or credentials? How will titles, roles, and responsibilities change? What turnover are you likely to have? Will you need to replenish turnover from experienced hires or will you train people who are new to the industry? In other words, as you look at the changes that will likely happen to your staff over the next five years, will those changes grow your firm, maintain it, or are you at risk for attrition to your collective intellectual capital.3. Stress Test Your MarginsIt’s more than a little ironic and unfortunate that there are so many forecasting tools for individuals but so few for businesses. Just like wealth management firms run Monte Carlo simulations on portfolios to model likely outcomes for clients given different market scenarios, so too you need to think about how your firm will fare during unfavorable external circumstances.Profit margins have a very real business continuity function that is easy to forget after long stretches of upward trending markets. If your firm currently boasts a 25% pre-tax margin, for example, you could suffer the loss of a quarter of your revenue stream and, theoretically, not have to cut your expenses. This isn’t pleasant to contemplate, but if a sustained bear market cut your AUM by 20%, and then client financial stress caused a greater than usual rate of withdrawals, you could see a considerable decline in your top line. Since the only way to meaningfully reduce expenses in the RIA business is to cut staff, responding to unfavorable financial market conditions can have a long-lasting impact on the scale and value of your firm. It’s worth considering such a likelihood, and it’s much easier when you aren’t under the stress of the event itself.4. Consider Your Exit OptionsWith M&A on the rise, private equity increasingly interested, and new consolidation schemes emerging on a weekly basis, there has never been a more interesting time to consider how you might liquefy an interest in an RIA. Remember, though, that most ownership transitions in investment management firms are still internal because transacting staff, clients, and culture is difficult, even with favorable industry conditions. Outsiders don’t always “get it,” and insiders don’t want them.If you had to sell right now, how would you do it? If you don’t think your firm is ready to take to market, what changes need to be made? If you intend to transact internally, do you foster a culture of succession? There’s no room here for an exhaustive analysis of exit planning for RIA owners, but suffice it to say that you should always be aware of your possibilities. If you can’t find the door in good times, what will your plan be following the next correction?5. Remember That Long-Term Industry Trends Are FavorableAt some point, things are going to get rough, and the performance of your RIA is going to deteriorate. When market valuations tumble, clients get nervous, and staff stress rises, it can feel like at least your professional world is coming to an end. Broad industry trends, though are very favorable to the investment management community. New retirees make up the largest source of new clients for wealth management firms (and, in turn, asset managers), and the number of retired persons in the U.S. will continue its upward trajectory for decades to come. Assets continue to flow away from wirehouses and toward independent advisory practices. And last but not least, markets are – over time – upward drifting. None of that is going to change with the next bear market.So while the fundamentals of your firm may appear to deteriorate during bear markets, the fundamentals of the industry will continue to drive success for a long time. Today, the fundamentals of your firm are probably the best they’ve ever been. That’s why this is the perfect time to consider your formula for success, prepare for the next downturn, and build the competitive momentum you’ll need to ride the industry trends to greater success in the future.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of November 29, 2021

Top Considerations for Acquirers When Evaluating a Potential Bank Acquisition

With year-end approaching, we are starting our annual process of recapping 2021 and considering the outlook for 2022. In doing so, we turned our attention to the bank M&A data to see what trends were emerging. While the number of bank and thrift deals is on pace to roughly double from 2020 levels (117 deals in 2020 vs 199 deals through 11/22/21), the number of deals still remains well below pre-pandemic levels. Valuations at exit illustrate a similar trend with the median price/earnings nationally for announced deals at ~15.0x earnings and the average price/tangible multiple at ~1.54x for the YTD period through mid-November 2021. These valuation multiples implied by YTD 2021 deals are up relative to 2020, roughly in line with 2019 levels, but are still down relative to 2017 and 2018 levels.A bank acquisition could present an opportunity for growth to acquirers that are facing a challenging rate and market environment. Some recent data confirmed this as almost half of survey respondents in Bank Director’s 2022 Bank M&A Survey say their institution is likely to purchase another bank by the end of 2022 — a significant increase compared to the previous year, and more in line with the pre-pandemic environment.For those banks considering strategic options, like a sale, 2022 could also be a favorable year, should the improving trends experienced in 2021 continue. These trends include a continued increase in buyer’s interests in acquisitions, a continued expansion of the pool of buyers to include both traditional banks and non-traditional acquirers like credit unions and FinTechs, and the tax environment for sellers and their shareholders remaining favorable relative to historical levels.Against this backdrop of the potential for an active bank M&A environment in 2022, we consider the top three factors that, in our view, should be considered by bank acquirers to help make a successful bank acquisition.1. Developing a Reasonable Valuation Range for the Bank TargetDeveloping a reasonable valuation for a bank target is essential in any economic environment, but particularly in the current environment. We have noted previously that value drivers remain in flux as investors and acquirers assess how strong loan demand and the rate environment will be. In addition to those factors, evaluating earnings, earning power, multiples, and other key value drivers remain important. Bank Director’s 2022 Bank M&A Survey also noted the importance of valuation in bank acquisitions as pricing expectations of potential targets were cited as the top barrier to making a bank acquisition (with 73% of respondents citing this as a barrier).Determining an appropriate valuation for a bank requires assessing a variety of factors related to the bank (such as core earning power, growth/market potential, and risk factors). Then applying the appropriate valuation methodologies – such as a market approach that looks at comparably priced transactions and/or an income approach focused on future earnings potential and developed in a discounted cash flow or internal rate of return analysis. While deal values are often reported and compared based upon multiples of tangible book value, value to specific buyers is a function of projected cash flow estimates that they believe the bank target can produce in the future.Price and valuation can also vary from buyer to buyer as specific buyers may have differing viewpoints on the future earnings and the strategic benefits that the seller may provide. For example, 2021 has seen an emerging trend of non-traditional acquirers such as credit unions and FinTech companies entering the mix. They often have different strategic considerations/viewpoints on a potential bank transaction.2. Appropriately Consider the Strategic Fit of the Bank TargetAs someone who grew up as an avid junior and college tennis player, I have always admired the top pros and found lessons from sports to apply in my personal and business life. With fifteen grand slam titles and fifteen years as the top doubles team globally, the Bryan brothers – Bob and Mike – are often held out as the most successful doubles teams of all time and offer some lessons that we can learn from, in my view. Their team featured a unique combination of a left-handed and right-handed player, which provided variety to challenge their opponents and expand their offensive playbook. It also had many similar intangibles, such as how they approached practicing and playing since they were twins and taught by their father (Wayne) from a young age.Their success illustrates the importance of identifying both the key similarities and differences of a potential partnership to strengthen the chances for success once combined. Key questions to consider regarding strategic fit and identifying the right partner/opportunity for a bank acquisition include: Does the Target expand our geographic footprint into stronger or weaker markets? What types of customers will be acquired (retail/consumer, business, etc.) and at what cost (both initially and over time)? Is there a significant branch/market overlap that could lead to substantial cost savings? Is the seller’s business culture (particularly credit underwriting/client service approach) similar to ours? Will the acquisition diversify or enhance our loan/deposit mix? Will the acquisition provide scale to expand our business lines, balance sheet, and/or technology offerings? What potential cost savings and/or revenue enhancements does the potential acquisition provide?3. Evaluating Key Deal Metrics Implied by the Bank AcquisitionA transaction that looks favorable in terms of valuation and strategic fit may flounder if other key deal metrics are weak. Traditional deal metrics to assess bank targets include capital/book value dilution and the earnback period, earnings accretion/dilution, and an internal rate of return (IRR) analysis. Below we focus a bit more on some fundamental elements to consider when estimating the pro forma balance sheet impact and internal rate of return:Pro Forma Balance Sheet Impact and Earnback PeriodTo consider the pro forma impact of the bank target on the acquirer’s balance sheet, it is important to develop reasonable and accurate fair value estimates as these estimates will impact the pro forma balance sheet at closing as well as future earnings and capital/net worth after closing. In the initial accounting for a bank acquisition, acquired assets and liabilities are marked to their fair values. The most significant marks are typically for the loan portfolio, followed by intangible assets for depositor customer relationship (core deposit). Below are some key factors for acquirers to consider for those fair value estimates:Loan Valuation. The loan valuation process can be complex, with a variety of economic, company, or loan-specific factors impacting interest rate and credit loss assumptions. Our loan valuation process begins with due diligence discussions with the management team of the target to understand their underwriting strategy as well as specific areas of concern in the portfolio. We also typically factor in the acquirer’s loan review personnel to obtain their perspective. The actual valuation often relies upon a) monthly cash flow forecasts considering both the contractual loan terms, as well as the outlook for future interest rates; b) prepayment speeds; c) credit loss estimates based upon qualitative and quantitative assumptions; and d) appropriate discount rates. Problem credits above a certain threshold are typically evaluated on an individual basis.Core Deposit Intangible Valuation. Core deposit intangible asset values are driven by market factors (interest rates) and bank-specific factors such as customer retention, deposit base characteristics, and a bank’s expense and fee structure.Internal Rate of ReturnThe last deal metric that often gets a lot of focus from bank acquirers is the estimated internal rate of return (“IRR”) for the transaction. It is based upon the following key items: the price for the acquisition, the opportunity cost of the cash, and the forecast cash flows/valuation for the target, inclusive of any expense savings and growth/attrition over time in lines of business. This IRR estimate can then be compared to the acquirer’s historical and/or projected return on equity or net worth to assess whether the transaction offers the potential to enhance pro forma cash flow and provide a reasonable return to the acquirer.Mercer Capital Can HelpMercer Capital has significant experience providing valuation, due diligence, and advisory services to bank acquirers across each phase of a potential transaction. Our services for acquirers include providing initial valuation ranges for bank targets, performing due diligence on targets during the negotiation phase, providing fairness opinions and presentations related to the acquisition to the buyer’s management and/or board, and providing valuations for fair value estimates of loans and core deposit before or at closing.We also provide valuation and advisory services to community banks considering strategic options and can assist with developing a process to maximize valuation upon exit. Feel free to reach out to us to discuss your community bank or credit union’s unique situation and strategic objectives in confidence.

Posturing for a Successful Succession

Failing to Plan is Planning to Fail

A recent Schwab survey asked RIA principals to rank their firm’s top priorities in the coming year. We were disappointed but not surprised to discover that developing a succession plan was dead last. This is unfortunate because 62% of RIAs are still led by their founders, with only about a quarter of them sharing equity with other employees to support succession planning. Not much progress has been made, and there doesn’t seem to be much of a push to resolve this issue any time soon. Brent Brodeski, CEO of Savant Capital, describes this predicament more crassly:“The average RIA founder is over 60 years old, and many are like ostriches: They stick their heads in the sand, ignore the need for succession planning, ignore that their clients are aging, let organic growth slow to a crawl or even backslide, and have increasingly less fun and a waning interest in their business.”Fortunately, it doesn’t have to be this way. There are many viable exit options for RIA principals when it comes to succession planning:Sale to a strategic buyer. In all likelihood, the strategic buyer is another RIA, but it could be any other financial institution hoping to realize certain efficiencies after the deal. They will typically pay top dollar for a controlling interest position with some form of earn-out designed to incentivize the selling owners to transition the business smoothly after closing. This scenario often makes the most economic sense, but it does not afford the selling principals much control over what happens to their employees or the company’s name.Sale to a consolidator or roll-up firm. These acquirers typically offer some combination of initial and contingent consideration to join their network of advisory firms. The deals are usually debt-financed and structured with cash and stock upfront and an earn-out based on prospective earnings or cash flow. Consolidators and roll-up firms may not always pay as much as strategic buyers, but they often allow the seller more autonomy over future operations. While there are currently only a handful of consolidators, their share of sector deal-making has increased dramatically in recent years.Sale to a financial buyer. This scenario typically involves a private equity firm paying all-cash for a controlling interest position. PE firms will usually want the founder to stick around for a couple of years after the deal but expect them to exit the business before they flip it to a new owner. Selling principals typically get more upfront from PE firms than consolidators but sacrifice most of their control and ownership at closing.Patient (or permanent) capital infusion. Most permanent capital investors are family offices that make minority investments in RIAs in exchange for their pro-rata share of future dividends. They typically allow the sellers to retain their independence and usually don’t interfere much with future operations. While this option typically involves less up-front proceeds and higher risk retention than the ones above, it is often an ideal path for owners seeking short-term liquidity and continued involvement in this business.Internal transition to the next generation of firm leadership. Another way to maintain independence is by transitioning ownership internally to key staff members. This process often takes significant time and financing, as it’s unlikely that the next generation is able or willing to assume 100% ownership in a matter of months. Bank and/or seller financing is often required, and the entire transition can take 10-20 years depending on the size of the firm and interest transacted. This option typically requires the most preparation and patience but allows the founding shareholders to handpick their successors and future leadership.Combo deal. Many sellers choose a combination of these options to achieve their desired level of liquidity and control. Founding shareholders have different needs and capabilities at different stages of their life, so a patient capital infusion, for instance, may make more sense before ultimately selling to a strategic or financial buyer. Proper succession planning needs to be tailored, and all these options should be considered. If you’re a founding partner or selling principal, you have a lot of exit options, and it’s never too soon to start thinking about succession planning. You will have a leg up on your competition that’s probably not prioritizing this. You’ve likely spent your entire career helping clients plan for retirement, so it’s time to practice what you preach. Please stay tuned for future posts on this topic and give us a call if you are ready to start planning for your eventual business transition.

Major Acquisitions of Alternative Asset Managers Signal Continued Outperformance

As we wrote in our most recent investment manager sector highlight, Public Alt Asset Managers Have Nearly Doubled in Value Over the Last Year, alternative asset managers have outperformed all other investment manager sectors in the RIA post-pandemic rebound. According to Institutional Investor, eight of the world’s ten largest investment management firms by market capital are now alternative asset managers. Most notably, the private equity firm Blackstone surpassed the world’s largest investment management firm by AUM, Black Rock, as the most highly valued stand-alone investment management firm back in September of this year.The demand for investment management firms continues to reach new highs and has culminated in a number of prominent acquisitions over the past year. In the past month alone, three deal announcements of alternative asset managers by larger, traditional asset management firms and diversified financial institutions suggest the sector remains bullish.Franklin Templeton to acquire Lexington Partners acquisition – Nov. 1, 2021. At the time of the announcement, Lexington Partners managed $34.0 billion in AUM primarily in secondary private equity investments and co-investment funds. The deal marks Franklin Templeton’s second private equity acquisition in the past three years after acquiring Benefit Street Partners in 2019.T. Rowe Price to acquire Oak Hill Advisors – Oct. 28, 2021. The alternative credit provider, Oak Hill Advisors, currently manages about $52.0 billion in AUM. The $4.2 billion acquisition marks T. Rowe Price’s first in more than a decade.Macquarie Asset Management to acquire Central Park Group – Oct 21, 2021. Central Park Group is a private equity and real estate investment firm located in New York and has AUM of approximately $3.5 billion.Demand Drivers for Alternative Assets vs. Demand Drivers for Alternative ManagersThe deals listed above are indicative of strong demand for both alternative assets and the firms that manage them. While the niche investment expertise and narrow market presence of alternative asset management firms can sometimes complicate transactions, traditional investment managers are nevertheless finding value in the alternative asset management models which have proven to be highly profitable, resilient, and may be bolted on to existing asset management teams. Below, we look at several factors driving investor demand for alternative assets and for alternative asset management firms.Alternative Asset Demand & Performance Drivers:A low yield environment. When interest rates fall, investors are encouraged to take higher degrees of risk to maintain prior levels of return. Certain alternative assets such as private equity and venture capital are generally considered higher risk, higher reward investments. Interest rates have remained at historic lows since the Great Recession and dipped further during 2020.Heightened volatility. In times of heightened market volatility, investors flock to real assets and private equity which is less prone to price swings. Additionally, certain options-heavy investment firms are also positioned to benefit as the volatility on the underlying is directly related to the options value. The historic market volatility throughout the pandemic era has benefited hedge fund performance and left investors flocking to “safer” asset classes.Robust exit activity. While markets have been exceedingly volatile over the past year and a half, they have more than recovered from the lows at the onset of the pandemic. Asset inflation has run rampant, particularly in the private equity and venture capital space which is now well positioned to benefit from strong exit activity in the coming years.Inflation. According to data from Trading Economics, annualized inflation in October 2021 was 6.2%, the highest level in decades. Certain alternative asset classes are widely considered to be inflation hedges. Real assets such as commodities and private real estate traditionally outperform in times of high inflation because returns are tied to capital appreciation.Demand Drivers for Alternative Asset Manager Acquisitions:Positive Fund Flows. According to PWC’s midyear outlook for private equity, investor appetite for private equity has outpaced traditional investment manager fund flows over the past five years. Sector AUM increased nearly 20% in 2020 alone, and the trend seems to be gaining momentum. Currently, PE dry powder is at an all-time high at $150.1 billion, which is reflective of strong fundraising and investor demand.Fees. Alternative asset managers seem to be somewhat immune to fee compression which has been one of the strongest headwinds for asset management for over a decade. The widespread consensus among money managers is that alternative assets justify premium fees due to purported diversification benefits, higher return, and expertise needed to execute such strategies. The opaque nature of the investment strategies and asset classes employed by alternative asset managers may also help these firms avoid fee compression.Diversification. Implicit in most asset management models is operating leverage. Because revenues are directly tied to the performance of the market and expenses remain somewhat fixed to compensation and overhead, diversifying firm exposure by broadening product offering may smooth out the bottom line. For this reason, alternative asset management firms can make strong acquisition targets for traditional asset managers. While fund flows may taper off if systemic tailwinds subside, alternative asset managers will likely remain strong acquisition targets for traditional asset managers due to diversification benefits and superior fees. Additionally, demand for alternative asset managers from other financial institutions such as banks and insurance companies looking to gain exposure to the investment space will also likely remain strong.

EV Start-Up Rivian IPOs at Valuation of $86 Billion

What It Means for Ford, Other OEMs, and Auto Dealers

The stock market is near record highs despite the global economy still working on climbing out of a once-in-a-century pandemic. A couple of themes for high-flying equities are ESG and companies that have yet to turn a profit. Rivian Automotive takes this a step further, as its prospectus indicates it will lose $1.28 billion in the third quarter while revenue will range from $0 to $1 million. However, as of its opening price, Rivian is already worth more than Ford and GM. From a valuation perspective, all the value is clearly placed in the terminal value with minimal production to date.Amazon and Ford are backing the electric vehicle startup, and investors are clearly betting the company can grab a meaningful amount of the burgeoning EV market. Rivian has beat Tesla, GM, and Ford to market with a fully electric pickup truck, the R1T. While this is expected to launch in December, it remains to be seen how meaningfully the company can scale production—if it can’t, being first may not mean much.Rivian indicates its factory in Illinois has the capacity to produce approximately 65,000 pickup trucks/SUVs and 85,000 commercial delivery vans, the latter of which is why Amazon is interested. Amazon owns 20% of Rivian and has ordered 100,000 Rivian vehicles to be delivered by 2030. Ford was also interested in collaborating on production for its EV business. The investment increased to become a meaningful part of Ford’s market capitalization, regardless of synergistic opportunities. However, on Friday, it was announced that Ford and Rivian had canceled their plans to jointly develop an EV.There are numerous potential reasons for this split, and Rivian indicated the decision to split was mutual. When Ford invested in Rivian in 2019, it was likely viewed as a way to jump-start its EV initiatives. Since then, Rivian’s production has been de minimis while Ford sold about 22,000 Mustang Mach E's alone in 2021, which was named Car and Driver’s Electric Vehicle of the Year. While Ford will continue to benefit from its investment in Rivian, it doesn’t “need” Rivian to be successful in EVs.Below, we have included a recent blog from my colleague Atticus Frank on Mercer Capital’s Family Business Advisory Services team, highlighting the decision to invest in Rivian from Ford’s perspective.Ford Motor Company (NYSE:F) is one of America’s most iconic brands. Did you also know they are still significantly led and run by the Ford family? One of the great-grandsons of founder Henry Ford, William Clay Ford Jr., leads the board of directors at Ford. Another great-grandson, Edsel II, is also on the board. Collectively, the Ford family holds enough Class B super-voting shares to elect 40% of the board of directors.A newer car maker, Rivian Automotive (NasdaqGS: RIVN), saw its IPO price the company at nearly $70 billion. Admittedly, my first thoughts are best reflected by an investor of “The Big Short” fame Michael Burry: speculation gone wild. Rivian is an electric vehicle (or “EV”) startup that has generated virtually no revenue. At the time of this writing (November 12, 2021), Rivian’s market capitalization was north of $127 billion, making it the second most valuable U.S. car maker behind Tesla. Rivian has made 156 vehicles, implying a cool $1 billion per vehicle delivered valuation. Those are numbers that would make Elon Musk blush. For perspective, Ford delivered over 5 million cars in fiscal 2019, or an implied $15,000 per car.As fate would have it, Ford has an effective 14.4% ownership interest in the electric car startup, giving it an implied stake of over $18 billion. Not bad, given its sub-$1 billion of invested capital. If one were to do a “back-of-the-envelope” sum of the parts valuation of Ford, Rivian now represents over 20% of Ford’s market capitalization. We don’t highlight the current irrational exuberance to spur you into investing in an EV startup or give you a case of ‘FOMO’, but to encourage us to think again about family business diversification, something we have written on previously. When thinking about diversification, it is helpful for family business owners to think about three questions: What, Who, and Why? What Is Diversification?Diversification is simply investing in multiple assets as a means of reducing risk. Suppose one asset in the portfolio takes a big hit. In that case, some other segment of the portfolio will likely perform well at the same time, thereby blunting the negative impact on the overall portfolio. A big question when considering diversification is a correlation: if what you are investing in is closely tied to your business currently, diversification benefits are blunted. The following example illustrates the two sides of the equation when diversifying expected returns and correlation. We note there is not a right answer to the investment choice example above ex-ante: That choice depends on who is investing and for what purpose (discussed in detail below). If you aim to maximize returns and have confidence in your industry, you would pick option #1. If you are more conservative or are not highly confident in your near-term outlook, you may likely choose #3. We discuss the who and why later in this article. When one thinks about Ford’s investment in Rivian, it appears the legacy car company took the middle road (some correlation, but higher expected return). Rivian is very much a car company, but one focused on electric vehicles. Initially, Ford invested in Rivian so the two would work together to develop a fully electric Lincoln. Ford has catapulted into the electric car space in recent years to much fanfare, with its Mustang Mach-E and F-150 Lighting, making its current investment in a certain light appear redundant, albeit lucrative. However, Ford considers Rivian a “strategic investment,” according to a spokesman’s comments to CNBC. “We’ve said that Rivian is a strategic investment and we’re exploring potential collaborations,” T.R. Reid said. “We won’t speculate about what Ford will do, or not, in the future.” What Ford decides to do with its very richly priced potential conflict-of-interest investment (competitor, plus Ford supplies certain parts to the startup) is yet to be seen. Diversification to Whom?Whose perspective is most important in thinking about diversification? As we have discussed in previous posts, a family business shareholder likely has a view on diversification within the company based on their own personal portfolio mix. For example, if the vast majority of a shareholder’s personal wealth (and income) is derived from the family business, that individual would likely be more concerned with the riskiness of the business overall and prefer more diversification within the company to ensure stability.Also, consider a well-diversified shareholder outside the family business, and their family business ownership represents a smaller allocation of their personal portfolio. That person would likely prefer to make their own diversification decisions (with dividends paid by the company) or prefer the company to make focused (undiversified) investment decisions to maximize expected returns.In the case of Ford, one wonders how the Ford family feels maintaining a heavy weighting in the new venture. The Ford family has considerable wealth outside their Ford stock stakes, lowering the need to maintain conservatism within Ford. The family may view the large EV car company stake as a distraction and prefer to make their own, if they so choose, large EV investments outside the business. This logic could lead to a sale or paring down of the stake. This would also allow Ford to utilize part of the proceeds and invest deeper in their own company efforts.Conversely, one could argue the ‘combustion engine’ is going the way of the Model T, and diversification into an electric vehicle company might be a way to stabilize company performance. The family may view the investment in the separate EV company as a ‘safety valve’ if Ford’s own EV efforts do not pan out. While it may partially distract from the core Ford mission, it could lead to more stable shareholder returns. Again, ‘who’ is experiencing diversification affects how the company will likely face this question in the future.Why Diversify?Family businesses often provide a different ‘who’ regarding diversification and a different ‘why’ to their publicly traded, non-family controlled counterparts. What the family business means to you impacts how you think about diversification decisions for the family business. Depending on what the business means to the family, the potential for diversification benefits (correlation, discussed above) may take priority over absolute return. There are no right or wrong answers regarding risk tolerance, but there are tradeoffs that need to be acknowledged and communicated plainly. Family shareholders deserve to know the ‘why’ for significant investment decisions. How do you or the Ford family think about your family business meaning? If dividends were key for Ford, with meaning in the ‘lifestyle’ or ‘wealth accumulation’ buckets, a divesture of sorts might be appropriate to generate liquidity for investing in other uncorrelated assets or maintain the family’s lifestyle. But as discussed, Ford’s recent performance and prior move into the EV space has been a big splash for the legacy car giant. Keeping Rivian may be a sign that the family views Ford as the combustion (or electric) engine for future generations of the family and is willing to keep diversification within the company lower and not attempt to overly diversify outside it. Your family must decide its meaning as a business before you begin to think about diversification to provide the framework and context for coming to a big decision. Next StepsFamily business owners can take these three questions and apply them to their businesses. Remembering what diversification is and the importance of correlation, who are the stakeholders seeing the largest impact of diversification, and defining what the business means to you all can help guide the diversification question. Some next steps he has highlighted in The 12 Questions That Keep Family Business Directors Awake at Night include:Calculate what portion of the family’s overall wealth is represented by the family businessIdentify the three biggest long-term strategic threats to the sustainability of the existing family business operationsEstablish a family LLC or partnership to hold a portfolio of diversifying assets (real estate, marketable securities, etc.)Create opportunities to provide seed funding to family members with compelling ideas for new business ventures And if in the end, your diversification plans send you into uncharted territory or lead you to maintain the status quo, Mr. Henry Ford Sr. has quotes for both.“If I had asked people what they wanted, they would have said faster horses.”“Any customer can have a car painted any color that he wants so long as it is black.”Takeaways From RivianAuto dealers are unlikely to be able to invest in the next Rivian, but that doesn’t mean there are no lessons to be learned here. The market is clearly indicating it believes EVs are the future, so dealers should be positioning themselves accordingly. With heightened margins in 2021, auto dealers need to decide the best way to reinvest their capital. That may mean using profits earned in the past years and investing in infrastructure to support EVs. Local markets will still be necessary and there won’t be a one size fits all solution, but Rivian making headlines should get auto dealers thinking about what it means for them.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.In addition to auto dealers, Mercer Capital also provides financial education services and other strategic financial consulting to family businesses. Click here to learn more about our Family Business Advisory Services.

CAUTION: Railroad Crossing Ahead

Minimizing Costs vs. Meeting Demands

Supply chain bottlenecks are causing companies to switch their cargo transportation from rail to truck. According to research conducted by JLL Inc, aggregate demand for goods is still 15% above its levels in the fourth quarter of 2019, just before the pandemic lockdowns began. Suppliers have drastically increased the volume of their output in response to this demand, which, along with other issues, has clogged supply chains. Challenges in retaining drivers and acquiring new trucks and trailers have exacerbated this problem. One of the results of the tangled supply chains has been the shift from rail to road transportation.

Differing Perspectives on the Used Vehicle Market

Feast or Famine?

With Thanksgiving around the corner next week, we hope that everyone will be able to visit with family, share a meal with loved ones, and rekindle old traditions from holidays past. All of us are not immune from the headlines that speak to disruptions in the global supply chain on a daily basis. Undoubtedly, each of us has been inconvenienced with those supply shortages with consumer products, food, and essential goods that impact our daily lives. The automobile market is no different.In a previous blog, we examined several key indicators for the entire automobile market incorporating the first six months of data. In this weeks’ blog, we offer commentary on the status of the used vehicle market and re-examine some of those metrics through third quarter data. Headlines persist describing inventory shortages, record transaction prices, record profitability and predictions for when conditions will return to normal. How do we make sense of all of it? What factors are contributing to the current conditions? Like the larger automotive industry as a whole, conditions can be described as the best of times and the worst of times, or feast or famine. Interpretation of the conditions can differ depending on the perspective of the consumer or the auto dealer. We examine some of the key used vehicle metrics and indicators and then discuss how we got here and where we are headed.PricesFeast for the Auto Dealers, Famine for the ConsumerAccording to Cox Automotive, the average transaction price for a used vehicle topped $27,000 for the month of September. This figure represents the largest average transaction price for used vehicles on record and indicates a 25% increase from the average price of used vehicles just one year ago in September 2020. Most car buyers understand the historical notion that the value of a car depreciates immediately after you drive it off of the dealership lot. In 2021, this notion simply isn’t true for the time being. There are plenty of examples in the marketplace of used vehicles that are 1-2 years old with minimal miles (25-30K) that are selling for prices higher than the original sticker price of the new vehicle!Gross Profit Per Unit Used VehicleFeast for the Auto Dealers, Famine for the ConsumerOf the department/profit centers for an auto dealership, historically, the new and used vehicle departments accounted for the largest contribution to revenue, but a substantially lower contribution to overall gross profit. According to the Average Dealership Profile from NADA, these departments typically comprised approximately 88-90% of revenues and approximately 52% of gross profits, with the remainder coming from fixed operations. Currently, these departments still comprise a similar percentage of total revenues but now comprise 60% of gross profits. This figure continues to climb as of September 2021 as reported by NADA. What is driving this increase? Rising transaction prices for used vehicles and, in turn, increased gross profit per unit (GPU). The graphic below details the current used vehicle GPU and the corresponding figures from the prior two year-ends.Average Days’ Supply Used VehiclesFamine for Auto Dealers and the ConsumerWe’ve written about average days’ supply previously in this blog, but it serves as a key indicator of the level of supply, or in this case, the shortage of used vehicles in the market. Average days’ supply is calculated as the number of used vehicles in inventory or in the market divided by the average daily number of used vehicles sold. Historically, this figure ranged between 55 and 66 for 2019 and 2020, as seen in the graphic below. The average days’ supply for used vehicles has not slumped nearly as bad as the same metric for new vehicles and has shown signs of steadying to slight improvement.Source: Cox AutomotiveThrough the early spring of 2021 and through September, this same metric cratered at 33 and has steadily maintained or slightly improved to 43.Source: Cox AutomotiveSourcing – Where do Used Vehicles Come From?To help explain the forces behind these metrics, let’s examine where used vehicles are sourced. Historically, used vehicles from an auto dealer were purchased from one of four areas: customer trade-ins, off-lease vehicles, fleet cars, and auctions.Trade-Ins – With plant shutdowns, microchip shortages, and supply chain issues, the supply of new vehicle inventory has been more adversely affected than its used vehicle counterpart. Average days’ supply for new vehicles dipped into the low 20s and dropped even lower for many local auto dealers. With fewer new vehicles to purchase, the number of customer trade-ins are also lower simply due to transaction volume and inventory availability.Off-Lease – Off-lease vehicles refer to a vehicle returned to a dealer at the end of its lease. Generally, off-lease vehicles have been gently used and tend to have lower mileage. Why are less leased cars being returned to the dealer? Most lease contracts have a clause where the consumer can purchase the vehicle at the end of the lease for a residual value. In most cases, the residual value is lower than the original value of the vehicle to reflect the depreciation of value.As discussed earlier, the value of used vehicles is at/near record highs. Many vehicles have a current value greater than the anticipated residual value stated in the original lease contract. Customers with leases face two choices: purchasing their vehicle for the residual value or returning the vehicle to the dealer at the end of the lease. Facing the inventory shortage conditions on both new and used vehicles and the prospect that the current value of their vehicle is greater than the residual value, most consumers are choosing to purchase the vehicle at the end of the lease. While others may purchase their leased vehicle and sell immediately to realize the arbitrage opportunity between the current value and residual value, most then face the prospect of locating and purchasing a more expensive vehicle. In either case, fewer off-lease vehicles are re-entering the used vehicle market.Fleet Cars – Fleet cars represent those vehicles sold to rental car companies, government agencies, or larger customer accounts. The trends affecting the current condition and the overall life cycle of these cars date back to the early days of the pandemic. In the Spring of 2020 with the advent of lockdowns and travel restrictions, rental car companies sold off much of their inventory which hit the used vehicle market at that time. Flash forward to the next 18 months that were characterized by plant shutdowns and lower sales by the OEMs in 2020, and then further inventory shortage issues caused by the lack of microchips and other factors in 2021.Historically, OEMs and the industry operated on an average days’ supply of new vehicles between 60-75. OEMs and auto dealers prioritized fleet sales with the extra inventory, as these contracts typically consisted of lower margins despite higher volumes. With the excess inventory being removed from the market, OEMs and auto dealers are now prioritizing direct consumers with the available inventory because they can achieve higher margins and offer fewer incentives. Fleet sales, and specifically rental car companies, have never been able to fully replenish their inventories. In turn, rental car companies no longer possess aging inventory that generally would get replaced and sold back into the used vehicle market. As a consequence, some rental companies are seeking to source their own used vehicles from auto auctions.The graphic below depicts total fleet sales from January through September for 2019, 2020, and 2021 as reported by Cox Automotive. While total fleet units are up slightly in 2021 from the same period in 2020, this figure is misleading when viewed in the context of more normal fleet sales in 2019. In fact, current year-to-date fleet sales are down nearly 41% over 2019 figures.Source: Cox AutomotiveAuto Auctions – Auto auctions are another source of used vehicles. The presence of auto auctions is also circular to the life cycle of the automobile. Auction cars come from various sources, including local car dealers, private sellers, police impounds, and bank repossessions. As detailed earlier in this post, the volume derived from the first two events has decreased simply due to the lack of overall transactions. Current economic conditions and forgiveness or grace periods have also led to fewer vehicles from the latter two events. If auto auctions are obtaining fewer cars, then auto dealers have fewer cars to potentially source from the auto auctions and the cycle and shortages continue.Predictions and ConclusionHow long can the good times (record profitability and margins) continue for the auto dealers and when will the bad times end for the consumer (high transaction prices and inventory shortages)? The simple answer is that they won’t continue like this forever, but no one knows when they will end. Many industry experts predict that the prevailing inventory and microchip shortages on the new vehicle side could last well into the first half or for the entire year in 2022 and beyond and will impact the used vehicle market for much of that time.For the used vehicle market, analysts at Black Book are predicting retail sales for the remainder of 2021 will equal or eclipse the levels for the same time period in 2019. Some analysts believe profit margins and transaction prices for used vehicles are already showing signs of moderating, despite some of those metrics still peaking. As a backdrop, 2019 is often considered by many as the best year ever for retail sales of used vehicles.For an understanding of how your dealership is performing along with an indication of what your dealership is worth amidst all of the noise, contact a professional at Mercer Capital to perform a valuation or analysis. Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business and how it is impacted by economic, industry, and financial performance factors.

How Does Your RIA’s Client Base Affect Your Firm’s Value, and What Can You Do To Improve It?

We’re often asked by clients what the range of multiples for RIAs is in the current market. At any given time, the range can be quite wide between the least attractive firms and the most attractive firms. The factors that affect where a firm falls within that range include the firm’s margin, scale, growth rate of new client assets, effective realized fees, personnel, geographic market, firm culture, and client demographics (among others).In this post, we focus on the client demographics factor, explain how buyers view client demographics and explore steps some firms take to reach a broader client base.Client relationships are one of the most significant assets that RIAs possess, and maintaining and profitably servicing these client relationships is key to an RIA’s financial success. In a transaction context, the strength of an RIA’s client relationships and the demographics of the client base can have a significant bearing on the multiple buyers will be willing to pay for the firm. An RIA’s outlook for future asset growth can be significantly impacted based on factors such as expected client retention, which stage current clients are at in terms of wealth accumulation (are they withdrawing assets or contributing assets), and the prospect for future liquidity events within the client base.Client relationships are one of the most significant assets that RIAs possess.Many of these factors can be proxied by the age profile of the client base. For most RIAs, the age of the client base tends to skew older (particularly on an asset-weighted basis) simply due to the fact that older clients generally have more assets. Decades of compounding returns can create some very large accounts for older clients, and the RIA can profitably service these accounts. However, with an older client base, the asset base usually declines as these individuals withdraw, rather than contributing additional funds. And, of course, the remaining life expectancy for older clients is less. As such, the age profile of the client base is a key area of inquiry for many buyers.Because an older average client base tends to suggest headwinds for future asset growth, an older client base is generally seen as a negative (all else equal) from a valuation perspective. In general, the younger the client base, the better the outlook for future asset growth and the higher multiple the firm commands. RIAs can expand their reach to a younger client demographic by focusing on retaining assets to the next generation and positioning themselves to appeal to a younger client demographic.Retaining Assets To Next GenerationIn general, RIAs are not particularly successful at retaining assets to the next generation. According to Cerulli, more than 70% of heirs are likely to fire or change financial advisors after inheriting their parents’ wealth. However, firms that prioritize engaging and developing relationships with next-generation family members today can significantly improve asset retention once the assets are transferred from the current client to the next generation. The earlier this is done, the better the chance at retaining assets into the next generation.Focusing on asset retention today is particularly important, given that more than $70 trillion is expected to transfer from older generations to heirs or charities by 2042. RIAs that can capture or retain these assets as they transfer to younger generations will have a competitive advantage against those that cannot.Attracting Younger ClientsA recent Wall Street Journal article highlighted the struggle many advisory firms face in attracting younger clients. See Rich Millennials to Financial Advisers: Thanks for the Golf Invite, but You Can’t Invest My Money. As the article suggests, many younger clients are electing to manage their own assets rather than hire a traditional financial advisor. While DIY investment management is popular among younger clients, many see this preference as temporary. Once these clients reach an asset or life stage threshold where their financial lives become more complicated, it’s anticipated that the need for traditional, personalized advice will increase.While attracting younger clients can be difficult, there are several strategies RIAs can use to position themselves to capture this emerging client segment. For one, RIAs should recognize that investment expertise is table stakes for attracting younger clients. These clients are often looking for financial coaching and holistic financial advice that goes beyond simple asset allocation. By offering these “soft” services in addition to traditional investment management, RIAs are better positioned to win younger clients.RIAs can also attract younger clients by hiring younger advisers. Anecdotally, advisers tend to attract clients within plus or minus ten years of their own age. Thus, having a broader age range of advisors can unlock younger client segments (and also contribute to the stability and continuity of the firm).RIAs can also attract younger clients by hiring younger advisers.RIAs can also revaluate which marketing strategies they are using to appeal to younger client demographics. As the WSJ headline suggests, golf invites have fallen by the wayside for most younger clients. While referrals and word of mouth are the traditional sources for new clients, having a strong online presence and digital marketing strategy is critical for attracting a younger client demographic.In order to effectively service accounts for a younger client demographic, RIAs may also want to reevaluate how they determine fees for these accounts. While the traditional percentage of AUM model works well for many clients, RIAs may find this model difficult to apply to a younger client demographic. For individuals still in the prime of their working career, it’s not uncommon to see a significant amount of their net worth tied up in privately held companies. The value of these assets is not generally included in AUM, and thus does not generate fee revenue. Other clients may have significant incomes and financial planning needs, but have not yet accumulated an asset base significant enough for an RIA to profitably service the account using a traditional percentage of AUM model. Many firms that have been successful at attracting a younger client demographic can offer alternative pricing arrangements to account for situations such as these.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides asset managers, wealth managers, independent trust companies, and related investment consultancies with business valuation and financial advisory services related to shareholder transactions, buy-sell agreements, and dispute resolution.

Themes from Q3 Earnings Calls

Part 1: E&P Operators

In Part I of our Themes from Q2 Earnings, an overarching narrative was an oil and gas industry reaching a relatively steady operational state, with efficiencies offsetting cost inflation and helping lead to growth in free cash flow despite the tumultuous past 18 to 24 months. These factors allowed most E&P operators to deleverage, and in some cases, also resume or increase their return of capital (either via dividends or share buybacks) to shareholders. In the latest earnings calls, these themes continue as the primary focus as we head towards year-end 2021. Some of the talking points in the Q3 earnings calls continue on the same trajectory as in Q2, such as maintaining capital discipline with flat or low growth in production volumes. However, there was more variance in the latest round of calls regarding E&P operators' possible approaches to fortify their value proposition to shareholders.Natural Gas ExportsAs noted in our recent blog post regarding natural gas prices and production levels, demand for U.S. LNG exports from European and Asian (primarily China) markets have resulted in elevated prices for natural gas despite the relatively high level of gas production coming from U.S. basins. This particular topic came up in several of the Q3 calls."We've talked in the past about the nearly 550,000 barrel a day increase in petchem demand in China from 2021 to 2023 and over 110,000 barrels a day of European and North American PDH growth during that same time period. What many did not anticipate was the global pressure for hydrocarbons this fall and winter that resulted in elevated LNG prices in Europe and Asia. This is driving additional demand for LPG in these markets through its use in industrial heating and power applications in lieu of today's high cost of natural gas. On a BTU equivalent basis, LPG is nearly half the price of LNG delivered in the Far East markets. The impact from this incremental demand for LPG is a widening export arb." – David Cannelongo, Vice President of Liquids Marketing & Transportation, Antero Resources"We're going to continue to look at new opportunities from an LNG standpoint and are very well-positioned. Again, it gets back to our transport, our export capacities, and just having that ability to transact, we can definitely be very nimble as we think about new opportunities." – Lance Terveen, Senior Vice President – Marketing, EOG ResourcesMany Paths to the Value PropositionPerhaps the most significant divergence in the Q3 E&P operator calls compared to the Q2 calls stemmed from how the management teams viewed their value proposition to shareholders. Global energy prices were shaken in early 2020 with the onset of the COVID-19 pandemic, with prices retreating further when the discussions regarding renewal of the OPEC+ production/price cooperation pact, a 3-year plan that was set to expire at the end of Q1 2021, fell apart as Moscow refused to support Riyadh's demand for additional production cuts. As energy prices recovered amid a background of heightened uncertainty in the global economic and financial markets, E&P operators tightened their belts and took this opportunity to enact highly disciplined capital programs in order to extract greater free cash flow from flat production levels.For some companies, the value proposition to shareholders remains focused on either increasing the intrinsic value per share via share repurchases or returns to shareholders through dividend programs."As we continue to trade at a material discount to our intrinsic per share value as we see it, we steadily increased our attention on share count reduction. And Q3 was a good example of this. Approximately 60% of free cash flow was returned to shareholders in the form of buybacks. We continue to see a significant opportunity to retire additional shares in what we believe to be currently attractive prices. And as a result, on October 25, earlier this week, the Board has increased our share repurchase authorization by $1 billion, now having a sizable share repurchase authorization at our disposal." – Nicholas Deluliis, President & CEO, CNX Resources"I don't want to get ahead of my Board, but I would say at Murphy, we're more tuned to dividend and getting our dividend back. We're a dividend payer for 60 years. And that would be best for us. And, of course, a variable dividend, I suppose, can come into that mix. And I would say at this share count, that would be the basis today." – David Looney, CFO, Murphy Oil For other E&P operators, the name of the game moving forward is flexibility to deliver returns to shareholders through share repurchases and dividend programs."In mid-September, our Board approved a $2 billion share repurchase program. After that announcement, we repurchased over 268,000 shares at an average share price of $82 for a total cost of $22 million in the third quarter. If we do not repurchase enough shares in the quarter to equal at least 50% of free cash flow for that particular quarter, then we will make our investors whole by distributing the rest of that free cash flow via a variable dividend. This strategy gives us the ability to be flexible and opportunistic when distributing capital above and beyond our base dividend, but importantly, at least 50% of free cash flow will be returned." – Travis Stice, CEO, Diamondback Energy Perhaps most interestingly, a handful of companies cited additional sources of future shareholder value, setting their sights on opportunities to be had out in the field, be it through acquisition activity or plans to enhance their exploration program.[Regarding the November 3rd announcement of Continental Resources's agreement to purchase Delaware basin assets from Pioneer Natural Resources] "We focus every day on maximizing both shareholder and corporate returns. The Permian Basin acquisition will be an integral contributor to these shareholder return plans. Possibly most importantly, this Permian transaction is projected to add up to 2% to our return on capital employed annually over the next five years. The acquisition of these assets strongly supports the tenants of Continental's shareholder return on investment and return of investment, dividends and share repurchases." – William Berry, CEO, Continental Resources"After weathering two downturns during which we did not cut nor suspend the dividend, the new annual rate of $3 per share reflects the significant improvement in EOG's capital efficiency since the transition to premium drilling. Going forward, we are confident in our ability to continue adding to our double-premium inventory without any need for expensive M&A by improving our existing assets and adding new plays from our deep pipeline of organic exploration prospects, developing high-return, low-cost reserves that meet our stringent double premium hurdle rate, expands our future free cash flow potential and supports EOG's commitment to sustainably growing our regular dividend." – Ezra Yacob, CEO, EOG ResourcesConclusionMercer Capital has its finger on the pulse of the E&P operator space. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.

In the Market for a Good Used RIA?

8 Tips for Being a Buyer in a Seller’s Market

Last week I got an email from the finance company that holds the lease on my car announcing that the “countdown had begun.” My lease ends in May, and the manufacturer was encouraging me to start thinking about my next vehicle – even offering to waive the $575 lease disposition fee if I terminated the lease early. Strange, I thought. Given the scarcity of new vehicles in the market, why is the manufacturer’s finance company offering me incentives to join the line of people who want but can’t get a new car?Eager to uncover the motivation for this surprising act of Teutonic generosity, I reviewed my lease agreement to see if I could solve the mystery. Knowing I had the option the buy the car at the lease’s stated residual value, I also checked some used car listings for comps with the age and mileage my roadster will have in May. This exercise suggested my car will be worth about 40% to 50% more than what I could buy it for at the end of the lease. So, my call option is in the money, and the finance company is keen to let me surrender that option to them.Alas, my good fortune isn’t all that good. If I choose to buy-and-hold my car at the end of the lease, I can’t monetize the option. If, instead, I buy-and-trade my car for something else, I may get market value, but I’ll have to find something to buy. These days that will cost me both in terms of time and money. At this point, the only thing I know for sure is that I won’t be returning my car to the finance company. Sorry fellas.In the Market for a Good Used RIA?A couple of times a week, we get calls from someone we’ve never met saying they’d like to talk with us about their RIA acquisition strategy. About half are RIAs or trustcos looking for expansion, and the other half are private equity or family offices. Very few are calling because they have a particular target in mind; fewer still have begun the process of negotiating with a potentially interested seller.If your acquisition strategy these days is starting from scratch, you’re in a tough spot. There’s nothing on the lot, and what is available looks expensive. That doesn’t mean you should give up, though. Here are some practical tips to pursue an acquisition strategy in this market environment, as well as the markets to follow.Build relationships. Sellers faced with a dozen potential suitors often exhibit a common behavior: they don’t know what they like – they like what they know. Sellers are drawn to preexisting relationships, even when the offer from those parties doesn’t quite measure up to other offers. This makes a lot of sense given that selling an RIA often means going into business with the buyer for several years. Acquisitions are a process, not an event, so get to know the people you might want to be in business with – early and often. It’ll help you win the auction – or avoid it altogether.Deliver what you promise. The most frustrating part of the transaction process is when counterparties (or their advisors) don’t meet deadlines. If indications of interest are due on Friday, don’t call on Friday to ask for more time. You might get it, but you’ll also earn a reputation for not meeting expectations, which will make sellers leery of dealing with you. Sellers are usually represented, and buyers often aren’t. If you need professional assistance in pursuing an acquisition, get them on board so that you’ll maximize your opportunity.Consider alternative structures. Not every seller needs or even wants a check. Some want a partner. Some want your stock. Some want a joint venture. Ask questions about the underlying needs of the seller to find out how you can creatively accommodate their needs and meet yours as well. Winning a deal isn’t always about being the high bid – it’s about being the best bid.Accept pricing for what it is. For lots of very rational reasons, pricing in the RIA space is high. It might not be quite as high as reported, because everyone in the deal community is motivated to dress up the multiples as much as possible (we’ve written before about reported versus pro forma numbers, pricing with and without earn-outs, the impact of rollover equity, etc.). But, like prices for new and used cars, RIAs are worth top-dollar. Neither situation is going to resolve itself anytime soon. Microchip availability may drive the supply/demand imbalance in automobiles for years. Low interest rates and a flood of PE capital may do the same for RIAs.Turn your acquisition strategy on its head. If you accept the fact that this is a seller’s market, why do you want to be a buyer? Think about selling - or merging - into a larger firm. As part of a larger buyer, you’ll have more support (talent and capital) for building through acquisitions, and you’ll have the benefit of firsthand experience as a seller.Don’t get caught up in FOMO. There is a frenzy to buy RIAs, but that doesn’t mean you have to be part of it. Discipline still matters. Some buyers are so desperate to acquire an RIA that they’re willing to look at “opportunities” that don’t make any sense. Remember that opportunity is a two-way street. The bull market of the past twelve years has redeemed a lot of bad acquisitions in the RIA space. These days, everybody on the buyside feels smart.Don’t wait for the market to become rational. If you’re sitting this “period” out because you’re waiting for valuations to come down, find another reason. Prices may drop – but it may be a long time from now. If paying full freight for acquisitions doesn’t suit you, I won’t judge you. But don’t base your expectations for the future on the hope that things will change. They may not change.You might do better on your own. For most firms, organic growth is the best growth. Competing for acquisitions is hard, and integrating them is even harder. Conventional wisdom these days is that organic growth opportunities in the RIA space are narrowing and growth is slowing. But conventional wisdom yields conventional results. If you can devise a way to generate organic growth, you’ll gain control over your future – and a standout presence as a target one day. Shortages and tight markets are more the exception than the rule right now. I’ve heard an emerging theory in fixed income that rates will stay “lower-for-longer.” If so, yield starved investors of all stripes will be drawn to the growth and income characteristics of RIAs – which will keep multiples “higher-for-longer.” Whether or not this turns out to be the case, the shortage of acquisition opportunities in investment management firms will likely outlast the shortage of microchips that’s plaguing car manufacturing, such that even scratch-and-dent RIAs will remain pricey. As a buyer, you can’t entirely sidestep this problem, but you can pursue some basic tactics that will help – both now and in the future.

October 2021 SAAR

October 2021 SAAR was just shy of 13.0 million, as new light vehicle sales saw their first month-to-month gain since April. The October SAAR is up 6.3% from last month but remains 20.8% lower than last October. Auto dealers began the month with record low inventory levels of 972,000 units, and low inventories continue to keep car buying activity constrained. Dealers are pre-selling a significant amount of the new inventory they receive as they attempt to satisfy demand. According to Thomas King, President of Data and Analytics, nearly 54% of vehicles will be sold within 10 days of arriving at a dealership.As of now, there is no expectation that inventory on the lot will increase anytime soon. There is some optimism around the industry that inventory levels will slowly increase throughout 2022, but it is likely that these inventories will remain below pre-COVID levels for the foreseeable future. Based on our discussions with dealers and reading of the tea leaves, we think it’s reasonable OEMs will see heightened profits under the status quo and seek to structurally tweak how much inventory is kept on dealer’s lots going forward. In October, prices have continued to rise and OEM incentive spending has continued to fall. This has been the case for several months now, and dealers have been realizing record profitability on vehicles sold for some time. If it seems like there are new profitability records being set every month, it is because there have been. Average incentive spending per unit has hit another record low of $1,628 in October. Total retailer profit per unit is on pace to reach another record high of $5,129 as well, the metric’s first time above the $5,000 mark. For perspective, this is an increase of $2,937 (more than double) from a year ago, and total aggregate retailer profits, a measure of the industry’s profitability as a whole, is up 213% from October 2019, reaching $4.8 billion. This October was the most profitable October on record for auto dealers, and it is likely that November will yield some of the same, if not better, results. Inventory shortages and record profitability are not the only persistent conditions in which auto dealers are operating. Fleet sales continue to be outpaced by retail sales, accounting for only 142,000 units over the last month. Trucks and SUVs are on pace to account for a record high 80.9% of new vehicle retail sales in October as well. As far as new vehicle prices are concerned, transaction prices on the average new car reached another record high of $42,921. While supply and demand imbalance plays a role in these increasing prices, we note the mix of vehicles is also important. Trucks tend to be more expensive than cars, so the mix continuing to shift towards higher profit trucks leads to higher transaction prices. The moral of the story is that October proved to be more of the same for auto dealers across the country, and most dealers are still thriving in a low inventory–high price environment. Microchip Background and UpdateMany OEMs, dealers, and research analysts following the industry have been looking ahead to try and predict when the ongoing inventory shortage might begin to improve. As we have mentioned earlier in this blog and on previous blog posts, the current estimate seems to be around the middle of 2022 at least, depending on your definition of improvement. One important determinant that many are looking at is the state of the semiconductor industry.Semiconductors, referred to by many as microchips or chips, are the brains behind electronic devices. As more electronic devices are being produced each year around the globe, the semiconductor industry has struggled to keep pace with demand for some time now. The rise of 5G technology can be blamed for increased demand, as well as increased demand from industries that have traditionally been semiconductor-free (auto makers can be included here, although chips have been common in new vehicles for years now). Another driver of increased demand is the rising number of semiconductors needed per manufactured unit across the many affected industries. For example, just one car can have anywhere from 500 to 1,500 different semiconductors. As we discussed previously, the pandemic exacerbated issues with people stuck at home reaching for electronics as a means of entertainment.The increased demand mentioned above, paired with supply chain disruptions have set up the perfect storm for a semiconductor crisis. The crisis is hitting OEMs particularly hard, as many manufacturers are announcing major slowdowns and stoppages during the fourth quarter of 2021. We have not touched on the geopolitical ramifications of the semiconductor shortage, although the sourcing of these chips going forward will be an important factor to keep an eye on.Toyota Motor recently announced that it was on pace to produce 40% fewer cars and trucks in October as a result of the chip shortage. This marks the second month in a row that Toyota slashed production estimates. GM, Ford, and Stellantis, who have all dealt with intermittent shutdowns over the last 6 months, account for 855,000 units of reduced vehicle production. Particular models from these OEMs that have been severely affected are Ford F-Series trucks, the Jeep Cherokee, the Chevy Equinox, and Chevy Malibu. Given that this crisis is becoming the single most important factor in getting vehicles on dealer lots, many executives are being asked when they think the supply chain for semiconductors will reach pre-pandemic levels.A Volkswagen executive recently released a statement, saying that “Without a doubt, this shortage is going to go well into 2022, at least the second half of '22."Likewise, Ford CFO John Lawler said that Ford is “doing everything we can to get our hands on as many chips as we can. We do see the shortage running through 2022. It could extend into 2023, although we do anticipate that the scope and severity of that to reduce.”Executives of the other major OEMs are echoing these concerns as all OEMs face similar challenges in securing chips for their vehicle production. That being said, the industry is prepping for an extended waiting game and cannot do much to produce more units in the meantime than what is allowed by current semiconductor inventories. While auto dealers are bearing the brunt of consumer frustration over the higher prices and lower availability, at least profits are up.ForecastLooking ahead to next month and the remainder of the year, we expect that the sales pace of the industry will continue to be constrained by the procurement, production, and distribution problems outlined above. From a dealer’s standpoint, inventories will most likely continue to be sold within days of arriving on the lot. However, the number of incoming units is not expected to materially change in November. Essentially, dealers can expect more of the same.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact a member of the Mercer Capital auto team.

NADA Is Busy Working on Capitol Hill on Behalf of Auto Dealers

In last week’s blog, we wrote about attending some of the Tennessee Automotive Association meetings and explored the buy/sell considerations discussed there. That topic is certainly timely for auto dealers, as record profits are the norm rather than the exception during the ongoing inventory shortages and supply chain disruptions. However, transaction considerations were not the only updates that attendees received. This week’s blog touches on federal legislation that NADA prioritizes and how that legislation could impact your dealership's operations.Tax Hikes That Impact DealershipsOne of NADA’s top priorities has always been to keep taxes low for dealerships, and that mission has not changed. In their outlined legislative priorities, NADA states that it is concerned that significant tax hikes will weaken the nation’s auto industry. Specifically, NADA is opposed to the tax structure currently laid out in the pending House Reconciliation Bill. Here is a breakdown of the potential tax changes included in the bill that could affect your dealership:Most auto dealerships are tax pass-through entities, and the current blended tax rate on pass-through earnings is about 29.6%. This tax rate accounts for the 20% Qualified Business Income (QBI) deduction, individual income taxes, and a Net Investment Income (NII) tax.According to NADA, if the House Reconciliation Bill were passed as proposed, the blended tax rate on pass-through earnings could be as high as 43.4%. The QBI deduction would reduce, corporate and individual income taxes would increase, and the NII tax would expand to essentially all pass-through income.From a valuation standpoint, higher tax rates reduce after-tax cash flows to auto dealers, which all else equal would lead to lower values for auto dealerships.No one wants to pay more than their fair share of taxes, and NADA is lobbying to improve the rates at which dealerships are exposed to them. Like all business owners, auto dealers would see lower after-tax proceeds that could be reinvested in their business. While NADA is lobbying on behalf of auto dealers, this is an issue that hits businesses across all industries, and it appears to be a legislative priority for the White House.From our perspective, we find it likely that taxes will increase from current levels, though just how much of an increase might occur and the timing of the increase remains to be seen. Dealers should be aware of the tax law changes and prepare accordingly. From a valuation standpoint, higher tax rates reduce after-tax cash flows to auto dealers, which all else equal would lower auto dealerships' values.Electric Vehicle Incentives Need to Work for DealersOn September 15th, the House of Representatives, Ways and Means Committee, approved a new electric vehicle incentive program as another part of the pending House Reconciliation Bill. This program supports tax credits to consumers for purchasing an electric vehicle and would increase the tax credit from $7,500 to $12,500. The bill would also make the tax credit “transferrable”, meaning that the dealership could claim the incentive and the consumer could treat that incentive as “cash on the hood”.NADA is concerned that dealerships are being asked to front-load the credit on these transactions and wants to make sure that the IRS pays the full value of these credits to dealerships in a timely manner. Dealers will remember this cash drag as an issue during the Cash for Clunkers program. Additionally, NADA wants to ensure that every franchised brand receives the benefits of these incentives, meaning that no one gets left out. From a valuation standpoint, we know certain brands change hands at higher blue sky multiples than others. If only certain brands were able to participate in a program that benefits dealerships, those brands could see better multiples in the short term.Further incentivizing consumers to purchase vehicles is almost always a positive thing for dealers. If the IRS is accurate and timely with its payment of EV credits, the program could be a success, but if credit payments become unreliable or too sluggish, dealers may choose not to participate in the program and lose sales to competitors.Treasury Should Grant Lifo Tax Relief for DealershipsLast November, NADA petitioned the Treasury Department to exercise its authority by allowing dealerships that use LIFO (Last-In, First-Out) inventory accounting to replace their new vehicle inventories over a three-year period. This request responds to LIFO recapture taxes that are expected to heavily impact dealers in the current environment of rising prices but declining inventories.While prices are generally expected to increase over time, inventory levels are also expected to remain somewhat constant or slightly increase over time as well.Many, though not all, auto dealers report their inventory on a LIFO basis. This typically leads to lower reported taxable income because inventories sold are based on the last price. In a typical inflationary environment, this means the cost of goods sold is higher under LIFO than FIFO.While prices are generally expected to increase over time, inventory levels are also expected to remain somewhat constant or slightly increase over time as well. However, during the recent supply shortages, inventory balances have dropped considerably, affecting dealers’ reported LIFO reserve more drastically than many dealers would expect.An example is provided below of how a dealer may have been impacted in 2020. However, because the supply chain issues have further devolved since this case was presented in December 2020, the income reported by dealers in 2021 is expected to be considerably higher due to accounting and not cash flow. Dealers should not hold their breath when it comes to the possibility of avoiding LIFO recapture taxes. The request was submitted by NADA a year ago and Treasury Department has not formally responded to the petition yet. While unique supply chain issues may be negative in the near-term, eventually inventory balances will rebuild, which would lower future tax bills. In essence, dealers on LIFO would be forced to pay taxes on front-loaded phony profits, which would eventually smooth out. Dealers that are subject to LIFO recapture could use the forgiveness as a chance to invest in replenishing inventory, EV infrastructure, and employee training. While this is clearly a negative for dealers, it is our understanding, legislators (generally speaking) would prefer to do away with LIFO entirely, so we do not anticipate much accommodation. It is more likely that subjected dealers should begin preparing for a larger-than-usual tax bill, though some options may exist. From a valuation standpoint, LIFO recapture is unlikely to impact valuations materially. Many valuation professionals already adjust to FIFO, so this would already be normalized whether it is positive or negative to cash flow in any particular period. As with many pieces of legislation or contemplated legislation, LIFO may impact the motivations of buyers and sellers, though it will have less impact on the determination of ongoing cash flows. ConclusionNADA is busy working on Capitol Hill on behalf of auto dealers, but the organization’s influence can only go so far. This makes it even more important that dealers know the legislative issues that could affect their dealership ahead of time and regularly communicate with their local politicians. Being proactive instead of reactive can make a big difference when running an auto dealership, making it worth the dealer’s time to stay plugged in.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Sharing Growth & Spotlight

Natural Gas & Renewables Join the D-CEO Awards Stage in Dallas

Mercer Capital’s energy team sponsored and attended the D-CEO 2021 Energy Awards in Dallas last week, October 26, 2021. It was a great event and a good opportunity to connect with clients, peers, and industry leaders in the energy space. Awards ranged from honoring top executives, including Scott Sheffield of Pioneer Energy, to private equity firm innovators like Pearl Energy Investments.Oil, Natural Gas, and RenewablesThe focus of the night was the interdisciplinary threads between oil, natural gas, and renewables. “Sustainability and profitability are not mutually exclusive,” said Vikram Agrawal of EarthxCapital who participated on a panel alongside Joe Foran, CEO of Matador Resources. According to the panelists, renewables and natural gas are to be watched as the energy mix needs evolve in the U.S. and around the world. As an example, natural gas fuels about 40% of our power in the U.S. according to Agrawal.If the move goes towards more electrification, as illustrated by the news this week that Hertz has ordered 100,000 Tesla electric vehicles, there will be a need for 20% - 40% more power in the next 20 years. As we’ve discussed before, the current trajectory of renewables appears unable to meet these demand growth needs. Therefore, cleaner-burning natural gas will be a key contributor. One panelist mentioned the exception was hydrogen as a potential contributor. Interestingly, this was echoed in comments on the latest Dallas Fed Energy Survey: “The more I become educated on EVs [electric vehicles] and the charging and battery disposal problems, the more I think they will have little effect on the market in the future. My investigation turns more toward the hydrogen cell as the long-term solution.”No matter what the source, recent price growth suggests that more investments will be needed. The panel also stated that oil and gas investment will drop 26% from pre-pandemic levels to $356 billion in 2021. Various sources, including Exxon, suggest that this figure needs to increase to around $600 billion by 2040.Optimism for investment opportunities was not limited to upstream, but also infrastructure, with nearly $18 trillion in investment opportunities for energy transmission alone.Interesting Tidbits & StatisticsWithin the theme of investment opportunities, renewables, and natural gas, several interesting factoids from the evening emerged (in no particular order):1.Electric Vehicles and Charging StationsHow many electric vehicles are there for every charging station in the U.S.? The current ratio is 17Many think this ratio needs to be closer to 10 (there are about 42,000 charging stations in the U.S. right now – many at hotels and other overnight destinations)The Biden Administration suggests we need 500,000. Agrawal thinks the real number is 1,000,000 to 1,500,0002.Electric Cars Are Not a New ThingDid you know that 120 years ago, nearly one-third of our cars were electric? Granted there were only 4,000 cars at the time. Did you also know that Thomas Edison invented the first electric-powered car?3.Investment in the Space Is Picking UpSo far this year 35 SPACs acquired businesses worth $100 billion4. What Do “Net Zero” or “Carbon Offsets” Really Mean? According to a Wall Street Journal article, only 5% of “carbon offsets” actually remove carbon.ConclusionThanks to our clients, friends, and partners that we saw at the event. It was fabulous and nostalgic to be getting out again! And thanks to D-CEO for putting on a great event. Until next time!

Public Alt Asset Managers Have Nearly Doubled in Value Over the Last Year

Hedge Funds and Private Equity Firms Capitalize on Market Volatility and Growing Investor Appetite for Alt Asset Products

Industry Overview and HistoryOver the last year, alternative asset managers have bested the market and most other categories of investment management firms by a considerable margin. Favorable market conditions, heightened volatility, strong investment returns, and growing interest from institutional investors are the primary drivers behind the sector’s recent rally. Our alt manager index actually doubled from October of 2020 to August of this year before giving back some of these gains during the market downturn last month. Before this uptick, many alternative asset managers had struggled over the last several years. Asset outflows, the rising popularity of passive products, fee pressure, and underperformance relative to broader market returns had caused many hedge funds and PE firms to lag other investment management sectors. Industry valuations appear to have bottomed out with the market collapse during the first quarter of last year and have since rebounded. Growing investor appetite for risky assets with purported diversification benefits has fueled a fairly substantial turnaround for the sector over the last eighteen months or so. Current pricing is close to the 52-week high, and forward multiples are noticeably lower than LTM multiples, suggesting peaked valuations and expected earnings increases over the next twelve months. While hedge funds have underperformed since the Financial Crisis (the S&P 500 index has dwarfed the performance of hedge funds as measured by the HFRI Fund Weighted Composite Index since 2009), recent volatility has improved their performance on a relative basis. Hedge fund capital typically lags its underlying fund performance, so the market seems to be anticipating that higher inflows in the coming months as investors reallocate their portfolios in light of recent performance. Alternative assets often serve to either increase diversification or enhance portfolio returns. In a near zero interest rate environment, institutional investors have sought return-generating assets. Over the last couple of years, pension funds have started diversifying their portfolios to include alternative investments in order to chase higher risk, higher return assets. It is more difficult for the average investor to gain exposure to alternative assets due to significant minimum investment requirements. While some efforts have been made to expand distribution to the retail market, institutional investors are still the primary target market for alternative managers. Over the last couple of years, pension funds have started diversifying their portfolios to include alternative investments in order to chase higher risk, higher return assets.Over the last several years, alternative asset managers have been largely successful at securing a spot in institutional investors’ portfolios. In terms of diversification, investors have started positioning themselves for longer term volatility due to the pandemic and a slowing IPO market. While investor interest in uncorrelated asset classes such as alternatives fell during the longest bull market run in history (2009-20), recent volatility has pushed investors back to the asset class.Franklin Resources’s (ticker: BEN) recently announced purchase of private equity firm Lexington Partners for $1.75 billion is illustrative of growing interest from more traditional asset managers in the alt space.Practice ManagementToday, the main priority for most alternative asset managers is raising assets. Assets follow performance and fee reduction, especially in the alternatives space, are the most consequential ways to attract fund flow. After a decade of lackluster performance, alternative managers have had no choice but to look to price reduction to bring in new assets. Amidst fee pressure, alterative managers are deviating from the typical “2 and 20” model.While traditional asset managers have been able to reduce fees by achieving some measure of scale, alternative managers must be careful to not sacrifice specialization. Alternative managers have seen some success utilizing technology in the front office or outsourcing certain functions in order to reduce overhead and spare time for management to focus on asset raising.SummaryDespite improving performance over the last year or so, the alt asset sector continues to face many headwinds, including fee pressure and expanding index opportunities. While the idea of passively managed alternative asset products seems like an oxymoron, a number of funds exist with the goal of imitating private equity returns. Innovative products are being introduced to the investing public every day. And while there is currently no passive substitute to alternatives, we do believe that the industry will continue to be influenced by many of the same pressures that traditional asset managers are facing today, despite the recent uptick in alt manager valuations.

Value Drivers in Flux

Last July I gave a presentation to the third-year students attending the Consumer Bankers Association’s Executive Banking School. The presentation, which can be found here, touched on three big valuation themes for bank investors: estimate revisions, earning power and long-term growth.Although Wall Street is overly focused on the quarterly earnings process, investors care because of what quarterly results imply about earnings (or cash flow) estimates for the next year and more generally about a company’s earning power. Earning beats that are based upon fundamentals of faster revenue growth and/or positive operating leverage usually will result in rising estimates and an increase in the share price. The opposite is true, too.For U.S. banks that have largely finished reporting third quarter results, questions about all three—especially earning power—are in flux more than usual. Industry profitability has always been cyclical, but what is normal depends. Since the early 1980s, there have been fewer recessions that have resulted in long periods of low credit costs. Monetary policy has been radical since 2008. What’s normal was also distorted in 2020 and 2021 by PPP income that padded earnings but will evaporate in 2023.Most banks beat consensus EPS estimates, largely due to negligible credit costs if not negative loan loss provisions as COVID-19 related reserve builds that occurred in 2020 proved to be too much; however, there was no new news with the earnings release as it relates to credit.Investors concluded with the release of third and fourth quarter 2020 results that credit losses would not be outsized. Overlaid was confirmation from the corporate bond market as spreads on high yield bonds, CLOs and other structured products began to narrow in the second quarter of 2020 as banks were still building reserves.As of October 28, 2020, the NASDAQ Bank Index has risen 78% over the past year and 39% year-to-date.Much of that gain occurred during November (October 2020 was a strong month, too) through May as investors initially priced-in reserve releases to come; and then NIMs that might not fall as far as feared as the yield on the 10-year UST doubled to 1.75% by late March. Bank stocks underperformed the market during the summer as the 10-year UST yield fell. Since late September banks rallied again as investors began to price rate hikes by the Fed beginning in 2022 rather than 2023.No one knows for sure; the future is always uncertain. For banks, two key variables have an outsized influence on earnings other than credit costs: loan demand and rates. In other industries the variables are called volume and price. If both rise, most banks will see a pronounced increase in earnings as revenues rise and presumably operating leverage improves. Street estimates for 2022 and 2023 will rise, and investors’ view of earning power will too.We do not know what the future will be either.Loan demand and excess liquidity have been counter cyclical forces in the banking industry since banks came into being.The question is not if but how strong loan demand will be when the cycle turns. Interest rates used to be cyclical, too, until governments became so indebted that “normal” rates apparently cannot be tolerated.Nonetheless, at Mercer Capital we have decades of experience of evaluating earnings, earning power, multiples and other value drivers. Please give us a call if we can assist your institution.

The Tricks and Treats of the Buy/Sell Process from a Selling Dealer’s Perspective

Fall District Meeting Roundup

Fall is upon us. The weather is getting cooler, the leaves are changing colors, football is in full swing, the World Series is beginning, and Halloween is right around the corner. For auto dealers this year, Fall may also be a sign of change.As we’ve written in this space, 2021 has been largely profitable for dealers, despite unique challenges. A combination of good fortunes, high blue sky multiples, consolidation in the industry, the onset of electric vehicles, proposed tax law changes, and other factors can have many dealers contemplating their future.October and November are also when many state auto associations hold their District Meetings to discuss timely topics with their dealer members. We recently attended a series of District Meetings in Tennessee and the topic at hand seemed to revolve around potential transactions.In the spirit of Halloween, we review some of the buy/sell considerations (from the perspective of the selling auto dealer) that were discussed at the district meetings. For those statements that are true, we will classify them as TREATS and provide additional commentary. For those statements that are false, we will classify them as TRICKS and provide additional commentary.TREAT - Timing Is EverythingDeciding whether to sell your dealership or continue to hold on to it should be a conscious decision. Don’t wait until you have to sell. Dealers should consider the following areas in their decision-making process:Family – What are the ages and current health status of the operating dealer and his/her spouse? Does the dealer have any children that are either active in the business or are capable of eventually running the business?Market – What are the prevailing market conditions? Is this a good time to sell or a bad time to sell? As we have discussed numerous times during 2021, the M&A market has been very active for auto dealers. Despite operating challenges with COVID and inventory supplies with the chip shortage, auto dealers have posted record or near-record profits. Favorable operational results combined with increased blue sky multiples have yielded a frenzy in the valuations of some dealerships.OEM/Brand – What conditions is the dealer currently facing with their own OEM? Has the brand been favorable in recent history, or does the dealership represent an OEM that has faced production issues or the inability to release attractive vehicle models? Is the OEM demanding additional image requirements? How is the OEM responding to the electrification of vehicles and how will they involve the traditional dealership moving forward?Monetary – What are the unique financial needs of the operating dealer and his/her family? Is the perceived value of the dealership equal to or greater than the offers in the marketplace? Are there sizable capital projects on the horizon needed to compete with other dealership groups or with OEM demands?TRICK - An Auto Dealer Contemplating a Sale Should Hire a Business BrokerTransactions can be very complicated and complex. A selling dealer should hire capable professionals to assist in the process. These professionals should include a transaction attorney and a CPA at a minimum. These roles shouldn’t automatically be filled by your existing professionals if those professionals aren’t seasoned in transactions of auto dealerships.Should the selling dealer hire a business broker?It depends.Not all business brokers can be helpful to the process. Be careful and selective about whether to hire a business broker, and if so, which business broker to hire. If the buyer or target is already identified, the business broker may not be necessary. Be cautious of business brokers that want to establish a long-term exclusive relationship. The selling dealer wants to maintain privacy and confidentiality about their potential decision to market their dealership. Some business brokers might market the dealership to everyone around town which can cause uncertainty and strain to existing employees and might cause harm to the value of the dealership if the seller loses the leverage of their decision.Business brokers can be helpful as can industry-specific valuation specialists like Mercer Capital. One obstacle to any potential transaction is the value or price of the dealership. Dealers may have an indication of what their store might be worth, but often a valuation is crucial to manage expectations or assist in the negotiation of price with the potential buyer.TREAT - A Selling Dealer Must Prepare for a Potential Sale Prior to the Transaction ClosingDealers that are contemplating a sale should begin to take steps to prepare for the eventual transaction. Some of those steps consist of the following:Capital Projects Pending – Are there capital projects that need to be completed or are required by the OEM? Has the dealer recently completed an image requirement or are additional requirements pending? The status of the facilities and capital projects can greatly affect the price paid for the dealership in a transaction.Key Personnel – Identify the key employees that you want to retain during the process and/or those the buyer might want to retain. The future success of a dealership can be impacted by key employees and department heads. Selling dealers might consider granting special bonuses to these key individuals to keep them focused during this process. A potential buyer would not want to see a hiccup in financial performance or turnover in key personnel during the process.Customer Obligations – Selling dealers should examine their long-term customer obligations. Are there any “warranties for life” such as free lifetime oil changes or obligations to provide loaner vehicles to prior owners or immediate/distant family members? A potential buyer would want to know their exposure in these areas and may not wish to continue these arrangements.Existing Contracts/Contract Renewals – Selling dealers should review their existing contracts. How long will they continue or are any set to expire? Key contracts would include the Dealer Management System (DMS) among others. Selling dealers must balance opposing factors with contracts: not wanting to experience an interruption during the transaction process versus renewing a long-term contract that a perspective buyer would not view as attractive or valuable.Environmental Survey – Does the dealership have any exposure to environmental issues? A selling dealer should complete an environmental survey at the beginning or during this process. Environmental concerns for dealerships usually involve in-ground lifts, underground storage tanks, and oil/water separators.TRICK - A Selling Dealer Should Inform Their OEM That They Are Contemplating a Potential TransactionSimilar to the decision regarding whether to hire a business broker or not, the decision to inform the OEM should be diligently thought out.Should a dealer inform their OEM that they are contemplating a transaction?Again, it depends.A selling dealer wants to maintain privacy and confidentiality within their community and their workforce. An OEM or area manager might inform other dealerships of the news of your potential sale, or the information could make its way back to your key employees. Selling dealers will want to continue consistency in operations and performance and maintain their leverage in their possible sale to ensure the highest success and value for a transaction. Conversely, the OEM will need to be informed at some point because they will ultimately have to approve the dealer principal after a transition.TREAT - A Buyer’s Due Diligence Is Essential to the Transaction ProcessDue diligence refers to the part of the process where the potential buyer collects and analyzes certain information from the seller, including financial statements and other reports, in an effort to make a decision about conducting the transaction and to ensure that a party is not held legally liable or any loss or damages. Key elements of the due diligence process include the following:Financial Statements – Buyers will typically want to review at least three prior years to gain an understanding of the dealership’s historical performance and an expectation of anticipated future performance. Sellers will want to make sure they have complete and accurate financial statements to aid in the transaction process.Existing Litigation – Prospective buyers will want to know of any pending litigation with any customers or employees.Environmental Assessment – As previously discussed, a buyer will want to know if there are any pending environmental liabilities. If a selling dealer had a survey performed recently it can keep the process moving and not cause any interruption waiting for a survey to be completed.Facilities Inspection – Buyers will want to inspect the physical premises of the dealerships. Buyers will also inquire and inspect the status of current conditions in light of OEM imaging requirements.TRICK - The Character of the Buyer Is Not Important to the TransactionOne might think that if a prospective buyer can be located at an agreeable price, then the process is over. However, the seller should be concerned with the character of the buyer. What is the buyer’s reputation with other stores that he/she operates? Has the buyer ever been involved in lawsuits with their OEM, their employees, or with other sellers in previous transactions? Has the buyer ever been turned down by an OEM for approval as a dealer principal in a previous transaction or transition?In most cases, a dealer may only sell a dealership once in their lifetime. Chances are they have established a legacy within their local community and with their employees. Despite exiting after a transaction, dealers do not want to see their reputation and legacy diminished.ConclusionMercer Capital can assist auto dealers that are contemplating a sale by joining the team of professionals involved in a transaction. Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business and how it is impacted by economic, industry and financial performance factors. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

RIA M&A Q3 Transaction Update

RIA M&A Activity Continues to Reach Record Highs

Despite the dip in the second quarter of 2021, RIA M&A activity continues to reach record highs putting the sector on track for its ninth consecutive year of record annual deal volume. The same three demand drivers discussed last quarter persisted throughout the third quarter of 2021: (1) secular trends, (2) supportive capital markets, and (3) looming potential changes in the tax code. While fee pressure in the asset management space and a lack of succession planning by many wealth managers continues to drive consolidation, looming proposals to increase the capital gains tax rate has accelerated some M&A activity in the short-term as sellers seek to realize gains at current rates. Increased funding availability in the space has further propelled deal activity as acquisitions by consolidators and direct private equity investments increased significantly as a percentage of total deals during the recent quarter. Private Equity Drives RIA M&AWe’ve written extensively on the prominence of acquisitions by private equity backed consolidators in the RIA industry. Over a decade of rapid growth and persistent profitability has established a class of RIAs with institutional scale as well as an influx of new entrants. According to a recent study by McKinsey, in 2020 there were 15 retail-oriented RIAs eclipsing $20 billion in AUM while approximately 700 new RIAs were started annually over the past five years. This dynamic of a handful of large, financially mature firms surrounded by a highly fragmented market has attracted immense buying activity from private equity sponsors looking to leverage the number of established firms with expertise and scale available to acquire lower valuation, high growth RIA firms in the earlier stages of development.... a handful of large, financially mature firms surrounded by a highly fragmented market has attracted immense buying activity from private equity sponsorsThree-quarters of Barron’s 2020 top 20 RIAs are owned by private equity firms or other financial institutions. Notable examples such as Focus Financial (backed by Stone Point Capital prior to IPO), HighTower Advisors (Thomas H. Lee Partners), Wealth Enhancement Group (TA Associates), and Mercer Advisors (Oak Hill Capital Partners) accounted for an outsized share of total deal volume during the third quarter of 2021, and the percentage of total acquisitions made by consolidators increased from 50% to over 70% of all transactions in the past quarter. Direct investments in the third quarter also reached an all-time high for a total of 12 transactions. Such interest from private equity backed buyers continues to support high valuation multiples.2021 RIA-to-RIA transactions as a percentage of total deal volume is expected to be at a ten-year low largely due to the increase in acquisitions made by consolidators and private equity direct investments. Increased competition for deals favors consolidators who have dedicated deal teams, capital backing, and experience to win larger transactions, and even multiple large transactions simultaneously. The trend is evidenced by increased AUM size per deal, which is on track to reach a record high for the fourth consecutive year. While this is partially a result of increased AUM due to strong market performance, Echelon Partners notes that the persistent increase is also likely due to the deep pocketed supply of capital by sophisticated buyers which has caused demand for acquisitions to outpace the supply of firms looking to sell.While systemic factors continue to be a primary driver of RIA deal activity, the surge in acquisitions made by financial buyers has led some to question the sustainability of recent M&A highs. Notably, while deal volume increased to record levels in September 2021, investor sentiment for RIA consolidators was mixed during the same period as investors have expressed concern about rising competition for deals and high leverage which may limit the ability of these firms to continue to source attractive deals in the future. Private equity buyers, and consolidators acting as private equity portfolio companies, are motivated by investment opportunity. As financial buyers flock to opportunities, they drive up valuations and simultaneously diminish IRR. Recent private equity and consolidator interest in the UK market exemplifies the saturated valuations in the U.S. market as buyers have begun to seek out cheaper entry points abroad.The RIA industry remains highly fragmented and growing.While deal volume has continued to reach new highs for nearly a decade now, there continues to be ample supply of potential acquisition targets (although not all of these firms are actively looking to sell today). The RIA industry remains highly fragmented and growing with over 13,000 registered firms and more money managers and advisors who are capable of setting up independent shops. Systemic trends and strong buyer demand will likely continue to bring sellers to market, and for now, there are no signs that momentum in deal activity is stalling anytime soon.What Does This Mean for Your RIA Firm?If you are planning to grow through strategic acquisitions, the price may be higher, and the deal terms will likely favor the seller, leaving you more exposed to underperformance. That said, a long-term investment horizon is the greatest hedge against valuation risks. As discussed in our recent post, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth compared to broker-dealer counterparts and other diversified financial institutions.If you are considering an internal transition, there are many financing options to consider for buy outs. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and in some instances may still be the best option), but bank financing can provide the selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs.If you are an RIA considering selling, valuations stand at or near historic highs with ample demand from buyers. That said, it is important to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. A strategic buyer will likely be interested in acquiring a controlling position in your firm with some form of contingent consideration to incentivize the selling owners to transition the business smoothly after closing. Alternatively, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Sellers looking to leverage the scale and expertise of a strategic partner after the transaction may have many buyers to choose from.

Natural Gas Production Levels Are High, But So Are Prices

There’s been much coverage of the run-up in oil prices since November 2020, from $37/barrel (WTI) to current prices in excess of $80/barrel. That of course ignores the April to October 2020 $28/barrel recovery from the Covid/OPEC+/Russia-induced oil price death plunge during the February to April 2020 period. Now it seems that it’s natural gas’s turn at the price run-up game.While Henry Hub (a benchmark for natural gas prices) also showed a post-Covid recovery from its March to June 2020 lows (near $1.60/MMbtu) to prices generally in the $2.60 to $3.00 range from October 2020 to May 2021, it has since been on a run that has taken it to recent highs over $5.70. So, what gives? In this week’s blog post, we address the market forces that have led to higher natural gas prices despite near record U.S. natural gas production levels.Production Is High, So Why Are Prices Rising?Per U.S. Energy Information Administration (EIA) data, 3Q2021 U.S. natural gas production neared its prior peak level, and EIA analysts expect that production will reach new record highs during 3Q2022. With such high production, basic economic theory would suggest that natural gas prices should be facing downward pressure. However, there’s the demand side of the equation to consider as well. Since the 2020 Covid-induced demand decline, the increase in natural gas demand has exceeded production recovery. Therefore, a supply versus demand imbalance has pushed prices up at an unusual rate. Why Not Just Increase Production to Satisfy Demand? A natural question to be asked is, why wouldn’t the gas producers simply increase production to meet the heightened level of demand? That’s where an interesting set of factors come into play, with one such factor being future gas price expectations.Why wouldn’t gas producers simply increase production to meet demand? Future gas price expectations.Tsvetana Paraskova, writing for OilPrice.com, notes that producers in Appalachia, America’s largest gas-producing basin, are expecting stronger pricing signals in the future curve for gas prices a year or two from now. As such, to some extent, those producers are looking at to (i) invest now to boost production for which they’ll receive current prices, or (ii) delay that investment to boost production until later when they’re expecting to sell the same volumes at higher prices. Depending on their level of confidence in those higher future prices, they may be significantly incentivized to hold off on those volume boosting investments. Furthermore, Peter McNally, with the consulting firm, Third Bridge, reminds us that the more recent trend among oil and gas investors in preferring more near-term return on investment (current distributions to investors), rather than more drilling (with larger distributions down the road), has pressured the producers to ease back on their drilling programs that would otherwise help maintain production levels.Where Is Demand Coming From?A natural question to be asked is, where is all the demand side pressure coming from? The answer, in large part, is exports. While the U.S. has exported natural gas via pipeline for many years, the capacity for LNG exports has ballooned in recent years and reached record levels in 2020 and 2021. Two regions are driving demand for U.S. LNG exports. The first is Europe. After the much colder than usual winter, natural gas inventories remain well below typical seasonal levels. As a result of the lower inventories, Europeans are paying four to five times as much for natural gas relative to what is being paid in the U.S. That creates quite the incentive for U.S. produced natural gas to be exported, rather than staying within the country. The second is China. Reuters reports that China has become concerned in regard to its country-wide fuel security and is facing a winter fuel supply gap. That, in the midst of Asian gas prices that have increased more than 400% in 2021, has led to advanced talks between top Chinese energy companies and U.S. LNG exporters for the purpose of locking-in future U.S. LNG export volumes. What Does This Mean for the U.S.?As a result of the indicated supply and demand forces at play, Reuters reports that power crunches are already hitting large economies such as China and India. While the impact in the U.S. (so far) has been relatively modest, expectations are for U.S. consumers to spend much more to heat their homes this winter. In the U.S., nearly half of homes use natural gas for heating purposes, as natural gas has traditionally been the most economical source for heating residences. The U.S. Department of Energy estimates that those homeowners will pay 30% more for natural gas this winter compared to last winter.What Are the Ripple Effects of Higher Natural Gas Prices?While home heating is a more straight-forward result of the higher natural gas prices, there are numerous ripple effects that are far less obvious. Natural gas is a key input to a number of industries where higher natural gas costs will naturally be passed through to consumers. Bozorgmehr Sharafedin, Susanna Twidale and Roslan Khasawneh, with Reuters, note several such industries including steel producers, fertilizer manufacturers, and glass makers having been forced to reduce production due to the higher natural gas prices.Industrial Energy Consumers of America, a trade group representing chemical, food and materials manufacturers has even urged the U.S. Department of Energy to limit U.S. LNG exports in order to ease their member firms’ energy-related expenses. Food producers in particular are reporting shortages of CO2 (a byproduct of fertilizer production) that is used in packaging processes, meat processing, and even for putting the “fizz” in carbonated drinks and beer. As a result, prices for those types of products are already on the rise.ConclusionAs indicated, the market forces at work in the supply and demand for U.S.-produced natural gas are many, and come from both domestic and foreign sources. The current supply/demand gap has pushed natural gas prices to recent record levels, with the impacts being both obvious in winter heating costs, and not so obvious in higher food and beverage prices. Keep reading this blog as we continue to track natural gas pricing and other energy-related industry topics.Mercer Capital has significant experience valuing assets and companies in the energy industry. Our energy industry valuations have been reviewed and relied on by buyers, sellers and Big 4 Auditors. These energy related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed energy industry valuations domestically throughout the United States and in foreign countries.Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Asset / Wealth Management Stocks See Mixed Performance During Third Quarter

After a Strong Summer, Public Asset Managers See Stock Prices Dip as Market Pulls Back in September

RIA stocks saw mixed performance during the third quarter amidst volatile performance in the broader market. In September, the S&P 500 had its worst month since March 2020, and many publicly traded asset and wealth management stocks followed suit.Performance varied by sector, with alternative asset managers faring particularly well over the last quarter. Our index of alternative asset managers was up 10% during the quarter, reflecting bullish investor sentiment for these companies based in part on long-term secular tailwinds resulting from rising asset allocations to alternative assets.The index of traditional asset and wealth managers declined 4% during the quarter, with performance reflecting the pullback in the broader market. RIA aggregators experienced a volatile quarter, but ended flat relative to the prior quarter end. The performance of RIA aggregators may be reflective of mixed investor sentiment towards the aggregator model. While the opportunity for consolidation in the RIA space is significant, investors in aggregator models have expressed mounting concern about rising competition for deals and high leverage at many aggregators which may limit the ability of these firms to continue to source attractive deals. Performance for many of these public companies continued to be impacted by headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. These trends have especially impacted smaller publicly traded asset managers, while larger scaled asset managers have generally fared better. For the largest players in the industry, increasing scale and cost efficiencies have allowed these companies to offset the negative impact of declining fees. Market performance over the last year has generally been better for larger firms, with firms managing more than $100B in assets outperforming their smaller counterparts. As valuation analysts, we’re often interested in how earnings multiples have evolved over time, since these multiples can reflect market sentiment for the asset class. After steadily increasing over the second half of 2020 and first half of 2021, multiples pulled back moderately during the most recent quarter, reflecting the market’s anticipation of lower or flat revenue and earnings as the market pulled back and AUM declined. Implications for Your RIAThe value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with privately-held RIAs should be made with caution. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds such as fee pressure and asset outflows to passive products. Many smaller, privately-held RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.The market for privately held RIAs has remained strong as investors have flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer. Deal activity continues to be significant, and multiples for privately held RIAs remain at or near all time highs due to buyer competition and shortage of firms on the market.Improving OutlookThe outlook for RIAs depends on several factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are somewhat tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has remained strong despite volatility over the prior quarter. AUM remains at or near all-time highs for many firms, and it’s likely that industry-wide revenue and earnings are as well. Given this backdrop, many RIAs are well positioned for strong financial performance in the fourth quarter.

Interpreting Inflation and Interest Rates for Auto Dealers

Can Retail Vehicle Prices Continue to Soar?

Inflation and interest rates are on more people's minds lately due to supply chain disruptions across all industries. People understand how inflation and interest rates affect their daily lives when noticing the rising cost of goods/services and the cost to borrow money to buy a house, but many don't realize that inflation and interest rates are interconnected. Inflation and interest rates are frequently linked when discussing macroeconomics and they tend to have an inverse relationship. When interest rates go up, in theory, inflation goes down. However, there are many more factors other than inflation and interest rates impacting the economy in the real world.In this post, we discuss how we got to our current reality, what auto dealers might expect regarding inflation and interest rates, and how it all might impact the dealership.How Did We Get Here?Back in April, Federal Reserve Chair Jerome Powell indicated the Fed wasn’t close to raising interest rates, labeling inflation as “transitory.” At the time, he cited strengthening economic indicators, including employment and household spending and continued vaccinations which were expected to ease uncertainty and continue the economic recovery.According to Powell, “An episode of one-time price increases as the economy reopens is not likely to lead to persistent year-over-year inflation into the future.” Further, the Fed indicated that clogged supply chains would not affect Fed policy as they were seen as temporary and expected to resolve themselves.While this transitory stance appeared reasonable at the time, confidence in this stance has waned and the Fed has begun signaling it would end its accommodative policies. Below we’ve included the first chart and table in the September edition of the Consumer Price Index (“CPI”) published by the Bureau of Labor Statistics last Wednesday (October 13, 2021).Source: Bureau of Labor Statistics- Consumer Price Index-September 2021Source: Bureau of Labor Statistics- Consumer Price Index-September 2021In our view, the graph of 12-month change supports the transitory view, at least in the beginning. Comparing prices in April 2021 to April 2020 is not very meaningful given the significant impediments to the economy at the time. However, as seen in the tables above, inflation has persisted on a monthly basis over the past six months. While 0.3% and 0.4% growth in the past two months is an improvement over March through July, it shows that the problem continues to linger.Are inflationary pressures still expected to be brief and transitory?On Tuesday, the day before September inflation numbers were published, Atlanta Federal Reserve President Raphael Bostic indicated inflationary pressures “will not be brief” and that he and his staff would no longer refer to inflation as transitory. Notably, Bostic is a voting member of the 2021 Federal Open Market Committee, and his public statement is the first to our knowledge challenging the transitory narrative. However, it shows how the Fed has evolved its stance over the past six months.In March, the Fed signaled it wouldn’t raise the Federal Funds rate until at least 2024. In June, the Fed stood by its transitory stance but began to indicate rate hikes would come sooner as the dot plot of expectations from FOMC members indicated two rate hikes in 2023. By September, half of Fed policymakers are expected to start raising rates in 2022, as seen below. While the timing of rate hikes is uncertain, it appears that accommodative policy will be eased in the not so distant future. What does that mean for auto dealers? Impact of Inflation on Auto DealershipsNotably for auto dealers, used vehicle prices surged by over 10% month-over-month in both April and June, which accounted for about a third of the total increase in the CPI for those periods. According to Cox Automotive Chief Economist Jonathan Smoke back in July, used vehicles were “the poster child illustration for transitory price hikes." While used vehicle prices, according to the CPI, have come back down to Earth in recent months, including decreases of 1.5% and 0.7% in the past two months, new vehicles have seen monthly growth of at least 1.2% since May due to supply shortages.New and used vehicle retail prices continue to climb to all-time highs. Even despite lower volumes, dealers are seeing higher revenues. Through August 2021, the average dealership was getting $3,668 in retail gross profit per new vehicle retailed. Through April of this year, that figure was $2,906 indicating a widening of profits for dealers on a per unit basis. This has played a role in the outsized profits achieved by auto dealers in 2021, who are likely wondering how long this can last.In our view, prices will continue to rise in the short-term due to supply constraints. However, consumers are becoming increasingly aware of these higher costs, and new vehicle buyers are likely delaying purchases if they are able to wait. While businesses across all industries are able to point at supply shortages and COVID as reasons for higher prices right now, at some point buyers will leave the market to wait for prices to normalize.While retail vehicle prices will eventually begin to level off, dealers are likely to remain in a strong position because dealerships have numerous complimentary profit centers. But how long will it last?While retail vehicle prices will eventually begin to level off, dealers are likely to remain in a strong position. As we’ve discussed before, auto dealerships have numerous complimentary profit centers. If a customer can’t find the new vehicle they want, a deft salesman can get them into a used vehicle. When consumers delay purchases of a vehicle, they put more mileage on their current vehicle, driving business to the higher margin service and parts operations. With fewer vehicles put on the road in 2021 due to shortages, we see a runway for more vehicle sales, even if the profit per unit declines. In the medium term, parts and service may be the area to watch. Fewer vehicle sales means parts and service will eventually dip in the future, though this likely won’t be felt for a few years. It will also be interesting to see where consumers get their vehicles serviced after purchasing from online used vehicle retailers that don’t have these operations. Along with the factors already mentioned, the future path of inflation for vehicles will likely also be impacted and interconnect to the path taken by interest rates.Impact of Interest Rates on Auto DealershipsAccording to an interesting Lexington Law study on how Americans are buying cars, auto loans are used on 85% of new car purchases and 53% of used car purchases nationwide. When interest rates fall to the prevailing low levels, consumers are able to afford more expensive cars. However, the mathematical movement of lower interest rates doesn’t necessarily mean consumers will correspondingly purchase a more expensive car. Similarly, when interest rates rise, that doesn’t mean vehicle prices have to decline. Still, dealers should be aware that this is the case, at least in theory.Interest rates matter. Auto loans are used on 85% of new car purchases and 53% of used car purchases nationwide.In practice, F&I departments can smooth out rising interest rates or rising vehicle prices by extending the length of loans. According to Lexington Law study, the amount of the monthly payment was the top priority for the average car buyer. It is natural for people to consider their monthly out-of-pocket costs and what they can afford, even if it leads to a longer loan term or higher interest rates. We should also note that APR and total interest paid are similar considerations, which when combined, amount to almost half of the decision.Source: Lexington Law | Study: How Are Americans Buying Cars?Rising interest rates will increase costs to consumers and if they’re on a fixed budget, this places downward pressure on vehicle prices. In December 2015, the Fed raised rates for the first time since the Global Financial Criss. Dealers will have to lean on their past experience on how to navigate vehicle sales in an environment of rising interest rates. Interest rates don’t only affect top line revenues for dealerships, however. The prevailing low interest environment and inventory shortage has significantly reduced one key operating expense for auto dealerships: floor-plan interest expense. Lower interest rates mean the price of keeping inventory on the lot for test drives is lower. With lower levels of inventory, interest expense is being reduced by volume as well as price. With inventories expected to normalize and interest rates expected to creep up, auto dealers will see floor plan expenses rising. It may not get back to pre-COVID levels if OEMs structurally change the level of inventories kept on dealers’ lots, but that’s another topic for another blog post.ConclusionMercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business and how it is impacted by the greater macroeconomic environment. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Chesapeake Finds Vine Ripe for the Picking

In August, Chesapeake Energy Corporation announced that it would acquire Vine Energy Inc. in a stock-and-cash transaction valued at approximately $2.2 billion. We previously discussed Vine’s IPO, which was the first upstream (non-minerals, non-SPAC) initial public offering since Berry Petroleum’s debut in mid-2017. Vine’s decision to be acquired in a ~0% premium transaction less than five months after its IPO speaks to the difficulty for E&P companies to manage public market dynamics even in a much-improved commodity price environment. In this post, we dig into the transaction rationale, look at relative value measures, and analyze how this transaction seems to indicate a shift in Chesapeake’s strategy.Transaction RationaleChesapeake’s acquisition generally follows the recent upstream M&A playbook: mostly stock, low-to no-premium, and a focus on cost synergies.Cash consideration of $1.20 per share represents 8% of the $15.00 total consideration per share. It is somewhat curious that there’s a cash component to the purchase, especially for a company that recentlyemerged from bankruptcy in a transaction that doubles the company’s leverage. However, even with the cash outlay and assumption of Vine’s debt, Chesapeake management indicates that the pro forma entity will have a relatively modest net debt to 2022E EBITDAX ratio of 0.6x.Based on market data, immediately prior to announcement, the transaction consideration represents a <1% premium to Vine’s stock price. While that may not seem like a great deal for shareholders, the 92% stock consideration means that legacy Vine shareholders should benefit from any synergies achieved by the transaction. On the announcement date, market reaction was generally positive, with both Vine and Chesapeake outperforming the broader upstream universe (as proxied by the SPDR S&P Oil & Gas Exploration & Production ETF, ticker XOP). As for those synergies, management expects to save $20 million per year on general & administrative and lease operating expenses, with another $30 million per year in capital efficiencies, resulting in an annual savings of $50 million per year. Valuation ConsiderationsRelative value measures for the transaction are shown in the following table: As with any transaction with a stock component, the transaction consideration is dynamic and fluctuates with the acquirer’s stock price. The initial transaction consideration of $15 per share was only $1 higher than Vine’s IPO price. But with the run-up in natural gas prices and continued exposure via stock consideration, Vine has recently traded at all-time highs and is now within its initial IPO offer range. Chesapeake Shifts Back to Natural Gas RootsChesapeake has historically focused on natural gas production. However, in the wake of persistently low natural gas prices from roughly 2010-2020, the company sought to diversify its production mix and become more oil focused. In pursuit of this goal, the company was particularly active on the M&A and A&D front, with actions including the sale of itsUtica assets in Ohio and acquisition of Eagle Ford producer WildHorse Development Corporation. Ultimately, the company overextended itself and entered bankruptcy in mid-2020. After emerging from bankruptcy earlier this year, management indicated that investment activity would be focused on natural gas assets. The timing seems apt with the recent increase in natural gas prices. The acquisition of Vine will stem Chesapeake’s recent trend of production declines and materially increase its natural gas mix. ConclusionVine’s brief stint as a public company looks to be coming to an end. With natural gas stealing the spotlight from crude oil, Chesapeake is seeking to return to its former glory as America’s natural gas champion. The combination with Vine will make Chesapeake a dominate force in the Haynesville and support the company’s pivot away from oil.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

“Permanent” Capital Providers Offer a Different Type of RIA Investor

Beginning With No End in Mind

Several pre-pandemic years ago, my family and I enjoyed a long vacation in England, touring the usual castles, cathedrals, and museums. At some point in the trip, my kids noticed that many of the buildings we toured and historical objects we saw were in some way tied to, owned by, or were on loan from, the royal family. Whether it was Windsor Castle, the Crown Jewels in the Tower of London, or the Bentley limousines garaged at Buckingham Palace, much of what you see as a tourist in England is recorded on Her Majesty’s balance sheet.I took the opportunity to point out to my kids that a reliable way to accumulate wealth was to invest in assets you would never want to sell, and then don’t sell them. The best assets tend to remain the best, and the avoidance of transaction costs removes a drag on returns that everyone – in my experience – underestimates.The increased prominence of “permanent” capital providers in the RIA space takes me back to the multi-generational buy-and-hold strategy of the royals, not just because of the avoidance of transaction costs but also because of the premium entry prices being paid. In 1852, Prince Albert and Queen Victoria paid £32,000 for a vacation home now known as Balmoral Castle. What was that price relative to market? I don’t know, but 170 years later, it doesn’t matter.GPs at private equity conferences once liked to boast about their success in booking “gains on purchase” – a clever way of saying they could buy at a discount to market. No one talks that way in the RIA community these days. If anything, I’m struck by how sponsor-backed acquirers are willing to state, publicly, their willingness to outbid each other. I won’t call anyone out with specific examples, but they aren’t hard to find.RIAs are probably the best coupon available in a low-to-no yield environment.It’s as if a land-grab is underway, with competing interests looking to consolidate as much market share in the investment management community as they can, as fast as possible. The trouble is that RIAs are a sort of land that is actually still being manufactured. Despite the rampant consolidation in the space, the number of RIAs is steadily on the increase. Nevertheless, there is legitimate cause for enthusiasm.As we’ve written many times in this blog, investing in the RIA space represents a singular opportunity. RIAs are probably the best coupon available in a low-to-no yield environment. They are a growth and income play like none other. They are practically the apotheosis of diversification in a way that Harry Markowitz could have only dreamed of when he started publishing his research nearly 60 years ago.Unfortunately, many reasonable ambitions, stretched far enough, eventually become wellsprings of regret.Returns and valuations are inversely related, after all. An unfettered willingness to pay more is just a race to the bottom on ROI. Financial engineering doesn’t repeal the laws of financial gravity. Taking more and greater risks leads to a greater variability of outcomes. Paying more compresses returns. To my way of thinking, this isn’t prudent – but I’m not paid to manage capital.Professional investors must work in the market they have, not the market they want. It’s all well and good to talk about “patient” capital, but LPs aren’t going to pay 200 basis points for someone to hold their cash, regardless of how advisable that might be. Given that mandate, the question of whether to make investments at these levels pivots to how best to do it. What opportunities are available in the present – and potentially lingering – environment of high entrance multiples?Financial engineering doesn’t repeal the laws of financial gravity.I’ll posit that the rise of “permanent capital” providers is both in response to and appropriate for current market conditions in the RIA space. This is in sharp contrast to the prevailing “fund” behavior in the private equity community, in which LPs commit capital for a specified length of time – ten years or so – and fund managers have to make investment decisions with an expectation of being in and out of an investment in less time than that – say five to seven – to generate the kind of ROI it takes to raise the next fund.Anyone who’s spent a few moments (or a career) with DCF models knows that there are a limited number of levers to pull to rationalize a high entry price with a five-year holding period. You can assume supernormal growth (unlikely in a mature space like investment management), high exit pricing (multiple arbitrage - aka the greater fool theory), squeezing margins (underinvestment), or low discount rates (race to the bottom on ROI).The other possible lever is, of course, leverage. Debt can enhance equity returns so long as it doesn’t wipe them out entirely. Unfortunately, it’s only in hindsight that we know what leverage ratio is (or was) optimal.Making a permanent capital investment doesn’t eliminate the depressive effects of current valuations on returns, but it mitigates them. Without the pressure to generate an exit within the foreseeable future, RIA investors can focus on the opportunities for sustainable and growing distributions. The longer distributions persist and the more they grow, the less of an impact the entry price has on total return.Further, without the financial friction of trading out of an investment in a few years and the costs and risks of reinvestment, the opportunity for superior returns – especially relative to those available at similar risk elsewhere in the current market – is greater.The question of how long “permanent capital” lasts is a good one. The investors backing many of these enterprises tend to be insurance companies with very long time horizons. The thousand-year outlook of William the Conqueror probably isn’t relevant to investing in RIAs, but the mindset of an indefinitely lengthy holding period leads permanent capital sponsors to different decision making, which may prove useful in times like this. It’s hard to think long term when the M&A headlines keep coming, but the business cycle has a lot of staying power. In this market, investors need staying power as well.

The Evolution of E&P ESG Scores

Trends from 2016-2020

As quarterly earnings calls have come and gone over the past several years, the frequency with which environmental, social, and governance topics are explicitly discussed have been ever-increasing. On the whole, ESG topics are sector and industry agnostic. While not all ESG topics come into play equally for every sector and industry, there are always some elements, issues or characteristics of any given company or industry that could be put into at least one, if not all, of those three buckets.Within the E&P space–and the oil and gas sector overall–operators have increasingly included ESG talking points in their management commentary, signaling proactive initiative rather than reactive response. One could argue this approach helps to lead the discussion by addressing what they can do, are doing, and will do, as opposed to having to answer to why they are not taking actions to mitigate some issues that were determined or assumed to be a priority by an outside party.Regardless of the impetus for ESG topics entering the zeitgeist, the result is an increase in self-reporting by E&P operators as to what they’re doing to improve, or at least address, noted ESG concerns.Naturally, however, the noble action of self-reporting does not mean the stated or signaled information is accurate or fully reflects all known or knowable information. Of course, it should not be assumed that such information is inherently or purposefully misleading either. Sometimes you take it with a grain of salt; sometimes you empty the shaker or season to taste.Given the potential for obfuscation, though, it helps to have a more objective party discern what information is verifiable and accurate, as far as that may be determinable. One such platform, S&P’s Global Market Intelligence, provides such ESG evaluation services, including the provision of ESG scores to gauge where companies stand with respect to their self-reporting.In this post, we take a brief look at several ESG criteria among E&P operators to see what trends may be present among the operators with the highest and lowest ESG scores, as provided by Global Market Intelligence.Total ESG ScoresIt is far beyond the scope of this article to explain the machinations and processes that underlie the production of the ESG scores determined by Global Market Intelligence. For simplicity, we consider the ESG scores in an ordinal and relative way. For example, if Company A and Company B have ESG scores of 10 and 20, respectively, it is not to say that the self-reporting by Company B is twice as good as Company A’s reporting, but simply that Company B reports more information which can be verified.The other side of the coin is that, in theory, a company could be a model example of ESG stewardship, but still have an ESG score of 0 if it doesn’t self-report or may not provide information that is readily verifiable. This would not be a likely scenario, but again, “in theory…”.Note that, in addition to a company’s “Total” ESG score, there are scores for the respective E, S and G groups, with more granular scores for specific criteria within each of those three buckets. We will refer to the Total ESG scores, as well as scores for three criteria that represent the environmental, social, and governance groups, respectively.We utilized the Global Market Intelligence platform to screen for U.S. E&P operators with market capitalizations over $10 million (as of October 6), with 124 resulting companies. We then pared this list down to 12 operators that consistently had annual Total ESG scores from 2016 to 2020 (the latest data available), presented as follows:Click here to expand the image aboveGenerally, the list is presented in ascending order, with the lower-scoring operators towards the top and higher-scoring operators towards the bottom.As may be gleaned from the chart above, the three lowest scoring E&P operators, on average, were Diamondback Energy, Continental Resources, and Coterra Energy.1The three highest scoring operators, on average, were Hess Corporation, ConocoPhillips, and Ovintiv (formerly Encana Corporation).We note that the ESG scores among the lowest-scoring companies all declined from 2016 to 2020, with Continental Resources’ and Coterra Energy’s scores among those with the greatest decline among the entire group of companies presented. The ESG scores for ConocoPhillips and Hess Corporation were approximately at the 3rd quartile with respect to their “growth”, while Ovintiv’s ESG scores showed a moderate decline from 2016 to 2020. Although we do not discuss Pioneer Natural Resources in depth here, we do note that it exhibited the greatest growth in its ESG score from 2016 to 2020.E, S, and GAs mentioned earlier, each of the environmental, social, and governance groups have respective subsets of criteria which are surveyed, analyzed, scored, and weighted by Global Market Intelligence. For example: criteria within the environmental group includes items such as “biodiversity,” “climate strategy,” and “water related risks”; the social group includes criteria such as “social impacts on communities,” “human capital development,” and “human rights”; and the governance group includes criteria such as “brand management,” “marketing practices,” and “supply chain management.”One environmental criterion we looked at was climate strategy, 2 with the company ESG scores as follows:Click here to expand the image aboveOnly 3 companies had ESG scores for this criterion that indicated improvement from 2016 to 2020. However, the growth between these two periods masks the development of these scores in the interceding periods. Notably, the score for Diamondback Energy dipped in 2018 and 2019, but returned to the levels seen in 2016 and 2017. Furthermore, several companies, including EOG Resources, Pioneer Natural Resources, Marathon Oil, and Ovintiv all showed significant improvement in the score from 2019 to 2020.Last, but not least, we reach the criterion selected representing the governance topics: policy influence.3Click here to expand the image aboveAs you will notice, all companies had “NA” in place of scores in 2016, indicating this criterion was not included on the Global Market Intelligence survey that year. We note that these scores objectively focus on the extent of the verifiable public disclosure related to the companies’ contributions to political campaigns, lobby groups, and trade associations which may influence the policies affecting industry operations and regulations; these scores do not indicate levels of financial contribution or subjective perspectives regarding levels of influence in promoting or interfering with any particular policy.On the HorizonMoving forward, it will be interesting to compare the objective ESG scores with the quantity and quality of the information divulged and discussed in E&P operators’ earnings calls. Presumably, the ESG scores should rise in tandem with the greater levels of discussion and disclosures in the calls. We may find out soon enough with the upcoming earnings call season, as Diamondback Energy, Continental Resources, EOG Resources, Pioneer Natural Resources, Marathon Oil, and EQT Corporation regularly make appearances in our quarterly blog post, Earnings Calls - E&P Operators.ConclusionMercer Capital has its finger on the pulse of the E&P operator space. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.1 We note that the results of our company screen included E&P operators which may have had an “na” in place of a Total ESG score in one of the years from 2016 to 2020, in which case these companies were excluded from the companies listed above. There are several reasons this may occur (most likely, a lack of self-reporting for whatever reason in that particular year), but we selected the presented companies to focus on E&P operators which have made a concerted effort to self-report with consistency in the recent past.2 From Global Market Intelligence: “Most industries are likely to be impacted by climate change, albeit to a varying degree; consequently, they face a need to design strategies commensurate to the scale of the challenge for their industry. While most focus on the risks associated with a changing climate, some seek to identify and seize the business opportunities linked to this global challenge. The questions in this criterion have been developed in alignment with the CDP methodology as part of a collaboration between us and CDP https://www.cdproject.net.” We note that CDP is a not-for-profit charity that runs a global disclosure system for investors, companies, cities, states and regions to manage their environmental impacts.3 From Global Market Intelligence: “Although companies legitimately represent themselves in legislative, political and public discourse, excessive contributions to political campaigns, lobbying expenditures and contributions to trade associations and other tax-exempt groups may damage companies’ reputations and creates risks of corruption. In this criterion, we evaluate the amount of money companies are allocating to organizations whose primary role is to create or influence public policy, legislation and regulations. We also ask for the largest contributions to such groups, and we assess the public disclosure on these two aspects.”

September 2021 SAAR

September 2021 SAAR was 12.2 million, dropping for the fifth consecutive month amidst an ongoing inventory shortage. The September SAAR was the lowest since May 2020’s 12.1 million units but has not fallen near the COVID-19 pandemic low of 8.6 million units in April of 2020.Tight inventories limited both fleet and retail sales in September, which has been the same case over the last four months. Fleet sales continue to fall as a percent of total sales, making up just 12% over the last month, as higher profit retail sales continue to be prioritized.As mentioned in last month’s SAAR blog, auto dealers started the month with industry-wide record low inventory levels of 1.06 million units. Inventory levels have not improved much since then, but the industry inventory to sales ratio has modestly ticked up from 0.68 to 0.72. This could be explained by sales rates finally slowing down and keeping pace with production rates. High levels of demand and low supply have been coexisting for months, and there are only so many new vehicles to go around as consumers are increasingly pre-ordering vehicles before they even arrive on dealers’ lots. While high prices are keeping away certain customers that have decided to wait, wider margins are keeping dealers profitable. However, at current production rates there are only so many vehicles being produced by OEMs that can make it to the lot, and high trade-in values and wide margins can only do so much to bridge the gap for dealers that may not have a new car to sell to a potential trade-in customer down the line. In response to the current climate, average transaction prices have continued to rise. The average transaction price of a new vehicle is expected to top $42,800, another all-time high and the fourth straight month that prices have exceeded $40,000. Dealers have taken advantage of high prices to sustain profitability by achieving high margins on each vehicle sold for months now, and the factors involved continue to benefit dealers. For example, average incentive spending per unit is expected to reach another record low of $1,755 per vehicle, down from $1,823 a month ago, driving GPUs up even further. Another factor that influences dealer profitability, inventory turnover, decreased again as well. The average time that a new vehicle sat in the lot during September was 23 days, down from 25 days in August and 54 days in September 2020 reducing floor plan interest expense. What Do Tech Investments By OEMs Mean For My Dealership?In a previous blog outlining the different options that dealers have when allocating capital amidst excess liquidity, a few options were highlighted. Dealers can either 1) reinvest in the business, 2) return capital to debt and equity stakeholders or 3) seek acquisitions to drive growth. These fundamental decisions apply to OEMs as well, and over the last several months many OEMs have decided to reinvest in the core operations of the business by shifting their focus to electric vehicles.Listed below are narratives of some of the investments OEMs have made and how they might affect the value of your privately held dealership.Nissan has developed a new technique for assembling vehicles more efficiently and with less waste. This technique, called SUMO, enables Nissan to produce vehicles 10% cheaper than before, despite them manufacturing increasingly complex vehicles like hybrids and EVs.General Motors is developing a supply chain for rare-earth metals for the production of EVs, a move expected to pave the way for a more reliable stream of General Motors EVs in the future.Ford has also reinvested in EV operations, and has recently partnered with Electrify America, ChargePoint and others to bolster its charging network.Ford has also announced a state-of-the-art production facility that is set to be built in west Tennessee, creating 5,800 positions to produce electric F-150 trucks. The plant is also said to be a zero-waste-to-landfill facility. The point is that almost every major vehicle manufacturer is investing in the future of its EV production process, a move that some analysts think will lead to higher, Tesla-like, valuations. However, it is unclear whether OEMs will start to invest in support for dealership maintenance infrastructure. Many have already chosen to pass along the costs of investments needed for the sale and service of EV vehicles onto the dealer, creating several issues surrounding the economics of an upgrade for rural and smaller dealerships. Time will tell whether OEMs will choose to prioritize the amount of EVs on lots by further subsiding transition fees.ForecastLooking ahead to October, expectations for the full year 2021 SAAR have once again been lowered. Experts estimate that the global industry has already lost around 9 million units of production related to supply chain issues, and that number should continue to mount with no end in sight for OEMS until and likely into 2022. The demand for new and used vehicles is expected to remain feverish, but sales will have to contend with ongoing production constraints. Sales can no longer outpace production as inventory has been drawn down.At this point, we are pretty confident sales in Q4 won’t be high enough to reach our initial 2021 target. Despite a challenging year from an operational standpoint, we doubt many dealers will be complaining with the results and the profits achieved this year.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact a member of the Mercer Capital auto team.

September Acquisitions by Sonic, Asbury, and Group 1 and What They Mean for Privately Held Auto Dealerships

Smallest Public Players Getting Larger

In three consecutive weeks, 117 auto dealerships were bought across 3 transactions, each scooping up more dealerships than the last. The three smaller pure-play public auto dealership companies (Group 1 Automotive, Sonic Automotive and Asbury Auto Group) all made sizable acquisitions in a red hot M&A market coming after Lithia purchased a large private auto group back in April. Surely, executives of these companies have been reading our blog about achieving growth by reinvesting in core operations through M&A.Group 1 (188 dealerships) is acquiring 30 stores (13.8% of pro forma dealership count) from Prime Automotive Group, which is the smallest acquisition by the largest player in this post, though it still shows a significant trend for the industry. Sonic’s acquisition of 33-store RFJ Auto Partners is sizable compared to its 84 franchised dealerships as of mid-year (28.2% of pro forma) and renders our writeup of Sonic from two weeks ago stale.Asbury is acquiring 54 new-vehicle dealerships from Larry H. Miller compared to 91 dealership locations at mid-year (37.2% of pro forma) which is a considerable transaction particularly on the back of its Park Place Acquisition of 12 luxury stores just over a year ago.These transactions highlight a couple of key themes in the marketplace for auto dealerships. First, elevated performance and valuations mean that now may be a good time to sell. Secondly, scale will be increasingly important in the online retailing age, and even the public players are looking to catch up while some of the largest private players are willing to exit.Group 1 Acquisition of PrimeAs reported by Automotive News on September 13, Group 1 agreed to pay $880 million for 30 dealerships, three collision centers and related real estate from Prime Automotive Group, the 18th largest dealer by 2020 new retail volumes. The timeline for execution of the deal was set for 75 days, though this could be delayed by framework agreements, which govern the relationships between automakers and their largest franchised dealers, limiting the number of stores one owner can have of the same brand or in a certain region.The deal could also be delayed by investors in Prime’s majority owner GPB Capital Holdings, an alternative-asset management firm that has been marred by scandal and lawsuits. These legal issues led those in the industry to expect a sale in 2021 as Prime had received termination notices from a couple of its brands at three of its dealerships.Prime Automotive Group is based in Westwood Massachusetts with operations in the Mid-Atlantic and New England markets. Its brand portfolio includes Acura, Airstream, Audi, BMW, Buick, Chrysler, Dodge, Ford, GMC, Honda, Jeep, Land Rover, Mazda, Mercedes-Benz, MINI, Porsche, RAM, Subaru, Toyota, Volkswagen, and Volvo. Once the acquisition is completed, Group 1's consolidated brand mix is expected to be approximately 43% luxury, 36% non-luxury import, and 21% non-luxury domestic.Group 1 executives highlighted cost synergies, diversification of its U.S. footprint, and extending the reach of its online digital retailing process “AcceleRide” as key reasons for the acquisition. While the Company has some international diversification (44 of 188 pre-transaction dealership locations are international in the U.K. or Brazil), this transaction should provide geographic diversification as Group 1’s domestic dealerships are heavily concentrated in Texas. The northeast is also a natural extension for Group 1, which already has 16 locations in the region.Sonic Acquisition of RFJ Auto PartnersAs reported by Automotive News on September 22, Sonic paid $700 million to add an estimated $3.2 billion in annualized revenues with its acquisition of RFJ Auto Partners. The deal is expected to close in December 2021 and management expects “day one” synergies based on its prior relationship with RFJ CEO Rick Ford, a former Sonic executive.Sonic management also noted the deal furthers their strategy to increase its geographic reach and expand its brand portfolio, diversifying within the auto retailing space which is important as the smallest of the pure-play franchised retailers. Like Group 1, Sonic also touted the benefits the transaction would have with launching its digital omnichannel platform later this year.RFJ Auto Partners, Inc. was established in 2014 and is based in Plano, Texas. It is one of the largest privately owned auto retail platforms in the United States, with nearly 1,700 employees and a dealership footprint of 33 rooftops located in 7 states throughout the Pacific Northwest, Midwest and Southwest. The RFJ Auto brand portfolio includes Chrysler, Jeep, Dodge, RAM, Chevrolet, GMC, Buick, Lexus, Toyota, Ford, Nissan, Hyundai, Honda, Mazda, Alfa Romeo, and Maserati.The transaction will add six incremental states (Idaho, Indiana, Missouri, Montana, New Mexico, and Washington) to Sonic’s geographic coverage and five additional brands to its portfolio, including the highest volume CDJR dealer in the world in Dave Smith Motors.The deal was touted as an acquisition of a top-15 dealer group. Reviewing the annual Auto News publication, RFJ came in as the 42nd largest dealership by new vehicles retailed. However, it is the 14th largest by revenues, meaning its portfolio has a heavier tilt towards luxury than those ranked above it. Also notable is that RFJ acquired 13 of its 38 dealerships in March 2020. While RFJ may or may not have benefitted from a price concession due to the uncertainty of the COVID-19 pandemic, the deal occurred well before the recent run-up in valuations.RFJ is currently owned by The Jordan Company, a middle-market PE firm headquartered in New York who classified the investment as an automotive dealership platform. While deal terms were not disclosed, it is likely the seller opted to monetize while valuations are relatively high. Private equity is typically viewed to not be a permanent source of capital with a typical investment horizon of 5-7 years. RFJ was founded in 2014, meaning its sale in 2021 was at the longer end of that range. The sale was likely aided by the market conditions for auto dealerships coming out of the pandemic.While other public players, namely Lithia, have sought to expand through numerous smaller acquisitions, Sonic opted to take a larger bite at the apple acquiring a dealership group that will contribute about 28% of Sonic’s post-acquisition stores. In valuation, a size premium is usually added to the cost of capital for smaller operations, meaning a premium is likely paid for larger dealership groups. However, this eases the efforts of integrating into Sonic’s established platform and also reduces excessive costs associated with doing due diligence across numerous deals.Asbury Acquisition of Larry H. Miller DealershipsNot to be outdone, Asbury announced its acquisition of Larry H. Miller Dealerships a week later paying $3.2 billion for annualized revenues of $5.7 billion. Larry H. Miller Dealerships ranked 8th in both revenues and new vehicles retailed in 2020, the second largest private dealership behind Hendrick Automotive Group. This is a significant statement made by Asbury, likely to make it the fourth largest new auto retailer behind only Lithia, AutoNation, and Penske.This “transformative” acquisition follows another transformative transaction all the way back in 2020 when it acquired Park Place, a deal that was downsized from its original announcement due to complications brought on by the uncertainty related to the COVID-19 pandemic. The deal is expected to close prior to the end of the year. Like Group 1, manufacturer approval is not anticipated to be a material concern though Asbury CEO David Hult did note one unidentified brand might pose an issue.Hult noted the acquisition will help the Company “rapidly expand [its] presence into these desirable, high-growth Western markets with strong accretion from day-one.” He continued to note how the geographic footprint will be complemented by “Clicklane,” its omnichannel platform.This transaction will diversify Asbury's geographic mix, with entry into six Western states: Arizona, Utah, New Mexico, Idaho, California, and Washington, and adds to its growing Colorado footprint. Larry H. Miller Dealerships portfolio mix is largely domestic brands, contrasting the Park Place Acquisition that was primarily luxury offerings.Going from 91 to 145 dealerships is a significant step up in size for Asbury. According to Automotive News, this acquisition may make Asbury too large for a takeover attempt by Lithia, who has been the most aggressive acquiror in the automotive retail space. While Asbury would have been complementary geographically to Lithia, the Miller locations would now create more overlap, complicating a deal.Trends for Private Auto DealershipsThese significant acquisitions show a clear appetite from the larger players to grow their operations. Current operating trends also provide some helpful perspective. Inventory shortages and potential for structural changes to inventory levels are likely to make sourcing vehicles increasingly important for auto dealerships.Dealers operating in multiple geographic areas are likely to benefit from sourcing vehicles from numerous places that can be reconditioned and sold where demand is highest. Vehicles can also be moved around to areas where demand is highest in order to maximize GPUs. From a valuation perspective, brand and geographic diversity also reduce risk for dealers looking to go all-in on automotive retail. While diversification is beneficial from a risk perspective, it’s also likely required from a practical standpoint due to framework agreements.Used-only retailers may have better name recognition among consumers than some of these public players because many acquired dealerships continue to operate under the name of the prevailing business. However, increasing scale and building out online platforms will help, and these dealers have the built-in advantage of also having the ability to sell new vehicles, which the Carvanas of the world cannot.For private dealers, it appears there is and will be a market for bolt-on acquisitions, though public players may be more likely to act on larger groups first if these transactions are any indications. Still, Group 1 acquired two dealerships in Texas on Monday, so it seems they are willing to listen to all sizes of deals. According to Erin Kerrigan of Kerrigan Advisors, these three transactions are “indicative of an accelerating pace of industry consolidation with the top 50 dealership groups that are private now looking, in many cases, to exit.” While the Asbury-Larry H. Miller deal may appear to be capping this trend with four mega-deals, Kerrigan indicates it may be “a harbinger for the future”.ConclusionLarger private dealerships exiting the business is something to keep an eye on. Transactions occur on a case-by-case basis, as illustrated by the turmoil surrounding Prime. However, a trend is clear with four of the largest privately held auto groups selling in 2021. Dealers will want to continue their dialogues with their OEMs for the future of automotive retailing and how they can best compete as the industry consolidates.As we’ve noted before, these transactions indicate that there are fewer owners now than in the past, but the number of dealerships hasn’t moved significantly, meaning even smaller players will continue to have a foothold and serve their local communities.Mercer Capital provides business valuation and financial advisory services, and our auto team focuses on industry trends to stay current on the competitive environment for our auto dealer clients. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

What Is a Reserve Report?

In this blog post we discuss the most important information contained in a reserve report, the assumptions used to create it, and what factors should be changed to arrive at Fair Value[1] or Fair Market Value[2].Why Is a Reserve Report Important?A reserve report is a fascinating disclosure of information. This is, in part, because the disclosures reveal the strategies and financial confidence an E&P company believes about itself in the near future. Strategies include capital budgeting decisions, future investment decisions, and cash flow expectations.For investors, these disclosures assist in comparing projects across different reserve plays and perhaps where the economics are better for returns on investment than others.However, not all the information in a reserve report is forward-looking, nor is it representative of Fair Value or Fair Market Value. For a public company, disclosures are made under a certain set of reporting parameters to promote comparability across different reserve reports. Disclosures do not take into account certain important future expectations that many investors would consider to estimate Fair Value or Fair Market Value.What Is a Reserve Report?Simply put, a reserve report is a reporting of remaining quantities of minerals which can be recoverable over a period of time. Rules of 2009define these remaining quantities of mineral as reserves. The calculation of reserves can be very subjective, therefore the SEC has provided, among these rules, the following definitions, rules and guidance for estimating oil and gas reserves:Reserves are “the estimated remaining quantities of oil and gas and related substances anticipated to be economically producible;The estimate is “as of a given date”; andThe reserve “is formed by application of development projects to known accumulations”. In other words, production must exist in or around the current project.“In addition, there must exist, or there must be a reasonable expectation that there will exist, the legal right to produce or a revenue interest in the production of oil and gas”There also must be “installed means of delivering oil and gas or related substances to market, and all permits and financing required to implement the project.”Therefore, a reserve report details the information and assumptions used to calculate a company’s cash flow from specific projects which extract minerals from the ground and deliver to the market in a legal manner. In short, for an E&P company, a reserve report is a project-specific forecast. If the project is large enough, it can, for all intents and purposes, become a company forecast.What Is the Purpose of a Reserve Report?Many companies create forecasts. Forecasts create an internal vision, a plan for the near future and a goal for employees to strive to obtain. Internal reserve reports are no different from forecasts in most respects, except they are focused on specific projects.Externally, reserve reports are primarily done to satisfy disclosure requirements related to financial transactions. These would include capital financing, due diligence requirements, public disclosure requirements, etc.Publicly traded companies generally hire an independent petroleum engineering firm to update their reserve reports each year and are generally included as part of an annual report. Like an audit report for GAAP financial statements, independent petroleum engineers provide certification reserve reports.Investors can learn much about the outlook for the future production and development plans based upon the details contained in reserve reports. Remember, these reserve reports are project-specific forecasts. Forecasts are used to plan and encourage a company goal.How Are Reserve Reports Prepared?Reserve reports can be prepared many different ways. However, for the reports to be deemed certified, they must be prepared in a certain manner. Similar to generally accepted accounting principles (GAAP) for financial statements, the SEC has prepared reporting guidance for reserve reports with the intended purpose of providing “investors with a more meaningful and comprehensive understanding of oil and gas reserves, which should help investors evaluate the relative value of oil and gas companies.” Therefore, the purpose of SEC reporting guidelines is to assist with project comparability between oil and gas companies.What Is in a Reserve Report?Reserve reports contain the predictable and reasonably estimable revenue, expense, and capital investment factors that impact cash flow for a given project. This includes the following:Current well production: Wells producing reserves.Future well production: Wells that will be drilled and have a high degree of certainty that they will be producing within five years.Working interest assumption: The ownership percentage the Company has within each well and project.Royalty interest assumptions: The royalty interest paid to the land owner to produce on their property.Five-year production plan: All the wells the Company plans to drill and have the financial capacity to drill in the next five years.Production decline rates: The rate of decline in producing minerals as time passes. Minerals are a depleting asset when producing them and over time the production rate declines without reinvestment to stimulate more production. This is also known as a decline curve.Mineral price deck: The price at which the minerals are assumed to be sold in the market place. SEC rules state companies should use the average of the first day of the month price for the previous 12 months. Essentially, reserve reports use historical prices to project future revenue.Production taxes: Some states charge taxes for the production of minerals. The rates vary based on the state and county, as well as the type of mineral produced.Operating expenses for the wells: This includes all expenses anticipated to operate the project. This does not include corporate overhead expenses. Generally, this is asset-specific operating expenses.Capital expenditures: Cash that will be needed to fund new wells, stimulate or repair existing wells, infrastructure builds to move minerals to market and cost of plugging and abandoning wells that are not economical.Pre-tax cash flow: After calculating the projected revenues and subtracting the projected expenses and capital expenditures, the result is a pre-tax cash flow, by year, for the project.Present value factor: The annual pre-tax cash flows are then adjusted to present dollars through a present value calculation. The discount rate used in the calculation is 10%. This discount rate is an SEC rule, commonly known as PV 10. The overall assumption in preparing a reserve report is that the company has the financial ability to execute the plan presented in the reserve report. They have the approval of company executives, they have secured the talent and capabilities to operate the project, and have the financial capacity to complete it. Without the existence of these expectations, a reserve report could not be certified by an independent reserve engineer.ConclusionMercer Capital has significant experience valuing assets and companies in the energy industry. Because drilling economics vary by region it is imperative that your valuation specialist understands the local economics faced by your E&P company. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries.Contact a Mercer Capital professional today to discuss your valuation needs in confidence.Endnotes[1] “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” – FASB Glossary[2] “The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts” – U.S. Treasury regulations 26 C.F.R. sec. 20.2031-1(b)

E&P Fourth Quarter 2021

Appalachian Basin

Appalachian Basin // The fourth quarter of 2021 marked a recent milestone in a long upward march for energy prices.

Transportation & Logistics Newsletter

Fourth Quarter 2021

Tax/Estate Planning Cheat Sheet for Auto Dealers

Winds of Change?

Benjamin Franklin famously said that the only things certain in this life are death and taxes. While both may be certain, taxes are always subject to change.Last fall, we wrote a blog post about the estate planning environment for auto dealers and other industries. In that post, we highlighted the prevailing conditions that existed in the marketplace that would enable auto dealers to capitalize on executing any estate planning opportunities. Those conditions included opportunities for depressed valuations caused by uncertain operational results (at the time), low interest rates, and changing political forces caused by the Presidential election.Fast forward to Fall 2021 and while some of these conditions have changed, rumors of potential tax changes have finally re-surfaced nearly three-fourths of the way through the first year of the Biden Administration.Earlier this month, President Biden and Congress introduced the Build Back Better Act (“BBB Act”). After its introduction, the House Ways and Means Committee commented and circulated a draft of many of the proposed policies. A brief synopsis of the entire BBB Act from BKD CPAs and Advisors is provided here.In this post, we focus on four particular proposals that impact estate planning and business valuations for auto dealers (and other industries): 1) Estate Tax / Lifetime Exclusion; 2) Corporate Income Tax Rates; 3) Capital Gains Rates; and 4) Valuation Discounts for Passive Assets.Estate Tax/Lifetime Exclusion AmountThe Estate Tax / Lifetime Exclusion Amount is also referred to as the Generation Skipping Transfer Tax Exemption. This concept consists of the amount of an estate that is subject to be transferred free from taxes either during the lifetime of an individual/couple or at death.Current Status: $11.7 million per individual or $23.4 million for a married couple as stated in the Tax Cuts and Jobs Act (“TCJA”) for gifts made between January 1, 2018 and December 31, 2025. Based on these figures, all estates under these amounts can be transferred during the lifetime or at death without incurring any estate taxes.Current Proposal: Revert back to $5 million per individual adjusted for inflation to arrive at a figure of approximately $6.02 million per person or $12.04 million for a married couple.Effective Date of Change: January 1, 2022Valuation Impact: If enacted, the current proposal would now lower the lifetime annual exemption to $12.04 million for married couples, nearly cutting the exclusion in half. Estates with a value over $12.04 million would now be subject to tax on the amount exceeding $12.04 million.Who Should Consider: Individuals who anticipate their estate may exceed the lower threshold of $12.04 million should consider executing estate planning strategies to transfer that wealth before the BBB Act is passed. Current estates with values exceeding $23.4 million or those estates that have not utilized the full prior lifetime annual exclusion amount, should also consider executing estate planning strategies before that heightened amount is reduced. The reduced exclusion amount also increases the number of affected people. Someone owning a business worth $15 million could now benefit from tax planning strategies that previously may have been less concerned when they fell below the threshold established by the TCJA.Corporate Income Tax RatesCorporate income tax rates are the amount of taxes paid on profits earned by a corporation.Current Status: Flat rate of 21%, reduced by the TCJALatest Proposal: Graduated rates with a top rate of 26.5%Effective Date: January 1, 2022Valuation Impact: Business valuations of auto dealerships are generally impacted by three broad overall assumptions: expected annual cash flows, growth of said cash flows, and risks to achieve those cash flows. A proposed increase in the corporate income taxes would reduce the annual cash flows of an auto dealership simply by the fact that income tax rates are higher. We saw the reverse of this trend when income tax rates were lowered by the TCJA. While many auto dealerships are organized in entities that consist of S Corporations, Limited Liability Companies, and Partnerships, the corporate income tax assumption still impacts the business valuation. We won’t belabor the mechanics of a business valuation in this post, but effectively the hypothetical earnings of a business are tax affected to a C Corporation equivalent basis since the assumptions for the discount and capitalization rates (the risks associated with achieving expected cash flows) are derived from public C Corporations.Who Should Consider: As briefly discussed above, income tax rates comprise one of the assumptions in a business valuation. On its surface, the proposed increase in corporate income taxes will certainly reduce expected the after-tax earnings of an auto dealership, all other things being equal. However, other prevailing industry conditions, such as heightened profitability due to operational efficiencies, might mitigate the overall impact caused by increased tax rates. The opposite was true in 2017.Capital Gains Tax RateThe capital gains rate is the tax rate paid on the disposition of an asset. Rates can differ based on the holding period of the asset prior to disposition and are often bifurcated into short-term (one year or less) or long-term (longer than one year) rates.Current Status: Rates of 15% to 20% + 3.8% surtax on net investment incomeLatest Proposal: Top rate of 25% + 3.8% surtax on net investment income for tax year 2022Effective Date: Transactions occurring after September 13, 2021, would be subject to new rates. Transactions occurring prior to September 13, 2021 would be subject to current rates.Valuation Impact: Most business valuations do not calculate or consider the net amount received after a sale or disposition of the company or asset because the premise of these valuations is a going concern. However, we know business owners are definitely interested in the proceeds that ultimately hit their bank account.Who Should Consider: Auto dealers that are contemplating whether to sell their dealership or continue to hold and operate should consider this potential rate increase. Dealers are currently experiencing record profits but also face challenges with the inventory shortages caused by suspended manufacturing from the pandemic and the microchip shortage. While it can be hard to let go when profits are rolling in, there are long term concerns surrounding the increasing capital costs of developing and maintaining digital platforms to compete with the public auto groups and larger private groups. Many dealers are choosing to sell, as evidenced by the current white hot auto dealer M&A market. If the BBB Act passes, auto dealers that sell in 2022 can expect fewer after-tax dollars from a sale or disposition due to higher capital gains tax rates, all other things being equal.Valuation Discounts for Passive AssetsBusiness valuations of auto dealerships, real estate holding companies, and related businesses typically consist of determining the value of the entire business, as well as the value of a particular interest in the business. Often the subject interest comprises less than 100% of the total business and exhibits elements of lack of control and marketability. As such, discounts for lack of control, lack of marketability, and lack of voting rights are often applicable and determined to reduce the fair market value of the overall pro rata value of the subject interest.Current Status: Valuation discounts for lack of control, lack of marketability, and lack of voting rights are allowed, but often require substantiation, quantification, and defense by a business appraiser communicated in a formal appraisal report.Latest Proposal: The current version of the BBB Act proposes to eliminate valuation discounts for an entity’s “non-business,” or passive, assets. The BBB Act defines “non-business” or passive assets as cash, marketable securities, equity in another entity, real estate, etc. Further, passive assets are those assets that are held for the production or collection of income and are not used in the active conduct of a trade or business. Passive assets which are held as part of the reasonably required working capital of a trade or business are also excluded. Real property is excluded from this rule if real property assets are used in the active conduct of real property trade or business in which the transferor actively and materially participates. Examples include real property used for rental, operation, and management, among others.Effective Date: January 1, 2022Valuation Impact: In a world where combined discounts for lack of control and marketability can range from 25-45%, this is a material impact. Passage of this piece of the legislation in its current form may not have a dramatic impact on the business valuation of dealership operations, which would still be subject to discounts. However, many auto dealerships carry excess cash or working capital in order to smoothly run operations or provide cushions in down periods. If the BBB Act were to interpret that all cash or working capital exceeds the “guide” figure on the dealer financial statement, this could inflate both the total value of the business as well as the portion attributable to passive assets, which would not be subject to discounts. Many auto dealers currently hold heightened levels of cash and marketable securities as a result of increased profitability and retainage of any PPP funds and loan forgiveness. Many of our auto dealer clients also own the operating real estate for the dealership in a separate asset holding company. These proposed rules could also jeopardize the applicable discounts for lack of control and marketability in those entities for any marketable securities or “non-business” or passive assets.Who Should Consider: If these discounts are eliminated for “non-business” or passive assets, auto dealers owning both types of entities, operating dealerships and real estate holding companies, should consider implementing and executing estate planning strategies. If all the discounts (not likely) or the discounts on “non-business” or passive assets are eliminated, the resulting business valuation of a subject interest in either of these types of entities will be dramatically higher. In turn, the overall values of the estates of auto dealers or the net value of transfers could be greatly increased for transfer tax purposes.ConclusionsJust as death and taxes are the only certain things in life, another relevant adage is that change is inevitable. As the BBB Act and proposals from the House Ways and Means Committee start to evolve, there are numerous tax and estate planning implications.While the final version of the Act will look almost certainly different than the current proposals for each provision, changes to existing rates and policies are anticipated. Fall 2021 is shaping up to be a busy estate planning season.Seek qualified professionals to assist you with your estate planning, from the attorneys determining and drafting the plan to the valuation professional providing the valuation. Not all valuations and valuation professionals are created equal. The role of all of the professionals in your estate planning process should be to protect the integrity of the proposed transaction. Often when these transactions are challenged, they are challenged based on the formation factors or the quality/conclusion of the valuation.Contact a professional at Mercer Capital to assist you and your attorney with your valuation needs involving your estate planning.

Bakken Recovery Falters

The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. This quarter we take a closer look at the Bakken.Production and Activity LevelsEstimated Bakken production (on a barrels of oil equivalent, or “boe” basis) decreased approximately 4% year-over-year through September. Production in the Permian and Appalachia increased 10% and 3% year-over-year, respectively, while the Eagle Ford’s production declined 2%. While production in the Bakken rebounded sharply once wells were brought back online aftercurtailments in mid-2020, it has generally trended lower during 2021. Production in the Eagle Ford and Permian was meaningfully impacted in February 2021, driven by Winter Storm Uri that disrupted power supplies throughout Texas. As of September 17th, there were 23 rigs in the Bakken up 156% from September 11, 2020. Eagle Ford, Permian, and Appalachia rig counts were up 300%, 109%, and 34%, respectively, over the same period. One may wonder why Bakken production has been on the decline given substantial rig count growth, while Permian production has continued to increase despite a more moderate increase in rigs. The answer has to do with legacy production declines and new well production per rig. Based on data from the U.S. Energy Information Administration, the Bakken needs roughly 19 rigs running to offset existing production declines. That number for the Permian is approximately 200 rigs. The Bakken’s rig count only recently broke above that maintenance level of drilling, whereas the Permian has had over 200 active drilling rigs since February 2021. Current activity in the Bakken should stem the recent production declines, but growth will likely be modest without additional rigs. Oil Stabilizes while Natural Gas SoarsAfter a significant run-up in the first two quarters of the year, oil prices were largely range-bound during the third quarter of 2021, with front-month futures prices for West Texas Intermediate (WTI) generally oscillating between $65/bbl and $75/bbl. Rising COVID-19 cases in the U.S. caused the Delta variant to put a damper on travel activity and associated fuel consumption. However, producers seem to be maintaining their capital discipline even in light of higher prices, which is limiting production growth. Henry Hub natural gas front-month futures prices began the quarter at approximately $3.63/mmbtu but broke above $5.00/mmbtu in September. The current run-up in natural gas prices has some concerned about what the winter may hold, when prices generally increase due to heating demand. In Europe, declining coal capacity and less-than-expected wind generation from North Sea wind turbines have contributed to surging natural gas prices, and the situation is beginning to impact industrial production. However, the current commodity price environment may be short-lived. Commodity futures prices are in backwardation (meaning that current prices are higher than future prices), implying some near-term tightness that is expected to subside. This sentiment is echoed by the U.S. Energy Information Administration, which stated in their September 2021 Short-term Energy Outlookthat “growth in production from OPEC+, U.S. tight oil, and other non-OPEC countries will outpace slowing growth in global oil consumption” and would likely lead to lower oil prices. Financial PerformanceThe Bakken public comp group saw strong stock price performance over the past year (through September 20th), with all constituents outperforming the broader E&P sector (as proxied by XOP). Continental and Whiting prices increased 175% and 151% year-over-year, compared to the XOP’s increase of 78%. Oasis, which emerged from bankruptcy in November 2020, is up 191% from its initial closing price post-bankruptcy. However, this impressive stock price performance is probably more reflective of the dire straits of these companies last year. Both Whiting and Oasis declared bankruptcy in 2020 and appear to have benefited from a cleaned-up capital structure.Keystone XL Finally CancelledThe Keystone XL pipeline, originally proposed in 2008, was finally cancelled by its developer, Canadian midstream company TC Energy. President Biden revoked a key permit needed for the project on his first day in office.The proposed pipeline caused significant controversy during its planning stages as it provided takeaway capacity for production from Alberta oil sands (which is more energy intensive, and thus less sustainable, than other forms of hydrocarbon extraction) and its path through Nebraska’s environmentally sensitive Sandhills region and Ogallala Aquifer. Keystone XL also would have provided additional pipeline capacity out of the Bakken, which could become very needed if the also-controversial Dakota Access Pipeline gets shutdown.ConclusionWhile the Bakken saw strong production increases in the wake of mid-2020’s commodity price rout, that recovery appears to have faltered in 2021. Production has generally been on the decline this year, though the recent increase in rigs operating in the basin should stem this decrease and provide for modest production growth going forward. However, companies’ current emphasis on returning cash to shareholders may lead to less investment than has been seen in previous periods with similar commodity price environments.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

Four "To Dos" Before You Sell Your Investment Management Firm

Considerations for Every RIA Owner

Selling the business you built from the ground up is a bittersweet experience. Many business owners focus their efforts on growing their business and push planning for their eventual exit aside until it can’t be ignored any longer. While this delay may only prove mildly detrimental to deal proceeds in other industries, in the investment management space, there are very few buyers who will be interested in YOUR business without YOU (at least for a little while).Long before your eventual exit, you should begin planning for the day you will leave the business you built. There are many considerations for investment managers contemplating a sale, but we suggest you start with these four:1. Have a Reasonable Expectation of ValueTaking an objective view of the value of your company is difficult. In many cases, it becomes a highly emotional issue, which is certainly understandable considering that many investment managers have spent most of their adult lives nurturing client relationships, growing their client base, and developing talent at their firm. Nevertheless, the development of reasonable pricing expectations is a vital starting point on the road to a successful transaction.The development of pricing expectations for an external sale should consider how a potential acquirer would analyze your company. In developing offers, potential acquirers use various methods of developing a reasonable purchase price. Most commonly, an acquirer will utilize historical performance data, along with expectations for future cash flow to generate a reasonable estimate of run-rate EBITDA, and an appropriate multiple that considers the underlying risk and growth factors of the subject company.With the recent run-up in RIA multiples observed, and the even faster run-up in headline multiples, setting reasonable pricing expectations given your firm’s specific risks and opportunities is an increasingly important step in preparing for a transaction.Valuations and financial analysis for transactions encompass a refined and scenario-specific framework. The valuation process can enhance a seller’s understanding of how a buyer will perceive the cash flows and corresponding returns that result from purchasing or investing in a firm. Additionally, valuations and exit scenarios can be modeled to assist in the decision to sell now or later and to assess the adequacy of deal consideration. Setting expectations and/or defining deal limitations are critical to good transaction discipline.2. Have a Real Reason To Sell Your BusinessStrategy is often discussed as something that belongs exclusively to buyers in a transaction, but this isn’t always the case.Without a strategy, sellers often feel like all they are getting is an accelerated payout of what they would have earned anyway while giving up their ownership. In many cases, that’s exactly right! Your company, and the cash flow that creates value, transfers from seller to buyer when the ink dries on the purchase agreement. Sellers give up something equally valuable in exchange for purchase consideration – that’s how it works.As a consequence, sellers need a real reason – a non-financial strategic reason – to sell. Maybe you are selling because you want or need to retire. Maybe you are selling because you want to consolidate with a larger organization to reduce the day-to-day headache of running a business, or need to bring in a financial partner to diversify your own net worth and provide ownership transition to the next generation. Whatever the case, you need a real reason to sell other than trading future cash flow for a check today. The financial trade won’t be enough to sustain you through the twists and turns of a transaction.3. Get Your Books in Order Today To Maximize Proceeds TomorrowAs Zach Milam, mentioned last week, in his post on bridging valuation gaps between RIA buyers and sellers, the best time to address a potential buyer’s concerns about your firm is before you start the process.In advance of transactions, sellers should consider an outsider’s perspective on their firm and take action to address the perceived risk factors that lower value. For example, distinguishing owner compensation and regular distributions of excess capital prior to a sale will decrease the buyer’s concern about liquidity and marketability of the investment and increase the perceived value of equity ownership.Similarly, focusing on staff development in client-facing roles, increasing the number of client contacts with the firm, and creating an internal pipeline of talent to manage the business will all serve to reduce key person risk from the perspective of a buyer, thereby increasing the value that the buyer ascribes to the firm.4. Consider the Tax ImplicationsWhen considering the potential proceeds from a transaction, you should contemplate the tax implications. A large number of RIAs are S-corporations and C-corporations, which is no longer the preferred structure as they constrain a company’s ability to easily grow and transfer equity. We recommend consulting with a tax attorney prior to a transaction on the tax implication of different transaction structures. Before selling your business, you should also be aware of the pros and cons of a stock versus an asset sale as well as an all cash transaction versus a combination of cash and stock consideration.How Can We Help?At Mercer Capital, we routinely perform valuations and financial analysis for buy-sell agreements and internal transactions as well as offer fairness opinions for proposed transactions. We can help you better understand the potential risks to your business model and the opportunities for growth, as well as help you establish reasonable pricing expectations so that when you are ready to sell, the process is more seamless.

Public Auto Dealer Profiles: Sonic Automotive

As we discussed in the first installment of this blog series, there are six primary publicly traded companies that own approximately 923 new vehicle franchised dealerships as of Q2 2021, or 5.6% of the total number of dealerships in the U.S. (16,623 at year-end 2020 per NADA). This demonstrates how fragmented the industry continues to be, despite recent consolidation.The total number of dealerships has remained largely the same, though the number of dealers is dwindling as big shifts towards e-commerce accelerated by the pandemic require heavier investment for smaller operations to compete.This issue of consolidation is not limited to just mom and pop stores.According to the Wall Street Journal, Suburban Collection of Michigan sold to Lithia this year in part due to the need for outside capital. David Fischer Jr. and his father sought a strategic partner to update their business to the new digital retailing environment despite having 56 franchises across 34 stores. In 2020, Suburban Collection was the 21st ranked auto group in terms of size, retailing just under 30 thousand new vehicle units.Given current blue sky values, the size of the deal and Lithia’s aggressive acquisition strategy, we realize premium pricing may have ultimately won the day in the Fischers’ decision to divest. Still, for an auto group of that size to be seeking a minority partner, prior to eventually being acquired, is noteworthy. We’ve also heard concerns from our clients that the potential for rising taxes and tweaks to the supply chain (with OEMs considering a model that reduces the autonomy of dealers) could lead to further consolidation.Our goal with these posts is to serve as a reference point for private dealers who may be less familiar with the public players, particularly if they don’t operate in the same market. Larger dealers may benefit in benchmarking to public auto dealers. Smaller or single point franchises may find better peers in the average information reported in NADA’s dealership financial profiles or more regional 20 Group reports. Public auto dealers also give dealers insight to how the market prices their earnings, the environment for M&A, and trends in the industry.Sonic Automotive Locations and BrandsBased in Charlotte, North Carolina, Sonic has 84 franchised dealerships, the lowest of any publicly traded company that operates principally as a new vehicle dealer. As seen below, the company earned over 50% of its revenue in Texas and California, with another 30% of 2020 revenue coming from Colorado, Tennessee, Florida, and Alabama. By year-end 2021, the company projects 25% population coverage. While the company is smaller and relatively concentrated in terms of its footprint compared to its public peers, Sonic is targeting 90% population coverage by 2025 (see projection below in recent investor materials). This growth will largely come from its EchoPark segment comprised of physical locations selling pre-owned “nearly new” vehicles with many having remaining OEM warranty. According to the Automotive News Top 150, Sonic sold the seventh most new retail units in 2020, at just over 93 thousand, trailing the other public dealers and Hendrick Automotive Group, the largest private auto group, also based in Charlotte. As seen in the table below, 55% of Sonic’s 2020 revenues came from Luxury brands, particularly BMW and Mercedes. This is more than double the company’s combined sales from domestic (10%) and EchoPark (15%), which are assumed to target a lower price point. Assuming continued growth in EchoPark, Sonic appears to be targeting consumers at various income levels which should provide balance in any market environment. Historical Financial PerformanceAs we’ve discussed frequently, there are numerous hurdles to clear when comparing a privately held dealership to a publicly traded retailer. Scale and access to capital make the business models different, even if store and unit-level economics remain similar. Sonic’s 10K’s and Q’s look different than the dealer financial statements produced by our dealer clients. For example, “Other income” items such as doc fees and dealer incentives can significantly impact profitability for privately held dealers. For dealers that sacrifice upfront gross margins to get volume based incentive fees, operating income can be negative for dealers before accounting for these profits.Due to differences in reporting, Sonic captures other income along with F&I as a revenue item with no corresponding cost of sales line item. The minimal amount of reported other income/expense not included as revenue if added to gross profit, would not change its reported gross margin of 14.85% by one basis point.Interestingly, its gross margin through the first half of 2021 was down immaterially from 14.89% in 2020. This comes despite industry-wide improvement in gross margins and a pickup in margin for new vehicles, whole vehicles, and parts, service and collision operations. That means Sonic has been negatively impacted by its declining margins on used vehicles (2.8% compared to 3.6%) and/or the contribution of gross profit (relatively less high margin fixed operations and/or more used vehicles).While EchoPark likely explains this, it is interesting to contrast to the average dealership as reported by NADA which saw gross margin improve from 11.8% to 13.4% in the first half of 2021. While this appears lower than the figures reported by Sonic, we note the difference between operating profit and pre-tax profits (largely aforementioned back-end profits) was 2.3% of revenues, which added to gross margin, would be 15.7%.Implied Blue Sky MultipleIn prior blogs, we’ve discussed how blue sky multiples reported by Haig Partners and Kerrigan Advisors represent one way to consider the market for private dealerships. Below, we attempt to quantify the implied blue sky multiple investors place on Sonic Automotive. If we assume that the difference between stock price and tangible book value per share is made up exclusively by franchise rights, then Sonic’s Blue Sky value per share is approximately $35.19.Given recent outperformance, Haig Partners prescribes a 3-year average be taken in determining ongoing pre-tax income (2018, 2019, and LTM June 30, 2021). Using this methodology and applying the 25% tax rate implied by Sonic’s financials, its ongoing pre-tax earnings per share would be $4.97 or just over 7.0x Blue Sky. While this is lower than all of its public counterparts besides Group 1 Automotive, it is relatively high compared to import or domestic dealerships likely due to its size and growth potential as well as its tilt towards luxury brands. ConclusionAt first glance, Sonic may appear to be a close comparable for private auto groups. Unlike other public auto dealers, it does not have other business lines (Penske) or international operations (Group 1). It’s not rapidly acquiring other dealerships (Lithia) and its franchised dealership count is about a third of AutoNation. However, like Asbury, it is tilted towards luxury with very little domestic sales, and still has significantly more dealerships than most groups.Sonic also has meaningful used-only operations in EchoPark, which is where the company is allocating much of its capital. Geographic diversification and access to capital markets can also materially impact comparisons, particularly for smaller dealerships. Still, management commentary on the macro environment in the auto dealer space is valuable and appropriate benchmarking comparisons are still possible if you know what you’re looking for.At Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. Surveying the operating performance, strategic investment initiatives, market pricing of the public new vehicle retailers, gives us insight to the market that may exist for a private dealership. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Bakken M&A

Transaction Volume and Deal Size Rebound in 2021

Over the last year, deal activity in the Bakken has been steadily increasing after a challenging 2020. Eight of the nine deals referenced below occurred in the last eight months as the price environment has turned more favorable. As the industry seems optimistic that the worst of COVID-19 is behind us, deal activity may continue to increase into next year, but there is always hesitation, especially with the Delta variant on the rise.Recent Transactions in the BakkenA table detailing E&P transaction activity in the Bakken over the last twelve months is shown below. Relative to 2019-2020, deal count was unchanged, but median deal size increased by roughly $480 million, which was lead by the $5.6 billion Devon-WPX transaction.Click here to expand the chart aboveOasis Adds Strategic Acreage in Core AreaOn May 3, 2021, Oasis Petroleum announced that it entered a definitive agreement to acquire select Williston Basin assets from Diamondback Energy in a cash transaction valued at approximately $745 million. The effective date of the acquisition will be April 1, 2021, and the deal has yet to officially close. The purchase consideration is expected to be financed by cash, revolver borrowings, and a bridge loan. Transaction highlights include:Production (2021 Q1) – 27 Mboe/dAcreage – 95,000 net acres in Dunn, McLean, McKenzie counties, ND200 drilling locationsProved Reserves - 80.2 mmboe A pro forma table of the transaction is shown below: Diamondback has built a reputation of being focused on the Permian Basin, but in late 2020, the company acquired QEP Resources which gave them exposure to Williston acreage. It took them roughly six months to sell their Bakken acreage package to Oasis, returning them to their pure-play Permian status. Equinor Lets Go of Its Bakken PositionOn February 10, 2021, Equinor announced that it was selling its Bakken asset portfolio to Grayson Mill Energy for $900 million. Grayson Mill Energy is a Houston-based exploration and production company backed by Encap Investments, a private equity firm that has raised over $38 billion of capital. An exit from the Bakken, which Equinor entered in 2011 by acquiring Brigham Exploration Company for $4.7 billion, follows the sale of its operated assets in the Eagle Ford for $325 million to Repsol in November 2019. The deal closed on April 27, 2021 and included the following:242,000 net acres, and associated midstream assets48,000 Boep/d as of Q4 2020 In parallel with the transaction, Equinor Marketing and Trading entered into a term purchase agreement for crude offtake with Grayson Mill Energy. Al Cook, Equinor’s executive vice president of Development & Production, referenced that the company is focused on improving the profitability of its international portfolio.ConclusionM&A transaction activity in the Bakken was steady through year-to-date 2021 and consisted of notable strategic acquisitions and exits in the basin. Deal activity in the Bakken will be important to monitor as companies shift their focus to other basins and are forced to prioritize other initiatives.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Selling Your RIA? Four Ways to Bridge the Valuation Gap

Valuation gaps are frequently encountered in RIA transactions. Buyers and sellers naturally have different perspectives that lead to different opinions on value: Where a seller sees a strong management team, a buyer sees key person risk. "Long-term client relationships" in the eyes of a seller translates to “aging client base” in the eyes of a buyer. When a seller touts a strong growth trajectory, the buyer wonders if that will continue.These different perspectives on the same firm, unsurprisingly, lead to different opinions on value, and the gap can be substantial. Bridging that gap is key to getting a deal done. Below, we address four ways that buyers and sellers can bridge a valuation gap.1. EarnoutEarnouts are a common way to bridge a valuation gap. Through an earnout structure, the buyer pays one price at closing and makes additional payments over time contingent on the achievement of certain performance thresholds. If, for example, a seller thinks that a firm is worth $100 and the buyer thinks the firm is worth $70, the deal might be structured such that $70 is paid at closing and an additional $30 is paid over time if certain growth targets are met.Through an earnout structure, if the seller’s optimistic vision for the future of the firm materializes, the price ultimately paid reflects that. Likewise, if the downside scenario envisioned by the buyer materializes, the hurdles for the earnout payment will likely not be met, and the price will reflect that reality. Rather than hoping they get what they pay for, the buyer pays for what they get. Similarly, sellers are compensated for what the firm actually delivers.2. Staged TransactionIf an RIA is being sold internally to next-generation management, then selling the firm in multiple stages is one way to help bridge valuation gaps. This is partly because it’s easier to come to an agreement on valuation when the stakes are smaller. But there’s also many potentially value-enhancing benefits to internal sales which take time to realize. Through internal transactions, founders get to hand pick their own successors and incentivize them to grow the firm through equity ownership. The buyers (next generation management) have a pathway to advance their career and increase the economic benefit they receive from their efforts.However, if an internal transaction is done all at once, the owner does not have time to benefit from the growth incentives management hoped the transaction would provide. By structuring the transaction over time, subsequent transactions will take place at higher valuations that reflect the growth that results from the alignment of next gen management’s incentives with existing ownership. As a result, sellers in internal transactions may be willing to come down on price for early transactions to incentivize employees to grow the business, while buyers may be willing to come up in price for the opportunity to become an equity partner in the business and participate in the upside.Selling an interest over time also lessens the capital requirement for the buyer, which is often a barrier in internal transactions where the buyer may not have the financial resources to purchase a large block of the company at one time.3. Deal FinancingBeyond the price, how the purchase price is paid can make a significant difference in the perceived economics of the deal. While external buyers will generally pay cash or stock at closing (with possible future earnout payments as discussed above), internal transactions are often seller-financed.We’ve seen a number of internal transactions where an otherwise attractive valuation was offset by payment terms that were extremely favorable to the buyer such as seller notes with low interest rates and long repayment terms. Similar to earnouts, such favorable payment terms allow the seller to feel like they are getting full value for the business while making the higher purchase price more palatable for the buyer.4. Mitigate Risk Factors Before You SellSellers can mitigate potential valuation gaps in advance of a transaction by addressing aspects of the firm that could be concerning to potential buyers. Consider an outsider’s perspective on your firm, and take action to address the perceived risk factors that lower value. For example, if transitioning the firm internally, distinguishing owner compensation and regular distributions of excess capital prior to a sale will decrease the buyer’s concern about liquidity and marketability of the investment and increase the perceived value of equity ownership.Similarly, focusing on staff development in client-facing roles, increasing the number of client contacts with the firm, and creating an internal pipeline of talent to manage the business will all serve to reduce key person risk from the perspective of a buyer, thereby increasing the value that the buyer ascribes to the firm.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides asset managers, wealth managers, independent trust companies, and related investment consultancies with business valuation and financial advisory services related to shareholder transactions, buy-sell agreements, and dispute resolution.

Fairness Considerations in Going Private and Other Squeeze-Out Transactions

Going Private 2023 presentation by Mercer Capitals’, Jeff K. Davis, CFA, that provides an overview of issues surrounding a decision to take an SEC-registrant private.Pros and Cons of Going PrivateStructuring a TransactionValuation AnalysisFairness Considerations

Not Every RIA Buyer Is a Control Freak

Despite Conventional Wisdom, Some Investors Prefer Minority Positions

Ideally, our work with investment management firms at Mercer Capital distills both conventional valuation principles and real-world industry experience. These two influences typically align; valuation theory develops to represent the thinking of actual transacting parties, and – in turn – transaction behavior validates theory.Sometimes, though, we witness rational actors engaging in transactions that challenge certain norms of professional thinking. At such times, we ask ourselves whether valuation theory, as we know it, is doctrine or dogma.The pricing of minority transactions in the RIA space leaves some people scratching their head. Traditional valuation theory holds that investors pay less for minority interests than controlling interests. Reality suggests otherwise. Some established institutional buyers of minority interests in RIAs invest at similar, or even higher, multiples to what other consolidators will pay for controlling interests. Some institutional buyers even prefer taking minority stakes in investment management firms – not a circumstance we see much from the private equity community. Even insider transactions don’t always follow valuation maxims, as valuations for succession are colored by considerations far beyond the sterile realm of hypothetical buyers and sellers. It seems to some that the RIA community has turned valuation theory on its head, but the truth is more nuanced.Valuation Vacuum WonkeryConventional wisdom holds that minority interests in closely held companies are worth less than their pro rata stake in the enterprise. A 15% interest in a business that would sell for $10 million is widely believed by valuation practitioners to be worth something less than the $1.5 million that its pro rata stake in the enterprise would otherwise command. The difference between value inherent in controlling interests and minority interests can be illustrated by way of a diagram known as a levels of value chart. The value of an enterprise can be described as the present value of distributable cash flow – and this parameter is useful for thinking about the different perspectives of control and minority investors. A control level investor effectively has direct access to enterprise level cash flows, with unilateral influence over operations, the ability to buy, sell or merge the enterprise, pay distributions, and set compensation policy. Absent special considerations, a control investor can achieve the greatest benefit, and therefore pay (or expect to be paid) the highest price for an enterprise. Most reported transactions in the RIA channel are made on this basis, and M&A multiples reported publicly, or whispered privately, reflect change of control valuations. Minority investors lack two important prerogatives of control: influence and liquidity.Minority investors lack two important prerogatives of control: influence and liquidity. Discounts for lack of control – also known as minority interest discounts – reflect the inability of minority interest holders to direct the enterprise for their own benefit. The marketable, minority interest level of value is analogous to an interest in a publicly traded company, wherein investors can access the present value of distributable cash flow by way of an open market transaction but have no particular sway over a company’s strategy or operations.Discounts for lack of marketability (a.k.a. marketability discounts) capture the lack of access to enterprise cash flows via distributions or a ready and organized market to sell the interest. The nonmarketable, minority interest level of value is what most valuation practitioners think of when they think of minority interests in closely held enterprises: a value which is materially distinct from a pro rata controlling interest.Internal Transactions Challenge Valuation TheoryReal world economics of minority transactions in RIAs can look very different than our professional discipline would suggest, reflecting issues unique both to the industry and to the universe of typical investors in the industry.Much of the reason that RIA transactions don’t always conform to traditional valuation pedagogy is the nature of the investment management model itself. The theory behind the levels of value is intended to represent the perspective of hypothetical disinterested investors. In a world of financial buyers who can choose freely between alternative instruments, this idea holds.But most RIA investors are insiders, practitioners who work at the investment management firms. The lines between returns to labor and returns to capital are often blurred (although we strongly advise structuring your model otherwise). Insiders have different motivations to show loyalty to their employer, and in turn firms often bestow ownership on staff on favorable terms because of the labor-intensive, relationship-based nature of investment management.Insider ownership is often managed by buy-sell agreements, which at the same time restrict owners from certain actions but also provide them with access to liquidity (under specified circumstances) and a claim on returns. Buy-sell agreements often establish particular parameters for valuation as a way to side-step valuation theory to benefit the ownership and the business model of the particular RIA. Valuation theory operates in a ceteris paribus (all else equal) universe, whereas buy-sell agreements do not operate in this vacuum.Valuation theory operates in an all else equal universe, whereas buy-sell agreements do not.Finally, the issue of discounts for lack of marketability – that minority investors suffer from lack of ready access to enterprise level cash flows – is a byproduct of focus on old economy, heavy industry businesses structured as C-corporations in which dividend policy can be parsimonious. Most RIAs are structured as tax pass-through enterprises (LLCs or S-corporations) and don’t rely on heavy amounts of capital reinvestment. High payout ratios (often nearing 100%) mean minority investors do, in fact, typically enjoy regular returns from enterprise cash flows. Consequently, discounts for lack of marketability are usually smaller for investment management firms than for minority investments in many other industries.Institutional Investors Make Minority Investments With Majority ConditionsOne would expect institutional investors, as financially driven actors who are free to invest across a broad spectrum of opportunities, to behave in a manner more consistent with the hypothetical investors described by valuation theory. The institutional community has, however, developed practices to protect itself from many of the vagaries of minority investing. Achieving rights and returns similar to control investors has led to transaction pricing on par with control transactions, a phenomenon which isn’t inconsistent with conventional wisdom.Institutional investors in the RIA space have corrected for many of the disadvantages associated with being a minority investor by way of contractual minority interest protections.Institutional investors in the RIA space have corrected for many of the disadvantages associated with being a minority investor by way of contractual minority interest protections. No two firms handle this the same way, but board representation, performance reporting, rights to change senior management, compensation agreements, bonus plans, restrictions on non-cash benefits, assurance of timing and performance for distributions, and even revenue sharing arrangements can go a long way to putting a minority investor on terms comparable to a majority owner. Without the risks that accompany lack of control and lack of marketability, minority participants can focus on the value of the enterprise.As an added benefit, if management still holds most of a firm’s equity, then outside investors have more assurance that insiders will pay attention to their jobs. This avoids the issue of RIA leadership “calling in rich” following a lucrative recapitalization and mitigates the monitoring costs that accompany most private equity investing. Sitting alongside management on an economic basis, but knowing management is sufficiently motivated, many institutional investors have effectively created the best of both worlds in minority investing: comparable returns without comparable responsibility.Valuation Theory Is the Real WorldUltimately, valuation models are descriptive, not prescriptive. The economic principles underlying valuation models are the real secret sauce.The behavior of insiders and professional investors is often seen in conflict with the notion that minority interests carry a lower value than pro rata control. In fact, these minority investors are not typical, coupling their money with conditions of ownership that mitigate or eliminate the distinctions between value on an enterprise basis and value on a fractional basis. In our view, the behavior of professional minority investors substantiates the presence of valuation discounts for investors who lack similar protections and privileges.About the car: In the late 1950s, while Detroit focused on building huge, heavy, powerful, front engine sedans and wagons, Italian automaker Fiat designed a petite coupe with a canvas roof and a two-cylinder rear-mounted engine. The Fiat 500 was as contradictory to conventional wisdom at the time as it was easy to park and cheap to own. Detroit boomed, but the Cinquecento sold almost four million units over 18 years. Different markets have different needs.

Oilfield Water Management

Clean Future Act Regulatory Concerns

In the midst of the COVID pandemic, the rise of the Delta-variant, and general summer distractions, not a lot of attention has been given to the 117th Congress’ H.R. 1512 – aka the “Climate Leadership and Environmental Action for our Nation’s Future Act” or the “CLEAN Future Act.” The Act was first presented as a draft for discussion purposes in January 2020. After more than a year of hearings and stakeholder input, it was introduced as H.R. 1512 in March 2021. The Act’s stated purpose is:“To build a clean and prosperous future by addressing the climate crisis, protecting the health and welfare of all Americans, and putting the Nation on the path to a net-zero greenhouse gas economy by 2050, and for other purposes.”As broad as that stated purpose is, it’s not surprising just how far-reaching the implications of the nearly one-thousand-page-long Act are for many sectors of the U.S. economy. While Congress is a long way away from any bipartisan climate legislation being enacted, the Act provides some insight regarding the plans of the House Democrat Leadership for a clean energy future. It also potentially serves as a “red flag” to many industry participants that will be materially impacted by those plans.Of particular interest to the Oilfield Water Management sector, is Section 625 of the Act. In that section, the Environmental Protection Agency would be ordered to determine whether certain oil and gas production byproducts, including produced water, meet the criteria to be identified as hazardous waste. The legislation in fact, mandates that the EPA must make its determination within a year after the Act becomes law.Per the EPA’s April 2019 study publication, Management of Exploration, Development and Production Wastes: Factors Informing a Decision on the Need for Regulatory Action, produced water is defined as “the water (brine) brought up from the hydrocarbon bearing strata during the extraction of oil and gas. It can include formation water, injection water, and any chemicals added downhole or during the oil/water separation process.” Since 1988, EPA has held that oilfield-produced water should be regulated as non-hazardous waste. As such, produced water has been subject to the Resource Conservation and Recovery Act’s (RCRA) much less restrictive Section D provisions regarding non-hazardous waste, instead of RCRA Section C’s much more restrictive provisions regarding hazardous waste.Per a June 2021 report by Rice University’s Baker Institute for Public Policy, if the EPA’s Act-directed review of the 1988 produced water’s non-hazardous classification is revised to a hazardous classification, an enormous disruption in oilfield water management would result. The report specifies that severe disposal capacity constraints would be brought into play.At the current time, oilfield produced water disposal is available at an estimated 180,000 Class II disposal wells located throughout the U.S. If the Act were to lead the EPA to reclassify produced water as hazardous waste, all produced water would have to be disposed of in Class I wells, of which there are far fewer. The EPA’s data on Class I wells indicates that approximately 800 such wells are in existence; however, the wells are located in only 10 states due to geological requirements. The majority of those Class I wells are located in Texas and Louisiana. The EPA also indicates that only 17% of the Class I wells are available for hazardous waste disposal. Adding to the limited Class I well availability matter, the University of Wisconsin Eau Claire reports that those hazardous waste disposal wells are located at a mere 51 facilities. Source: EPA The cost of transporting Eagle Ford and Permian Basin produced water (in excess of 10 million barrels per day), for example, hundreds for miles to Class I facilities on the Texas and Louisiana Gulf Coast would be prohibitive to many producers. As a result, a substantial reduction in U.S. oil and gas production would be a natural and expected consequence, with the economic and industry ripple effect of such reduced production being enormous. Gabriel Collins, the Baker Botts Fellow in Energy and Environmental Regulatory Affairs at the Baker Institute, notes that any such re-classification would very likely lead to multi-system disruptions severe enough to make achieving the Act’s climate, energy, environmental, and social objectives impossible.While the Act is awaiting action by the U.S. House of Representatives, it’s well worth Oilfield Water Management industry participants keeping a close eye on it. Although Congress’ attention has been focused on COVID relief and is now focused on infrastructure matters, the CLEAN Future Act will eventually come to the forefront, with potentially far-reaching impacts if unchanged from its current form.ConclusionMercer Capital closely monitors the Oilfield Water Management and other areas of the Oilfield Services industry. We’re always happy to answer your OFS-related, or more general valuation-related questions. Please contact a Mercer Capital professional to discuss your needs in confidence.

Growing Pains

Is the RIA Industry in Growth Mode or Shake-Out?

While the wealth management industry is not new, the amount of change, churn, and growth that has occurred in the industry over the past ten years make it easy to forget how far the RIA industry has come since the heyday of broker-dealers.Following a financial crisis brought on by scandal and exacerbated by leverage, the fiduciary model has become the solution to restore trust in the industry among both clients and regulators. Since this transition, AUM has grown dramatically, as has the number of RIA firms. After a ten-year bull run, which was only momentarily stalled by the country’s shortest economic recession, strong performance from passively managed funds has enabled fee compression throughout the industry.Contextualizing the challenges facing the wealth management industry leaves one to wonder if many of these trends are no more than growing pains in the sector’s life cycle. And if so, what might such analysis suggest about the prospects for the fiduciary model?The lifecycle of an industry is often characterized by the following phases: start-up, growth, shakeout, maturity, and decline.Start-Up. During an industry’s infancy, customer demand is at first limited due to unfamiliarity with the new product and its performance. From the aftermath of WWII until the advent of ERISA in the 1970s, the broker dealer model flourished. During the 1970s, bad market conditions kept the lid on RIA growth, but by the 1980s registered reps were leaving wire-house firms and young trust officers were leaving banks to set up registered investment advisors, usually offering a very wide variety of services priced under what was then the new fee-based concept, instead of commissions.Growth. Just as customer demand is limited at first, so is competition which can lead to impressive growth and profits until more players enter the space. However, the inevitability of competitors chasing profits, is an elementary principal of economics. Over the past couple of decades, the count of RIAs, the number of professionals who work for RIAs, and the dollar volume of assets managed by RIAs, has exploded. But, competition has led to the need for differentiation, and that need has led to specialization.Shakeout. Periods of high profits, low market concentration, and pressure for consolidation is often described as the shakeout period because many firms aren’t positioned to survive. As market participants vie for a limited supply of market share, all the while cutting costs to remain competitive, consolidation is inevitable. In theory, ‘economic profit’ in an industry is only temporary. If the recent history of the wealth management industry can be grafted to a typical industry life cycle framework, the wealth management industry may be in a shakeout period. Consider the following trends that have dominated the independent advisor narrative in recent years:The wealth management industry may be in a shakeout period.Product Innovation: Product innovation is the catalyst for every industry lifecycle. That initial great idea, product, or service is adopted by many market players as the industry grows. These adopters often bring their own ideas to the table, or spawn other industries in response. In short, innovation, and the industry life cycle for that matter, is an iterative process bound by serendipity—or disaster as was the case for the fiduciary model after the Financial Crisis. While fiduciary money management has been around for quite some time, its rapid adoption resembles something like a genesis. The growth in the RIA space over the years has been charged by innovation, be it money managers finding new business models that allow their teams more independence or clients demanding new services or increasing levels of specialization. As seen in the 2021 Charles Schwab RIA Benchmarking Study, firms of all sizes are continuing to increase their offerings (across all service types: tax planning, charitable planning, estate planning, family education, bank deposits, and lifestyle management) as firms look to distinguish their value proposition.CLICK HERE TO ENLARGE THE IMAGE ABOVENumber of firms: A shakeout period is often defined by both low market concentration and rapid consolidation as firms use acquisitions to maintain economic profit rather than seek growth organically. As we recently noted, the number of RIA firms continues to grow to record numbers despite intense deal activity that would otherwise be considered a hallmark of consolidation. Meanwhile, wire-houses have consistently lost market share over the past ten years as the myth of corporate brand continues to be undermined by AUM flow. This conflict between the increasing number of firms and the pressure for consolidation is in large part being driven by the same profit dynamics that categorize the beginnings of a shakeout period. Growth & Profitability: While assets managed by independent advisors nearly tripled during the ten years between 2009 and 2019 profitability has begun to lag as clients have become increasingly fee sensitive. Much of the fee compression in the RIA space is being driven by competition with passively managed funds, which until recently have had the longest bull run in history to go unchallenged. But, as evidenced by the record number of independent advisors, competition among firms is just as easily responsible. Regardless, profitability explains the high deal volume in a wealth management space that benefits from economies of scale. Because revenues are tied to AUM and certain overhead costs are more or less fixed, operating leverage can have a positive impact on margins even with modest fee pressure. But it’s not just fees that are feeling pinched. RIAs are increasingly competing for talented money managers who have become more aware than ever of the value of their book of business.Economic utility might just be a better metric than economic profitability for understanding the incentives behind consolidation in the wealth management space.For this reason, economic utility might just be a better metric than economic profitability for understanding the incentives behind consolidation in the wealth management space. In an industry as labor intensive as wealth management, advisors are just as much clients as they are the product, and advisors are leaving wire-houses in favor of independence, often for reasons not always tied to pure economics.Ultimately, as the industry tries to accommodate both the price preference of clients and the lifestyle preferences of its most valuable assets, market concentration will remain low and deal values high. As such, and despite ballooning valuations, acquisitions remain at all-time highs while so too does the number of RIA firms. A shakeout period explains the conflict between the need for scale and the pressure to retain talent as economic utility is being carved out.CLICK HERE TO ENLARGE THE IMAGE ABOVEOr, is the RIA Industry still in Growth Mode?For now, we see no end in sight for the RIA acquisition frenzy. And, despite the large number of RIA transactions, most firms are not looking to sell. In a yield starved environment, RIAs continually are perceived as the ultimate growth and income investment. AUM growth, and ultimately earnings growth, show no signs of slowing. An upward trending market is a further catalyst. So, while there may be a growing quantity of RIA firms, the appetite for acquisitions appears to be greater with many owners holding on.What does this mean for your independent wealth management firm? While the industry lifecycle may be a helpful tool for understanding current industry headwinds, the timeline of industry phases is impossible to predict. Innovations can arise that can propel an industry back into a growth phase or just as likely syphon profitability towards rival industries. Additionally, firms can always achieve high growth through product innovation or superior capital budgeting no matter what industry they operate in. At most, the industry lifecycle helps make sense of the challenges facing the industry today and perhaps where to look for solutions, be that through additional services, reduced fees, or acquisitions.That said, the wealth management industry is competitive and will continue to be so. Fee compression will continue to be a headwind, and as a result staying cost competitive is as important as ever. Higher fees should be justifiable by premium services, value adds or ancillary services. But perhaps equally as important, retaining talent will continue to be crucial as advisors have more market power than perhaps ever before. And while the days of charging 1% of AUM might be waning, the combination of high cash flow and high growth continue to be attractive as evidence by elevated deal volume and multiples.

M&A, Reinvesting in Core Operations, or Paying Dividends

How Public and Private Dealerships Should Think About Allocating Capital Amidst Excess Liquidity

Over the past year or so, many auto dealers “outperformed” particularly as inventory shortages have raised margins on new and used vehicles in 2021. Additionally, cost cutting initiatives have dealerships running more efficiently, leading to record profitability. The question now comes for public and private auto dealerships alike: what do I do with this excess liquidity?In last week’s blog, we looked at second quarter earnings calls from public franchised auto dealers. Several themes were present in these calls, one of which was the movement toward share repurchases in several firms’ capital allocation approach over the quarter. Many CEOs implied that high multiples and frenzied activity in the M&A market was a determinant in the decision to repurchase shares.In this post, we consider what options are available to both public and private dealers. We look at what decisions the publics are making, and what that could mean for private dealers.Capital Allocation OptionsAuto dealers, and many other businesses more broadly, have numerous options when it comes to allocating capital, including:Reinvest in the business Expand organically (including adding rooftops to current locations or adding new locations)Acquire other dealerships/companies to increase revenue and earningsReturn capital to providers of capital Debt repaymentsDividendsShare repurchasesReinvesting in the BusinessDuring the depths of the pandemic, M&A activity plummeted as significant uncertainty created a chasm between what buyers were willing to pay and what sellers were willing to sell for. As the operating environment stabilized and ultimately improved, deal activity picked up considerably. For the public auto dealers and larger private auto groups, acquisitions have been a clear way to reinvest in automotive retail. However, if recent earnings calls are any indication, this activity may begin too slow as sellers seek peak multiples on peak earnings, something we’ve discussed as unlikely to be palatable for acquirers for obvious reasons.Outside of M&A, options for growth or reinvesting in the business may be limited particularly for private auto dealerships with only a few stores/rooftops. Auto dealers, like other retail businesses have four primary avenues for growth:Penetration (same product, same markets: increase frequency of trips or size of transactions to get an increased share of discretionary spending). Auto dealers can focus advertising spend to seek to capture more market share, particularly on fixed operations side where there are more regular interactions with consumers.Expansion (same product, new customers: adding new store locations in different markets to get new customers with current product offerings). Auto dealers can look to open points in adjacent markets. This can also include investing in the Company’s digital sales strategy, if we consider the digital ether as another “market” itself even if the dealership location doesn’t change.Innovation (new product, same customers: to offer in their existing footprint or additional sales channels). This can be somewhat limited for auto dealers as OEMs exert control over what vehicles are produced. However, dealer principals can improve their product offering by adding new rooftops, whether connected to their existing footprint, or nearby. There are also opportunities to introduce or refine the suite of F&I products offered to consumers.Diversification (new product, new customers: companies can seek to vertically integrate their supply chain or enter adjacent/new lines of business in order to diversify both their product offerings and customer base). Auto dealers aren’t able to vertically integrate as they are dependent on their OEM. However, entering adjacent industries that may have synergies is still possible, whether that be a heavy truck dealership, powersports dealership, or business interest entirely. OEMs have significant power when it comes to awarding new points, which can limit Expansion. OEMs are also in charge of product innovation (what new models will be available), and OEMs and competitive market forces can leave relatively little wiggle room on vehicle pricing (part of penetration). Even capital expenditure decisions can be influenced by imaging requirements. Dealer principals seeking growth are likely to look at adding rooftops or new locations, increasing market share, or adding new business lines. However, efficient allocators of capital seek to hit certain return thresholds. Absent attractive prospects, it may be wise to instead return capital to its providers.Returning Capital to Debt Providers and ShareholdersIndustries have been impacted by the pandemic in various ways. While some saw material declines in activity, others have performed greater than they did in 2019, which has been the case for many auto dealerships. Companies that received PPP loans are likely to have even more liquidity, which has caused business owners to contemplate what to do with the funds once they’ve been forgiven. Many have chosen to pay down debt, reducing ongoing interest costs and helping the owners of more heavily indebted companies to sleep better at night.However, since inventory is financed by floor-plan debt and many auto dealers opt to hold the real estate in a separate entity, many do not carry material third party debt related to the core operations of the auto dealership. That leaves two options: paying dividends/distributions or share repurchases.Private companies are much more likely to be paying distributions as there is either not an active market for their shares, or those holding minority positions in the company are not interested in selling. There’s been much talk about restrictions on share buybacks in industries that received considerable stimulus (like airlines). Since executives of the auto dealers have begun buying back shares instead of splurging on what they view as expensive M&A, we give some thoughts on stock buybacks below.Stock BuybacksFor public companies, management teams may elect to buy back shares for a number of reasons. First, they likely will not buy back shares if they think the market is overvaluing their stock. As a corollary, buying back shares can serve to raise the stock price as it provides a signal to the market that they believe the stock is undervalued. Signaling is important in the presence of asymmetric information, which exists when corporate insiders have access to better information about the company’s prospects than outside investors.While the company may not receive any direct benefit from an increase in the stock price (no cash received), this can lower the cost of capital for the company. If the company takes on debt to repurchase shares, this shifts the weighted average cost of capital more towards debt than equity, which can lower the cost of capital if it helps achieve a more optimal capital structure. So long as the debt does not become burdensome to the point it leads to higher interest rates or increases the equity discount rate, this can be advantageous.Fundamentally, share buybacks are another form of distributing capital to remaining shareholders. While some investors pick companies for dividends, many investors, particularly in recent years, are investing for long-term capital appreciation. Share buybacks is a tax-advantaged way to return capital to shareholders that does not trigger dividend taxes. Instead, a company that elects to buy back shares instead of paying dividends would be expected to see higher levels of share price appreciation, and capital gains taxes are deferred until the investor decides to sell their shares.ConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These trends give insight to the market that may exist for a private dealership which informs our valuation and litigation support engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of August 24, 2021

Q2 2021 Earnings Calls

Public Auto Dealers Weigh Record Profits, Days’ Supply, and Capital Allocation

Second quarter earnings calls across the group of public auto dealers began with similar themes: record profits and earnings, record Gross Profits Per Unit (GPU) on new and used vehicles, and tightening inventory conditions. Additionally, the public franchised dealers continue to post large scale improvements in SG&A expense as a percentage of gross profit.Executives revisited the reductions in personnel expense and their sustainability as GPUs are expected to decline at some point in the future. In a previousblog post, we discussed the prevailing industry conditions in inventory as reflected in the average days’ supply of new and used vehicles. The table below displays SG&A expense as a percentage of gross profit and the average days’ supply for the public auto companies for the second quarter:Click here to expand the image aboveThe trends reported by the public franchised dealers mirror those of the industry as a whole: continued tightening on the new vehicle side, but improvements on used vehicles. Executives offered their predictions for how the OEMs and the industry might evolve to supplying new vehicles once plant production and the microchip crisis normalize. Executives also discussed the ability to leverage their dealership platforms to source used vehicles from several sources including trade-ins, lease returns and campaigns such as “We’ll Buy Your Car” by AutoNation. As a result, the public franchised dealers are less reliant on auctions for used vehicle sourcing and are seeing some improvement in their used vehicle counts.Last week’s blogexamined the investment thesis and results of used-only public retailers such as CarMax, Carvana, Shift and Vroom. With record profits and a red hot M&A market, public executives discussed the opportunities for capital allocation and how they are evaluating and prioritizing the best fit for their companies. Three of the public companies in particular, AutoNation, Sonic and Penske, have chosen to invest in their used vehicle supercenter locations branded as AutoNation USA, EchoPark, and CarShop, respectively.Sonic provided some insight into the overall strategy of its used-only retail locations in its second quarter investor presentation. While front-end GPUs are expected to be lower (and sometimes negative) at the EchoPark locations, executives expect superior returns to be driven by the increased F&I GPU and overall volume of transactions at these platforms, compared to their franchised dealerships. These investments and strategies combined with other omnichannel investments by all of the public companies are in an attempt to capture the overall trend of an online retail experience.A deeper dive into some of the themes listed above is provided below, including remarks from management, related to expectations moving forward.Theme 1: The public companies continue to post improvements in SG&A as a percentage of Gross Profits driven by both sides of the equation: decreased expenses and record gross profits. While gross margins are universally expected to decline at some point, the jury is out on sustainability of cost reductions?“Our strong performance continues to be driven by strict cost discipline, leverage of our digital capabilities and robust vehicle margins. […] overhead decreased by 760 basis points, compensation decreased by 380 basis points, and advertising decreased by 30 basis points on a year-over-year basis […] I think for this year we will be in around the 60% range […] over 90% [of the increase in SG&A] is coming through variable cost. We are doing a very good job of keeping the fixed costs fixed, with strong discipline and leveraging the digital tools that we have” – Joe Lower, CFO, AutoNation“Same store SG&A to gross profit was 56.4% in the quarter, an improvement of 1,440 basis points over 2019. While we expect SG&A to gross profit to normalize [as] new vehicle supply and gross margins bounce back to historical levels […] we continue to benefit from the permanent headcount reductions of almost 20% or almost 300 basis points of SG&A and other efficiency measures implemented last year.” - Christopher Holzshu, COO of Lithia Motors“Obviously if growth comes down, that impacts SG&A…we’ve taken 11.5% of our workforce out […] we’re finding out we’ve got better productivity. Our mechanics are all over 120%. We see sales now per unit for a sales associate going from 9% to maybe 12% or 13%.” – Roger Penske, CEO Penske Automotive Group“If you look at our productivity on our sales associates […] we used to sell 12 units per month […] now we’re running 18,19. […] the other one [cost saving] is centralization of advertising […] we’re spending a lot less on advertising, and it’s even more effective.” - Heath Byrd Chief Financial Officer, Sonic AutomotiveTheme 2: Public executives boast of continued improvements in their omnichannel/digital platforms displaying that customer behaviors justify the infrastructure costs from these platforms. Advancements are illustrated in unique number of visitors, online transactions, and increased use of DocuSign and other electronic forms of signature software. Digital channels also allow the public companies to expand their footprint.“Our customers continue to vote yes on Acceleride […] we continued our upward trajectory in the second quarter by selling a record 5,600 vehicles through Acceleride, more than double the prior year. […] when incorporating all steps of the sales process, nearly 30% of our customers are using Acceleride. […] there’s opportunity to leverage Acceleride to expand our used vehicle business through our existing footprint […] in this quarter, we acquired almost 4,000 units through Acceleride […] and that was in a lot of markets that we’re not in today.” - Darryl Kenningham, President of US and Brazilian Operations, Group 1 Automotive“Driveway generated over 350,000 monthly unique visitors in June. Driveway eclipsed the 500-unit milestone with 550 transactions in June […] 98% of our Driveway customers during our second quarter were incremental and have never done business with Lithia or Driveway before […] we can now market and deliver our 57,000 vehicle inventory to the entire country under a single brand name and negotiation free experience […] 97.5% of customers in Driveway are entirely new to Lithia and Driveway […] we are delivering cars at a lot further radius […] last quarter we were at 740 miles or so […] we’re at 930 miles [because of] scarcity in vehicles." - Bryan DeBoer, CEO and President, Lithia MotorsTheme 3: A frenzied M&A market and heightened valuations have forced public executives to be more disciplined in their capital allocation approaches. Some of the publics (AutoNation, Group 1 and Penske) have prioritized share repurchases, others (AutoNation, Sonic) have prioritized reinvestment into their existing used vehicle platforms, while all must constantly evaluate acquisition opportunities against their individual growth, geographic and rate of return requirements.“A lot of different sellers that would like to work multiples off of Covid earnings. […] in the last six months [we] have walked away from $3 billion or $4 billion in business because we didn’t feel like it was priced appropriately.” – David Hult, President and CEO, Asbury Automotive Group“We’re investing in our existing stores […] keeping them top-notch […] but when we see that AutoNation is an attractive price, we have not hesitated to buy aggressively […] we view purchasing our own company relative to the pricing we see as other choices as the best use of that capital after having taken care of investing in our existing stores and building out [AutoNation] USA. […] I bought 9% of AutoNation rather than doing a lot of acquisitions that I thought were overpriced.” – Mike Jackson, CEO, AutoNation“During the second quarter, we repurchased 125,000 shares […] while the first priority for capital allocation remains M&A, we continue to be open to returning cash to our shareholders in the form of both share repurchases and an increase in our quarterly dividend. […] But the acquisition market is probably as frothy as it’s ever been […] it’s best if our acquisitions are accretive […] so we’re going to keep that as our top priority for capital allocation […] I would say it’s clear that share buybacks have been our second priority when we’re not able to find acquisitions to meet our financial hurdle.” – Daniel McHenry, Senior VP and CFO, and Earl Hesterberg, President and CEO, Group 1 Automotive“Despite a slightly more competitive environment, we continue to successfully target after tax returns of 15% plus, investments of 15% to 30% of revenues, and three to seven times EBITDA […] potential acquisitions that we believe are priced to meet our return thresholds […] we are expecting acquisition cadence for the remainder of 2021 to be strong.” - Bryan DeBoer, CEO and President, Lithia MotorsTheme 4: While average days’ supply on used vehicles is beginning to improve, the supply of new vehicles still remains near record lows due to production challenges from plant shutdowns, microchip shortages and increased consumer demand. Public and private franchised dealers have navigated these conditions to record profits. Will the current levels of production and inventory supply prove transitory, or will the OEMs adapt to the current conditions that one executive compared to the aphorism “rising tides raise all boats”.“I’m hopeful that when things normalize, we don’t quite settle back at the 70-80 day supply, we’ve run a good 20 days below that. […] OEMs are building the inventory the consumer wants.” - David Hult, President and CEO, and Dan Clara, SVP of Operations, Asbury Automotive Group, Inc.“The manufacturers […] are using the chips that they do have to produce vehicles that consumers want [to] buy. […] I really don’t know if we will ever see a crossover point back to the old push system […] maybe the best path is somewhere in between. […] it’s not 14 days […] but maybe its 30-40 days […] somewhere like we run pre-owned […] I was expressing more of a hope of where the industry would see as a new goal and not going back to the 70,75,80, 90 days’ worth of inventory. […] I have never been a strong proponent or advocate of the build-to-order model […] People are getting 95%, 98% of what they really want in a relatively short period of time of 30 days to 45 days.” - Mike Jackson, CEO, AutoNation“With our geography, we’re very big truck retailers […] You traditionally carry a pretty high day supply of those domestic brands because of the proliferation of models on full-size pickup trucks […] so if we could run a leaner distribution system, it would really reduce our inventory carrying costs and our land requirements.” – Earl Hesterberg, President and CEO, Group 1 Automotive“I think there’s a big wave between 60-70 days supply and a zero-day supply […] even at a 23-day supply, customers are able to get immediate gratification […] this idea that you’re going to have 100 cars to choose from that are all quite similar, that Americans seem to like […] I think consumers will ultimately determine that by not buying cars on the lot that are run of the mill and rather get that additional individuality that maybe they’re looking for.” - Bryan DeBoer, CEO, Lithia Motors“The big question there is can we keep the discipline at the OEM level from the standpoint of days’ supply in the 30 to 40 days […] and see what it does for them from a profitability standpoint. And obviously it’s been key for us at the dealer level.[….][OEMs] understand that their costs are down on supporting inventories […] if they start building units to fill these plants that aren’t the ones that customers want we’re then going to see an inventory pickup of vehicles that are not ones that people want to buy and then it’s going to start bouncing back in the same direction we were before.” - Roger Penske, CEO, Penske AutomotiveTheme 5: With the proliferation of Electronic Vehicles (EVs), private franchised dealers are left wondering what their involvement will be from the retail and service side. Most of the public executives envision the continued use of the dealer franchise system for EVs as opposed to a direct to consumer model.“The best model of supply [EVs] to the consumer is through the dealer franchise system. These cars are very complex, people need to be able to communicate locally [….] the highest dollar spent [in the service department] on electric vehicles […] its first generation technology, there’s a lot of software glitches […] we’re already working them into our collision center […] over time […] they still need brakes, batteries….[…] we’ve made a lot of investments already and we’ll continue to make more investments both in physical training and equipment.” - David Hult, President and CEO, Asbury Automotive Group“The complexity of the automobile is going exponentially. And that when there are issues […] the number of entities that actually can care for it and fix it are fewer and fewer. And that we look at only the electric vehicles, the investments we are having to make in specialty equipment and technical training. Expertise is unbelievable in the connected [EV] car.” - Mike Jackson, CEO, AutoNation“We’re supporting our OEMs with EV. EV is going to be driven by political [forces] […] from a dealership standpoint, until we get a significant market of EVs, I don’t see a big issue from the standpoint of parts and service growth. It’s going to take a different technician…because of the technology. […] the warranty [work] will have to be done by us and we’ll also obviously have to deal with the complexity.” – Roger Penske, CEO, Penske AutomotiveConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight to the market that may exist for a private dealership which informs our valuation and litigation support engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Why Is No One Selling in a Seller’s Market?

Even in One of Hottest M&A Markets in Recent History, Most RIA Principals Still Do Not Plan to Sell Their Business in the Next Three Years.

According to a recent Franklin Templeton Survey, only 14% of RIA principals expect to transact their ownership-interest in their investment management firm over the next year while 36% expect to sell between one and three years from now.Source: Franklin Templeton InvestmentsThese statistics are perplexing for an aging industry where less than half of advisors over the age of 65 have a formal succession plan and acquisition multiples continue to climb higher.Source:Franklin Templeton InvestmentsThere are some explanations to this disconnect. From an economic perspective, many RIA principals are hesitant to forego their high dividend coupon in a yield-starved environment. Additionally, when an RIA principal exits the business, they forfeit their salary and bonus payments, so the sale price would have to justify this substantial loss of annual income. Many principals also prefer to keep their firm employee owned, but it’s often difficult to sell the business to younger staff members who may be unwilling or unable to purchase the firm at its current market value. Additionally, the sale of smaller advisory practices (under $100 million in AUM) may not be practical since the primary principal often manages most of the client relationships, which may not transfer after he or she exits the business.These realities don’t excuse the industry’s ownership from failing to plan for an eventual sale or exit from the business. Most investment management firms have value beyond their founding principals. Not only can planning for that eventuality maximize your sale proceeds, but it can also ensure your key employees and clients will stick around long after your departure.How To Ensure a Successful SuccessionA logical starting point for accomplishing a successful transaction is tying management succession to ownership succession. Many of our clients’ principals sell a portion of their ownership to junior partners every year (or two) at fair market value (FMV). This process ensures that selling shareholders (who hope to sell at a maximum value) are incentivized to continue operating the business at peak levels while allowing rising partners to accrue ownership over time. Many buy-sell agreements also call for departing partners to sell their shares at a discount to FMV if they are terminated or leave within a pre-specified period to ensure they remain committed after the initial buy-in.Simply put, a successful succession requires the alignment of buyer and seller interests. Gradually transitioning ownership to the next generation of management at a reasonable price is one way to align your interests with the next generation of management.A successful succession plan also requires decoupling your day-to-day responsibilities from ownership. This can’t (and shouldn’t) happen overnight. After you’ve identified a capable successor(s), make sure he or she assumes more of your management responsibilities and not just your share count. Your work hours should decrease over this transition period.When advising clients on management and ownership succession, we often tell principals that are approaching retirement to ask themselves where they want to be in five or ten years (depending on their age and other factors) and work towards that goal. We rarely hear that they want to maintain their current work levels for the rest of their career. Have a goal in mind and steadily work towards it as others assume your responsibilities and ownership. It should pay off in retirement.

Themes from Q2 Earnings Calls

Part 2: Mineral Aggregators

Last week, we reviewed the second quarter earnings calls for a select group of E&P companies and briefly discussed the macroeconomic factors affecting the oil and gas industry. In this post, we focus on the key takeaways from mineral aggregator second quarter 2021 earnings calls.Operators Maintaining Drill Bit DisciplineAggregators keep a close eye on E&P companies as they often reap the benefits of the drill bit, but also fall victim to capital discipline initiatives. In the second quarter, many aggregators made note of operators’ disciplined approach as prices and rig counts continued to rise.“Our portfolio has benefited as bigger and better capitalized operators have taken over operatorship of our minerals to enable more consistent and disciplined development. Our focus on the highest rate of return undeveloped locations throughout our history ensures that our mineral position migrates to the top of any operator's drilling inventory.” – Ben Brigham, Executive Chairman & Director, Brigham Minerals“Despite the increase in rig count through the second quarter, we do anticipate that trend to flatten through the remainder of the year, as operators maintain their capital discipline.” – Jeff Wood, President & CFO, Black Stone Minerals“Operators in the U.S. continue to practice discipline with their drilling activity even in the face of significantly higher commodity prices.” – Bob Ravnaas, Chairman & CEO, Kimbell Royalty PartnersCapitalizing on Favorable Price EnvironmentIndustry participants remain optimistic as prices have increased significantly over the last year. Some aggregators were heavily hedged, and others, like Brigham Minerals, are reaping the benefits of their unhedged position.“In fact, this is the best macro setup I've seen in my career, and I've lived through numerous cycles. Benefiting from our diversified portfolio of high-quality mineral assets, our shareholders are positioned to benefit from what I believe is very likely a long ramp of elevated pricing for oil, NGL and natural gas prices. This is particularly true given that unlike some of our peers, we are unhedged.” – Bud Brigham, Founder & Executive Chairman, Brigham Minerals“Oil prices are now well above pre-COVID levels, but the U.S. land rig count is 39% below year end 2019 levels. Furthermore, natural gas prices are trading at multiyear highs, driven primarily by increased power demand in the U.S. and surging exports of LNG to Europe and Asia. Given that a significant portion of our daily production is natural gas, we expect this improved pricing to benefit our cash available for distribution in Q3 2021 and into the winter months based on the current strip pricing.” – Bob Ravnaas, Chairman & CEO, Kimbell Royalty Partners“The increase in royalty volumes was mainly due to the Midland and Delaware properties but we also saw nice increases outside of our major shale plays as well, but seen a remarkable rebound in commodity prices since the middle of last year and are currently well above pre-pandemic price levels.” – Tom Carter, Chairman & CEO, Black Stone MineralsDistributions Ramping UpAggregators have built a reputation of acting as a yield vehicle with the ability to reinvest, unlike traditional royalty trusts. Their popularity increased as they maintained healthy distributions over the years, however the challenging environment in 2020 put most payouts in jeopardy. With the uptick in prices and a more optimistic outlook, aggregators seem confident to return to historical payout levels.“The $0.31 per common unit distribution this quarter reflects a 75% payout of cash available for distribution. We will use the retained amount, 25%, to pay down a portion of the outstanding borrowings under Kimbell’s credit facility.” – Davis Ravnaas, President, CFO & Chairman, Kimbell Royalty Partners“This allowed us to maintain a 100% distribution in the second quarter of 2020 and importantly enter 2021 unhedged with our investors fully exposed to the run-up in commodity prices as the economic reopening took hold toward the end of last year and more fully during the first quarter of this year associated with the vaccine rollout.” – Robert Roosa, CEO & Director, Brigham Minerals“We generated $72.1 million of distributable cash flow for the second quarter or $0.35 per unit. That gave us a lot of flexibility to increase our distribution while still holding some cash and reserve for further debt repayment.” – Jeff Wood, President & CFO, Black Stone Minerals Conclusion Aggregators seemed optimistic across the board in the second quarter of 2021. Prices have rebounded, and distribution policies are returning to normal, which in their minds creates good shareholder sentiment. However, the continued capital discipline of E&P operators may affect aggregators in the short to intermediate term.Conclusion Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership. Contact a Mercer Capital professional to discuss your needs in confidence.

ATRI’s Report on Critical Issues in 2021

In October 2021, the American Transportation Research Institute released its 2021 survey of Critical Issues in the Trucking Industry. The ATRI survey was open from September 8, 2021 through October 15, 2021 and includes responses from over 2,500 stakeholders in the trucking industry in North America. Respondents include motor carrier personnel (52.4% of respondents), commercial drivers (24.1%), and other industry stakeholders (23.5%, including suppliers, trainers, and law enforcement).

Used Vehicle Margins in 2021

How Large Used-Only Auto Retailers Are Measuring Up

As our dealer clients know, automotive retailing competition has intensified with large, well-capitalized online-only retailers getting plenty of attention. Due to imbalances between supply and demand, gross margins on both new and used vehicles have increased in 2021.In this post, we survey gross margins for the publicly traded dealerships, in light of the current operating environment and reconsider the investment thesis put forth by the new entrants.Investment Thesis of Online Used-Only RetailersInvestors in used-only retailers likely have numerous reasons for believing in these companies. We’ll highlight some of the reasons below, then delve deeper into a few of them.Lack of franchise agreements in used vehicle space enable significant growth/market reachCOVID-19 anticipated to accelerate auto retailing towards e-commerce seen in other retail sectorsCustomer dissatisfaction with traditional retail experienceGross margins tend to be higher on used vehicles than new vehiclesAsset-light business modelLack of Franchise AgreementsFor the publicly traded traditional auto retailers, franchise agreements can inhibit growth. Executives have discussed on earnings calls the obstacles that can occur when they accumulate numerous stores in the same brand. For used-only retailers, there are no similar restrictions as the sale of used vehicles are not subject to franchise agreements. While this may be a positive for growth and geographic diversification, this limits the market available to these companies.Vroom’s 2020 investor deck highlighted used auto as one of the largest markets at $840B trailed by grocery ($683B) and new auto ($636B). Using these figures (which are pre-pandemic), used-only players are limited to ~57% of the market.While growing to become the premier used vehicle operator would have obvious benefits, if any of these players can meaningfully consolidate the highly fragmented market, there is a downside to only interacting with consumers when they want a used vehicle. This is also why executives of franchised auto dealers have started harping on the number of "touch-points" they have with consumers which includes new and used sales as well as service appointments. source: Vroom, Inc.COVID-19 and the Shift to EcommerceA core strength of pre-pandemic automotive retail was the lack of penetration from ecommerce. As seen above, ecommerce penetration prior to the pandemic was less than 1% as determined by Vroom. The space has been Amazon-proof to a degree, though auto dealers and consumers were thrust into a digital world last March and April. Over a year later, it seems clear that the number of transactions and the percentage of transactions completed online will increase.Online retailers tout that they are the future, and the pandemic has only accelerated trends in consumer preference towards online. Only time will tell how truly transformed the environment is. Does the lack of ecommerce penetration represent a massive opportunity for new entrants in the market, or does it just paint a picture of how difficult it will be for these companies to attract profitable market share?Gross Margins and Profitability at LargeAnother long-term key consideration will be profitability. As with Amazon and Facebook, tech companies can command huge valuations prior to turning profitable. Many Silicon Valley startups claim to be the next unicorn that will achieve scale, ramp down expenses relative to revenue growth, and watch red ink turn to black.Because Carvana, Shift, and Vroom are still relatively young companies, their lack of profitability has not yet detracted from their value. However, gross margins can still be compared because companies spending significant amounts on advertising will have a hard time turning the corner if the unit level economics aren’t there.Let’s revisit what was mentioned at the outset. Used vehicle margins have been stronger than new vehicle margins. That remains to be true. Gross profit margin for the average dealership through the first half of 2021 was 13.4%, up from 11.8% through 1H20. For the new vehicle department, gross as a percentage of selling price increased to 8.3% YTD 2021, up significantly from 5.5% in the prior year period. The same is true for used vehicles: 14.0% YTD 2021 versus 11.4% in 2020. New and used margins are up in 2021, and used margins continue to outpace new.Parts and service departments have higher margins than vehicle sales departments, and these departments account for a significant portion of gross profit for auto dealers. According to NADA, through the first half of 2021, gross profit contribution from parts and service was considerably lower than historical levels (37.4% of total gross profit), but it still outpaced that of both new and used vehicle departments despite making up a much lower percentage of revenue. Below, we have calculated gross margins in 2021 for the public auto dealers.Click here to expand the image aboveUsed vehicle gross margins exceed new vehicle gross margins for Asbury, AutoNation, Group 1, and Lithia. Notably, however, that is not the case for Penske, LMP, or Sonic. Sonic’s 2.8% used vehicle gross margin stands out as an outlier, but we do see here that used vehicle gross margins are not exclusively higher than new. This could be due to the difficulty of sourcing vehicles in this environment.LMP and Penske also have the highest new vehicle margins, which could be at the detriment of used vehicles margins if they extract higher ASPs on new vehicles by offering higher trade in values.For total gross margin, however, the impact of fixed operations is clear. Blended total gross margin for traditional franchised auto dealers is approximately 15-18%. For used-only retailers, used and total gross margins are much lower as seen below.Click here to expand the image abovePerhaps these retailers are underpricing their vehicles to gain market share, and it is true that lost incremental vehicle sales from these retailers has a compounding effect. In addition to a lost vehicle sale, consumers are also less likely to go to a dealership for parts and service if they didn’t originally purchase the vehicle from that dealership. While this could have a long-term negative impact on total gross profit for dealerships, it remains to be seen if there will be mass adoption to buying vehicles from these platforms. Unless there is a material change in franchise laws, these companies won’t be able to sell new vehicles.ConclusionUsed-only online retailers may be the future. Customer dissatisfaction with "the old way" may push more people to try something new. The Carvana's of the world may improve their gross margins with data-driven technologies lowering costs and tactfully raising prices without losing their new customers.The asset-light model may help attract enough investors to lower the cost of capital for larger players enabling a virtuous cycle of greater scale and efficiencies. These players may eventually also look to get into the service and parts business to improve gross margins, though this would be hard to square with an asset-light approach.For now, though, franchised auto dealers will continue to operate with the strong foothold afforded to new vehicle dealers that can cater to customers throughout the life cycle of their vehicles.Mercer Capital provides business valuation and financial advisory services, and our auto team focuses on industry trends to stay current on the competitive environment for our auto dealer clients. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Treasures in the Attic

The Value of Future Fiduciary Appointments

Independent trust companies are frequently named in wills to serve as the trustee of an estate or living trust. These appointments may create a revenue opportunity for an independent trust company next year or fifty years from now. A trust company is sometimes notified of their assignment but isn’t always. Future fiduciary appointments certainly have some value; but how much and how do you measure it?Valuation MethodologyFuture fiduciary appointments are one element that factors into a trust company’s overall valuation. As such, the value of these relationships isn’t generally considered separately from the rest of the business, and the guidance on how these appointments contribute to the overall value of the business is limited. There are, however, many situations where analogous assets may be valued on a stand-alone basis for accounting or other purposes. These similar concepts from other disciplines or industries can provide direction and perspective on the value of future fiduciary appointments.Future fiduciary appointments are one element that factors into a trust company’s overall valuation.Contract ValuationsWhen a business combination such as a merger or acquisition occurs, accounting standards generally require that an exercise known as a purchase price allocation (PPA) be performed. The purpose of a PPA is to allocate the consideration paid for a business to the acquired tangible and intangible assets, which can include acquired technology, customer relationships, contracts (customer and supplier), noncompete agreements, tradenames, etc. Future fiduciary appointments for trust companies bear some similarity to a customer contract; although, a trust company does not have to agree to a fiduciary appointment, the executor of an estate is contractually obligated to hire the trust company unless it does not accept.There are many different commonly accepted approaches to contract valuation, but the most relevant as it relates to future fiduciary appointments is the income approach. In a purchase price allocation, the value of a contract can be determined using the income approach by projecting out the future cash flows that result from the contract and applying an appropriate discount rate. But in purchase price allocations, the existence of the contracts and terms of the contracts are known, whereas independent trust companies are not always notified of their appointment in a will, and even if notified, the size of the estate and potential revenue is often unknown.Oil & Gas Reserve ValuationsAt first glance, it’s hard to imagine two industries more different than independent trust administration and oil and gas. But the future fiduciary appointments held by trust companies do have a notable similarity to oil and gas reserves. Oil and gas reserves represent a real asset to the landowner, but the size and profitability of these reserves is often unknown. Likewise, future fiduciary appointments are a real asset for trust companies, but the size and profitability of these relationships is generally not known in advance. Oil and gas reserves are categorized as Proven Developed Producing (PDP), Proven Undeveloped (PUDs), Possible (P2), or Probable (P3). PDP reserves currently generate revenue and can be valued using a discounted cash flow analysis. But PUD reserves, which are proven to exist but not currently developed or revenue generating, and probably and possible reserves, which are less likely to be recovered, are not as easily valued.Can future fiduciary appointments be viewed similarly to the PUDs, P2, and P3 reserves?So, can future fiduciary appointments be viewed similarly to the PUDs, P2, and P3 reserves? Are known appointments comparable to PUDS and unknown appointments comparable to P2 and P3 reserves?Valuation practitioners sometimes rely on option pricing to capture the value of PUDs, probable, and possible reserves. As the price of oil increases, PUDs, probable, and possible reserves become more economical to develop. The PUD and unproved valuation model are typically seen as an adaptation of the Black Scholes option model. Applying this same principle to value fiduciary appointments would require significant assumptions about the possible number of appointments, the size of the estates, and the average number of deaths per year. Additionally, a future fiduciary appointment is not necessarily option-like, as there is no set exercise price. And for most independent trust companies who are likely to generate significant cash flows in the near term, the impact of these future cash flows may be too small to matter (once present value math has been applied).The Right Way To Value Fiduciary Appointments May Be More SubjectiveFiduciary appointments do have value, but separating this value from the enterprise as a whole may not be the best way to think about it. Rather than valuing these separately, we typically adjust our projection and discount rate assumptions and our guideline company analysis.Discounted Cash Flow Method. As we discussed above, discretely projecting cash flows from future fiduciary appointments is not always possible. But an analyst can factor in the potential upside of these assignments when selecting the appropriate discount rate and terminal growth rate. Should the discount rate be lower since there are additional future revenue opportunities that weren’t built into the projections? Or maybe the terminal growth rate should be higher, as these appointments will allow the company to sustain higher levels of ongoing cash flow growth.Guideline Public Company Method. Although there are no publicly traded pure-play trust companies, publicly traded investment managers do have a similar structure to independent trust companies. Both earn fees on assets under management / administration and have operating leverage such that when AUM / AUA increase, fixed costs do not increase at the same rate. Therefore, we often use the pricing of publicly traded investment managers to gauge investor sentiment and establish a reasonable range for pricing expectations for businesses that manage or administer assets on behalf of clients.We may apply an adjustment to the implied valuation multiples of the public companies to account for the differences between an independent trust company and the selected group of publicly trade investment managers. While many independent trust companies are smaller in size, have less access to capital markets, and have lower margins (trust administration is labor intensive), some of this risk may be offset by the growth opportunity presented by future fiduciary appointments. How much of that risk is offset is a matter of the facts and circumstances of the particular independent trust company.Who Should Value Your Independent Trust Company?Choosing someone to perform a valuation of your independent trust company can be daunting in and of itself. There are plenty of valuation experts who have the appropriate training and professional designations, understand the valuation standards and concepts, and see the market in a hypothetical buyer-seller framework. And there are a number of industry experts who are long-time observers and analysts focused on the industry, who understand industry trends, and have experience providing advisory services to independent trust companies.At Mercer Capital, we think it is most beneficial to be both industry specialists and valuation specialists.

Consolidation in the RIA Industry

RIAs Are Being Acquired at a Record Pace, But Does That Really Mean the Industry Is Consolidating?

Consolidation is a theme that has a lot of traction in the RIA industry: that a growing multitude of buyers are scrambling to outbid each other for a limited and shrinking number of firms.Circumstances, such as, aging founders or a lack of internal succession planning are bringing firms to market, where firms are quickly bought up and rolled into any one of a number of acquisition models that have emerged (and continue to emerge) in the industry. Aggregators are bolting RIAs onto their platforms, branded acquirers are assembling RIAs with national scale through a series of acquisitions, and larger RIAs are growing through strategic acquisitions of smaller firms. Competition amongst these buyers for the limited number of firms coming on the market has driven acquisition activity and multiples to all-time highs.With the rapid pace of deal activity in the RIA industry, you might expect to see the number of firms decline, as that is typically the norm for consolidating industries. The banking industry, for example, has been consolidating for three decades and, as a consequence, the number of banks in the U.S. has steadily declined from about 18,000 in 1990 to about 6,000 today. But that’s not been the case in the RIA industry, at least yet.Despite consolidation pressures and record levels of acquisition activity, the reality is that the number of RIAs continues to increase, with formations outpacing consolidation. In 2019, there were approximately 13,000 individual SEC registered investment advisory firms, up from about 10,900 in 2014.Several factors have contributed to the increase in the number of RIA firms. For one, the RIA industry has experienced secular tailwinds from the shift from the broker dealer / commission model to the fee-based, fiduciary model. As the chart demonstrates, the number of FINRA registered broker dealers has gradually declined in recent years—the mirror image of the growth seen in the RIA industry. In many cases, broker dealers have shifted to fee-based models, and firms with dual registrations have gradually shifted to the RIA side of the business.This overarching shift from the broker dealer model to the RIA model is multi-faceted. For one, it’s clear that clients (in general) prefer the advisory relationship offered by RIAs over that offered by their broker dealer counterparts. And a model that’s in demand by clients is also in demand by advisors. Additionally, we’ve found that building significant enterprise value (value attributable to the business, not the individual) is generally easier for firm owners to achieve under the RIA revenue model than the broker dealer model. This prospect of building a business with enduring value that can be sold to an external buyer at the end of the founder’s career or transitioned to next generation management is a key motivation behind many advisors’ decisions to start their own RIA. It also doesn’t hurt that, compared to the broker-dealer model, the amount of capital required to start an RIA is relatively minimal.When looking at the increase in the number of RIA firms, though, there are a couple of nuances to keep in mind. Some acquisition models in the industry result in the acquired firm maintaining its SEC registration, so consolidation doesn’t necessarily mean a decline in the number of registered firms. Another caveat is that the data captures only SEC-registered investment advisors and not state registered investment advisors (generally, advisory firms with over $100 million in AUM are required to register with the SEC, whereas firms below that threshold are regulated by the state in which they do business). These wrinkles aside, the data is unambiguous that there are more SEC registered advisory firms today than ever before—and that’s hardly indicative of an industry in the throes of consolidation.Another way to track consolidation is to look at how assets under management are distributed across firms of different sizes, rather than at the number of firms. The industry hasn’t seen significant consolidation by this metric either. Consider the chart below, which shows the distribution of industry assets across different sized firms in 2011 and 2021. After a decade of significant M&A activity and strong market growth, the distribution of assets across different size firms looks about the same as it did ten years ago. Then, as now, firms under $100B AUM controlled approximately one-third of industry assets, while firms over $100B control approximately two-thirds of industry assets. What we haven’t seen is an erosion of market share for smaller firms; in fact, they’ve maintained market share in a growing market.What does all this mean for the industry? As it stands today, rising supply of RIAs has done little to dampen the pricing for RIAs; instead, it’s seemingly added fuel to the M&A fire. Notwithstanding an increase in the number of firms, attractive firms whose founders are open to selling today remain scarce, and the ratio of buyers to sellers remains high. As a consequence, multiples for RIAs are at or near all-time highs today. Whatever downward pressure there’s been from the supply side of the equation, strong buyer demand has more than offset it.While the consolidation pressure in the industry is real, we are still in early stages. Many successful advisory practices prefer to go at it alone and transition internally, unless circumstances such as age of the principals or lack of next-generation management arise to force an external transaction. Consolidation pressures may ultimately lead to an increase in the number of firms that are on the market and a shift in the supply/demand equilibrium, but as it stands today, sellers are scarce, and building a new firm from scratch is difficult. Time will tell if the RIA industry sees the same level of consolidation as we’ve seen in the banking industry, but at least in the near term, the number of RIA firms appears poised to continue growing as the supply of new firms more than offsets a significant level of M&A activity.

2021 Transportation Industry Update | COVID in Review

COVID-19 has had a lasting impression on many industries throughout the world, but the U.S. trucking and transportation industry was among the first industries to feel the impact of the pandemic.Lockdowns in China (initiated in December 2019) began affecting the U.S. trucking industry in very early 2020 as Chinese imports account for nearly 40% of all shipments entering the U.S. By the beginning of March, the U.S. had already begun to see massive declines in incoming freight with an escalation of shipping cancellations. The ports of Seattle and Long Beach experienced 50-60 container shipment cancellations reflecting declines of 9% relative to the prior year.When discussing the decline of imports in the port of Seattle, Sheri Call of the Washington Trucking Association said, “That’s the kind of decline we’d normally see over the course of an entire year.” Disruption of international trade led to transportation companies reducing capacity as early as the beginning of March. Outbound rail and trucking shipments from LA dropped 25% and 20% respectively, in March 2020.Due to social distancing requirements throughout the United States, many roadside eateries and rest areas were closed in the first several months of the pandemic, which reduced truck drivers’ access to food and other necessities for long days on the road. Trucking companies were forced to alter their transportation network, frequently carrying empty loads as a result of uneven and declining demand. According to Reuters, “trucks hauling food and consumer products north to the United State are returning empty to Mexico where mass job losses have hit demand, leaving cash-strapped truckers to log hundreds of costly, empty miles.” Empty loads increased nearly 40% worldwide in the immediate aftermath of the lockdown.An indication of the health of U.S. trucking industry can be seen through the ratio of full north bound trips to full southbound trips at the Mexico-US border. The ratio is typically one full southbound trip to every three full northbound trips, but the ratio began to lean closer to a one to seven ratio during the pandemic with the remainder being empty or partially full. Additionally, new freight contracts have fallen 60% to 90% since the rise of COVID-19 in 2020.Increased online shopping from consumers has led to a spike in demand for last-mile delivery services. Amazon reported $75.5 billion in 2020 first-quarter sales which was a 26% increase from the first quarter of 2019. Many last-mile delivery companies like FedEx and Amazon continued to hire workers with Amazon seeing an increase in company employment of nearly 175,000 workers from March to April of 2020. Last-mile delivery carriers also eliminated signature requirements so that they can now achieve a “contactless” delivery process.The level of domestic industrial production is correlated to the demand for services within the transportation industry. The Industrial Production Index is an economic measure of all real output from manufacturing, mining, electric, and gas utilities.Lockdowns that began in March of 2020, as a result of the pandemic, led to a sharp decline in the Industrial Production Index. The index began a rapid recovery during the summer months of 2020. At the end of the first quarter of 2020, the Industrial Production Index saw a quarter-over-quarter decrease of 16.7% while also being down 17.7% on a year-over-year basis. The index rebounded in the second quarter of 2020 with a quarter-over-quarter increase of 12.7%. The index continually increased over the last three quarters of 2020, but it had not reached pre-pandemic levels as of April 2021. The outlook for the trucking industry at the beginning of 2020 was promising with economists predicting that freight rates would grow 2% over the course of the year. Strong economic growth in the first two months of 2020 was halted by the outbreak of the unforeseen pandemic. The impact was dramatic – though not entirely negative for all carriers. Carriers of essential goods like groceries, cleaning supplies, and medical supplies experienced skyrocketing demand for their services while industrial, manufacturing, and other non-essential carriers are still undergoing lasting effects from the pandemic. One non-essential industry that experienced a downward turn at the onset of the pandemic was the vehicle shipping services industry. A strong economy with high disposable income and consumer confidence ramped up consumer spending for the American automobile industry in the periods leading up to the pandemic. The industry’s growth prospects were halted during 2020 due to a high unemployment rate and a drop-off in disposable income. The success of the vehicle shipping services industry is closely intertwined with new car sales and consumer confidence. The graph below shows the relationship between revenue of the vehicle shipping services industry and new car sales and consumer confidence. Overall, decreased consumer confidence in 2020 led to many Americans electing to defer vehicle upgrades, which created a major economic downturn for the vehicle shipping services industry.With many businesses closed, overall Cass Freight trucking shipments plummeted, seeing a decrease of 15.1% and 22.7% from April 2019 to April 2020. Truck tonnage also dropped 9.3% on a from March 2020 to April 2020 while declining 8.90% from April 2019 through April 2020.The fall of the number of shipments along with overall truck tonnage caused transportation companies to lower contract and spot rates. Flatbed and reefer rates hit a five-year low in April of 2020, though they rapidly recovered and had surpassed pre-pandemic rates by the fourth quarter of 2020. Truck tonnage has not recovered at the same rate as spot and contract pricing and had not reached pre-pandemic levels by March 2021. These trends are reflected in the Cass Freight and Shipment Indices. While the Shipments index has increased relative to its April 2020 level and has surpassed pre-pandemic levels, the Expenditures index increased over 27% from March 2020 through April 2020.Even though contract rates did not have as sharp of a decline in March of 2020 as spot rates, both experienced a drop-off at the onset of the pandemic. Spot rates dropped below numbers that had been seen in recent years. After the sharp decline of spot rates in March, rates for all categories began to steadily increase. Rates hit a seasonal decline at the end of December due to decreased consumer spending after the holiday season. Rates resumed their climb during the first months of 2021. Overall, the rising price of contract and spot rates spins a positive image for overall outlook of the trucking industry, while also encouraging new competition to enter the market.At the beginning of 2020, there were strong predictions for revenue in both the long distance and local trucking industries. Once the COVID-19 pandemic hit, revenues for both parts of the trucking industry dropped along with future revenue predictions. After a few months of lockdowns, the trucking industry began a rapid rebound as a result of businesses reopening and increased online retail. Future revenue predictions from March and April of 2021 from both the long distance and local sectors exceed predictions made in October 2020.Industrial production and consumer spending, spurred on by the substantial stimulus programs enacted by federal government, have recovered more rapidly than initially expected. This rapid recovery has seemingly reduced the expected long-term impacts of COVID-19 on the long-distance and local trucking industries.The effects of rising trucking rates and revenues coupled with optimistic outlooks for both categories can be seen in the number of long-distance and local trucking establishments. Lured in by appealing spot and contract rates, March 2021 predictions for the number of establishments in the trucking industry look to be on the rise. Naturally, there was a drop-off in the number of establishments in 2020, but the industry seems to have recovered with numerous new entries into the market in 2021. The long-distance trucking industry is projected to have more than one hundred thousand more establishments than originally forecasted in January of 2020.

July 2021 SAAR

The July 2021 SAAR was 14.8 million units, roughly flat compared to July 2020, but down 12% from July 2019. SAAR was expected to fall for the third straight month, but this figure is lower than many experts predicted in June. As far as contributing factors to this slip, automotive manufacturers continue to struggle producing enough vehicles to meet insatiable demand that is emptying car lots around the country. Inventories continue to be drawn down and consumers are beginning to abandon their preferred color and trim selections as well as their preferred model and production year in favor of similar vehicles simply because they are actually available for purchase.As we detailed in last week’s blog, retail sales have crowded out fleet sales with an estimated 90% of total sales volumes in July, and this trend is also expected to continue as dealers no longer need to sell larger blocks of inventory at discounted prices. Dealers are doing everything they can to get new cars in the hands of consumers, as elevated prices continue to boost profits on a per unit basis.The average new-vehicle retail transaction price in July is expected to reach a record $41,044. The previous high for any month, $39,942, was set last month in June. Dealers are also capturing a greater share of these transactions prices as average incentive spending per unit, a measure of financial inducement used by manufacturers to motivate sales of specific vehicles, is expected to fall to $2,065, down from $4,235 in July 2020 and $4,069 in July of 2019. However, this doesn’t necessarily translate to skyrocketing costs for consumers as high trade-in values and low interest rates mean average new vehicle monthly payments of $622in July are only up 6.4% while transaction prices have increased 17%.Despite lower volumes, dealers are seeing record revenue levels as supply/demand imbalances have led to these surging prices. It also illustrates the relatively inelastic demand for consumers. Record vehicle prices have been noted across mainstream media outlets, yet customers continue to buy what little inventory dealers have. Consumers who can wait to buy a vehicle may be starting to hold off. But for those returning to the office in the wake of a public health crisis, there may not be many functional alternatives to personal vehicles. As noted above, monthly vehicle payments also haven’t surged as much as sticker prices.The trends outlined above tell the story of what auto dealers have been experiencing for months now. Tight supply unable to keep up with demand are leading to a red hot market, and it looks like price and turnover metrics may continue to reach new heights until supply issues are alleviated.Pickup Truck Market Share StumblesOne effect that these current market conditions have had on the automotive industry involves sales of pickup trucks. According to Wards Intelligence, large-pickup truck market share was 13% of total sales in July 2021, down from 15.2% in July 2020. This was the lowest market share figure for the vehicle class since July 2016. In April of this year, Ford decided to prolong its production shutdown for the F-150 pickup truck, citing parts shortages as the primary cause. During this period of shutdown for Ford, General Motors pressed forward with its production of the GMC Sierra, mentioning the importance of its pickup truck sales to the firm’s bottom line. Ford was able to restart truckproduction in June, but the decision by General Motors to sink available resources into its truck models eventually resulted in its own forced production shutdown in late July.Stories like these have dominated automotive news cycles over the last several months and it is not hard to believe that, despite the importance of pickups to the profitability of these firms, trucks are equally as hard to produce during this period of input shortages as other vehicle classes, particularly for the larger trucks as compared to other trucks and crossovers. Manufacturers are having to make decisions regarding which models to prioritize, and it seems like start-stop production has already become normal for most manufacturing plants around the country. Manufacturers are expected to continue to intermittently shut down truck production until automotive supply chains recover, while production of other best sellers are prioritized for weeks at a time.With a more complete understanding of the lumpy nature of model-specific production during the last several months, it can be expected to see large swings in market share for under-produced vehicle classes. Shutdowns in April and May related to the F-150 and shutdowns in July and August for the GMC Sierra have resulted in fewer trucks hitting lots, and therefore less market share in the sale of all vehicles for an underrepresented truck class. For the ones that are sold, many may not even see lots as pre-selling has become increasingly important. Once the dust settles and the necessary inputs for vehicle production become more readily available, the market share for pickups is expected to normalize at historical levels or even expand in response to pent-up demand. Until then, expect volatility in metrics like market share going forward.What To Expect? ForecastOver the last three months, many experts have tried to predict vehicle production rates to no avail. Mercer Capital’s own December 2020 Forecastfor the 2021 SAAR was in the range of 16 million units, quite bullish at the time. Looking forward to the end of supply shortages and heightened demand has proven a difficult task, and many previously bullish analysts are rolling back their expectations for a third quarter rebound. For example, the LMC Automotive forecast was reduced by 200,000 units on its last iteration. With more frequent announcements on manufacturing stoppages hitting the presses each week, the industry should not expect inventory levels to change much over the next month. With this in mind, total light vehicle sales are still expected to be around 16.5 million unitsin 2021.ConclusionIf you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact any members of the Mercer Capital auto team. We hope that everyone is continuing to stay safe and healthy.

DUC Clock Ticks On Cheap Production: Low-Cost Cash Flow Won’t Last

As we await second quarter earnings for publicly traded upstream producers, there are several markers and trends that suggest cash flows and profits will swell. Investment austerity and the recently resulting profits will almost certainly be bandied about on management calls. However, what might not be touted as loudly will be how much longer this can last? Existing U.S. production, much of it horizontal shale, is declining fast, operational costs and inflationary pressure are rising again, and the only way to augment production is through some combination of drilling and fracking.Cash Flow Crowned KingAccording to the latest Dallas Fed Energy Survey, business conditions remain about as optimistic as they were in the first quarter whilst oil and gas production has jumped. In the meantime, U.S. shale companies are on the precipice of delivering superior profits in 2021: in the neighborhood of $60 billion according to Rystad. How are they doing that? A combination of revenue boosts and near static investment levels. Analysts are pleased and management teams are crowing about cash. The industry should be able to keep it up, but only for a finite period. How long is that? Nobody knows for sure, but a good proxy may be the shrinking drilled but uncompleted (DUC) count of wells in the U.S. Overall DUC counts peaked in June of 2020 at 8,965, with the Permian leading the way. June 2021 statistics show DUCs at 6,252 or a 2,713 (30%) drop in one year. Just last month 269 DUCs disappeared with nearly half of those coming out of the Permian. This matters because DUC wells are much cheaper to bring online than fully undeveloped locations. Around half the drilling costs are already sunk and therefore it is incrementally cheap to complete (frack) and then produce from a DUC well. It’s low hanging fruit and producers with high DUC counts can profitably take advantage of recent price surges. However, these easily accessed volumes can’t be tapped forever. Last month’s DUC drawdown pace leaves less than a two-year backlog of DUC’s remaining, and it’s worth remembering that companies like to keep some level of inventory on their books, so the more realistic timing may be before 2022 ends. Inventory On The DeclineAll this is in conjunction with permit counts way below even 2019 levels (although rising – particularly among private companies). There’s likely going to be supply shortages in the future, as most producers in the Dallas Fed Survey suggest - but who will pick up that slack? OPEC may not be the only answer here. Granted, not every OPEC country has the spigot capability Saudi Arabia does and some other OPEC+ members have not been above cheating on their production limits in the past.Nonetheless, global inventories continue to decline. The U.S. Energy Information Administration’s short term energy outlook expects production to catch up due to OPEC+ recent production boost announcements, but nobody exactly knows what that will look like in the U.S. The EIA acknowledged that pricing thresholds at which significantly more rigs are deployed are a key uncertainty in their forecasts. There’s no certainty the U.S. shale industry will be able to pick up the demand slack either. They are preparing to live on what they have already drilled. Producers are under immense pressure to keep capital expenditure budgets under wraps and focus on investor returns. As such not much external capital is chasing the sector right now. A good example is this respondent to the Dallas Fed’s Survey: “We have relationships with approximately 400 institutional investors and close relationships with 100. Approximately one is willing to give new capital to oil and gas investment…This underinvestment coupled with steep shale declines will cause prices to rocket in the next two to three years. I don’t think anyone is prepared for it, but U.S. producers cannot increase capital expenditures: the OPEC+ sword of Damocles still threatens another oil price collapse the instant that large publics announce capital expenditure increases.” Pretty said. As a result industry analysts at Wood Mackenzie say U.S. crude production will grow very modestly during 2021 and likely 2022. OPEC+ is adding production, but not a lot – only 400,000 barrels per day being added back compared to the nearly 10 million per day cut in 2020. That leads to price pressure and the market has been catching on. Valuations on the AscentThese industry forces have contributed to the E&P sector having an outstanding year from a stock price and valuation perspective. Returns have outpaced most other sectors, and Permian operators have performed at the top of the sector. However, it is important to note that much of this gain is recovery from years of prior losses.An interesting observation (and consistent theme of mine) is that proven undeveloped reserves (PUDs) are the biggest beneficiary of this value boost. As production from existing wells declines, the value from tomorrow’s wells is getting a big bump. Mergers and acquisitions in the past year at what now appear to be attractive valuations, often paid very little if anything for PUDs, but buyers got them anyway. They are gaining valuation steam now. What were out of the money options are now moving into the money. Acreage values are intrinsically going up in West Texas (both Delaware and Midland basins), South Texas (Eagle Ford) and recovering in other areas such as the Anadarko basin in Oklahoma.Companies like Diamondback Energy have acquired acreage recently (QEP and Guidon deals) that surround or is contiguous with legacy acreage positions. This will come in handy when new wells come into view of capex budgets, and as I mentioned – there is a visible path whereby they could come into view in the next couple of years with oil above $70 per barrel.Investors appear to be cautious in view of OPEC+ perceived sword of Damocles hanging overhead, which is logical. However, the fundamentals remain lopsided towards high prices for some time, barring another catastrophic event, which of course could always be lurking around the corner.Originally appeared on Forbes.com.

The Fundamental Value of RIAs? Scarcity.

If the Choice Is Buy vs. Build, "Build" Doesn’t Even Come Close

Are RIA transaction multiples getting out of hand? Contrary to the usual laws of supply and demand, each week it seems like we hear about another blockbuster deal rumored to have happened at an astronomical price, and correspondingly, we meet a new capital source we hadn’t known previously who is looking for a way to implement an acquisition strategy in the RIA space. Is this FOMO on a grand scale, or just part of a grander moment in market dynamics? If you weren’t hiding under a rock last week, you probably read plenty about the Robinhood ($HOOD) IPO. Robinhood is a noteworthy counterpoint to the RIA space because it is practically the anti-RIA. RIAs target high net worth investors who want returns and capital preservation; $HOOD targets young speculators with money to burn. RIAs develop recurring revenue streams from investment management; $HOOD builds transaction volume by hyping "opportunities." RIAs follow a fiduciary standard; $HOOD monetizes clients with margin accounts and payment for order flow. If you wanted to define the typical RIA business model, you would do well to just assume the opposite of Robinhood.If you wanted to define the typical RIA business model, you would do well to just assume the opposite of Robinhood.Yet, $HOOD’s initial few days of trading bear out a revenue multiple that is mind-numbing, even compared to the high-watermark transactions in the RIA space. I can’t explain it, and I’m tempted to dismiss it as a sideshow altogether. But, a glance at Robinhood, digital assets, or 10 year treasuries for that matter, suggests that the wall of money that has moved an array of asset valuations higher over the past 15 months has yet to abate.Valuation practitioners are wired to respect intrinsic value. We can’t help but view assets like Bitcoin and Meme-stockbrokers with a curmudgeonly air. And it’s hard to get excited about bond yields measured in basis points instead of percentage points, regardless of your inflation outlook. RIA valuations, on the other hand, we can defend.RIAs remain the ultimate growth AND income play.RIAs remain the ultimate growth AND income play. What other business model produces a coupon in the upper single to low double digits, and then increases the dollar amount of that return with market and organic growth? Even at EBITDA multiples that would have made people blanche a few years ago, the return profile on RIAs is hard to match. Low yielding treasuries don’t come close, even on a risk adjusted basis.This isn’t to say that investing in RIAs is without risk. Investment management is labor intensive so much that we’ve been told by one very experienced buyer that he feels one can "rent" an interest in an RIA, but never really "own" one. Many RIAs struggle with genuine organic growth, and the most recent Schwab industry study shows AUM growth outstripping revenue growth, suggesting that realized fees are eroding – even in wealth management. Nevertheless, looking back over the past 18 months, it’s hard to find a business that was more adaptable and resilient than investment management – what looked like bottomless downside turned into banner performance.Our perspective isn’t unique. The problem is that for all the interest in acquiring RIAs, there aren’t that many to be had. While the total count of RIAs is debatable (about 15,000 to 40,000 – depending on who’s counting), what is easier to see is that the portion of substantial RIAs, especially those in the wealth management space (where much of the acquisition interest is these days) is small. There are maybe 500 wealth management firms with AUM in excess of $1.0 billion, and a good portion of those see themselves as acquirers rather than sellers. You can always consolidate smaller firms, of course, but it’s hard to build a $100 billion shop with $300 million add-ons.Acquisition activity is hot, multiples are strong, and there’s no end in sight.Bitcoin aficionados can talk about verifiable scarcity all day, but most people aren’t qualified to audit the bitcoin algo that limits the number of coins. We know what it takes to build multi-billion dollar AUM firms – time – a lot more time than it takes for server farms to mine digital coins. The best growth for RIAs is still organic, but life is short, and most grandiose investment strategies in investment management don’t budget the decades it takes to do it from scratch. Ergo, acquisition activity is hot, multiples are strong, and there’s no end in sight.The Aston Martin DB4 GT pictured above looks very similar to the ones produced in the early 1960s, but it was actually built in 2019. The GT version (more power, less weight) of the DB4 was supposed to total 100 cars, compared to the 1200 or so regular models. The DB4 GT production run ended early, though, as Aston Martin introduced the DB5 (the model ultimately mythologized in James Bond movies) after building only 75. As a consequence, auction prices of the GT version usually had an extra digit compared to those of comparable non-GT series cars.Five years ago, Aston Martin decided to do a special production run of the final 25 cars. Each car took an estimated 4,500 man-hours to build, and all were presold at £1.5 million. Interestingly, the 33% increase in supply didn’t dent auction prices for original DB4 GTs, and I suspect a similar increase in larger RIAs would just add to buyer enthusiasm.I wonder if crypto-investors would have a similar experience.

First Half 2021 Review of the Auto Dealer Industry

What Are Key Statistics Saying?

As we enter into the second half of 2021, first half statistics are being released and second quarter earnings calls are on the horizon for the public auto companies. We’ve all read the headlines of the auto dealer industry in 2021: heightened profitability, historic gross profits per unit and soaring retail sales prices for new and used vehicles, and inventory shortages and challenges caused by plant shutdowns and the microchip shortage. What are some of the key statistics saying about the current and future health of the auto dealer industry? Have they peaked, are they continuing to increase or beginning to decline, and/or how long will the current conditions hold?Back in December, we analyzed the state of the auto dealer industry through the use of various statistics/metrics: Retail Gross Profit Per Unit – New Vehicles, Retail Gross Profit Per Unit – Used Vehicles, and Used to New Vehicle Sales Unit Ratio. In this post, we revisit and examine those statistics through the first half of 2021 and discuss other key statistics including Average Days’ Supply, Fleet Sales, and Vehicle Miles Traveled.According to Dealership Profiles reported by NADA, average dealerships have posted pre-tax earnings at 5.1% of revenues as of May 2021 (most recently published data at the timing of this post). This figure has climbed through the start of 2021 and is higher than any reported annual figure since 2010, (when the NADA began publishing the data). How long can this continue and what are the key drivers of the historic profitability?New VehiclesThe sale of new vehicles continue to be impacted by imbalances between supply and demand. While auto dealers are selling fewer new vehicles, the average selling price and the retail gross profit per unit ("GPU") are at all-time highs.Let’s revisit retail gross profit per new vehicle: the numerator is gross profit achieved on the retail sale of new vehicles (as measured by the retail selling price less the cost paid to the manufacturer to acquire the vehicle) and the denominator is the total number of new vehicles retailed (fleet sales are excluded).As seen in the graphic below, the new vehicle GPU rose throughout late 2020 and has continued that rise through May 2021, to a total of $3,139 per unit. New vehicle GPU has risen every month in 2021, but will/can it continue? To answer that question, let’s start with the average days’ supply of the new vehicle equation. Average days’ supply is a metric used to measure the amount/supply of new vehicles that either an auto dealership or the auto dealer industry as a whole holds in relation to the average daily demand. The ratio is calculated by first determining the average monthly daily units of new vehicles by taking the prior month’s or average month’s unit sales divided by 30 days to arrive at average daily units. Finally, the number of new units in inventory at any given point in time is divided by the average daily units to determine the average days’ supply. This ratio is tracked on both new vehicles and used vehicles. Historically, the auto industry operated at an average days’ supply for new vehicles around 60 days. Average days’ supply on new inventory continues to plummet in 2021, reaching a low of 25 days’ supply as of June 2021. At the two state auto conventions that we attended last month, every auto dealer that we spoke with reiterated these conditions. It was very common to hear dealers state inventory unit numbers in the single digits for most of their franchise’s best models. Industry experts are predicting that July numbers will continue to follow these trends. July sales are expected to decline due to a lack of inventory, putting downward pressure on both the numerator and denominator. If the average days’ supply for new vehicles continues to fall, that means supply is falling faster than demand. Some early highlights from the Q2 earnings calls from the public auto companies indicate that they are experiencing average days’ supply less than 20 days and in some extreme cases, less than 10 days. New vehicle production and inventories are not anticipated to stabilize until the latter part of 2021 or perhaps not until 2022. In the next few months, the lack of supply will eventually cut into the heightened profitability that auto dealers have experienced for the first half of 2021. Even if GPUs are high, eventually such a decline in volume will necessitate a decline in overall gross profit levels, even if margins remain solid. It will be interesting to see how the OEMs respond to new vehicle production and average days’ supply when plants and conditions return to normal. The industry has proven it can operate more efficiently at leaner levels of inventory, but will the OEMs return production to the historical levels of 60 average days’ supply? While profits are higher, consumers are unlikely to be as understanding to the lack of inventory after the difficulty of reopening post-pandemic is solved. Used VehiclesLike new vehicles, used vehicles have also been impacted by supply and demand. Demand for used vehicles has increased rapidly due to shortages of new vehicle inventory and also changing consumer preference for those impacted financially by the pandemic.According to Cox Automotive, the average retail price of a used vehicle climbed to an all-time high above $25,000 for June 2021. As a result, auto dealers are experiencing record highs for retail gross profit per used vehicle.GPU for used vehicles is calculated the same as new vehicles discussed earlier, just for used vehicles. As seen in the graphic below, the used vehicle GPU rose in late 2020 and continued to rise through May 2021, to a total of $3,275 per unit. Used vehicle GPU has also risen every month in 2021, but will/can it continue? To answer, we again turn to average days’ supply. According to data published by Cox Automotive, the average days’ supply of used vehicles ranged between 55-66 as seen by actual data from November 2019 (pre-pandemic) and December 2020 (during the pandemic). Average days’ supply on used inventory has shown signs of improvement from a low of 33 units in March 2021. June 2021 levels have risen to 41 days supply as seen below. The bigger impact for auto dealers continues to revolve around sourcing for used vehicle units. Historically, auto dealers have sourced used vehicles from trade-ins, purchasing wholesale units at auction, buying back rental car fleets, and purchasing off-lease vehicles. With fewer new vehicle sales, there are fewer trade-ins. Sourcing vehicles at auction can be tricky for auto dealers in a market where used vehicle prices are at all-time highs and will likely revert back to normal at some point. Dealers must be cautious not to purchase large amounts of used vehicles at these elevated prices for the fear that they won’t be able to sell all of those units before prices return to more normal levels. As we will discuss later, the number of used vehicles available from rental car fleets has been drastically reduced from historical levels. Finally, there are fewer off-lease vehicles available for repurchase as customers are choosing to purchase those vehicles outright once the lease term ends. As discussed in our December post, the ratio of used vehicles to new vehicles sold approached 1:1 as dealers experienced heightened GPUs on both sides. That ratio continued to climb in the early part of 2021 topping out at 98.2% in January but has declined slightly to 87.5% in May 2021. Historically, the gap between GPU earned on used vehicles to new vehicles was wider than it has been in recent months. Now auto dealers are seeing margins nearly as high on new vehicles. This ratio continues to be impacted by shortages in inventory supply, increased retail prices, and uncertainty of financial constraints caused by the pandemic. We can think of two potential demand-related reasons GPUs earned by dealers on new vehicles are catching up to used vehicles. Surging auto prices have made it into the headlines; consumers continuing to shop likely have some level of inelastic demand and if they have to pay heightened prices, they may as well pay a little more to get a new vehicle. Also, with the “K-shaped recovery” we’ve seen during the pandemic, it’s possible those with more disposable income, who may be more likely to buy a new vehicle than a used vehicle, are composing a greater percentage of buyers, tilting demand and thus profits, towards new. Fleet SalesFleet sales consist of sales to large rental car companies, commercial users and government agencies.Historically, fleet sales allowed auto dealers to sell surplus inventory and to sell larger blocks of units at one time. While fleet sales typically occurred at reduced margins compared to retail sales, they allowed auto dealers to put more vehicles in service to hopefully benefit the fixed operations of an auto dealer as those vehicles will eventually require service maintenance and parts. Auto dealers anticipate that buyers of new vehicles will continue to return to the same dealership for those services during the lifetime of the warranty period and hopefully beyond.During the height of the pandemic, fleet sales declined significantly. Rental car companies weren’t just canceling orders, they actively sold off their existing fleet to build up cash as cities endured temporary shutdowns and much of domestic travel was halted or significantly curbed. While travel has returned in the second quarter of 2021, overall fleet sales remain depressed.As discussed earlier, auto dealers no longer have excess inventory, and so OEMs are prioritizing all the vehicles they can produce to be sold at heightened retail prices and gross profit margins to individuals.Fleet sales for the first half of the year totaled 969,751 units according to Cox Automotive. This figure represents an increase of nearly 5% compared to the same period in 2020 as demand has increased. However, comparisons to 2020 are not as meaningful due to the interruptions in the auto dealer industry caused by the pandemic. For a truer comparison, 2021 fleet sales represent a decline of over 40% from the same six month period in 2019 as seen below. So far, auto dealers have not been fazed by the lack of fleet sales. Perhaps the biggest impact of fleet sales has been felt by consumers. If anyone has traveled recently and tried to obtain a rental car, you likely have experienced an overall lack of supply and a dramatic increase in rental car prices. The impact felt by the fleet market on auto dealers has been on the used vehicle side of operations. While rental car companies sold off large portions of their fleets in 2020 with the lack of travel, they have not been able to replace that inventory as travel demands have increased. In turn, rental car companies are currently no longer a source of used vehicle units for auto dealers since those purchases were pulled forward in 2020. It will be interesting to see how these conditions evolve over the latter half of 2021 and 2o22 as manufacturing begins to return to normal from the OEMs. Vehicle Miles TraveledAnother key indicator that portrays the health of the automotive industry is the number of miles driven or vehicle miles traveled ("VMT"). As with the number of vehicles in service, the number of miles driven contributes to the fixed operations of an auto dealer as vehicles require more parts and service as they are driven more frequently or for longer distances. Increased miles will also lead to the eventual purchase of a new vehicle either from new or used vehicle inventory.VMT has been tracked since 1971, and a graphical view of the rolling 12-month average can be seen below.Over time, VMT has generally increased as the population has grown and more vehicles have been put in service. Since 1971, there have only been a few occasions where the rolling-12 month average has declined, which as noted above, tend to correlate with recessions: 1974, brief periods in the late 1970s and the early 1980s, the Great Recession in 2008 and 2009, and the pandemic in 2020.During the height of the pandemic, the rolling-12 month VMT average dropped below 3 trillion miles for the first time since mid-2014 and even below 2.8 trillion for the first time since the early 2000s. The rolling-12 month average bottomed out in February 2021 at approximately 2.77 trillion miles and has steadily climbed back up to 2.97 trillion miles as of May 2021.During the pandemic, a report from KPMG highlighted some of the factors impacting the VMT and also hinted at longer-term trends that could eventually push that figure back up to historical levels. Obvious factors from COVID-19 included temporary stay-at-home orders and restricted travel. As the pandemic continued, work and commute habits also changed as more individuals either worked from home initially, or others have continued to work from home in some capacity. These behaviors drastically contributed to fewer and shorter work commutes. An additional factor impacting VMT was fewer shopping trips. Digital platforms and e-commerce continue to grab market share from traditional shopping trips to the store. This phenomenon was already occurring prior to the pandemic but continues to persist as some consumer behaviors may have been permanently altered due to long-term health and safety concerns.Is it all bad news as far as VMT is concerned? As mentioned above, the rolling-12 month average has been steadily climbing since January 2021. Shutdowns and stay-at-home orders have all mostly expired and there is pent-up demand in domestic travel.As a result of the pandemic, more people could eventually decide to move out of larger metropolis areas into smaller suburbs. Moving out of the city could create longer commute times and miles driven. Additionally, people may continue to avoid public transportation and rideshare services due to the health impact scares of the pandemic. Both of these trends could lead to more individuals purchasing vehicles, which would eventually contribute to more miles driven.Conclusions The first half of 2021 has been a memorable one for auto dealers highlighted by all-time profitability, heightened gross margins on new and used vehicles, and shortages of new and used inventory. How long will these trends continue and have some trends already shown reversion back to normal levels?As we’ve discussed, certain metrics such as gross margins per unit continue to rise, while others such as average days’ supply of used vehicles, overall auto sales, and vehicle miles traveled appear to be trending toward historical levels. Industry experts are mixed on predicting when inventory conditions stabilize; some indicate later this year, while others indicate it could be 2022 before inventory/supply issues return to normal.For an understanding of how your dealership is performing along with an indication of what your dealership is worth amidst the noise, contact a professional at Mercer Capital to perform a valuation or analysis.

How to Value an Oilfield Services Company

As the volatility continues with oil field service companies (the OSX has nearly doubled since November 2020), valuation and techniques associated therewith are important to consider right now. Therefore, this week we are reposting our blog post and whitepaper as it pertains to how to understand and value oil field service companies. When valuing a business, it is critical to understand the subject company’s position in the market, its operations, and its financial condition. A thorough understanding of the oil and gas industry and the role of oilfield service (“OFS”) companies is important in establishing a credible value for a business operating in the space. Our blog strives to strike a balance between current happenings in the oil and gas industry and the valuation impacts these events have on companies operating in the industry. After setting the scene for what an OFS company does and their role in the energy sector, this post gives a peek under the hood at considerations used in valuing an OFS company.Oil and Gas Supply ChainThe oil and gas industry is divided into three main sectors:Upstream (Exploration and Production)Midstream (Pipelines and Other Transportation)Downstream (Refineries)Source: Energy Education Exploration and production (E&P) companies search for reserves of hydrocarbons where they can drill wells in order to retrieve crude oil, natural gas, and natural gas liquids. To do this, E&P companies utilize oilfield service (OFS) companies to help with various aspects of the process including pumping and fracking, land contract drilling, and equipment manufacturers. E&P companies then sell the commodities to midstream companies who use gathering pipelines to transport the oil and gas to refineries. Finally, refiners convert raw crude and natural gas into products of value. Oilfield Services OperationsE&P companies may own the rights to the hydrocarbons below the surface, but they can’t move them down the supply chain without the help from OFS companies in the extraction process. We can think of various OFS companies being subcontractors in the upstream process much like a general home builder might bring in people specially trained to set the foundation or wire electrical or plumbing. Because the services provided often require sophisticated technology or extensive technical experience, it stands to reason OFS companies would be able to charge a premium price. Thus, OFS would appear to be insulated from the commodity pricing that is inherent in the industry. However, E&P companies are the ones contracting these companies, and if oil prices decline enough, they are pressured to decrease production (and capex budgets), reigning in activity for OFS companies. This is where the specific service provided matters.Regardless of service provided, or industry for that matter, there are certain aspects of a business that should always be considered.As previously shared in May of 2019, there are a variety of different services provided by OFS companies. Companies that fall into the category of OFS can be very different from one another as the industry is fragmented with many niche operators. For example, companies servicing existing production are less impacted by changes in commodity prices than OFS companies that service drilling, as these activities are the first to decrease. Regardless of service provided, or industry for that matter, there are certain aspects of a business that should always be considered.Oilfield Equipment and Service Financial AnalysisA financial analyst has certain diagnostic markers that tell much about the condition of a business both at a given point of time (balance sheet) and periodically (income statement).Balance Sheet. The balance sheet of an OFS company is considerably different from others in the energy sector. E&P companies have substantial assets attributed to their reserves. Refiners predominantly have high inventory and fixed assets. OFS companies will depend on the type of product or service, but generally, they tend to have a working capital balance that consists more of accounts receivable than inventory, like other service-oriented businesses. According to RMA’s annual statement studies, A/R made up 22.3% of assets while inventory was 9.3% for Drilling Oil and Gas Wells (NAICS #213111).[1] These figures were 26.6% and 10.8%, respectively for Support Activities for O&G Operations (#213112). Notably, drilling operations had a higher concentration of fixed assets (46.8%) compared to other support services which comprised 35.7% of assets. Broadly speaking, this illustrates the different considerations within the OFS sector as far as the asset mix is concerned.Income Statement. The development of ongoing earning power is one of the most critical steps in the valuation process, especially for businesses operating in a volatile industry environment. Cost of goods sold is a significant consideration for other subsectors in the energy space, particularly as the product moves down the supply chain towards the consumer. This is not the case for OFS companies. RMA does not even break out a figure for gross profit, but instead combines everything under operating expenses. Still, OFS companies deal with significant operating leverage. If expenses are less tied to commodity prices that means costs may be more fixed in nature. That means when activity decreases and revenues decline, expenses don’t decline in lock-step resulting in margin compression and profitability concerns. While the balance sheet does not directly look at income, it can help determine sources of return. Fixed-asset heavy companies like drillers tend to be more concerned with utilization rates as the more their assets are deployed, the more money they will earn. On the other hand, predominantly service-based companies that rely on their technology and expertise tend to be more concerned with the market-determined prices they are able to charge and terms they are able to negotiate. Additionally, OFS companies may have significant intangible value that may not be reflected on the balance sheet. Intangible assets developed internally are accounted for differently than those that are acquired, and a diligent analyst should be cognizant of assets recorded or not recorded in developing an indication of value.How to Value OFS?There are fundamentally three commonly accepted approaches to value: asset-based, market, and income. Each approach incorporates procedures that may enhance awareness about specific business attributes that may be relevant to determining an indication of value. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value.The Asset-Based ApproachThe asset-based approach generally represents the market value of a company’s assets minus the market value of its liabilities.The asset-based approach can be applied in different ways, but in general, it represents the market value of a company’s assets minus the market value of its liabilities. Investors make investments based on perceived required rates of return, so the asset-based approach is not instructive for all businesses. However, the capital intensive nature of certain OFS companies does lend some credence to this method, generally setting a floor on value. If companies have paid off significant portions of their debt load incurred financing its equipment, the valuation equation (assets = liabilities + equity) tilts towards more equity and higher asset approach indications of value. Crucially, as time goes on and debt is serviced, the holding value of the assets must be reassessed. Price paid, net of accumulated depreciation may appear on the balance sheet, but if the equipment or technology begins to suffer from obsolescence, it will have less value in the marketplace. For example, due to the shale revolution in the United States and the increased demand for horizontal drilling, equipment and services that facilitate vertical drilling have less market value than it did less than a decade ago. Ultimately, the asset-based approach is typically not the sole (or even primary) indicator of value, but it is certainly informative.The Income ApproachThe income approach can be applied in several different ways. Generally, analysts develop a measure of ongoing earnings or cash flow, then apply a multiple to those earnings based on market risk and returns. An estimate of ongoing earnings can be capitalized in order to calculate the net present value of an enterprise. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market through the use of a capitalization rate. Stated plainly, there are three factors that impact value in this method: cash flows, growth, and risk. Increasing the first two are accretive to value, while higher risk lowers a company’s value.The income approach allows for the consideration of characteristics specific to the subject business.To determine an ongoing level of earnings, scrutiny must be applied to historical earnings. First, analysts must consider the concentration of revenues by customers. A widely diversified customer base is typically worth more than a concentrated one. Additionally, an analyst should adjust for non-recurring and non-normal income and expenses which will not affect future earnings. For example, disposing of assets utilized in the business is not considered an ongoing source of return and should be removed from the company’s reported income for the period when the disposition occurred. The time period must also be considered. Assuming cash flows from last year will continue into the future may be short-sighted in the energy sector. Instead of using a single period, a multi-period approach is preferable due to the industry’s inherent volatility, both in observing historical performance and projecting into the future. Discounted cash flow (DCF) analyses are an important tool, but factors such as seasonality, cyclicality, and volatility all call for a longer projection period.After developing the earnings to be capitalized, attention is given to the multiple to be applied. The multiple is derived in consideration of both risk and growth, which varies across different companies, industries, and investors. When valuing an OFS company, customer concentration is of particular concern to both risk and growth. Developing a discount rate entails more than applying an industry beta and attaching some generic company risk premium. Analysts must look deeper into the financial metrics addressed earlier and consider their market position. Are they financially stable or over-levered by either fixed costs or debt? Are they a sole provider or one of many? If more players are entering the market, prices charged may be lower than those historically observed. If a company stops investing in its equipment and technology, demand for the company’s products and services declines. Again, metrics such as utilization and day rates are important to analyze when developing a discount rate.Income is the main driver of value of a business as the goal is to generate a reasonable return (income) on its assets. People don’t hang a sign above their door and go into business if they don’t think they will eventually turn a profit. Still, differences of opinion on risk and growth can occur, and analysts can employ a market approach as another way to consider value.The Market ApproachAs the name implies, the market approach utilizes market data from comparable public companies or transactions of similar companies in developing an indication of value. In many ways, this approach goes straight to the heart of value: a company is worth what someone is willing to pay for it. The OFS subsector is a fragmented industry with many niche, specialty operators. This type of market lends itself to significant acquisition activity.However, transactions must be considered with caution. First, motivation plays a role, where a financially weak company may not be able to command a high price, but one that provides synergies to an acquirer might sell for a premium. Transactions must also be made with comparable companies. With many different types of companies falling under the OFS umbrella, analysts must be wary of comparing apples to oranges. While they work in the same subsector, there are clearly important differences between equipment manufacturers and pumpers and frackers. Untangling the underlying earnings sources of these businesses is important when looking at guideline transactions as well as directly comparing to guideline companies.In many ways, the market approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.Larger diversified players, such as Schlumberger and Halliburton, are more likely to provide similar services to companies an analyst might value, but their size, sophistication, and diversification of services likely renders them incomparable to smaller players. Given the relative considerations and nuances, taking their multiples and applying a large fundamental adjustment on it is crude at best and may miss the mark when determining a proper conclusion of value.Analysts using a market-based approach should also be judicious in utilizing the appropriate multiple and ensuring it can be properly applied. Industries focus on different metrics and it is important to consider the underlying business model. For E&P companies, EV/EBITDAX may be more insightful as capital expenditure costs are significant and can be throttled down in times of declining crude prices. For OFS companies, potentially relevant multiples include EV/Revenue and EV/Book Value of Invested Capital, but there is no magic number, and these useful metrics cannot be used in isolation. Ultimately, analysts must evaluate the level of risk and growth that is implied by these multiples, which tends to be more important than the multiples used.The market approach must also consider trajectory and location. There’s a difference between servicing vertical wells that have been producing for decades as opposed to the hydraulic fracturing and long horizontal wells in the Delaware Basin. Distinctions must also be drawn between onshore and offshore as breakeven economics are similar (don’t produce if you can’t earn a profit), but costs related to production vary significantly.Ultimately, the market-based approach is not a perfect method by any means, but it is certainly insightful. Clearly, the more comparable the companies and the transactions are, the more meaningful the indication of value will be. When comparable companies are available, the market approach should be considered in determining the value of an OFS company.Synthesis of Valuation ApproachesA proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations. This is why industry “rules of thumb” or back of the napkin calculations are dangerous to rely on in any meaningful transaction. Such calculation shortcuts fail to consider the specific characteristics of the business and, as such, often fail to deliver insightful indications of value.A thorough approach utilizing the valuation approaches described above can provide significant benefits. The framework provided here can facilitate a meaningful indication of value that can be further refined after taking into account special considerations of the OFS industry that make it unique from other subsectors of the oil and gas industry.ConclusionWe have assisted many clients with various valuation needs in the oil and gas space for both conventional and unconventional plays around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.[1] 2018-2019 RMA Statement Studies. NAICS #213111 and 213112. Companies with greater than $25 million in sales.Originally posted on Mercer Capital's Energy Valuation Insights Blog June 3, 2019

Strong Quarter Propels Alt Managers to New Highs

The second quarter was especially kind to the alt manager sector, which benefited from favorable market conditions and growing interest from institutional investors. Heightened volatility creates more opportunities for hedge funds to generate alpha (when their positions aren’t concentrated in meme stocks), and market peaks often spur interest in alternative asset classes, like private equity and real estate. These trends initially took root last fall before gaining considerable momentum in the second quarter. Much of this momentum is attributable to the VC space as investors turn to private equity and start-up tech firms for higher returns than more traditional asset classes. According to CB Insights, a record 249 firms achieved the $1 billion “unicorn” valuation status in the first half of 2021, almost doubling the total tally from last year.Growing interest in the sector also stems from the fact that alt managers are often better positioned during a prospective downturn than their traditional asset management counterparts. Alt assets aren’t directly correlated to market conditions and are often held in illiquid investment vehicles, which means their investors are locked up for years at a time with no withdrawal rights.While sticky assets can provide a cushion for alt managers in a downturn, the longer-term performance of many of these managers depends on their ability to raise new funds and put that money to work. Raising institutional capital is often a long and involved process in the best of circumstances. For many managers, the economic interruption of last year’s global shutdown presented challenges to their fundraising process that often involves extensive in-person due diligence. And if new funds are raised, there is the question of how fast managers can put that money to work without sacrificing proper due diligence.M&A declined significantly in the second and third quarter of last year, leaving deal teams at many PE firms on the sidelines before rebounding sharply over the last nine months or so.It’s also important to keep in mind that these alt managers and their assets are still vulnerable to bear markets. Public alt managers were particularly affected during the selloff last March, reflecting the decline in portfolio asset values and reduced expectations for realizing performance fees. From February 19, 2020 (the prior market peak), our index of alt managers declined nearly 45% in just over a month. Since then, an outsized recovery has pushed the index back to all-time highs.Such a sharp gain in alt manager stock prices means the market is increasingly optimistic about the sector’s prospects. Performance fees and carried interest payments are likely to increase with rising asset prices. Strong investment performance also tends to entice inflows from institutional investors, which will buoy AUM balances and management fees for most of these firms. The market is therefore anticipating higher revenues for the industry, which should be accompanied by even greater gains in profitability given the sector’s relatively high level of operating leverage (fixed costs).Many alt manager funds also have high levels of financial leverage (debt) that can augment returns when things go well. The trouble is that both forms of leverage can exacerbate earnings when revenue dips or investments underperform. These attributes are what make the alt management industry so volatile and are part of the reason why the sector lost nearly half its value last March before doubling over the next year.On balance, we believe the recent run-up is justified, but it’s important to remember what can happen when alt asset prices go the other way. Expect volatility to remain as investors weigh the impact of a recovering economy and rising inflation on alt asset returns.

Formula Clauses for Auto Dealerships

Pros and Cons of Using Formula Clauses in Buy-Sell Agreements

In prior pieces, we have expressed our general disdain for formula clauses. While there are many flaws and specific issues that can arise, formula clauses can also serve a valuable purpose, particularly for family members or people with an interest in an auto dealership that do not know much about the industry. In this post, we explain formula clauses, when they are used, why they are used, and why we ultimately recommend they not be used.A formula clause explains how a business will be valued, usually as part of a buy-sell agreement, employment agreement, transfer of interests under certain circumstances, or other agreement entered between owners of a company. Formula clauses are most often used for the purposes defined in their respective governance documents. Common triggering events include death, disability, retirement, divorce, or termination of an owner.Formula clauses typically involve a combination of accounting and valuation information. For example, formula clauses may begin with a company’s book value of equity from the most recent month’s financial statement, most recent year ended, or some average of periods. Formula clauses may also include some component of a valuation multiple such as a multiple of revenue, EBITDA, earnings, or some other financial metric. These valuation multiples are often kept static throughout the life of the buy-sell agreement.What Are the Benefits of a Formula Clause?Formula clauses are simple and leave little room for debate as to the value of an interest in a business. This is particularly helpful for family members that might own an interest in a dealership but have little idea of how the business works. The learning curve for auto dealerships can be quite steep, but most people can navigate to a page and line on a financial statement and do the basic math involved with adding an indication of Blue Sky value to net assets. No long division required.This can also lead to less contentious transfers if everything goes smoothly. If partners are frequently coming and going, or minority investors have always been cashed out at a Blue Sky value of 4x LTM pre-tax income, a reasonable expectation can be set for the worth of the business and people can plan accordingly. However, this tends not to be the case, and formula clauses do not always make for the smooth ownership transitions that their writers envisioned.What Are the Common Pitfalls of Formula Clauses?While simplicity can be good in certain cases, there are obvious drawbacks to having such a cut and dry conclusion. Three main issues we’ve seen include:Formulas may be drafted by those without industry knowledge which leads to less meaningful conclusions.Formulas that make sense at the writing of the agreement may become stale in time.Rigid calculations do not allow for normalization adjustments that may be obvious to parties on both sides of an actual negotiation between a willing buyer and willing seller.Formulas That Consider and Correctly Apply Valuation Methods Used Frequently in the Auto Dealer IndustryBy its nature, the value indicated by a formula clause is unlikely to be the most analytically rigorous conclusion. This means an auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.An auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.For starters, if the formula clause starts by talking about P/E multiples or EBITDA multiples, the drafter of the agreement is likely not aware of how auto dealerships are valued. It is important that the valuation methodology that the formula clause seeks to approximate reflects how industry participants discuss value.The multiples also must be appropriately applied. If a blue sky multiple is used to approximate intangible value, it’s important not to double count any franchise rights that may be on the books from an acquisition. If an EBITDA multiple is used, it is important that the calculation appropriately captures floor-plan interest as an operating expense and does include floor-plan debt in enterprise value.Formula Clauses Can Become Stale Over Time, Particularly if Not Used RegularlyValuation multiples also ebb and flow through the business cycle. If the buy-sell agreement is written to include a blue sky value of 5x LTM pre-tax income, for example, that may make sense when the document is written. Fast forward five years. Is your dealership going for the same multiple?An easy way around this would be to have the multiple be dynamic. Haig Partners and Kerrigan Advisors publish blue sky ranges quarterly, so pinning the multiple on the most recently published range could better approximate what dealerships are going for in the marketplace when the valuation is needed.Fast forward five years. Is your dealership going for the same multiple?However, as my colleague here in Nashville likes to point out, our work tends to be less on the multiple and more on estimating the ongoing earnings correctly. Multiples, whether from market transactions or built up using a discount rate, are largely based on market based indications. It is up to experienced appraisers to determine what earnings stream is applicable to these multiples.Simple Calculations Can Miss Crucial Normalization AdjustmentsFirst, we should say that we believe a multi-year approach is appropriate. In light of heightened profits in 2020 extending into this year, other industry participants are moving toward a multi-year viewpoint as dealers looking to divest are unlikely to receive high multiples on peak profits. In previous posts, we’ve discussed some common normalization adjustments for auto dealerships. Here, we’ll give a simple example that shows the pitfalls of not making adjustments or using a multi-year approach.Consider a dealership with $5 million in tangible net asset value and pre-tax income levels as shown below. Also assume the dealership received a PPP loan of $500 thousand that was forgiven. Taking a 3-year average from 2018-2020, as suggested by Haig Partners, adjusted ongoing pre-tax income would be $1.1 million. Assuming a blue sky multiple of 5.0x is applicable to this dealership, Blue Sky would be $5.5 million and the total equity would be $10.5 million. Now, assume the 3-year average is based on pre-tax income directly off the dealer financial statement with no adjustments. While reasonable people would agree that the PPP loan is clearly an example of something that is not expected to happen every year, the formula clause does not leave room to make this adjustment. Despite only giving this period 1/3 of the weight, we see total equity value would go up by over $833 thousand or about 8%. Taking this one step further, look at the implied value by taking the multiple based on only one year of performance. While $2 million in earnings is almost double historical levels, a formula clause with a static multiple will likely lead to overvaluation. In the example above, value increased by $4.5 million, or 43%. These simplified examples show the potential pitfalls of formula clauses. We’re only scratching the surface of potential adjustments that might be applicable, including market adjustments to rent, owner’s compensation, discretionary expenses, non-recurring items, and any other adjustments in order to determine what a buyer of the dealership might reasonably expect to earn. ConclusionHopefully, we’ve illustrated the potential issues with formula clauses that we find in buy-sell agreements. In our opinion, there is truly no substitute to having a qualified business appraiser with experience valuing auto dealerships analyze the company to determine the value of an interest in the dealership. We think there are still some benefits, particularly for those outside the business to have an idea of the value of the dealership. It is more important, however, to get the appropriate value of a business, particularly if the transaction has the potential to become contentious.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Formula Clauses for Auto Dealerships

Pros and Cons of Using Formula Clauses in Buy-Sell Agreements

Pioneer Natural Resources Pay to Play

A Tale of Two Transactions

As noted in our June 2021 blog post covering Permian M&A activity, M&A transactions picked up in the twelve months ended mid-June relative to the twelve-month period preceding it. Perhaps more importantly, there seemed to be an inflection point in transaction multiples that hinged around the U.S. elections in November 2020.Among all the transactions that occurred over this period, one pair jumped out involving a common buyer and for which valuation metrics were available. These related to Pioneer’s acquisition of Parsley Energy in October 2020 and DoublePoint Energy in April 2021, with implied transaction metrics well above the average and median values in the the respective sub-periods of the reviewed period. Statistics of the valuation metrics for the transactions occurring between mid-June 2020 to mid-June 2021 and the bifurcated sub-periods, both including and excluding Pioneer transaction data, are as follows:Click Here to Enlarge the ImageWe note that, as compared to the transactions table in the aforementioned Permian M&A activity blog post, the transaction counts and statistics presented exclude four transactions for which acquired assets were working interests, as opposed to a property or corporate acquisition. We also note that only one of the four excluded transactions involving the acquisition of a working interest had any useful transaction data available, and the metrics for this one transaction tended to be outliers (on the high side) in the context of the full set of transactions.Tech talk aside, the main point here is Pioneer consistently paid top dollar for its acquisitions from the perspective of the transactions’ valuation metrics. Why?Easy Answer: Pioneer Is a Large Strategic BuyerIn Pioneer’s October 2020 press release covering its acquisition of Parsley Energyand April press release for its acquisition of DoublePoint Energy, the strategic nature of the acquisitions was cited. Prominent in both releases was mention of significant synergies and “unmatched scale” with respect to Pioneer’s footprint in the Permian play.Regarding the Parsley acquisition, Pioneer’s President and CEO, Scott D. Sheffield, stated, “This combination is expected to drive annual synergies of $325 million and to be accretive to cash flow per share, free cash flow per share, earnings per share and corporate returns beginning in the first year.…” It was further noted that, “The combined company will be the leading Permian independent exploration and production company with a premium asset base of approximately 930,000 net acres [representing an approximately 37% increase over its pre-transaction net acreage] with no federal acreage and a production base of 328thousand barrels oil equivalent per day (“MBoepd”) and 558 MBoepd as of the second quarter of 2020. Additionally, based on year-end 2019 proved reserves, this transaction will increase Pioneer’s proved reserves by approximately 65%.”Similarly, synergies were noted in the DoublePoint acquisition, including expectations annual cost savings over the next 10 years of $175 million, stemming from increased operational efficiencies and reduced G&A and interest expenses, with a total present value of savings of approximately $1 billion. This transaction also expanded Pioneer’s Permian footprint by an additional 97,000 net acres to over 1 million total net acres in its core Permian position. This addition implies an increase of 10% over its 930,000 total net acreage holdings following the Parsley Energy acquisition, and further fortifies the company’s position as a premier Permian E&P operator.While the strategic argument makes sense fundamentally, arguably any transaction involving an existing E&P company entering or expanding their presence in the Permian could be deemed a “strategic” acquisition. Let’s dive a little deeper into the numbers behind Pioneer’s acquisitions to see if there may be another differentiating factor.Deeper Answer: Production DensityIn our analysis of Permian M&A activity over the past twelve months, we presented deal values and valuation metrics such as deal value per acre and per production (Boepd). As might be gleaned from those metrics, our data set included the net acreage and production values associated with the acquisitions, though these specific data points were not presented outright.Utilizing the full set of data to examine the transactions, we developed and reviewed certain indicators beyond the presented valuation metrics. In particular, we calculated the implied annual production (total implied Boe) per acquired acre for each transaction. We’ll refer to this as “production density.” The following table presents the full data set which will be referenced:Click Here to Enlarge the ImagePioneer’s acquisition of Parsley Energy indicated a production density factor of 267 Boe/acre. Among the six transactions that occurred from July to October 2020, this was the second highest value, being only 7 Boe/acre lower than the highest indicated value implied by the Devon Energy-WPX Energy transaction. Conversely, this production density factor of 267 Boe/acre was 26% greater than the next highest factor of 212 Boe/acre implied in the ConocoPhillips acquisition of Concho Resources, which was announced the day prior to the Parsley acquisition announcement.Among the transactions announced from November 2020 through mid-June of this year, the production density factor of the Pioneer-DoublePoint Energy acquisition was 376 Boe/acre, which was just over 13% higher than the production density of the next highest value of 332 Boe/acre implied by the Vencer Energy-Hunt Oil acquisition, and was the highest value among all the acquisitions in the Permian listed over the full 12-month period ended mid-June.ConclusionIn our prior analysis of Permian M&A activity from mid-June 2020 to mid-June 2021, several points came to light:Transaction multiples appeared to have an inflection point, with significantly lower multiples indicated from the transactions announced after October 2020 relative to the indicated multiples for transactions announced prior to November 2020.Given the publicly available information, Pioneer was the only buyer in both sub-periods noted (for which useful transaction data was available).The transaction multiples stemming from the Pioneer acquisitions were among the highest, if not the highest, in the respective sub-periods, making them among the highest multiples for the entire 12-month period reviewed. While commodity prices could have been a factor, we note that WTI futures as of April 2021 were, on average, 30% higher than WTI futures as of October 2020 when looking at a 12-month span consecutively for nine annual periods that followed the respective measurement dates. On one hand, this could be interpreted to mean that valuations should have been greater in the latter sub-period (with higher futures prices). On the other hand, the higher prices in the future might have been indicative of uncertainty regarding the Biden Administration’s rhetoric and possible actions that would more than likely prove to be headwinds to the oil and gas industry overall. Commodity prices notwithstanding, the data available and subsequent information gleaned from it suggest Pioneer was able to act on two prime opportunities that would further enhance the quality of its acreage and production portfolio. We have assisted many clients with various valuation needs in the full stream of the oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

RIA M&A Q2 Market Update

Whispered Numbers Shout

RIA MIA activity slowed somewhat in the second quarter of Q2, but RIA markets are still on track to record the highest annual deal volume on record.In the latest RIA M&A Deal Report, Echelon Partners attributes the pace of RIA M&A to (1) secular trends, (2) supportive capital markets, and (3) potential changes in tax code in the future. As we discussed last quarter, fee pressure in the asset management space and a lack of succession planning by many wealth managers are still driving consolidation. But the increased availability of funding in the space, in tandem with more lenient financing terms, has also caused some of this uptick. Further, the Biden administration’s proposal to increase the capital gains tax rate has accelerated some M&A activity in the short-term as sellers seek to realize gains at current tax rates. But could some of this activity be attributable to the RIA rumor mill and the hype of double-digit multiples in the space? He Says, She Says … "They sold their firm for 12x"Although there are over 13,000 RIAs in the U.S., during times like these, the investment management world feels pretty small. Word travels far and fast, and often with minimal detail.Clients have been asking us about double-digit deal multiplesOver the last few months, more of our clients are asking us about double-digit deal multiples and many owners of small firms are understandably confused when they see our comparably lower indications of value.So how does all this transaction activity affect valuations?Guideline Transaction MethodAs independent valuation analysts, we are tasked with finding market transactions of privately held companies in the same or similar business that may provide a reasonable basis for valuation of the company we are valuing. Market transactions are used to develop valuation indications under the presumption that a similar market exists for the subject company and the comparable companies. Activity and earnings multiples developed using the market transactions method are used to capitalize appropriate estimates of AUM, revenue, and earning power for the subject company.In most of our valuations of investment management firms, we seek perspective on the M&A market’s pricing of closely held investment management firms by evaluating transactions involving acquired U.S.-based investment management firms with between $1 billion and $25 billion of AUM. However, given the lack of publicly available information for transactions in the industry, the data from guideline transactions has limited significance for making inferences.Even when deal multiples are “known,” they can be misleadingEvery transaction has different motivators that affect the buyer’s willingness to accept a certain price and the seller’s willingness to pay up. Most RIA transactions include some form of earnout, which can skew the implied deal multiples. And more frequently, deals include some form of an earn-more consideration that may or may not be reasonable to include when calculating implied deal multiples.Even when deal multiples are “known,” they can be misleading. A transaction priced at, say, nine times pro forma earnings – with normalized compensation, back-office synergies, anticipated changes in fee schedules, and other adjustments – might also be viewed as fifteen times earnings, as reported. So, is the deal multiple nine or fifteen?RIA buyers are, for the most part, very sophisticated, and not disconnected from realityUnfortunately, there is a perverse incentive to talk about the higher multiple. Sellers want to brag about how much they got. Buyers want to be seen as the most generous to attract other sellers into the process (reality can wait until after the LOI is signed). And in a market with surplus of buyers, intermediaries (the investment bankers), naturally, want to encourage sellers however they can.Don’t get us wrong, the RIA market is very strong, and multiples are very high. But RIA buyers are, for the most part, very sophisticated, and not disconnected from reality.Much of the confusion we see in expectations is being fueled by dozens and dozens of deal announcements with undisclosed terms. In the absence of real information, imagination fills the void. Although we have knowledge of the pricing of many undisclosed deals, we can’t directly rely on this information in a business Appraisal (with a capital “A”) – as it doesn’t constitute known or knowable information to hypothetical buyers and sellers. But all this transaction activity and the increase in observed deal multiples has, nonetheless, impacts investment management valuations. This conflict between publicly available pricing information and rumored deal multiples makes it even more important to hire a valuation firm experienced in this space.There is no argument that multiples across the investment management space have increasedBecause reliable guideline transaction information is scarce, it is essential to build the factors driving the volume of transaction activity and heightened pricing into projections and the cost of capital. Improved equity markets have been driving AUM growth. The inherent operating leverage in the business along with the realization over the last year that RIAs can operate just as efficiently with less or cheaper office space, is driving margin expansion. While it is harder to model increased demand for these businesses into a discounted cash flow model, it can serve to minimize risk and reduce discount rates. Overall, these changes to valuations are generally more subjective.But there is no argument that multiples across the investment management space have increased. As our president, Matt Crow, has said before about RIA transaction multiples, “an option has value, even if you don’t exercise it.”

June 2021 SAAR

The June 2021 SAAR totaled 15.4 million units, which is up 12.4% compared to June 2020 (the lowest June figure in recent memory due to the COVID-19 pandemic) but down 9.9% from May 2021. New light vehicles sales fell for the second straight month in June, highlighting the ongoing supply and demand imbalances in the market for new cars and trucks.After a strong start to the year, driven by feverish demand from retail and fleet consumers, a shortage of new car and truck inventory has started to weigh on sales. The Inventory to Sales Ratio, published along with SAAR, continues to fall, as seen in the graph below. This ratio captures what many auto dealers already know: demand has been strong and supply chain issues have not gotten any better. With such strong demand intersecting low supply, many vehicles are selling at or above MSRP. According to J.D. Power, in mid-June, 75% of vehicles sold for MSRP or above, up from 67% in May 2021 and up even more from the pre-COVID-19 pandemic average of 36%. SAAR ran hot from 17.0 million to 18.6 million from March to May this year, making supply even shorter. Inventories have plummeted as dealers are not able to replenish their lots. While this has led to lower floor-plan costs and higher GPUs, the decline in SAAR in June shows dealers may finally be experiencing what people were concerned about. Business owners can draw down inventories to maintain sales levels, but eventually, those inventories will run out. Lower inventory levels are expected to continue to limit the sales pace of dealers around the country. Microchip Issues PersistAccording to the NADA, the inventory crunch is likely to get worse before it gets better. Average inventories are expected to remain flat in June compared to May at around 1.5 million units, before dropping again to around 1.3 million units by the end of July. Microchip shortages continue to plague the industry and are a predominant factor in the slowdown, though dealers have noted other parts and areas of vehicles are in short supply as well. With little to mitigate the situation on the horizon, it has become clear that this shortage will impact the manufacturing of new vehicles for months to come. This chip shortage is not unique to the United States or to the Automotive industry, as Automotive News Europe recently reported that the “exponential increase in demand for microchips will need a long term solution.”We note the “end” to the microchip shortage continues to be kicked down the roadMany sovereign governments are considering taking steps to increase production, as the number of industries that require microchips continues to grow. Economic agents are considering economy-wide solutions to this sweeping problem, but relief is not expected until sometime in early 2022. Until then, dealers will most likely have to continue to operate at lower-than-normal inventory levels or focus on vehicles that utilize less chips. We note the “end” to this shortage continues to be kicked down the road, so even the expectation this situation will be alleviated in early 2022 may not comfort dealers that have seen expectations continue to get pushed out.Several U.S. automotive manufacturing plants have had to suspend operations in response to the chip shortage. For example, the Ford plant in Chicago that produces the Ford Explorer will be shut down from the week of July 5th to the week of July 26th. Additionally, the Ford plant in Kansas City that produces the best-selling F-150 pickup truck announced it will be shuttering the production line for a few weeks in July as well. Ford’s Michigan assembly plant that recently started shipping the Ford Bronco will also be down for two weeks in July due to parts shortages. These shutdowns are not specific to Ford, as most auto manufacturers have been trying to find ways to react to the ongoing situation.It’s Not Just Microchips Many automotive plants have temporarily shut down due to the microchip shortage, but microchips are not the only input that has been scarce. Seating foam, plastics, and other petroleum-based products have been harder to acquire over the last several months due to longer lead times on orders, historically high prices, and very tight supplies.According to Industrial Specialties Manufacturing, the market is currently unable to supply the U.S. demand for plastics. Experts say that the complete restoration of the plastics industry could come in late 2021 or early 2022, but certain factors must be in play for this recovery to occur, like repairing oil and gas infrastructure, returning to normal volumes of chemical feedstock for plastics production, and repairing plastics compounding and extruding machinery in plants that have yet to ramp up to full production capacity.Used Vehicles In High DemandWhile the story surrounding new cars and trucks has been characterized by supply constraints over the last two months, used cars have stepped into a more prominent role at most car lots to fill this gap. Pent up demand for new cars is pushing car buyers into the used-car market, driving up prices of used cars in the process. Edmunds reported that the average price for used vehicles jumped from $20,942 to $25,410 from this point last year, the highest price jump on record for the auto research firm. This has had ripple effects throughout the economy.Edmunds reported that the average price for used vehicles jumped from $20,942 to $25,410 from this point last yearThe Consumer Price Index jumped 5.4% in June, stoking concerns about runaway inflation. However, the Federal Reserve has maintained its view that inflation is transitory, which appears to be supported by the significant year-over-year increases in used vehicles, gas, and airfare, which have played a large role in the jump in CPI. Excluding these, month-over-month core CPI would have only risen by 0.18% in June according to Bank of America.Used vehicle prices have climbed at a steep pace due to similar supply and demand-related pressures as the new car market, with scarcity issues coming in the form of hotly contested wholesale markets where dealers typically acquire most of their used inventory. Dealers are being forced to spend more to fill their lots with used vehicles, making it harder for buyers to negotiate on used car prices than in the past. Jonathan Banks, Vice President of Valuation Services at J.D Power had this to say about the used market:"After increasing for 24 consecutive weeks, wholesale auction prices peaked in June, attaining their highest level on record, and have now begun to gradually decline. Despite the recent cooling, the used market remains incredibly strong and, at the end this year, prices are expected to be up by approximately 29% on a year-over-year basis. The used market’s continued strength is driven primarily by the expectation that used supply will remain a challenge and that new-vehicle market challenges will remain in place for the foreseeable future."What Forecast to ExpectAfter an unusually hot start followed by a tightened market environment, this year has been unpredictable for dealers and manufacturers in the automotive industry. As far as demand is concerned, it is unlikely that the desire for new and used vehicles will cool off any time soon, as many consumers return to work and may be in search of a new or used vehicle to get them there. However, new light vehicle sales for the remainder of the year will likely continue to be supply-constrained. If production can recover and exceed expectations, we could see sales close to 17 million units by the end of the year. However, given the more likely outcome, total light vehicle sales are expected to be somewhere between 16.3 and 16.5 million units in 2021.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact any members of the Mercer Capital auto team. We hope that everyone is continuing to stay safe and healthy.

Does Vine Debut Portend Ripe Market for More E&P IPOs?

It’s been tough out there for equity capital markets bankers covering the upstream sector. Since 2016, there have only been five U.S. exploration & production company IPOs. [1] The dearth of activity is driven by a number of factors, including poor historical returns from the space, special purpose acquisition companies (SPACs) supplanting the traditional IPO process, and environmental, social, and governance (ESG) pressures resulting in less capital availability. Three U.S. E&P IPOs took place in late 2016 and early 2017. Berry Petroleum, a California producer focused on conventional production methods, went public in mid-2018. Nearly three years would pass until the next IPO: Vine Energy. Vine IPOVine Energy, a pure-play Haynesville gas producer, broke this nearly three-year dry spell with their IPO in March of this year. However, Vine had a rough start as a public company. The IPO priced at $14 per share, below the anticipated offering price of $16 to $19 per share indicated in Vine’s S-1. Once trading began, there was no typical IPO pop, as the stock opened at $13.75. The stock continued to trade down over the next several weeks, closing below $11 in mid-April. However, Vine’s stock price performance since the nadir has been relatively strong. The stock price rose to almost $16 in late June, up more than 44% from its low. Overall, the stock is up 8% from its IPO price, outperforming the broader E&P sector (as proxied by XOP, the SPDR S&P Oil & Gas Exploration & Production ETF), though still lagging the S&P 500. Are More E&P IPOs Coming?While we don’t have a crystal ball, there several are factors that could lead to additional E&P IPOs over the next several years.Restraint Leading to Returns: E&P companies were maligned for a “drill, baby, drill” mentality which led to huge amounts of capital being deployed to generate suboptimal returns. However, they seemed to have learned their lesson and are now showing capital discipline, even in light of a much-improved commodity price environment. The result is that shale drillers are actually delivering free cash flow. That appears to be impacting stock prices, as the year-to-date performance (through 7/13/2021) of XOP has trounced the S&P 500 (shown in the following chart). If this performance holds, investors who previously shunned the industry may begin dipping their toes back in with increased allocations to the sector.Need for Private Equity to Exit: Between 2015 and 2019, private equity funds raised approximately $86 billion of capital to deploy on U.S. oil & gas assets. However, that capital raising has slowed, and traditional oil & gas PE sponsors (including Riverstone, EnCap, and NGP) have begun focusing on energy transition investments. With less private equity capital in the ecosystem, and public E&Ps showing restraint with respect to capital spending, public markets may be the best exit opportunity for certain larger PE-backed companies. It Might Be Another Long Dry Spell Before We See Another E&P IPOLack of Public S-1 Filings: The IPO process is an involved and lengthy affair. One of the first steps required to go public is filing an S-1, which is the initial registration form for new securities required by the SEC. The S-1, which is usually filed well in advance of an actual public offering, describes the company’s operations and includes financial information. According to data from Capital IQ, there do not appear to be any U.S. E&P companies with active registration statements for material sized (>$50 million) offerings. The most recent S-1 filings for uncompleted offerings are from Tapstone Energy and EnVen Energy Corporation. However, both of those registration statements have been withdrawn. With no E&P companies currently teed up to go public, it will likely be a while before one makes it through the process.Less Need for Growth Capital: As previously discussed, with many shale drillers generating free cash flow, there is less need for growth capital to support operating activities. As such, private operators may eschew the scrutiny and pressure of public markets and remain private.Continued ESG Pressures: With increasing emphasis on ESG issues, it could be challenging to generate the typical level of investor appetite necessary to successfully execute an IPO, especially among large institutional investors who typically anchor many IPO processes.SPAC Alternative: SPACs have emerged as a viable alternative to the traditional IPO process. Several E&P companies were early adopters of SPACs as a means to go public, including Centennial, Alta Mesa, and Magnolia. While many energy-focused SPACs indicate that they are seeking opportunities in the energy transition space, there are a handful that may be seeking to acquire E&P companies.ConclusionVine’s public market debut brought an end to a long-running drought of E&P IPOs, though it may be more of an anomaly than a harbinger of things to come. With no public S-1 filings among upstream energy companies and continued investor focus on ESG issues, we don’t expect to see any new public E&P companies any time soon.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.[1] We note that there have been other upstream companies that have gone public via a SPAC (e.g., Centennial, Alta Mesa, and Magnolia) as well as mineral-focused companies that have had traditional IPOs (e.g., Brigham Minerals and Kimbell Royalty Partners). However, this post is focused on traditional IPOs of exploration & production companies.

Asset / Wealth Management Stocks See Another Quarter of Strong Market Performance

Publicly Traded Asset / Wealth Managers See Continued Momentum Through Second Quarter as Market Backdrop Improves

RIA stocks continued to have strong performance during the second quarter, with most individual stocks in our indices hovering near 52-week highs today. Performance varied by sector, with alternative asset managers faring particularly well over the last quarter. Our index of alternative asset managers was up 26% during the quarter, reflecting bullish investor sentiment for these companies based in part on long-term secular tailwinds resulting from rising asset allocations to alternative assets. The index of traditional asset and wealth managers rose 15% during the quarter, with performance driven by rising AUM balances and favorable market conditions. The stock price performance of RIA aggregators trailed other categories, with the aggregator index increasing only 6% during the quarter. Weak relative performance for the RIA aggregators may be reflective of mixed investor sentiment towards the aggregator model.While the opportunity for consolidation in the RIA space is significant, investors in aggregator models have expressed mounting concern about rising competition for deals and high leverage at many aggregators which may limit the ability of these firms to continue to source attractive deals. The upward trend in publicly traded asset and wealth manager share prices over the last quarter is promising for the industry, but it should be evaluated in the proper context. Many of these public companies continue to face headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. These trends have especially impacted smaller publicly traded asset managers, while larger scaled asset managers have generally fared better. For the largest players in the industry, increasing scale and cost efficiencies have allowed these companies to offset the negative impact of declining fees. Market performance during the second quarter was generally better for larger firms, with firms managing more than $100B in assets outperforming their smaller counterparts. As valuation analysts, we’re often interested in how earnings multiples have evolved over time, since these multiples can reflect market sentiment for the asset class. LTM earnings multiples for publicly traded asset and wealth management firms declined significantly during the first and second quarters last year—reflecting the market’s anticipation of lower earnings due to large decreases in client assets attributable to the overall market decline. Multiples have since recovered as prospects for earnings growth have improved with AUM balances. Implications for Your RIAThe value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with privately held RIAs should be made with caution. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds such as fee pressure and asset outflows to passive products. Many smaller, privately held RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.The market for privately held RIAs has remained strong as investors have flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer. Like the public companies, value likely declined during the first quarter of last year, but these were largely paper losses (not many transactions were completed based on value during the height of the downturn). Likely, not more than a quarter or two of billing was impacted last year by the market downturn. Since then, revenue and profitability have recovered rapidly, and value has likely improved as well similar to the publicly traded asset/wealth managers.Improving OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are somewhat tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has generally improved with market conditions over the last several months. AUM has risen with the market over this time, and it’s likely that industry-wide revenue and earnings have as well. With markets near all time highs, most RIAs are well positioned for strong financial performance in the back half of the year.

The Electric Vehicle Race

Tesla vs. Everyone

Is Tesla’s Grip On the EV Market as Iron Clad as It Once Seemed?Electric vehicles have continued to gain momentum, forecasted to reach 3.55% of the U.S. market share of total vehicles by the end of this year. While this is still a relatively small portion of total auto sales, manufacturers continue to invest in their electric technology to prepare for a future in which electric vehicles may be the norm. When you think “electric vehicles,” there has been one brand that has established itself as a clear leader: Tesla. Elon Musk, Tesla CEO, when he’s not tweeting about Dogecoin or other memes, is solidifying the company as the go-to manufacturer for electric vehicles. According to data from Experian, Tesla accounted for 79%of U.S. EV registrations in 2020, with 200,561 of its electric battery operated vehicles registered. This is an increase of 16% from 2019 when owners registered 172,438 Teslas. Tesla has dominated the industry, with the three highest selling EV models since 2018 as seen in the graph below. Tesla’s Model 3 alone has more sales than all the other electric vehicles combined and when you consider the Model S and the Model X, there have been three times more Tesla vehicles sold than the trailing top 5 competitors. While Tesla’s dominance in the U.S. is clear, the graph below helps illustrate that Tesla’s lead may not be as iron clad as it once was when looking at market share on a year-to-year basis. Tesla’s Model 3 has been losing market share since 2019, largely attributable to the influx of new EV options in the marketplace. In 2021, Model 3 market share is anticipated to drop even further, with expected new EV options diluting the market. With more auto groups intent on gaining a slice of the pie, competition is expected to continue to steepen going forward. CompetitorsWho is challenging Tesla in the EV space? We have laid out the top competitors:VolkswagenAfter half a million diesel Volkswagen models were cited for violations in the 2014 emissions scandal, the company is clearly trying to clean up its image. One way they are doing this is in electric vehicle initiatives. In 2020, the brand delivered nearly three times as many pure-electric vehicles as they did the year before, up to 134,000 electric vehicles and 212,000 electrified cars in total worldwide. By 2030, the company hopes that their fully-electric vehicles will account for more than 70% of the brand’s European sales and a market share of over 50% in U.S. and China.Deutsche Bank analysts have bullish predictions for Volkswagen. As a team of analysts led by Tim Rokossa noted that with a new target for electric vehicles of 1 million this year, the majority of which will be electric battery vehicles, the German automobile maker should come “very close to Tesla’s battery electric vehicle sales.” Volkswagen is already taking a lead in European markets, as they accounted for more than 22%of the market shares after 10,193 vehicles were registered. This compares to Tesla’s market share in 2020 of only 13% across the pond. Looking forward, Volkswagen’s ability to convert customers in the U.S. market will be crucial in gaining market share.StellantisLike Volkswagen, Stellantis presents a substantial threat to Tesla’s electric vehicle dominance in the United States after it has performed impressively in Europe. The world’s fourth largest car maker’s electric vehicle share accounts for nearly 17% of the market share in Europe, trailing only Volkswagen. The company announced last Thursday that it would invest more than $36 billion through 2025 as a plan to accelerate in the EV race. The company had already announced in April that they set out targets to offer an electrified version of nearly 100% of its models by 2025. With this investment initiative is the bold plan of targeting 70% of European sales and 40% of U.S. sales coming from low emission vehicles by 2030. The company has significant ground to make up in the U.S. markets in order to achieve this goal, and like Volkswagen, will need to focus efforts on conversion in this market.FordFord’s sales of EVs expanded 117% in June, reaching a new first half sales record of 56,570 vehicles. Behind these figures were the success of Ford’s fully electric Mustang Mach-E and F-150 PowerBoost Hybrid. More importantly than just the recent increase is the fact that 70% of customers who bought the battery electric SUVs are new to Ford, meaning the additions may be helping them to capture market share.Ford’s ability to produce an electric pick-up, the F-150 Lightning Electric truck, makes them dangerous in a U.S. auto market driven by light truck sales (light trucks accounted for 75.9%share of U.S. auto sales in 2020). With Ford having thesecond largest total vehicle market share in the U.S., trailing only GM, their ability to convert current users of their traditional vehicles to electric will be just as important as gaining new customers in expanding their EV market share reach.General MotorsThe largest auto manufacturer of traditional vehicles in the U.S. is hoping to have success in the EV space as well. The Chevy Bolt has the highest number of sales in the U.S. of non-Tesla brand vehicles. Additionally the company has committed to becoming an all-electric vehicle company by 2035, meaning there is significant investment in this business line that is occurring. The company is also hoping to cut costs through making their own battery cells through a joint venture with LG Chem in Ohio. A facility is under construction and expected to be completed by 2022. Like Ford, a key component in gaining electric vehicle market share will be converting some of their current users of traditional vehicles.Batteries Are KeyDespite the encroachment of other traditional OEMs on Tesla in the EV space, the hurdle that they will have to overcome to catch up lies in one specific part of the vehicle: the battery. It is currently a race to the bottom, with the battery costs in an electric vehicle being a primary reason that electric vehicles continue to be pricier more costly than traditional vehicles. However, this price has been dropping, with Tesla leading the way. Tesla has managed to drop their cylindrical cell battery pack down to around $150 per kWh last year, nearly an 87% decline from 2010 as seen in the graph below: Tesla is the only automaker to use this type of cylindrical battery cells in its battery pack. Its competitors, like those discussed above, use battery packs containing pouch or prismatic battery cells. According to Cairn, these cost on average more than $200per kWh in 2019. Automakers are aware that even though they are throwing billions of dollars at batteries and EV production, Tesla’s lead on the technology of these vehicles is undeniable. Colin Rusch, auto analyst for Oppenheimer notes, “At core there is really incredible battery technology within the organization and that is material science that they have been working on for well over a decade. We think they have some substantial advantages on that.” Tesla competitors eager to get the edge on the EV giant will have to continue to invest in their battery technology in order to drive down prices. The Real WinnersThough uncertainty remains surrounding whether or not Tesla will be dethroned in the U.S. EV space, there is one clear winner among all of this investment and competition: the consumer. More investment into EV technology and competition between brands means that electric vehicles likely will become more readily available to car buyers at more affordable prices. While Tesla is the largest player in the U.S. market, their image of luxury vehicles prevents many people interested in electric from joining the market. Larger offerings of mass market vehicles will help to show the true demand that is there for these types of cars and trucks.Additionally, auto dealerships also stand to benefit from this push. With two thirds of car consumers interested in electric vehicles, they may present a unique opportunity for dealerships particular those whose OEM is able to produce the most attractive models. However, there are some concerns about how EV’s will affect the bottom line on the service portions of the business. A 2019 reportfrom AlixPartners estimates that dealers could see $1,300 less revenue in service and parts over the life of each EV they sell. If electric vehicles ultimately gain the market share that they are anticipated to, dealerships may need to become more savvy in mitigating these service and parts revenue declines. Like NADA, we remain bullish on the role of auto dealerships in the EV sales process despite concerns regarding direct-to-consumer sales channels from the OEMs. Additionally, dealership owners have expressed some concern over how OEMs will handle the EV units from their traditional dealership models. If OEMs continue to allocate units to each dealership, this presents an opportunity. However, if they instead follow Tesla’s lead and adopt a more direct to market approach to selling new units, this may pose a problem for dealerships.If you would like to know more about the electric vehicle industry and what this all may mean for your auto dealership, feel free to reach out to anyone on Mercer Capital’s Auto Team.

E&P Third Quarter 2021

Bakken

Bakken // Oil prices were relatively stable in Q3 2021 following a significant run-up in the first two quarters.

Transportation & Logistics Newsletter

Third Quarter 2021

Industry Trends From the Road

Key Takeaways from State Automotive Annual Conventions

We recently attended the annual conventions of two state automotive groups – Kentucky and the Tri-State Convention consisting of Tennessee, Alabama, and Mississippi. It was refreshing to attend live events again after the virtual world we have all grown accustomed to over the last fifteen months. Live events like these serve as a great venue for shared information about industry trends and cultivating business relationships.In this post, we summarize certain sessions that our readers might find of interest. If the topics were similar, we present those topics together. We also layer in highlights from our conversations with dealers and other industry participants.Cybersecurity for Auto Dealerships and Fraud and the Distracted EmployeeCybersecurity IssuesOver the last year, there have been several high-profile instances of cybercrimes and fraud, including the ransomware hacks on Colonial Pipeline and JBS. These topics that typically lurk in the shadows have been brought into the national discourse, and there were two sessions devoted to best practices to protect against cybercriminals and how to detect fraud from within an organization.While we typically think of these sorts of things as something that happens to other people, speakers showed just how much they can impact the auto dealer industry and how the economic fallout of the COVID-19 pandemic has increased the motivation and prevalence of fraud.Auto dealers experience nearly six times the amount of cyber criminal activity than other industriesIdentity Theft crimes account for $50 billion in damages and recovery expense annuallyOne of the most common methods for committing a cybercrime in auto dealers is through the use of business emailOne of the most common methods for committing a cybercrime in auto dealers is through the use of business email. Key management and particular controllers, payroll managers, and accounts payable clerks should pay special attention to the spelling of names in emails received and also the domain name portion of the address. The strongest defenses against compromises in cyber crimes attempted through business emails are the following:Strong Password – have unique and lengthy passwords for all of your various accountsTwo-Factor AuthenticationTelephone confirmation for fund transfers before wiringBeware of unexpected urgency – Phishing emails prey on the urgency of the situation they create by saying that funds must be wired within a short amount of time to guilt the recipient into immediate actionCyber Security Training – Create a culture of training and accountability for your staff. Create a message from the top that permeates throughout your dealershipHow to Understand and Protect Your Dealership from FraudUnfortunately, these threats are not exclusively external threats. Too often internal and trusted employees can be the culprits. Auto dealers should consider the following statistics.Over 50% of companies have been victims of embezzlement by their own employeesTypical organizations lose 5% of their top line revenue to fraudOver 50% of employees committing fraud have been with the company over five yearsMedian length of time to detect fraud is 18 months58% of fraud cases have no recovery at allAnonymous tip lines are one of the greatest ways to detect fraud because someone within the organization is probably aware of what is going on If fraud is occurring in your dealership and it is most likely being committed by longer tenured employees. What behaviors should you be observing as possible red flags?Employees living above their means, or the opposite, experiencing financial difficultiesEmployees that are unwilling to share their duties with other members of the organization and/or rarely take time offEmployees who have recently divorced or are experiencing other family problemsEmployees that have an unusually close relationship with a particular vendorKey TakeawaysAuto dealers should communicate to their employees the potential damage to the business from a ransomware attack or other similar threats. This includes training employees on what these schemes look like and creating a culture to protect against external and internal threats. Auto dealers must confront conflicting agendas to protect their dealerships: while you want to empower your employees to do their jobs well and trust them without micromanaging, it’s also important to not be too detached and “inspect what you expect” might be potential fraud. Finding that balance is critical. A three-pronged approach to internal fraud is key: deter, detect and prevent.How can auto dealers put this approach into practice? Set up internal controls so that one employee isn’t responsible for all elements of transactions. Segregate duties among various employees. Rotate functions so that the same person doesn’t handle the same aspect of the business at all times. Besides being good practice against fraud, this also reduces systemic risk of the dealership that we in the valuation world discuss as a “key person risk.” Businesses whose operations are not specifically reliant on one person tend to be less risky and therefore more valuable. While typically this is thought of as the dealer principal or upper level management, it’s important to have these considerations throughout your organization.The Dealership of Tomorrow and Regulatory Items in the Biden EraFuture Trends and Their Possible ImpactThe pandemic had an acute economic impact on many Americans, and it accelerated many trends from before 2020. One of our speakers took a long view at these trends and offered his view of the future of traditional auto dealers.Then, we look at recent trends in the industry from a more regulatory point of view. When the White House administration changes, particularly to a different party, there is likely to be change to regulations at the federal level, particularly considering Biden was a part of the administration that preceded his predecessor. How will these changes impact dealerships?Despite the ebbs and flows of trends that come and go, dealerships have utilized all of their profit centers to their advantage, so when one area of the business is declining, another is likely benefiting. Even through challenges such as electric vehicles, autonomous vehicles, rideshare, and connected cars, the industry has proven it can adapt and remain viable.No country in the world exclusively utilizes a direct sales model for retail automotive salesWhen it comes to electric vehicles, speakers at our conferences offered some rebuttals to some prevailing arguments, particularly those proffered by proponents of direct to consumer sales. No country in the world exclusively utilizes a direct sales model for retail automotive sales. While some upstarts like Tesla have adopted that model, all countries still maintain and utilize some OEM/dealership model. While direct sales proponents insinuate that franchise laws are the only thing preventing a shift in the market, countries without these laws do business very similarly. If EVs are going to be successful, it will likely be dealers who have made the investment in personal relationships in their community who can help consumers understand the benefits and challenges of the new technology.There has been plenty of talk around the topic of consolidation in the industry, but the total number of automobile dealerships or stores has only declined approximately 1.9% from 1970 through 2019. There are approximately 18,000 stores in the U.S., and it looks like this number may stay relatively consistent.In the past decade, the number of owners has declined from 10,000 to 7,500. Despite the challenges related to the pandemic, the auto dealer industry only lost 31 dealers in 2020, or ~0.2%. While some dealers may capitalize on heightened valuations and exit with more Blue Sky value, there’s a sense that the total number of rooftops nationwide won’t similarly decline. Despite the recent uptick in investment by the public auto dealers, their share of the entire automotive market is less than 10% by location. If Lithia and others continue to acquire and Blue Sky values stay high, this could change. However, years of evidence does not seem to clearly indicate that public dealers necessarily can operate more efficiently than their privately held counterparts.Will OEMs exercise restraint with their facilities and imaging requirements? The buying experience for consumers and their preferences shifted during the pandemic. Shutdowns and health fears led to more investment in the digital/online channels for vehicle retail sales. With dealers seeing less foot traffic at their dealership locations, will they want to downsize their facilities, or will the OEMs continue to require continuous upgrades and imaging requirements? Trends surrounding facilities that could evolve after the pandemic include unbundling facilities (i.e., sales and service operations not being conjoined on the same property), placing greater importance on convenience and flexibility.From a regulatory standpoint, there appear to be more threats than opportunitiesPossible RegulationFrom a regulatory standpoint, there appear to be more threats than opportunities:Trade can be an area of opportunity now with the removal of 25% tariffs, but dealers should be aware of how the USMCA, which replaced NAFTA, may impact themLabor constraints have made operations more difficult across all industries, but the speaker pointed to the classification between W-2 employees and independent contractors as a regulatory issue to watchFuel economy standards have changed depending on the current administration, which can make it hard for OEMs and dealers to make long-term plans when the goals for 2035 and beyond continue to be a moving target. Hopefully for dealers, these requirements will be tied to economic viability50-60% of dealers report on LIFO, which is beneficial when inventory levels and/or values are increasing. When volumes dropped during the pandemic (which have been extended by the chip shortages), LIFO dealers are stuck recognizing income, which is unlikely to be changed despite NADA lobbying effortsF&I has increasingly become a profit source, with dealers recognizing more and more of overall profit from F&I rather than the sale of the actual vehicle itself. Will that lead to concerns from the Consumer Financial Protection Bureau that dealers are in effect selling products with interest rates too high, or is this just semantics of how profit is allocated?Key TakeawaysWhile the external alternatives to traditional automobiles continue to arise and the imaging requirements may change in the future, traditional auto dealerships appear to be stable and on solid footing for years to come. Auto dealers should become active and stay in communication with their state associations and politicians to ensure their best interests are being protected during periods of regulatory changes.Succession PlanningGeneral succession planning forces individuals to confront uncomfortable topics including their personal financial circumstances and needs, circumstances and feelings of other family members, and circumstances of the business, age, and quality of key managers/employees. Auto dealers face additional decisions contemplating the OEM requirements for their children or other family members to become a dealer and what will be required for them to become a successful dealer. The approval of a second generation or other family member as a dealer principal is not guaranteed by the OEM. We have encountered this situation at the untimely death of a dealer principal.A critical element of succession planning is determining the value of the business to implement the particular action stepsOne of our speakers demonstrated the difference between “having a plan” and succession planning. Having a plan is more like the noun, or the passive part of the process. Succession planning is the verb, or the active part of the process.A plan can consist of a Buy-Sell Agreement. The success of the process is to live by the terms of the Buy-Sell Agreement or plan and make it a living document rather than have it become a static document that resides in a file cabinet. A Buy-Sell Agreement may appear stronger if it includes a mechanism for the pricing of a dealership that accounts for its Blue Sky value. However, if the document simply indicates a static multiple (say 5.0x, for example) from when the document is drafted, it may not capture how the dealership and the market for dealerships change over time.Key Takeaway: At the risk of appearing self-serving, we offer this truth: a critical element of succession planning is determining the value of the business to implement the particular action steps. Mercer Capital assists auto dealers around the country by performing business valuations to assist with succession planning and wealth transfers. Do you have a plan or have you engaged in succession planning with a financial advisor?ConclusionWe’re glad to be back attending in-person conferences and talking with dealers in person. This leads to a better exchange of ideas on current trends and best practices. If you would like to discuss any of information in this post and how your dealership might be impacted, please contact any of the members of the Mercer Capital auto team.Sources“Cybersecurity for Auto Dealerships,” John Iannerelli, former FBI Special Agent – KADA Convention“Fraud and the Distracted Employee,” Lori Harvey, CISA, CISM, PCI QSA, DHG – Tri-State Conference“Dealership of Tomorrow,” Glenn Mercer, Glenn Mercer Automotive – KADA Convention“Regulatory Items in the Biden Era,” Paul D. Metrey, NADA – Tri-State Conference“Plan Now or You Could Lose Everything,” Loyd H. Rawls, Rawls Group – KADA Conference

What Is Your Firm’s “Brand” Worth?

Building the Value of an RIA Involves Making it More Than a Group of Professionals

This week we look back at a post from November 2018. Don't let the dates fool you, the topic is still very relevant today. The announcement from Merrill Lynch last week that it was cutting advisor compensation stood in stark contrast to a lawsuit filed in October by former Wells Fargo brokers, alleging that their practices had been impaired by association with the bank. While Merrill feels comfortable flexing their brand muscles by redirecting advisor cash flow back to the firm, Wells Fargo is accused of actually having negative brand value. These two situations highlight the dynamic interaction between investment management professionals and the firms they work for while demonstrating the significance of branding to build professional careers and advisory firm value.An Ensemble Product With an Ambiguous BrandA couple of weeks ago I was driving around Memphis and spotted a unicorn, or, more specifically, a Bricklin SV-1, an independently produced sports car with a small-block V-8 engine, two seats, a fiberglass body, and gullwing doors. Malcolm Bricklin debuted his eponymous car at a celebrity-studded event at the Four Seasons restaurant in New York in the summer of 1974. Despite the innovative nature and affordable price of the Bricklin, it wasn’t terribly quick (not unusual for cars of that era), reliable (the hydraulic pump for the gullwing doors would sometimes break if you tried to open two doors at once), or practical (it lacked both a spare tire and a cigarette lighter). Only 3,000 or so Bricks were sold in 1974 and 1975, and fewer than half of those are extant today.If the Bricklin were a metaphor for a cohort of RIA practice, it would be an “ensemble” practice. The company was run from Arizona but manufactured cars in Canada, shared taillights with the DeTomaso Pantera and the Alfa Romeo 2000, sourced its engine from American Motors and Ford, transmissions from Ford and Borg Warner, brakes that included parts from three manufacturers, and a steering wheel from Chevrolet. What Bricklin lacked was a compelling brand to pull it all together, so instead of projecting the image of a “best of everything” product, it came off as more of a Frankenstein.Brand substantiates the value of goodwill and makes a firm worth more than simply a collection of broker books.Reading through the industry news of late, we’ve been thinking about the role of branding in the investment management industry. Branding is more than a firm name or logo, it encompasses the identity of an RIA such that the practice is elevated above the practitioner, with the potential to benefit both. As such, we consider brand to be more than tradenames or logos; it is a concept that substantiates the value of goodwill and makes a firm worth more than simply a collection of broker books.Personal Goodwill and Corporate GoodwillIn the valuation community, there are techniques for determining whether a portion of a given enterprise’s goodwill is (in reality) allocable to one professional or to a group of professionals instead of the company. I’ll spare you the technical details, but suffice it to say that when an RIA matures to the stage that it can report a legitimate bottom line – i.e. that there are profits left over after covering both non-personnel costs and paying a market rate of compensation to all staff – then it has brand value that has generated a return on corporate goodwill. Profitability is evidence of brand value.Returns to Labor Versus Returns to CapitalWhen the C suite at Merrill Lynch decided to cut advisor payouts a few years ago, they were shifting cash flow returns from labor to capital. Advisors probably felt like they were being devalued, and arithmetically they were. But Merrill was also testing its brand value. Could they enhance their return on corporate goodwill by retaining more client fees from existing brokers at the risk of either disincentivizing their advisor network or even running them off to other wire-house firms or RIAs? Merrill’s opting to remain in the broker protocol can be seen as confidence in its brand to attract, grow, and retain an advisor network.Negative Goodwill?At the other extreme, the Wells Fargo lawsuit from about the same time suggested the possibility that negative brand value at the firm level can impinge on an advisor’s income. Two brokers alleged that the string of negative publicity at Wells Fargo made it difficult for them to build their books of business or even to maintain the level of business they built previously. Investment management is a reputation business, and the lawsuit indicated that even association with a tarnished brand can impair a career. It was an interesting lawsuit, because in blaming the firm for advisor performance, it suggested that the advisor/client relationship was more significant than the client’s relationship with the firm – otherwise the advisor could mend the relationship simply by changing firms. Yet the lawsuit was basing the damage claim on the bad reputation of the firm.Brand Value in the Independent ChannelOutside of the bulge-bracket broker channel, it is more common for personal goodwill and firm goodwill to overlap. There is a thread of conventional wisdom that suggests small RIA practices aren’t salable (i.e. don’t have enterprise goodwill). The reality is more nuanced, of course, but to the extent that the identity of a small RIA is really just that of the founder and principal revenue producer, then clients are difficult to transfer and the business is more difficult to transact. Building an RIA beyond dependence on the founder should be a focus of any firm wishing to build value.Building an RIA beyond dependence on the founder should be a focus of any firm wishing to build value.There’s more than one way to build brand value beyond the founder, as shown by high profile firms like Edelman Financial and Focus Financial. Edelman employs a highly centralized approach, with uniform and templated marketing programs and client service techniques. While Edelman has successfully built a large and profitable platform from this, the risk is that the secret sauce is vulnerable to being copied. Focus Financial, on the other hand, has employed a highly decentralized approach of acquiring cash flow interests in independent RIAs and then leaving their client-facing identities intact. You won’t find Focus’s name (much less than name of its founder, Rudy Adolf) on any of its partner firms, and thus individual firms (and Focus itself) are far less exposed to reputational risk from bad actors in individual offices. Besides this, Focus doesn’t base its business model on intellectual property that could be replicated elsewhere. What Focus lacks is a certain level of corporate identity and efficiency that comes from uniformity.In the End, Brand Value Is Defined by Your ClientMuch of the debate over the value of investment management firms can be distilled into one question: what is the value of a firm’s brand? More than “what’s in a name?”, the question is an investigation into the relationship between client and investment management service provider. Do clients of your firm define their relationship as being with your firm, or with an individual at your firm? If you can answer that question, you know where your RIA is on the journey to building firm value.

Permian Production Pushes Higher

The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. In this post, we take a closer look at the Permian.Production and Activity LevelsEstimated Permian production increased approximately 8% year-over-year through June, though current production remains below the peak observed in March 2020. Production in Appalachia increased 5% year-over-year, while the Eagle Ford’s production was essentially flat. The largest production gain was observed in the Bakken (up 26%), as the Bakken saw a high level of shut-in wells(in response to low commodity prices) which have subsequently been brought back online. Permian production has generally been increasing over the past year, but there was a meaningful decline in February driven by Winter Storm Uri that disrupted power supplies throughout Texas. The Permian’s production increase is the result of more drilling activity in the basin. There were 237 rigs in the Permian as of June 18th, up 73% from June 12, 2020. Bakken and Eagle Ford rig counts were up 55% and 146%, respectively, while the Appalachia rig count was down 3%. Permian production should continue to increase modestly over the next several months based on the current rig count, legacy production declines, and new-well production per rig. Commodity Prices Grind HigherThe second quarter of 2021 saw rising commodity prices, driven largely by accelerating travel and economic activity amid the vaccine rollout and fewer COVID cases in many parts of the world. Front-month WTI futures began the quarter at ~$60/bbl and broke above $70/bbl before the end of the quarter. The rise in prices was generally slow and steady, with the exception of a dip in mid-May, though that was likely driven by short-term dislocations caused by the shutdown of the Colonial Pipelinein response to a ransomware attack. Henry Hub natural gas front-month futures prices began the quarter at approximately $2.60/mmbtu and have been above $3/mmbtu for all of June thus far. However, the current commodity price environment may be short-lived. WTI futures prices are in backwardation (meaning that current prices are higher than future prices), implying some near-term tightness that is expected to subside. This sentiment is echoed by the U.S. Energy Information Administration, which stated that “continuing growth in production from OPEC+ and accelerating growth in U.S. tight oil production—along with other supply growth—will outpace decelerating growth in global oil consumption and contribute to declining oil prices” in their June 2021 Short-term Energy Outlook.Financial PerformanceIn a nice change of pace for energy investors, the Permian public comp group saw strong stock price performance over the past year (through June 22nd). All of the Permian companies except Pioneer outperformed the broader E&P sector, as proxied by XOP (which was up 73% during the past twelve months). That stock price performance is probably more reflective of the dire straits of some companies last year in the aftermath of the Saudi/Russian price war and COVID-19 lockdowns, as small, leveraged companies like Centennial and Laredo have had the biggest gains. However, stock prices for all of the Permian comp group companies remain below all-time highs.Federal Lands Drilling Ban Could Shift Production Within the BasinPart of President Biden’s environmental platform was banning new oil and gas permitting on public lands. An initial action under this platform was a 60-day moratorium on permitting activity, though that was recently blocked by a federal judge. While many think a ban would haverelatively modest impacts at a macro level, the impacts could be more severe for companies and areas with a high level of exposure to federal lands.The Federal Reserve Bank of Dallas performed an analysis to look at the potential impact to the Permian Basin. Under a restrictive policy scenario, production growth would slow (relative to no change in policy), though overall production from the basin is still expected to increase.[1] However, approximately half of New Mexico’s Oil & Gas production comes from federal acreage. As such, the impacts to New Mexico are much more acute under a restrictive policy scenario. The consequence is a shifting of drilling activity (and associated employment and spending) from New Mexico to Texas. ConclusionThe Permian was not immune to the impacts of historically low oil prices observed in 2020, though it has proven to be resilient. Production, while still below peak levels, is growing, and growth is generally expected to continue. Activity levels are improving, though companies’ current emphasis on returning cash to shareholders may lead to less investment than has been seen in previous periods with similar commodity price environments.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.[1] The Dallas Fed describes the policy scenarios as follows:Reference Case: This serves as the benchmark and assumes little-changed leasing, permitting and drilling from first-quarter 2021 levels.Hybrid Case: It assumes no new federal leasing, but existing leaseholders continue receiving drilling permits. Permit reviews are more rigorous, leading to slower approvals and a costlier operating environment beginning in 2022. Based on companies’ public statements, firms that hold acreage across the basin gradually relocate drilling rigs and completion crews to their nonfederal locations.Restrictive Case: No new federal permits or extensions are granted starting in 2023. This is when the most-recently issued permits will expire. The existing permitting freeze adversely affects production in the near-term due to a lack of approvals of permit modifications and pipeline rights-of-way. As in the Hybrid Case, companies shift their focus to nonfederal acreage.

Whitepaper: Understand the Value of Your Auto Dealership

If you’ve never had your auto dealership valued, chances are that one day you will. The circumstances giving rise to this valuation might be voluntary (such as a planned buyout of a retiring partner) or involuntary (such as a death, divorce, or partner dispute). When events like these occur, the topic of your auto dealership’s valuation can quickly shift from an afterthought to something of great consequence.The topic of valuation is of particular importance to owners of auto dealerships due to the complex and unique nature of the industry. In our experience working with auto dealers on valuation issues, the need for a valuation is typically driven by one of three reasons: estate planning, transactions, or litigation.The situation giving rise to the need for a valuation could be one of the most important events of your professional career. Familiarity with the various contexts in which your dealership might be valued and with the valuation process and methodology itself can be advantageous when the situation arises. To this end, we’ve prepared a whitepaper on the topic of valuing interests in auto dealerships.In the whitepaper, we describe the situations that may lead to a valuation of your auto dealership, provide an overview of what to expect during the valuation engagement, introduce some of the specific industry information and key valuation parameters that define the context in which an auto dealership is valued, discuss value drivers of an auto dealership, and describe the valuation methods and approaches typically used to value auto dealerships.If you own an interest in an auto dealership, we encourage you to take a look. While the value of your dealership may not be top of mind today, chances are one day it will be.Our hope is that this whitepaper will provide you with a leg up towards understanding the valuation process and results, and further that it will foster your thinking about the valuation of your auto dealership and the situations—good and bad—that may give rise to the need for a valuation.Editor's Note: This whitepaper was originally published in August 2020. WHITEPAPERUnderstand the Value of Your Auto DealershipDownload Whitepaper

Permian M&A Update: A Buyer's Market

Pocketbooks Open for More Deals and Larger Positions

Transaction activity in the Permian Basin picked up in earnest this past year, indicating greater optimism in extracting value from the West Texas and Southeast New Mexico basin.A table detailing E&P transaction activity in the Permian over the last twelve months is shown below. Relative to 2019-2020, deal count increased by five transactions, representing an increase of 23% over the 22 transactions in the prior period. Furthermore, median deal size nearly tripled from $138 million to $405 million, period-over-period. The median acreage among these transactions increased 2.5x from 14,500 acres to 36,250 acres (not shown below). Given the concurrent increase in transaction values and greater acreages acquired, the median price per net acre was down a slight 4% period-over-period.The big story though, was production. The median production among transactions from June 2018 to June 2019 was 2,167 barrel-oil-equivalent per day (“Boepd”); while over the past twelve months, the median production value was 8,950 Boepd (not shown). As buyers “purchased in bulk” this period relative to the prior twelve-month period, the median transaction value per production unit declined nearly 41% from $53,584 per Boepd to $31,886 per Boepd. Transactions came in waves. There was one transaction announced regarding Permian properties between June and August 2020. September saw three deal announcements, and 10 transactions were announced during Q4 2020. Activity fell silent in Q1 2021 as the industry waited for the Biden Administration to settle in Washington. Deal announcements then resumed in earnest in Q2 as WTI crude oil and Henry Hub natural gas prices showed signs of fairly stable upward trajectories, with the exception of a temporary spike in gas prices due to the mid-February freeze.Click here to expand the imageLooking a bit closer at the data, it appears there may have been an inflection point in deal valuations over the past twelve months. First and foremost, there was a notable concentration of larger-than-average deals, in terms of transaction values, from July to October 2020. Except for the Pioneer Natural Resources DoublePoint Energy transaction in early April, all deal values after October 2020 pale in comparison to those in the early period. As presented in the comparative statistical tables below, bifurcating the presented metrics further between the periods of July to October 2020 and November 2020 to the present reveals the potential pivot in valuations.The post-October median transaction value declined 95% to just $294 million from the pre-November median value of $5.6 billion. However, more tellingly, the cost per acre nearly halved with the median metric value declining from $20,449/acre in the July-October 2020 transactions to $10,482/acre in the post-October transactions. If you remove the outlier value of the Northern Oil and Gas transaction ($180,303/acre), the nearly 50% decline is slightly reduced to an indicated decline of 45% in the price per acre. I am not a gambler, but without soliciting direct commentary from the respective management of the buyers listed above, I would wager that the inbound Biden Administration and the uncertainty surrounding potential regulatory changes were a significant factor in this valuation decline.Click here to expand the imageOne noteworthy pair of transactions, which may receive further Mercer Capital analysis sooner than later, relates to acquisitions made by Pioneer Natural Resources, including the October 2020 announcement of a definitive agreement to acquire Parsley Energy and its April 2021 announcement of a definitive agreement to purchase the leasehold interests and related assets of DoublePoint Energy. Pioneer was the only buyer to appear more than once on our list of transactions with a major transaction before November and one after (for which deal metrics were available), with indications of significant increases in the cost-per-net-acre and cost-per-Boepd valuation metrics.Northern Oil and Gas Enters the Delaware BasinIn September 2020, Northern Oil and Gas announced its entrance into the Permian with its acquisition of non-operated working interests in Lea County, New Mexico from an undisclosed seller. The deal consisted of 66 net acres, with an initial 1.1 net wells proposed to be spud in late-2020 to early-2021 and production expected to start in Q2 2021. The total acquisition costs (including well development costs) were expected to be $11.9 million. At first blush, these metrics indicate a cost per net acre of approximately $180,300, which suggests a notable premium.The next highest cost per net acre value among the transactions listed was $67,000 forthe Pioneer Natural Resources-DoublePoint Energy dealannounced in April. A premium was paid as far as net acreage acquired is concerned. However, at the expected peak production rate of 1,400 Boepd, the cost per production unit was $8,500 per Boepd, the second-lowest metric after Contango Oil & Gas’s acquisition in late November, and one-third of the minimum $-per-Boepd metric among the transactions listed in the June 2019-2020 season. Despite recent volatility in the industry due to energy prices and domestic regulatory changes–whether real or proposed–the economics of the Permian have remained attractive enough to induce Northern Oil and Gas, a stalwart Bakken E&P company, to try its hand in Southeast New Mexico.Vencer Energy Acquires Hunt Oil Company’s Midland Basin AssetsIn late April, Vencer Energy, the U.S. upstream Oil & Gas subsidiary of the Dutch energy and commodity trading giant, Vitol, announced its first investment in the Midland Basin. While the total transaction value was not disclosed, the acquisition included approximately 44,000 net acres with a total estimated production of 40,000 Boepd. This represents an estimated total annualized production of approximately 332 Boe per net acre. This “production density” value (annualized production per net acre) is the second-highest value among the listed transactions, only behind the comparable metric of 376 Boe per net acre indicated from the Pioneer-Double Point deal (with acquired/estimated production of 100,000 Boepd across 97,000 net acres).Ben Marshall, Head of Americas – Vitol, commented on the transaction: “This is an important day for Vencer as it establishes itself as a significant shale producer in the U.S. Lower 48. We expect U.S. oil to be an important part of global energy balances for years to come, and we believe this is an opportune time for investment into an entry platform in the Americas. This acquisition represents an initial step to building a larger, durable platform in the U.S. Lower 48.”ConclusionM&A transaction activity in the Permian was a bit of a roller coaster over the past year in terms of deal timing, but the overall story is one of resurgence over the past twelve months relative to the twelve months before it. Still, despite a renewed interest in acquiring greater acreage and production positions, even greater changes could be on the horizon. This past week, it came to light that Shell was reviewing its Permian holdings for potential sale, according to certain people familiar with the matter. However, it is pure speculation at this juncture as to what option(s) Shell may pursue regarding the partial or full sale of the company’s estimated more-than-$10 billion of Permian holdings. Assuming any dispositions, though, this news could portend even more opportunities for continued buy-in into the Permian by existing regional E&P companies and potential new entrants.

May 2021 SAAR

After three straight months of impressive gains, the SAAR fell 9.6% in May from 18.8 million units to 17.0 million units. The summer is typically a strong season for auto sales, but several supply-side factors have limited the availability of vehicles over the last month.May 2020 SAAR (12.1 million units) is a poor comparison to this year’s rate, as the pandemic’s impact was still sending shock waves through the industry at that time. In comparison to May 2019, SAAR is down roughly 2%.The dip in SAAR from April highs should not be viewed in a totally negative light, as many industry experts have spoken to the adaptability and resilience of the industry during a period of record high demand and increasingly less inventory. As seen in the graph below, the inventory to sales ratio has hit record lows as dealers cannot keep inventory on the lots. As noted in JD Power’s Automotive Forecast for May, the average number of days a new vehicle sits on a dealer lot before being sold is on pace to fall to 47 days, down from 95 a year ago. Dealers are also selling a larger portion of vehicles as soon as they arrive in inventory, with 33.4% of vehicles being sold within 10 days of arrival, which is up from 18.2% in May of 2019. Rising vehicle prices continue to reflect this supply and demand imbalance and benefit retailer profits. As reported by JD Power, total aggregate retailer profits from new vehicle sales will be $4.5 billion, the highest ever for the month of May, and up 162% from May 2019. Fleet customers are continuing to suffer as OEMs prioritize deliveries to retail customers over fleet customers. NADA reported that fleet deliveries accounted for just 10% of new-vehicle sales in May, after averaging 16% the first four months of the year. Notably, this was already depressed in 2021 as pre-pandemic levels were closer to 20% of monthly sales. As we noted in our April SAAR, rental cars will continue to be hard to come by. These high prices on rental cars and limited selection will most likely continue until the chip shortage has been straightened out and supply has stabilized. Consumer ReactionsConsumers are having to get creative in order to secure a vehicle. As we mentioned on our April SAAR blog post, manufacturers are hoping that consumers will be flexible and purchase models with less features to save on chips.Consumers seem to be going the extra mile however, with Cars.com finding that nearly 1 in 3 recent buyers drove 100 miles or more to secure the car they want. Kelsey Mays, Cars.com assistance managing editor, noted “With the current auto inventory challenges, recent car buyers are going to great lengths to find the car they want…I don’t anticipate this trend slowing down, either. Of consumers currently in the market and shopping for a car, 65% said they would consider purchasing in another state.”While the extra mileage to find car options presents a clear inconvenience for consumers, they may reap some benefits as well. Over half (53%) of those looking for a new car also plan to trade in their current vehicle to the dealerships. As the inventory shortage has limited the availability of cars on lots, the dealerships are often willing to pay a premium for new inventory. The extent to which consumers are willing to travel to find a car sheds further light on the current supply and demand incongruencies.Government ReactionsThe chip shortage has reached such an extent that the U.S. government is trying to assist. According to Automotive News, the Senate has passed an expansive bill to invest nearly $250 billion in bolstering U.S. manufacturing and technology to meet the economic and strategic challenge from China. More specifically for auto dealers, the bill includes $52 billion in emergency outlays to help domestic manufacturers of semiconductors expand production, which was a bipartisan addition sought by Republican Senators John Cornyn (Texas) and Tom Cotton (Arkansas) and Democrats Mark Kelly (Arizona) and Mark Warner (Virginia). The addition of the semiconductor expansion was cheered by those in the industry who have been struggling to meet demand for months. Though the bill would be welcomed with open arms by the auto dealer industry, its fate is still uncertain as support in the House of Representatives is somewhat unknown. However, Senate Majority Leader Schumer has indicated that he believes the House will be able to get something passed through to President Joe Biden’s desk.When It Will End?With 93%of respondents to a survey conducted by Automotive News about the global chip shortage finding that they believe the chip shortage will have a severe impact on the auto industry, the question on everyone’s mind is when is the end date.While 72% of respondents believe that it will last the rest of the year, Goldman Sachs chief Asia economist Andrew Tilton believes the worst may be over. He has noted that there has been “noticeable tightening” of supply chains and shipment delays in North Asia, which will ultimately have an impact on downstream sectors such as auto production. He and his team believe the chip shortage could improve in the second half of 2021. However, this is a continuously evolving situation as multiple aspects of the supply chain are being disrupted, most recently in Taiwan. Chip manufacturing plants use large amounts of water, and Taiwan, home of the world’s largest contract chipmaker, is facing its worst water shortage in 56 years. This, as well as the continuing COVID-19 pandemic, will need to be monitored closely as the auto dealer industry hopes to move out of this ongoing chip shortage.ForecastWith the chip shortage still in full effect, inventory constraints are going to continue to be an issue through the remainder of the summer. Thomas King, president of the data and analytics division at J.D. Power notes:“Looking forward to June, with sales continuing to outpace production in aggregate, falling inventory levels may start to put pressure on the current sales pace. However, based on what we have seen so far, retailers may continue to adapt by turning inventory more quickly to maintain sales velocity. However, regardless of inventory position, manufacturers and retailers will continue to benefit from strong consumer demand and a higher profit per unit sold.”Through June and the rest of the year, ability to turnover what inventory auto dealers are able to get their hands on will be critical to maintaining profitability levels. Consumer’s willingness to go the extra mile (literally) in order to secure a new car is a positive tailwind, and a continuation of this trend will be beneficial for dealerships. However, the chip shortage continues to need to be monitored closely, though expectations of it easing and government assistance are providing some optimism to the situation.ConclusionIf you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact any members of the Mercer Capital auto team. We hope that everyone is continuing to stay safe and healthy.

To the Moon or Back to Earth?

RIA Valuations Have Increased Substantially Over the Last Year, but That Doesn’t Necessarily Mean These Stocks Are Overpriced

To the Moon?A few weeks ago we blogged about how RIA stock prices have increased over 70% on average over the last year. This rapid ascent begs the question if valuations have gotten too rich with the market run-up during this time. To answer this question, we have to analyze the source of this increase.Click here to expand the table aboveMoving from left to right on the table above, we see that financial performance actually deteriorated over this time – revenue declined and margins compressed, leading to a 20% drop in EBITDA on average for this group of publicly traded RIAs with less than $100 billion in AUM. The increase in the EBITDA multiple more than compensated for the decline in profitability and is the primary driver of the overall increase in value from March 31, 2020 to March 31, 2021. At first glance, a 70% increase in value (when year-over-year earnings have actually declined) suggests that current pricing may be overstretched.Back to Earth?When we observe historical levels of RIA valuations, however, we get a much different perspective. Even after the recent run-up, EBITDA multiples are still at the lower end of their historical range. The multiple expansion follows an all-time low for the industry last March when these businesses were trading at 4x EBITDA during the bear market. There’s also a logical explanation for the multiple doubling over this period. These multiples are directly related to the outlook for future revenue and profitability, which tend to fluctuate with AUM since management fees are typically charged as a percentage of client assets. AUM balances have risen with the stock market over the last year, so the outlook for future revenue and earnings has rebounded accordingly. Trailing twelve-month (TTM) earnings in March of last year were also suppressed by the bear market’s impact on profitability during the first two quarters of 2020, so a higher TTM multiple is justified when historical earnings lag ongoing levels of profitability. This trend marks a complete reversal of what happened last March when AUM and run-rate performance declined with the market but trailing twelve-month earnings had not yet been impacted. As earnings figures lagged the abrupt price declines, multiples hit all-time lows. Because of this phenomenon, RIA multiples can be especially erratic during volatile market conditions. ConclusionWhile the significant gains in RIA valuations over the last year is fairly alarming, the fundamentals warrant such an increase. The market’s significant rise over the last year buoyed AUM and ongoing profitability, so investors are rationally anticipating higher earnings relative to recent history. Another correction or bear market would certainly reverse this trend, but at the moment, all industry metrics are pointing to the moon.

How to Value Oil Companies in the Biden Era

Like a small boat navigating a big sea, oil & gas valuations are impacted by a plethora of factors that can change almost instantly. Some factors help in arriving at a shareholder’s destination, others do not. Some factors the crew can control, others not so much (and some factors are more predictable than others). As this vessel heads for the destination shores of high returns, it must navigate through natural economic influencers such as production risk, commodity prices, supply logistics and demand changes. In addition, it also must face regulatory shifts that the Biden Administration is and could generate in the future such as tax changes, policy shifts and more. Most likely, these policies will create some volatility and headlines, but in the aggregate will not change valuations much. Let us examine a few of these regulatory items and how they might change the course of an oil and gas company’s valuation going forward.HeadwindsThere are several recent policy actions, and some that are being debated that are affecting the industry, primarily by disincentivizing new U.S. production. Actionsalready taken include a moratorium on federal oil & gas drilling permits and a construction stoppage of the Keystone XL pipeline. While it can grab a headline, from a valuation perspective it should not be a direction changing headwind. Most drilling is not done on federal lands, and a lot of companies with existing permits that will allow multiple years of drilling. Even if this becomes an enduring policy, the impact would likely be a revision too, rather than a material reduction of planned drilling activity.There are also some long-standing tax incentives that may be ended as well: the intangible drilling cost deduction and the percentage depletion allowance. Theintangible drilling cost deduction (which expenses as opposed to capitalizes certain drilling costs) has been around for over 100 years, and thepercentage depletion allowance (15% reduction in gross income of a productive well) has also been around nearly that long. The rationale behind both is to encourage investment by allowing tax breaks for development activity by delaying or decreasing cash taxes in any given year. This is an enjoyed benefit for investors and has allowed cash flows to either be higher or come faster than if the tax breaks were nonexistent. This is considered a headwind for the industry However, since many upstream companies are not cash taxpayers these days, and capital expenditure budgets have already been slashed in the past year, this issue (if it comes to pass) may end up being not much more consequential than a slight breeze.Another matter on U.S. producers’ radar is the expectation that Iranian oil sanctions will be lifted. Iran’s president Hassan Rouhani has said that a broad outline to end sanctions has been reached. Since November 2020 Iran’s crude and condensate exports have already gone up and the global market must contend with another 500 thousand barrels a day of exports. The good news is that the market may have already priced this in and WTI is still over $68 per barrel with Brent Crude over $70.TailwindsNot everything coming out of Washington is detrimental to upstream producers. In fact, some of it may end up being materially beneficial over the course of time. One example is the budget proposal to utilize federal funds for plugging old wells. Biden’s $2 trillion infrastructure proposal includes $16 billion for cleaning up disused wells and mines. Long a balance sheet issue for producers, this can has been kicked down the road for decades. The opportunity to be addressed from a subsidized standpoint would be a welcome development for producers. Even if it is executed inefficiently (North Dakota plugged 280 wells for $66 million: approximately $236k per well) as many government actions can be, it could help producers clean up over 50,000 “orphan” wells that can be over 100 years old in some cases. Considering the beating that oilfield service companies have taken in recent years, this initiative could be a shot in the arm for them as well.The other major tailwind is less about a direct policy, but more an indirect derivative of it. As the Biden Administration restricts drilling on federal lands, the supply of oil is (at least somewhat) constrained. Coupled with the multi-trillion dollar federal budget being proposed, these bring about inflationary pressures that are positive for commodities such as oil. As Sir Isaac Newton once said: “For every action there is an equal and opposite reaction.” Oil and gas companies have been consistently sailing towards capital discipline for several years now, as growth is out of favor in comparison to free cash flow. This strategy is expected to start showing fruit as cash flow and dividends become more prevalent in the industry, something that investors have been awaiting.Tempests on The Horizon?One area where headwinds and tailwinds could clash into a storm system is how inflationary pressures could impact production costs. As commodity prices rise, labor and material costs will impact production (particularly new drilling costs). There are varying opinions as to how much and how long the impact of inflation will be, but most analysts I have read agree that it is either coming or already here. One thing to consider is that while oil prices are global, development costs will be more constrained to the U.S.. Another disturbance will also be the costs of mineral rights payments as the shift of production moves to private lands and away from federal lands. Those items could counterbalance some of the expected commodity price gains and are something that should be on management teams’ radars.Mythical KrakensThere are two things that have been mentioned that could have seismic effects on the industry: banning fracking and limiting LNG exports. However, at this point the odds are low enough to place them in the fabled category. There have been state level fracking policies for years already (New York for example), but nothing about banning fracking has ever gone very far federally. Still, some voices who echo this idea are now close to the Biden Administration. Even with the 50/50 Senate split, most think Senator Manchin (D-WV) would never let it happen.The other idea is to choke the nascent Gulf Coast LNG export industry for ESG or other related priorities. However, that is also highly unlikely. A few months ago Energy Secretary Jennifer Granholm said:“[U.S. LNG is often headed to] countries that would otherwise be using very carbon-intensive fuels, it does have the impact of reducing internationally carbon emissions. However, I will say there is an opportunity here, as well, to really start to deploy some technologies with respect to natural gas in the Gulf and other places that we are siting these facilities for that we are obligated to do under the law.”While an argument can be made that there may be some environmental reasons for shutting this down, pragmatically there is little to no way it will happen anytime soon. If it did somehow, the natural gas business in the US would take yet another ship sinking blow.Heading For Home: High ReturnsWhile upsetting a few, the Government’s action is mostly having the effect of accelerating a lot of things investors have pressed for some time now. Capital discipline is positive for prices. Prices have crept up for months, but announcements for more aggressive drilling plans have been sparse. Matador added a rig in February, but the stock price quickly dropped 5%. Most US producers are more wary of OPEC and Russia than they are of the Biden Administration. Besides, many producers have multiple years of drilling inventory already permitted so federal permit moratoriums do not stop drilling in any substantive sense. Capital has already fled the industry, some for economic reasons, some for more ideological reasons. However, if the prices keep going up and cash flow returns become the norm in an inflationary economy, this vessel could make itself a popular destination for high returns in the future.Originally appeared on Forbes.com.

Tax Planning for Auto Dealerships

Why Auto Dealers Might Not Pay “Market” Rent

In business valuation, appraisers seek to normalize historical earnings to establish the level of earnings an investor might reasonably expect from an investment in the subject company. These adjustments may increase or decrease earnings, and they can be for a variety of reasons. Normalization adjustments include surveying various expense categories and determining whether the amount historically paid is considered “market rate.”Rent paid to a related party is frequently judged to be above or below market, which can be for a variety of reasons. Dealers’ priorities lie more with sales and operating efficiency than tracking what the market says they should pay in rent. The rent paid also may be artificially high or low for tax purposes. In this post, we examine what exactly this means, and why auto dealers may hold real estate in a separate but related entity from the one that owns the dealership operations.What Are the Options and Are Taxes in Play?To understand why paying above market rent might be advantageous for an auto dealer, we need to know the options available and the tax implications. There are a few ways for gross profits to end up in the pockets of dealers:Retain as profit and pay a distribution (corporate income tax and personal dividend tax)Pay as compensation to owner (personal income tax and payroll tax)Pay as rent to related pass-through entity that owns the real estate (personal income tax)Pay Corporate Taxes on Profits and Pay a DividendMaking the decision for “tax purposes” has frequently implied avoiding the double taxation inherent in C corporations. A dealership organized as a C corporation would owe approximately 25% in state (assuming a 5% state tax rate) and federal corporate income tax, meaning $1,00,000 in pre-tax earnings would equate to a dividend of about $750,500. Then, the owner would likely owe an additional 15-20% in dividend taxes, meaning $1,000,000 may be closer to $600,400 in after-tax(es) proceeds. An all-in tax rate of approximately 40% in 2021 is much lower than what dealers would have paid prior to the 2017 Tax Cuts and Jobs Act as shown below:The reduction in the federal corporate income tax itself was a fundamental change to how business owners think about these excess profits. While it significantly increased after-tax proceeds under this payment structure, many owners had already been using more advantageous tax strategies. That’s why most private dealerships aren’t organized as C corporations.Pay Excess Profits as Compensation to DealerIf excess profits are paid as compensation, a dealer is likely to owe the top marginal personal tax rate of 37%. While this appears better than the ~40% tax contemplated above, this fails to capture payroll taxes. Up to certain income levels, a payroll tax of 15.3% is split by employers and employees to fund Social Security (6.2% each) and Medicare (1.45% each). While companies’ exposure to the social security tax is capped at $142,800 in compensation, there is no limit for individuals; in fact, there is an additional Medicare tax of 0.9% added on to the 1.45% on income over $200,000. These calculations can become more complicated depending on the level of payment, and the analysis gets further muddied by the level of pre-bonus compensation to the dealer (below analysis assumes no base salary).As seen above, the analysis becomes more nuanced, but there does not appear to be a huge opportunity for tax savings as the implied all-in tax is near the 40% calculated above post-TCJA.Pay Excess Profits as Rent to a Pass-Through Owned by the DealerPaying higher rent is likely the cleanest way to transfer profits from the dealership to a separately held entity. If the rent paid on the property was $1,000,000 more than it otherwise would be with no commensurate increase in expenses to the entity, income would be passed through at personal rates, like compensation just without payroll taxes. While pass-through entities may also be able to benefit from the Qualified Business Income Deduction, we have not considered this in our calculations because the deduction phases out well before the contemplated $1,000,000 in excess profit/rent. While this appears most advantageous, we should caveat that the IRS may not take to kindly to egregious overpayments of rent to shelter income. Regardless, income and payroll taxes aren’t the only reason a dealer might own the dealership’s real estate operations in a separate entity. There are other strategic reasons it makes sense for auto dealers to have the real estate held in a separate entity, as is common in the industry. An example of this is legal protection from creditors by separating assets. It also enables dealers to retain upside in valuable real estate if they choose to divest of their dealership but retain steady income. As discussed below, there are also other tax planning benefits from this structure. Tax Planning Benefits of Using Multiple EntitiesEarnings on real estate may receive a higher multiplein the marketplace than a business, including auto dealership real estate. This is because rents are paid before equity holders and are therefore viewed as less risky. These steady earnings streams can be beneficial from a financial planning standpoint. In the case of a divorce, the “out-spouse,” or the divorcing party that doesn’t actively participate in the business, might receive alimony, or an equitable division of the marital estate. It may make sense for an auto dealer’s spouse to receive an interest in a real estate entity, receiving more steady cash flows, while the auto dealer would retain the upside of their work in the business.There may also be estate planning benefits that similarly align incentives. If an auto dealer has numerous children and one works in the business, it may similarly make sense for them to either purchase or be gifted an equity interest in the dealership as they actively contribute to its profitability. For a child not involved in the business, it may be the most equitable solution to instead allow them to receive an interest in the real estate, receiving both a steady income and also passive appreciation.ConclusionAs we’ve seen, auto dealers have numerous considerations and options when it comes to excess profits that might be paid as a bonus, dividend, or rent. As appraisers, we are unlikely to opine a higher or lower valuation to a dealership’s operations based on these decisions. While the calculations can become more complex, it is unlikely one of these will increase the value of the enterprise for two reasons: a buyer is less likely to care about the current ownership structure, and if one structure always resulted in greater value, wouldn’t everyone simply choose that structure?As we’ve discussed previously, it appears the Federal Corporate tax rate does not materially impact valuations. If tax rates change again, auto dealers will again have to consider what works best in their unique situation. This can be complicated when there are numerous owners and other life events can impact what makes the most sense from a strategic standpoint.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers understand the value of their business as well as the greater implications of its value. Contact a Mercer Capital professional today to learn more about the value of your dealership.

Succession Planning for Independent RIAs

The Best Time To Plan Is Now

Succession planning has been an area of increasing focus in the RIA industry, particularly given what many are calling a looming succession crisis. The demographics suggest that increased attention to succession planning is well warranted: over 60% of RIAs are still led by their founders, and only about a quarter of them have non-founding shareholders. Yet, when RIA principals are asked to rank their firm’s top priorities, developing a succession plan is often ranked last.What Is a Succession Plan?Despite the headlines suggesting that there is a wave of strategic takeovers that will ultimately consolidate the investment management profession into a few large firms, the reality we’ve encountered suggests that most RIAs will transition ownership and leadership from one generation to the next internally. The reasons for this are fairly obvious.Many RIA owners prefer working for themselves, and their clients prefer working with an independent advisor. Internal transitions allow RIAs to maintain independence over the long-term and provide clients with a sense of continuity and comfort that their advisor’s interests are economically aligned. Further, a gradual transition of responsibilities and ownership to the next generation is usually one of the best ways to align your employees’ interests and grow the firm to everyone’s benefit. While this option typically requires the most preparation and patience, it allows the founding shareholders to handpick their successors and future leadership.When managers at RIAs start thinking about succession, they immediately jump into who buys out whom at what price and terms. While this is one piece of a succession plan, we would suggest, instead, that the starting point is strategic planning for the business.One of the keys to understanding succession planning is understanding what it is not.A Succession Plan Is Not…A succession plan is not a continuity plan. A continuity plan ensures that your clients will have uninterrupted services in the event of a disaster. Your eventual retirement should not be treated in the same manner as a sudden death or earthquake.A succession plan is not an exit plan. An exit plan is a business owner’s strategic plan to sell their ownership to realize a profit or limit losses. This line can be fuzzy, but strategic transactions rarely obviate the need for succession planning. Leadership transition issues can loom large even in strategic transactions.The Time To Plan Is NowIf you’re a founding partner or selling principal, you have several options, and it’s never too soon to start thinking about succession planning. Proper succession planning needs to be tailored, and a variety of options should be considered. See our recent whitepaper for more information on succession planning.ConclusionSince our founding in 1982, Mercer Capital has provided expert valuation opinions to over 15,000 clients throughout the U.S. and six continents. We are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides asset managers, wealth managers, and independent trust companies with business valuation and financial advisory services related to shareholder transactions, buy-sell agreements, and dispute resolution.

Purchase Price Allocations for Asset and Wealth Manager Transactions

There’s been a great deal of interest in RIA acquisitions in recent years from a diverse group of buyers ranging from consolidators, other RIAs, banks, diversified financial services companies, and private equity. These acquirers have been drawn to RIA acquisitions due to the high margins, recurring revenue, low capital needs, and sticky client bases that RIAs often offer. Following these transactions, acquirors are generally required under accounting standards to perform what is known as a purchase price allocation, or PPA.A purchase price allocation is just that—the purchase price paid for the acquired business is allocated to the acquired tangible and separately-identifiable intangible assets. As noted in the following figure, the acquired assets are measured at fair value. The excess of the purchase price over the identified tangible and intangible assets is referred to as goodwill.Transactions structures involving RIAs can be complicated, often including deal term nuances and clauses that have significant impact on fair value. Purchase agreements may include balance sheet adjustments, client consent thresholds, earnouts, and specific requirements regarding the treatment of other existing documents like buy-sell agreements. Asset and wealth management firms are unique entities with value attributed to a number of different metrics (assets under management, management fee revenue, realized fees, profit margins, etc). It is important to understand how the characteristics of the asset management industry in general and those attributable to a specific firm influence the values of the assets acquired in these transactions. Because most investment managers are not asset intensive operations, the majority of value is typically allocated to intangible assets. Common intangible assets acquired in the purchase of private asset and wealth management firms include the existing customer relationships, tradename, non-competition agreements with executives, and the assembled workforce. Customer RelationshipsGenerally, the value of existing customer relationships is based on the revenue and profitability expected to be generated by the accounts, factoring in an expectation of annual account attrition. Attrition can be estimated using analysis of historical client data or prospective characteristics of the client base.Due to their long-term nature, relatively low attrition rates, and importance as a driver of revenue in the asset and wealth management industries, customer relationships often command a relatively high portion of the allocated value. We can see this in the public filings of RIA aggregator Focus Financial. Between 2016 and 2020, Focus completed 106 acquisitions of RIAs. Of the aggregate allocated consideration for these transactions, a full 53% was allocated to customer relationships and 3% was allocated to other assets, with the remaining 44% comprising goodwill.Expand ChartTradenameThe deal terms we see employ a wide range of possible treatments for the tradename acquired in the transaction. The acquiror will need to decide whether to continue using the asset or wealth manager’s name into perpetuity or only use it during a transition period as the acquired firm’s services are brought under the acquirer’s name. This decision can depend on a number of factors, including the acquired firm’s reputation within a specific market, the acquirer’s desire to bring its services under a single name, and the ease of transitioning the asset/wealth manager’s existing client base. In any event, for most relatively successful small-to-medium sized RIAs, the tradename has some positive recognition among the customer base and in the local market, but typically lacks the “brand name” recognition that would give rise to significant tradename value.In general, the value of a tradename can be derived with reference to the royalty costs avoided through ownership of the name. A royalty rate is often estimated through comparison with comparable transactions and an analysis of the characteristics of the individual firm name. The present value of cost savings achieved by owning rather than licensing the name over the future period of use is a measure of the tradename value.Noncompetition AgreementsIn many asset and wealth management firms, a few top executives or portfolio managers account for a large portion of new client generation and are often being groomed for succession planning. Deals involving such firms will typically include non-competition and non-solicitation agreements that limit the potential damage to the company’s client and employee bases if such individuals were to leave.These agreements often prohibit the covered individuals from soliciting business from existing clients or recruiting current employees of the company. In the agreements we’ve observed, a restricted period of two to five years is common. In certain situations, the agreement may also restrict the individuals from starting or working for a competing firm within the same market. The value attributable to a non-competition agreement is derived from the expected impact competition from the covered individuals would have on the firm’s cash flow and the likelihood of those individuals competing absent the agreement. Factors driving the likelihood of competition include the age of the covered individual and whether or not the covered individual has other incentives not to compete aside from the legal agreement (for example, if the individual is a beneficiary of an earn-out agreement or received equity in the acquiror as part of the deal, the probability of competition may be significantly lessened).Assembled WorkforceIn general, the value of the assembled workforce is a function of the saved hiring and assembly costs associated with finding and training new talent. However, in relationship-based industries like asset and wealth management, getting a new portfolio manager or advisor up to speed can include months of networking and building a client base, in addition to learning the operations of the firm. Employees’ ability to establish and maintain these client networks can be a key factor in a firm’s ability to find, retain, and grow its business. An existing employee base with market knowledge, strong client relationships, and an existing network may often command a higher value allocation to the assembled workforce. Unlike the intangible assets previously discussed, the value of an assembled workforce is valued as a component of valuing the other assets. It is not recognized or reported separately, but rather is included as an element of goodwill.GoodwillGoodwill arises in transactions as the difference between the price paid for a company and the value of its identifiable assets (tangible and intangible). Expectations of synergies, strategic market location, and access to a certain client group are common examples of goodwill value derived from the acquisition of an asset or wealth manager. The presence of these non-separable assets and characteristics in a transaction can contribute to the allocation of value to goodwill.EarnoutsIn the purchase price allocations we do for RIA acquirors, we frequently see earnouts structured into the deal as a mechanism for bridging the gap between the price the acquirer wants to pay and the price the seller wants to receive. Earnout payments can be based on asset retention, fee revenue growth, or generation of new revenue from additional product offerings. Structuring a portion of the total purchase consideration as an earnout provides some downside protection for the acquirer, while rewarding the seller for continuity of performance or growth. Earnout arrangements represent a contingent liability that must be recorded at fair value on the acquisition date.ConclusionThe proper allocation of value to intangible assets and the calculation of asset fair values require both valuation expertise and knowledge of the subject industry. Mercer Capital brings these together in our extensive experience providing fair value and other valuation and transaction work for the investment management industry. If your company is involved in or is contemplating a transaction, call one of our professionals to discuss your valuation needs in confidence.

Issue No. 9 | Data as of Mid-Year 2022

Feature Articles: In 2022, How Is the Auto Industry Doing and What Does the Future Hold? and Earnings Calls: Executive Summary

Issue No. 10 | Data as of Year-End 2022

Feature Articles: 2022 Auto Dealer Industry Metrics Review and Q4 2022 Earnings Calls

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of May 26, 2021

Post-Pandemic Tax Planning for RIAs

Is It Time To Consider a Change in Your Corporate Structure, or Your Address?

Most of our colleagues at Mercer Capital live in Texas or Tennessee – two states with very low tax burdens. This is not by design so much as by circumstance: our firm grew up where we already lived. Until recently, the relatively low cost of living, short commutes, and moderate climate came with a tradeoff: most of our clients are on the coasts, so regular travel away from home was a necessity.Now that the pandemic has made geographic proximity for many meetings a non-issue, we’re beginning to wonder how many of our clients are ultimately going to join us. Dynasty’s move from New York to Florida and UBS’s relocation to Tennessee got plenty of attention. And we’re starting to hear of smaller RIAs contemplating similar moves. This isn’t a crowded trade yet though; most investment management firms still call high-cost, high-tax states home.Texas and Florida have been climbing the rankings of states with the most RIAs, but two states still dominate this survey – New York and California. New York’s position is even stronger if you include adjacent communities of investment management firms in Connecticut, New Jersey, and Pennsylvania.California is in an enviable position as the fifth largest economy on the globe, not to mention mostly-beautiful weather. That hasn’t been enough for Schwab, which has been migrating staff to Texas, Colorado, and Arizona for years. Now we’re starting to hear from California clients with staff members who moved out of state during the worst of the pandemic and would like to continue working remotely. When will their employers follow?Manhattan is another story altogether, with city tax burdens layered on top of state taxes. With all due respect to Manhattan’s theme song, in the post-pandemic, remote-work world, if you can make it anywhere, why make it there? We have another wealth management client who just relocated from New York to Tennessee – cost structure and concern over the quality of life in Manhattan for the foreseeable future were key factors.What the table above doesn’t show is the value of the talent pools already established in financial hubs like San Francisco and New York. But the relative cost of living may be enough to convince some of that talent to relocate. If that becomes a trend, all bets are off.The wrong corporate structure can exacerbate the state tax differential. Imagine the extreme scenario of a Manhattan based C Corporation that considers moving to Florida and converting to an LLC.After-tax dividends/distributions to the Florida LLC member are about 30% higher than for a shareholder in a New York City C Corporation with the same EBIT (earnings before interest and taxes). But this differential is far greater if you consider the cost of living in Florida versus New York – a difference that will widen further if President Biden successfully rolls back some or all of the reduction in corporate taxes enacted in 2017.As for proximity to clients, there are reasons to expect ultra-high net worth families in California and New York to relocate. Florida still has no estate tax, while New York just raised theirs. Tennessee and Texas (two states with no personal income tax) also have no estate tax, and Tennessee has strong and well-developed trust laws considered on-par with South Dakota.Anecdotal experience supports this trend. Friends on the west coast and in the northeast have told me they have a recurring conversation with their neighbors that revolves around the question: “how much longer are you going to stay here?” The implication of this question is that, as soon as they could, they would decamp for a lower-tax, lower-cost of living part of the U.S. Just as the pandemic accelerated many trends, we expect to see a migration of wealthy clients to more cost-effective jurisdictions, as well as the firms that serve them.

Valuation and M&A Trends in the Auto Dealer Industry

Full Speed Ahead or Partly Cloudy?

A few weeks ago, I sat down with Kevin Nill of Haig Partners to discuss trends in the auto dealer industry and the release of their Fourth Quarter 2020 Haig Report. Specifically, I wanted to focus on the unique conditions impacting the industry, and also the changing methodology that buyers are utilizing to assess dealership values. Haig Partners is a leading investment banking firm that focuses on buy/sell transactions in the auto dealer industry, along with other transportation segments. As readers in this space are familiar, Haig Partners also publishes Blue Sky multiples for various auto manufacturers based on their observations and data from participating in transactions in this industry.The Haig Report mentions many buyers are utilizing a three-year average of earnings to calculate the expected performance of the dealership. Why has this new trend occurred and how has a buyer’s pricing methodology shifted in 2020/2021?KN: Prior to the pandemic, the auto retail market had effectively plateaued with sales declining slightly and dealership profitability fairly stable. The roller coaster of 2020 - a lockdown, then a big upswing as pent up demand and stimulus money flowed through the system in the summer, followed by continued retail demand and tight inventories, created a lot of “noise” in dealer financial statements. Even with exclusion of PPP fund impact, overall dealership profitability was incredibly strong with many stores achieving all-time record profits. This created a challenge for buyers as they attempted to identify the correct income to base their buying decisions. When you apply a multiple against expected earnings to determine value, one needs to have confidence the earnings will materialize. Given the volatility in performance, buyers have been reluctant to price a deal solely on 2020 results, making the argument the performance was artificially inflated. Sellers counter by illustrating the strong results were not a summer phenomenon but have continued into 2021 and no end is in sight. Going forward inventory availability remains an issue creating nice margins, interest rates will remain low for the foreseeable future, and expense controls have taken some of the bloat out of the business. As a result, many buyers are using a three-year average (2018-2020) as their earnings baseline. This gives the seller credit for the strong 2020 numbers but reflects expectations that future results will likely settle back to pre-pandemic numbers. Notably, some markets that were harder hit by the pandemic did not generate record numbers, and some buyers are utilizing 2019 as their baseline so as not to punish a seller for a down year in 2020. Regardless, it takes more massaging of past performance to establish a baseline for future results. SW: The methodology described by Kevin compares to our longer-term view of a dealership’s earnings and profitability. A valuation considers the expected ongoing earnings or cash flow of the dealership, and as such, several factors should be considered including historical, current, and expected operations in the future. We are cautious not to overvalue a dealership in its best year or undervalue a dealership in its worst year, if neither are sustainable. As to the impact of the pandemic on dealership valuations, we think it is relative to each individual dealership and their unique set of factors.Will buyers revert to Trailing 12 Months (TTM) as their baseline or will the three-year average method remain for some time?KN: Adjusted TTM earnings became the primary baseline for applying a multiple because the industry performance had been fairly stable for some time. Yes, there were specific dealerships that had better or worse results, and those were valued with appropriate modifications to forecasted earnings. Given the aforementioned volatility in 2020, the expectations of a strong 2021 and a potential gradual return to pre-pandemic levels, using a three-year average of earnings has become a more accepted strategy. Until we see stability in the automotive retail sector for some time, it’s unlikely TTM will return as the primary earnings metric. Of course, there are always exceptions including unique market dynamics, identified changes to the business or a highly competitive market for a dealership that may require buyers to give more credit for 2020 and 2021 results.Has there been a prior time when a three-year average was the preferred method for calculating earnings and, if so, what were the underlying conditions at the time?KN: Using a three-year average was a fairly standard method until recently but as dealership performance became stable and predictable, both buyers and sellers gradually settled on TTM as an effective proxy to base their valuation. Simplicity and the lack of variance in performance made it an easy calculation and removed some of the tension during negotiations. Of course, there has and will continue to be discussion and debate on add-backs and proforma earnings when strategic shifts at the dealership might yield better results. In general, the more consistent the performance, the more likely the buyer can get comfortable using the most recent financial period to calculate a value. SW: As we discuss on a monthly basis, the auto SAAR (number of lightweight automobiles and trucks sold on an annual basis) is one of the general indicators of the conditions in the industry. To view Kevin’s rationale behind the stability in the industry through the lens of SAAR, SAAR was fairly stable and roughly averaged between 16 and 18 million units from mid-2014 through the first few months of 2020 prior to the pandemic. SAAR collapsed to 11.361 million units in March 2020, before bottoming out at 8.721 million units in April 2020.What other changes or areas of focus are buyers concentrating on given the unique 2020 environment?KN: As buyers look to 2021 and beyond and evaluate how a target might perform going forward, there are certainly some areas of the business that are receiving attention:New vehicle margins – Given industry constraints on production, new inventory levels on dealer lots are quite low, allowing dealers to increase transaction prices and realize stronger margins. This is expected for most of 2021 and possibly into 2022. There is also dialogue that given improved profitability at OEMs, suppliers, and dealers, a more balanced production vs. demand market may continue, maintaining improved margins.Used vehicle margins – The used vehicle market dropped initially during the pandemic lockdown, spiked again, and has remained fairly strong since the fall. Now with new vehicle shortages, we are hearing dealers are driving up acquisition prices on used vehicles. The lack of new availability could drive consumers to used and keep margins strong or the frenzy to buy inventory could lower margins if consumers balk at the higher costs of the vehicle.Fixed operations – Most dealers saw a drop in 2020 fixed operations as the lockdown cost them weeks and months of customers. Given most dealership service bays are at or near capacity, you can’t make the business up. However, the 4Q of 2020 saw fixed revenue return to pre-pandemic levels. Thus, we expect 2021 to show nice growth in fixed operations over a lower 2020 and the past trend of annualized revenue increases should continue in 2022 and beyond.SG&A expenses – Key expense categories including floor plan interest, advertising and personnel saw nice declines in 2020. It is likely interest rates will remain close to zero, possibly into 2023. Many dealers see lower advertising as a continued theme for the foreseeable future given demand is exceeding supply. Finally, as dealers refine their sales and delivery channels and more transactions move online, we hear a number of dealer principals indicate their staffing levels will be permanently lower.SW: Gross profit per unit numbers for new and used vehicles continues to be very strong, with average reported figures for March at $2,764 and $2,859 per unit respectively, according to the average dealership statistics published by NADA Dealership Profiles. As daily reports of inventory shortages and challenges due to the microchip crisis continue, it will be interesting to see if/when these constraints catch up to the industry and halt the record profitability. Perhaps, we will begin to see some of these hiccups finally materialize in the financial performance either in the April or May figures when they are published.With rumors of tax rates rising, what impact could this have on Blue Sky multiples?KN: The Biden administration platform includes a material increase in capital gains taxes which directly impacts sellers of dealerships. As a result, some sellers who have been considering a sale are accelerating their plans and pursuing a sale in 2021 before a likely tax change in 2022. There are a number of attractive opportunities for buyers and dealers looking to expand so its expected values will remain robust. If/when tax rates rise, several situations might occur:Fewer sellers come to market, reducing dealership inventory and putting upward pressure on valuations.Less after tax proceeds to the seller pressures them to require higher valuations to sell their store.Higher taxes reduce consumer spending, lower sales, reduce dealer profits and bring valuations down. As a result, it’s difficult to predict the future but there’s no doubt higher taxes will have a ripple effect throughout the dealer buy/sell market. SW: My colleague David Harkins previously authored a post highlighting the proposed tax changes and their impact on valuation by comparing expected earnings under several tax bracket structures.Looking back, how did the Tax Cuts and Jobs Act (TCJA) affect multiples and values?KN: Lower taxes certainly provided a boost to consumers and helped ensure stability in vehicle sales in an environment where we were beginning to see declining sales. Corporate tax rate changes did little to help dealers as most are not C-corporations, and some dealers saw personal taxes go up due to the changes in deductibility of certain items. Overall, the rates kept the momentum rolling, nice profits for dealerships, and stable valuations for stores. Buyers were also able to forecast higher after-tax proceeds from their stores to justify paying more. We thank Kevin Nill and Haig Partners for their insightful perspectives on the auto dealer industry. While the last year has been a turbulent one for the industry, auto dealers have been resilient in navigating the changing conditions. The first four to five months of 2021 have continued the momentum of the last half of 2020 in terms of dealership profitability and transaction volume. It will be interesting to see how long these trends will continue, or if auto dealers will experience any hiccups as market constraints threaten current profitability. To discuss how recent industry trends may affect your dealership’s valuation, feel free to reach out to one of the professionals at Mercer Capital.

Themes from Q1 2021 Earnings Calls

Part 2: Mineral Aggregators

Last week, we reviewed the first quarter earnings calls for a select group of E&P companies and briefly discussed the macroeconomic factors affecting the oil and gas industry. In this post, we focus on the key takeaways from mineral aggregator first quarter 2021 earnings calls.Favorable M&A OutlookTransaction volume was largely muted throughout 2020 as the depressed pricing environment drove bid-ask spreads wider. Buyers were offering what they believed was supportable based on current market conditions, and sellers were convinced that their assets were being undervalued. This led to sellers holding onto assets for dear life unless they were forced to liquidate. As mineral aggregators have the reputation to reinvest capital, participants on the earnings calls were intrigued to learn about their strategy in what many believe may be a price recovery environment.“We had a stock price where we didn't really feel like the equity was a usable acquisition currency, and I think sellers still had higher expectations than the environment warranted. And so with prices and equity recovering, and frankly where sellers were sitting on those assets for another 12 to 18 months, we think the environment is just getting much more constructive.” –Jeffrey Wood, President & CFO, Black Stone Minerals“Since the third quarter of last year, we've continued deploying capital to mineral acquisitions and believe the assets we've acquired over the past three quarters will generate differentiated performance over the next several years. We will continue to employ our disciplined underwriting of deals to enhance shareholder value and at the same time see more of our acquisitions internally funded via retained cash.” –Bud Brigham, Founder & Executive Chairman, Brigham MineralsHedgingHedging strategies differed among the aggregators. Some companies, like Black Stone and Viper, executed hedges that mitigated risk in 2020, but have been a detriment to recent financial performance. On the contrary, Brigham Minerals stated that their hedging portfolio was minimal which allowed them to participate in the positive pricing environment seen in the first quarter.“As most of you are aware, we have always been active hedgers of our commodity risk. Those hedges benefited us greatly last year when prices cratered, but also tempered the impact of the dramatic rise in prices for us during the first quarter.” –Jeffrey Wood, President & CFO, Black Stone Minerals“First, we did not need to panic at any point during the rollercoaster year of 2020 and execute hedges, which today are currently serving as strong headwinds to numerous companies in the energy space. Here at Brigham, we are managers of a premier mineral portfolio, non-commodity traders and we prefer to give our investors full exposure to the commodity.” –Bud Brigham, Founder & Executive Chairman, Brigham Minerals“Also, we believe our hedging strategy is a prudent methodology for managing the company’s future price risks on oil and natural gas. Having substantial hedges in place on a rolling two-year basis before the price shocks that occurred in 2020 proves to be a very effective risk mitigation strategy.” –Davis Ravnaas, President, CFO & Chairman, Kimbell Royalty Partners“We had a lot of ‘21 hedges put on this year that are unfortunately, underwater because of the recovery. But I think as you think about 2022 and beyond, putting some sort of floor under the low end of distributable cash flow is something we’re thinking about.” –Kaes Van’t Hof, President, Viper Energy PartnersDebt SituationAggregators continued to pay down debt and improve liquidity, which was a major priority heading into the new year. Relationships with lenders was a concern during 2020, but Jeffrey Wood, President and CFO of Black Stone Minerals, stated that the company was able to execute a favorable extension to their existing debt facility. This is a positive sign for the industry moving forward. Aggregators will continue to allocate free cash flow between debt paydown and shareholder return as the year progresses.“After the end of the quarter, we finalized an extension of our existing revolving credit facility last week. We added 2 years to the maturity date of that facility, which is now November of 2024. It's been a very difficult bank market over the past year, so we're really happy to get this extension done with relatively minor modifications to the terms of the facility and we appreciate the continued support from our long-term lending relationships.”–Jeffrey Wood, President & CFO, Black Stone Minerals“As we have done in previous quarters, the company utilized 25% of its Q4 2020 cash available for distribution to pay down a portion of the credit facility in Q1 2020. Since May 2020, the company has paid down approximately $25 million in debt by allocating a portion of its cash flow to debt paid down. We expect to continue to allocate 25% of our cash available for distribution for debt pay down in the future.” –Davis Ravnaas, President, CFO & Chairman, Kimbell Royalty Partners“As a result, Viper generated almost $55 million in net cash from operating activities, which enabled us to reduce debt by $27 million during the quarter. We have now reduced total debt by over $136 million, or roughly 20%, over the past 12 months.” –Travis Stice, CEO, Viper Energy PartnersConclusionIt is safe to say that sentiment among the participants was positive in the first quarter earnings calls, especially relative to last year. Aggregators seemed to grind through 2020 and flip the script for a new year. Although a price recovery may be in sight, challenges remain, specifically with the Biden Administration taking office. The calls largely glossed over political implications of the new administration but those issues may come into focus as the year unfolds.Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership. Contact a Mercer Capital professional to discuss your needs in confidence.

Q1 2021 Earnings Calls

Improved Profitability, Online Tools and Market Share, and High Valuations

The earnings calls in Q1 began with a focus on many of the same trends as prior quarters: increasing or record EPS despite inventory struggles as gross margin improvement drove operating leverage. The chip shortage has taken center stage, with cloudy expectations of when inventory levels might normalize. Contrast to factory shutdowns last year, dealers are faring much better as strong demand has improved vehicle pricing, benefiting both dealers and manufacturers. OEMs have tried to mitigate the impact of the chip shortage by removing certain features requiring chips, while others have prioritized more in-demand models to maximize profits.A couple of other trends require the proper framing of the subject to truly understand what’s happening. First, many execs talked about “pent-up demand” for parts and service work. If “pent-up demand” means parts and service revenue is expected to increase in the coming months, then that appears likely as vaccination rates increase and mandates are relaxed. However, on previous calls, many discussed the notion of consumers deferring maintenance on their vehicles since they could get by because they were driving less. Deferred maintenance has not been discussed as much, suggesting deferred maintenance activity has not meaningfully presented itself. In many instances such as the winter storms, execs noted that unit sales may have been delayed but service revenue losses would not be recovered.We also need to appropriately frame the degree to which online sales are truly “incremental,” or not cannibalizing traditional in-person sales. Execs highlighted online sales to customers who had not previously bought from them before as evidence that online tools were incremental. Given the long life cycle of vehicles, we are less convinced this necessarily says a consumer only purchased from their company because of the online feature. While Lithia noted nearly 98% of its online sales were to first time Lithia purchasers, we believe the 43% sold to customers outside of their retail market presence is a better representation of incremental sales, which is to say the company is improving its market share. While there were technical difficulties throughout the Sonic call reducing our ability to pull meaningful quotes, their investor deck similarly noted 30% of customers of its EchoPark segment (its stand-alone Pre-Owned operations) traveled more than 30 minutes to shop their inventory.On the other hand, Penske casts doubt on the notion that these sales were truly additional in the sense that consumers aren’t buying cars they didn’t otherwise need solely because the option to buy online now exists. While we tend to agree, it is meaningful if larger players are able to poach customers with the scale provided by their online platforms. Over the longer term, this could negatively impact unit volumes for smaller dealerships who choose to not take advantage of online options or are not able to meaningfully compete. Simply having a website may not be enough for the local Honda dealership to compete if comes up 5th on a Google search.The franchised auto dealer space is fragmented by nature. As such, the few publics are frequently asked about consolidation in the industry, as they have both the experience to operate at scale and a liquid market for their equity which allows acquired dealers to achieve liquidity without necessarily losing the upside of their dealership in a transaction (either receiving stock or investing cash from the deal into that stock). However, despite plenty of transactions in the industry, public auto dealers have not typically provided much financial information on their targets aside from revenues. In a recent investor deck, Lithia took things a step further, quantifying its intangible investment as a percentage of revenues as shown below: Many noted increasing valuations, and an analyst on the AutoNation call mentioned his M&A modeling at about 15% to 30% of sales. CFOs for multiple companies noted their focus on EBITDA multiples when doing deals, which are highlighted in theme #4. For perspective, the market ascribes about a 7.7x EV/EBITDA multiple for AutoNation with floor-plan interest treated as an operating expense as calculated below: Theme I: Microchip shortages have extended longer than initially anticipated, but strong demand, in part due to stimulus funds, has supported robust sales and gross profits. The industry’s limited chip supply has led to retail customer, particularly in hot selling models, getting vehicles first.“As it relates to the hot selling products as you point to, the OEMs are really great at this. And while the chip shortage is there, they've really been shifting their production to the faster selling vehicles. […] everyone is showing high margins. We didn't all of a sudden get that much better, it's simplistically supply and demand. There is that point where you're missing a lot of sales because you just don't have the inventory. […] the industry performs well and stability exist when there's probably a 60 to 70 days supply in the market. And right now with all the government spending that's going on and people coming out, the demand is going to be high right now, and the fear is the inventory won't be there to match the demand.” -David Hult, CEO, Asbury Automotive Group“As of the end of the quarter, we had a 41-day supply of new vehicle inventory, indicating we have well over a month's supply of vehicles on the ground and an adequate supply of in-transit that are replenishing our on-ground inventory every day. However, new vehicle margins may remain elevated in the near term due to continued microchip and other supply chain shortages, coupled with elevated consumer demand levels driven by additional stimulus funds. While select OEMs are experiencing reduced level of inventory, we currently have sufficient inventory to balance the current supply and demand trends expected over the coming months.” – Christopher Holzshu, President, and CEO, Lithia Motors“There is no question that there is more demand than supply, that is the headline. On the new vehicle side, there supply is tight, but shipments and production are disrupted with the chip crisis and will be for the rest of the year. But it's nothing like a year ago during the pandemic when we had the factory shutdowns. […] we've adjusted pricing to reflect that, and you've seen the improvement in our front-end gross. […] There is no reason to rush things out the door. You can’t easily replace it.” - Mike Jackson, Chairman & CEO, AutoNation“I've been amazed in the recent months, how we've continued to maintain pretty impressive sales levels with declining inventory levels. […] Also, the OEMs have adjusted. It seems that the only vehicles they're making are the ones that sell the fastest. So when they come off the truck, they go right to a retail customer. […] we're getting to the point where inventory is a problem, if not at this moment very soon. So ideal for us is about 45 days supply when we mix all of our different brands together. And as you saw, we ended the quarter at little over 30. And we're actually fine in the 30s. But we're a big truck market. When you get very far below 30 days of supply, you have trouble having many of the configurations that the truck customers want. And so that's where it starts to get a little challenging for some of our brands.” - Earl Hesterberg, President and CEO, Group 1 AutomotiveTheme 2: Service and parts continue to lag vehicle sales for many dealers, though those struggling for inventory are relying more on fixed ops. While a return to “normal” levels of miles driven should increase service demand, opinions among public dealers were mixed as to the degree there was pent-up demand from consumers deferring maintenance during the pandemic.“Obviously pent-up demand is a big driver. And we are starting to see that coming out of March where we actually started to finally see some real big volume increases year-over-year were great, but what we're really trying to do is figure out when will we start to get to a normalized recovery over what was really the 2019 kind of year, if we use that as a base case. And in the quarter, we saw ourselves about 5% up over that 2019 level. And prior to the pandemic last year, we were projecting a double-digit -- a low double-digit increase in our parts and service business. So we definitely see that trend continuing into April and we expect that to continue through the summer months as we kind of rally into customers coming -- normalizing their lives again and getting back on the road and driving their vehicles and then needing parts and service work.” – Christopher Holzshu, President, and CEO, Lithia Motors“We expect good things out of parts and service for the rest of the year. We see the traffic counts building. Our gross for RO is quite good as we've made some adjustments during the pandemic on that better inspections, better reporting, better selling skills with customers. And we we've added over 300 technicians back to our dealership base in the last 12 months. Very few hourly technicians, which tend to be less productive than flat rate technicians, and that helps us be more productive as a business. And we expect good things as miles driven continue to increase. And if vehicle supplies do become an issue, people will hold on to their cars and they will be in our shops more. […] The customer pay business is extremely strong […] but warranty we don’t control, and warranty has been a bit weak. […] it’s been collision and warranty, which had been soft over recent quarters.” - Earl Hesterberg, President and CEO, Group 1 Automotive“Well, there is no question that miles driven have come down […] in January, we were down 16% in parts and service revenue. Now, that’s really swung around. So, people are getting out. […] So, I think we’ve got to look sequentially how we’re going to look from March to April. This year will give us probably a better picture. But, I can say that there is definitely more momentum and more interest in the shop. […] So we still have some real opportunity there and just a matter of getting people out and that's strictly miles driven will drive that.” - Roger Penske, Chairman & CEO, Penske AutomotiveGroup“March came back so strong, it was actually ahead of '19 pace numbers. And as we sit here in April, we're experiencing the same. So, the customers are back on the road, the service business is back. […] while we're feeling it on the variable side with some shortages with inventory, thankfully Parts and Service is picking up on that. […] We think there’s a lot of pent-up demand.” -David Hult, CEO, Asbury Automotive GroupTheme 3: While many dealers tout incremental sales on their online platforms, it’s important to understand which sales replace would-be in-person dealership transactions and which the company would not have been able to achieve, such as sales to customers where the dealer doesn’t have a physical dealership.“97.8% of our Driveway customers during our first quarter were incremental and had never done business with a Lithia dealership before. […] 43% of our [Driveway] sales are out of region and our average shipping distance is 732 miles […] so we're not really getting into that cannibalization of our existing pipeline.” -Bryan DeBoer, President and CEO, Lithia Motors“There is a lot of incremental [online] sales that we would not have received, and I made that comment, because looking at the information we weren't doing business with [those customers] before.” -David Hult, CEO, Asbury Automotive Group“I think that to a certain extent, it's substitutional where people have the opportunity to buy online, delivery at home, come to the dealership. […] we’re really not growing the business at this point incrementally. And I think that’s going to be the true test where we can tell the analysts in the market, we’ve actually grown our overall business by using the online tool.” - Roger Penske, Chairman & CEO, Penske AutomotiveGroupTheme 4: While Lithia at least reports transactions in terms of price to revenue, multiple companies specified they think in terms of EBITDA multiples. While this might not be true for smaller acquirers, it may affirm the reasonableness of correctly applied EBITDA multiples from the publics.“[W]e generally think more about it as a multiple of EBITDA than revenue. And it's kind of in that high single-digit range, and returns are mid-teens.” - Joe Lower, CFO, AutoNation“[W]hen we evaluate an opportunity, we're looking at EBITDA multiples and then factoring in the synergies we think we can achieve, and then we look at the IRR relative to our cost of capital. And we need to see a margin there to deliver an accretive deal.” - PJ Guido, CFO, Asbury Automotive GroupConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight to the market that may exist for a private dealership which informs our valuation engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

FAIR … The F-word in RIA M&A: Part 2

What Is a Fairness Opinion?

Last week we explained why RIA principals and board members should consider getting a Fairness Opinion; FAIR … The F-word in RIA M&A: Part I; When Do You Need A Fairness Opinion?.Under U.S. case law, the so-called “Business Judgment Rule” presumes directors will make informed decisions that reflect good faith, care, and loyalty. If any of these criteria are breached in a board-approved transaction, then the directors may be liable for economic damages.RIA boards hire valuation and advisory firms like ours to opine on the fairness of contemplated transactions in an effort to protect themselves from potential liability.In a challenged transaction, the “entire fairness standard” requires the court to examine whether the board dealt fairly with the firm and whether the transaction was conducted at a fair price to its shareholders. As a result, Fairness Opinions seek to answer two questions:Is a transaction fair, from a financial point of view, to the shareholders of the selling company?Is the price received by the Seller for the shares not less than “adequate consideration” (i.e. fair market value)? Process and value are at the core of the opinion. A Fairness Opinion is backed by a rigorous valuation analysis and review of the process that led to the transaction. Some of the issues that are considered include the following.ProcessProcess can always be tricky in a transaction. A review of fair dealing procedures when markets have increased should be sensitive to actions that may favor a particular shareholder or other party.Management ForecastsA thorough analysis of management’s projections is a key part of a fairness analysis. After all, shareholders are giving up these future cash flows in exchange for cash (or stock) consideration today. Investment managers’ revenue is a product of the market, which over the past year has withstood significant volatility. A baseline forecast developed in the middle of the COVID-19 pandemic may be stale today. Boards may want to consider the implications of the V-shaped market recovery on their company’s expected financial performance and the follow-through implications for valuation.TimingDeals negotiated mid-COVID, when it was unclear whether the market was in a V-shaped or W-shaped recovery, may leave your shareholders feeling like money was left on the table. It is up to the board to decide what course of action to take, which is something a Fairness Opinion does not directly address. Nevertheless, fairness is evaluated as of the date of the opinion, such that the current market environment is a relevant consideration.Buyer’s SharesIf a transaction is structured as a share-for-share exchange, then an evaluation of the buyer’s shares in a transaction is an important part of a fairness analysis. The valuation assigned to the buyer’s shares should consider its profitability and market position historically and relative to peers. If the purchaser is a public company, it is imperative that all recent public financial disclosure documents be reviewed. It is also helpful to talk with analysts who routinely follow the purchasing company in the public markets.It is equally important to note what a Fairness Opinion does not prescribe, including:The highest obtainable price.The advisability of the action the board is taking versus an alternative.Where an RIA’s shares may trade in the future.The reasonableness of compensation that may be paid to executives as a result of the transaction. Due diligence work is crucial in the development of the Fairness Opinion because there are no rules of thumb or hard and fast rules that determine whether a transaction is fair. The financial advisor must take steps to develop an opinion of the value of the selling company and the investment prospects of the buyer (when selling stock). We believe it is prudent to visit the selling RIA (if feasible), conduct extensive reviews of documentation, and interview management (either in person or virtually). Fairness Opinions are often memorialized in the form of a Fairness Memorandum. A Fairness Memorandum examines the major factors of the Fairness Opinion in some detail and summarizes the considerations of each factor for discussion by the board of directors. In many cases, the advisors rendering the Fairness Opinion will participate in these discussions and answer questions addressed by the board.ConclusionMercer Capital’s comprehensive valuation experience with investment managers enables us to efficiently provide reliable, unbiased Fairness Opinions that provide assurance to stakeholders that transactions underway are fair and reasonable. We’re happy to answer any preliminary questions you have on Fairness Opinions and when it makes sense to get one.

Themes from Q1 2021 Earnings Calls

Part I: E&P Operators

Things appear to be on the upswing, albeit with cautious optimism, in the exploration and production (“E&P”) space.Most of the eight E&P operators we tracked reported that operations in the first quarter were relatively stable. This was in spite of winter storm Uri, which wreaked havoc from New Mexico and Texas northeast through upstate New York and New England.It may be worth examining the effects of Uri on E&P operators’ Q1 performance more in-depth, with a focus on how natural gas prices may have affected revenues vs. any associated increase in operating expenses or the intangible costs stemming from marketing and sales disruptions.Regardless of Uri’s net effect on financial performance, the ultimate trending phrase in E&P operators’ earnings calls was “positive free cash flow,” indicating continued upward trajectory out of the crude abyss.Deleveraging remains a primary goal for many operators. Several have resumed their dividend programs, while others have announced special (i.e., non-recurring) dividends to project their positive outlook to investors.In tandem with this bullish perspective, few E&P operators seemed overly concerned with the potential tax implications stemming from regulatory changes brought forth by the Biden Administration.ESGContinuing the trend we saw in the 2020 Q3 and Q4 E&P operator earnings calls, the Q1 earnings calls featured increased discussions regarding ESG topics. For some operators, the commentary covered basic items such as reduced greenhouse gas ("GHG") emissions and quarter-over-quarter reductions in flaring. Other operators had more comprehensive talking points related to ESG topics in the context of company operations on a forward-looking basis.“In March, we issued a press release announcing changes to our executive compensation program and outlining our new greenhouse gas emissions reductions targets. Comprehensive changes to our executive compensation program included accountability for achieving both quantitative and qualitative ESG goals in the near and medium term.”–Joe Gatto, President & CEO, Callon Petroleum“[This year] we introduced methane-related KPIs into our executive compensation program. We've committed to make a substantial multi-year community investment of $30 million over the next six years to widen the path for the middle class in our local community while growing the local talent pipeline. We have redoubled our efforts to spend local and hire locally. 100% of our new hires will be from our area of operation and will maintain that - we will maintain at least 90% local contract workforce.” –Yemi Akinkugbe, Chief Excellence Officer, CNX Resources“This year will also be an exciting year for Antero's ESG initiatives as we make progress toward our 2025 best in class goals. These … include achieving net zero carbon emissions, reducing our industry leading GHG intensity and methane leak loss rates. We also plan to complete and publish our TCFD analysis with our 2020 ESG performance results later in 2021.”–Glen Warren, CFO, Antero ResourcesReturn of Capital to ShareholdersIn recent earnings calls, many E&P operators suggested that they would resume dividend and share buyback programs when positive free cash flow, and in some cases higher-priority deleveraging initiatives, made it conducive to do so. As noted in the introduction, this time has come for many operators in Q1.“We reinstated a quarterly dividend of $0.11 per share, … this is double our previously issued dividend, which has been temporarily suspended at the onset of the global pandemic. We believe this is expected to be sustainable given our strong cash flow generation and interest expense savings from our significant debt reduction.”–William Berry, CEO, Continental Resources“Going forward, our goal is to continue growing the regular dividend. We have never called for suspending the dividend and we remain committed to its sustainability. … Now, EOG is positioned to address other free cash flow priorities by returning additional cash to shareholders. The $1 per share special dividend [announced May 6] follows through these consistent long-tailed priorities.”–Tim Driggers, CFO, EOG Resources“So, for the quarter we repurchased 1.5 million shares at an average price of $12.26 per share at a total cost of $18 million. We still have ample capacity of around $240 million under our existing stock repurchase program…”–Nick Deluliis, CEO, CNX ResourcesProposed Tax ChangesAmong the potential energy tax changes under the Biden-Harris Administration,the most prominent talking point discussed by E&P operators in the Q1 earnings calls was the proposed change to disallow the reduction of taxable income stemming from intangible drilling costs (“IDCs”), and the subsequent increase in taxes and reduction in future free cash flow. The discussion and response to questions about these proposed tax changes overwhelmingly suggest that most of the operators we tracked do not foresee any material tax payments for at least the next four years, due primarily to substantial net operating losses (“NOLs”) that may be used to offset future taxes.“We are not a cash taxpayer in the U.S. this year. And at prevailing commodity prices, we don't expect to be paying U.S. cash federal income taxes until the latter part of this decade. This holds true even if the tax rules for IDCs are changed or if the corporate tax rate has increased. We have significant tax attributes in the form of NOLs in addition to foreign tax credits. These attributes will be used to offset future taxes.”–Dane Whitehead, CFO, Marathon Oil“Our plan through '26, we're not material cash taxpayers during that plan. Most of it's the way we treat sort of the NOLs and utilize those as regards to the cash taxes that we would have to pay, and managing and optimizing that versus sort of the IDCs and the other attributes that you have on the tax side. So, the color we've given to date is no material cash taxes through 2026 is the current plan.”–Don Rush, CFO, CNX Resources“We have substantial NOL carryforwards at a federal and a state level. So, if you look at it in a current regime, putting off a free cash flow at the level that we are, certainly, you convert to cash taxes at some point. We see it being five to seven years in the future in a current regime.”–John Hart, CFO, Continental ResourcesOn the HorizonWhile we selected three primary themes among the Q1 E&P operator earnings calls, several other notable topics were also discussed. Perhaps chief among them, the general consensus is that significant production growth is not desirable at this juncture. Steady operations is the name of the game at the moment. Furthermore, operators are seeing inflation in field service provider costs, which are expected to continue growing, though it remains to be seen just how those may affect future margins.ConclusionMercer Capital has its finger on the pulse of the E&P operator space. With increased volatility in the energy sector these days, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.

April 2021 SAAR

SAAR has continued its impressive run in 2021, increasing for the second straight month to 18.5 million. This is a 3.1% increase from March 2021. As we have mentioned in our previous SAAR blog post, comparing spring 2021 SAAR to 2020 does not hold much merit, especially in April which experienced the weakest sales of the pandemic in 2020.For those of you who are curious however, April SAAR is up 112% from last year.Compared to April 2019, a better comparison in our view, April 2021 is up 12.1%. Because of strong demand, OEMs continue to rely less on incentive spending. According to JD Power, average incentive spending per unit in April is anticipated to be $3,191, a decline of $1,762 from April 2020 and $382 from April 2019. Still, average transaction prices are expected to reach another month high, rising 6.8% from last month to $37,572. This is the highest ever for the month of April and the second highest of all time behind December 2020. Incentive declines and price increases serve as a major win for dealerships this month.In regards the expected April statistics, Thomas King, president of the data and analytics division at JD Power notes:“While falling numbers of vehicles in inventory at retailers is the primary risk to sales results in the coming months, to date, low inventories have not had a material effect on aggregate sales results. Instead, they have enabled manufacturers and retailers to reduce discounts and consumers are demonstrating a willingness not only to buy vehicles closer to MSRP, but also to buy more expensive vehicles.”Inventory Scarcity Continuing to be in PlayThough pent-up demand and higher levels of disposable income continued to drive SAAR growth this month, a surprising factor we considered to be a headwind may have actually boosted sales for the month: the microchip shortage. As the shortage continues to drag on and has started affecting other industries and big names (such as Apple), the shortage has become a household topic and consumers are taking notice. Behind the increase in April SAAR may be consumers rushing to dealerships to snag a vehicle before they become more difficult to find in the coming months.Automakers, keen on not having to completely shut down productions, are trying to work around the chip shortage by removing features, which may be incentivizing consumers to pay up for them now.As Automotive News reports, Nissan is leaving navigation systems out of thousands of vehicles that typically would have them because of the shortages. Ram no longer offers its 1500 pickups with a standard "intelligent" rearview mirror that monitors for blind spots. Renault has stopped offering an oversized digital screen behind the steering wheel on its Arkana crossover. All of these feature cuts being for the same reason: to save on chips. This may become more prevalent going forward this year as the chip shortage is anticipated to continue.Despite automaker’s best efforts, inventory levels are suffering. While April inventory levels are not available yet, NADA forecasts that they likely will be at a decade-long low with no relief in sight. According to BEA, the inventory to sales ratio for March (the most recent data available) is at the lowest levels of the reported data going back to 1993, at 1.36 (though the chart below only shows data through 2015). According to Auto Forecast Solutions, the semiconductor microchip shortage has caused worldwide production to fall off to 2.29 million vehicles. Current forecasts put projected total vehicle production losses from the global chip shortage at 3.36 million units, with 1.11 million from North American production. With production flagging, dealers are having to draw down inventories to maintain and grow sales. However, April’s strong sales figure is unlikely to be sustainable as inventories cannot be drawn down forever, which explains why NADA forecasts 2021 SAAR of 16.3 million, or 11.9% below the April figure. Fleet Customers SufferingWhile the inventories of auto dealers are down, inventories for fleet customers are down even more, as OEMs continue to prioritize production for retail customers over fleet customers. Retail sales in April are estimated to be up 114% from April 2020 and up 23% from April 2019 according to Wards Intelligence. Meanwhile, fleet deliveries increased by 88% from April 2020, but fell by 42% from April 2019.This is especially poor timing for fleet customers as travel has begun picking up again and rental car companies and other fleet buyers are in need of inventory as many had to sell chunks of their fleets in order to preserve money during Covid-19, creating a situation that many are referring to as “car-rental apocalypse.” Due to the new car shortages, they are having to look elsewhere.As Yahoo News reports, Hertz is "supplementing its fleet by purchasing low-mileage, pre-owned vehicles from a variety of channels including auctions, online auctions, dealerships, and cars coming off lease programs," a Hertz spokesperson told Insider in an email statement.The result of all of this is that rental cars may cost consumers over $500 a day for an SUV, compared to prices of $50 a day 2 or 3 years ago. Until the chip shortage is back under control, travelers may be stuck having to pay sky high prices for rental vehicles on their next vacation.Looking ForwardThe best phrase we can think of to describe the auto industry going into May is “something’s got to give.” While demand for vehicles is still being fueled by pent up demand and traveling picking back up due to Americans getting vaccinated and a return to normalcy, the microchip shortage isn’t going away anytime soon.According to Mike Jackson, AutoNation’s CEO, that expiration date might even be 2022, as he notes “we performed despite the disruption from the shortages created by the chip disruption, which we expect to fully continue for the rest of this year."Stay turned for our blog next week when my colleague David Harkins breaks down the Q1 earnings calls and what the other leaders in the industry are noting about this year’s prospects.However, despite the lack of chips, if consumers are willing to make some sacrifices in terms of the number of features their vehicle has, SAAR may not see huge declines. If that is not something they are willing to do, the supply constraints may hinder SAAR’s recent run.

FAIR ... The F-word in RIA M&A: Part I

When Do You Need A Fairness Opinion?

Fair. It’s the first-four-letter word that most children learn, and it often leads to more arguments than other choice words. Although children eventually learn that life is not always fair, we spend a lot of time ensuring that major economic events are. Transactions are rarely straightforward, and as the pace of M&A activity in the investment management community continues to accelerate, more shareholders are scrutinizing both the pricing and terms of transactions. Over the next two posts, we will explain when you should consider getting a Fairness Opinion and what that involves.What Is a FAIR Transaction?Under U.S. case law, the concept of the “Business Judgment Rule” presumes directors will make informed decisions that reflect good faith, care, and loyalty to shareholders. If any of these three are not met, then the “entire fairness standard” requires that, in the absence of an arms-length deal, transactions must be conducted with fair dealings (process) and atfair prices.Directors are generally shielded from challenges to corporate actions the board approves under the Business Judgement Rule provided there is not a breach of one of the three duties. However, once any of the three duties is breached, the burden of proof shifts from the plaintiffs to the directors. If a Board obtains a Fairness Opinion in significant transactions, they are more likely to be protected from this liability.Questions of value and fair dealing are subject to scrutiny, even in bull markets. Rapidly improving markets may lead your shareholders to question whether the price accepted in the context of negotiating and opining on a transaction could have been better. Below, we outline some circumstances when you should consider getting a Fairness Opinion before closing a deal.9x EBITDA in a 15x EBITDA World Fantasy The prominence of headlines touting impressive deal multiples has led to some unrealistic shareholder expectations around valuation. Yes, average deal multiples have increased over the last decade, more prospective buyers for your RIA exist today than there were five years ago, and maybe an irrational buyer with capacity will stroke checks for double-digit multiples. But the increase in average valuation multiples is being driven by a myriad of factors that do not perfectly correlate with the valuations of small to mid-sized RIAs.Echelon Partners 2020 RIA M&A Deal Report noted that the number of $1B+ transactions has doubled over the last five years. Most of these acquisitions, and especially the ones that attract headlines, warrant these higher multiples due to their sheer scale, rarity, and strategic significance. Not every RIA has the scale, growth pattern, and risk profile to warrant top-tier pricing. And, ultimately, no two asset managers, wealth managers, IBDs, OCIOs, or independent trust companies are alike.Nevertheless, boards facing a mismatch between shareholder expectations and market realities are in a tough position justifying a transaction. The evaluation and negotiation process is tricky when markets continue to climb day after day. Yet, Fairness Opinions can be used as one element of a decision process to evaluate significant transactions.Would You Prefer $10M or $7M Today, and $2M Each Year for the Next 3 Years?Most acquisitions of investment managers involve some form of contingent consideration. When evaluating multiple offers that involve varying amounts of upfront cash; equity consideration; and earn-out payments, periods, and terms, a Fairness Opinion can help Boards evaluate the economic merits of the terms being offered.Unsolicited OffersMany RIAs receive unsolicited offers from their friends, competitors, or institutional consolidators. When there is only one bid for the company and competing bids have not been solicited, the fairness of the transaction can more easily be disputed. Not every sale is best conducted in an auction process, but the prospective buyer making an unsolicited offer knows that it is, at least for the moment, the only bidder. The objective of an unsolicited offer is to get the seller’s attention and cause them to start negotiations, often giving the bidder an exclusive right to negotiate for a fixed amount of time. As the head of our investment management group, Mercer Capital President, Matt Crow, explains, “An unsolicited offer may be a competitive bid, but it is not a bid made in a competitive market.”The Investment Management Community Is SmallAlthough there are over 13,500 SEC-registered investment advisors in the U.S., the investment management community within a given sector or geography is fairly close-knit. Many RIAs join forces or sell to other RIAs they have known for many years. This is part of the reason deals work. In a relationship-driven business, it is hard to merge with or sell to someone with whom you don’t have an existing relationship. But anytime insiders or related parties are involved in a transaction, a Fairness Opinion can serve as a confirmation to a company’s shareholders that improper acts of self-dealings have not occurred.ConclusionWe have extensive experience in valuing investment management companies engaged in transactions during bull, bear, and boring markets. Mercer Capital’s comprehensive valuation and transaction experience with investment managers enables us to provide unbiased fairness opinions that directors can rely on to assure their stakeholders that the decisions being made are fair and reasonable.

Recent SPAC Boom Largely Leaves Out Oil & Gas Companies

The rise of SPACs, or special purpose acquisition companies, has been the hottest trend in capital markets during the past year. However, after years of poor returns and increasing investor emphasis on ESG (environmental, social, and governance) issues, oil & gas companies were largely left out of the recent SPAC mania.We look at a few oil & gas companies that were early adopters of the SPAC structure, the recent pivot of SPACs towards energy transition companies, and take a look forward to see what the future might hold for the few remaining oil & gas-focused SPACs.Previous Energy SPAC TransactionsEnergy companies were early adopters of the SPAC structure as a means to go public.Private equity firm Riverstone was one of the first to launch an energy-focused SPAC with Silver Run Acquisition Corp. in 2016. The SPAC combined with Centennial Resource Production later in the year and renamed itself Centennial Resource Development. Riverstone followed with Silver Run Acquisition Corp. II in 2017, which acquired Alta Mesa Holdings and Kingfisher Midstream to form Alta Mesa Resources. However, Alta Mesa filed for bankruptcy in 2019. Another early energy SPAC suffered the same fate. KLR Energy Acquisition Corp., which went public shortly after Silver Run in 2016, acquired Rosehill Resources and filed for bankruptcy in 2020.Fortunately, some have fared better. TPG Pace Energy Holdings merged with Magnolia Oil & Gas in 2018. Currently, the Eagle Ford operator’s stock price is well above the initial SPAC IPO price of $10. Vantage Energy Acquisition Corp., sponsored by energy-focused private equity firm NGP, announced acquisition of QEP’s Bakken assets for $1.725 billion in 2018. The transaction later fell through, and Vantage liquidated, with shareholders receiving $10.22 per share. QEP’s Bakken assets wererecently acquired by Oasis (from QEP’s new owner Diamondback) for $745 million.The Pivot Toward Energy TransitionGiven the troubled performance of oil & gas SPACs, overall poor returns from the sector, and increasing emphasis on ESG issues, several SPACs that were originally targeting oil & gas companies have pivoted and acquired (or announced acquisitions of) “energy transition” companies.Apollo touted its expertise “in the upstream, midstream and energy services sectors” in Spartan Energy Acquisition Company’s prospectus, though ultimately acquired electric vehicle manufacturer Fisker. Switchback Energy Acquisition Corporation, sponsored by NGP (which previously sponsored Vantage), was rumored to be targeting companies in the minerals space, but recently completed its acquisition of ChargePoint, which develops electric vehicle charging stations. And Alussa Energy Acquisition Corp., headed by James Musselman (former CEO of offshore E&P company Kosmos), has announced its planned acquisition of FREYR, a Norwegian battery manufacturer.The trend of capital moving away from traditional oil & gas companies and toward energy transition companies does not look like it will abate soon. Several private equity funds historically focused on oil & gas have sponsored SPACs specifically targeting energy transition companies.Riverstone has moved away from the Silver Run naming convention and now has three “Decarbonization Plus” entities that are publicly traded, with a fourth that has filed an S-1. While the entities reserve the right to seek a business combination with a company operating in any sector, I think it’s safe to assume that an acquisition of a company focused on developing hydrocarbons is off the table.First Reserve, which has historically invested in traditional oil & gas companies, launched their first SPAC, First Reserve Sustainable Growth Corp., in March. As the name implies, the SPAC’sstated focus areawill be “opportunities and companies that focus on solutions, processes, and technologies that facilitate, improve, or complement the ongoing energy transition toward a low- or no-carbon emitting future.”After NGP’s success with Switchback’s acquisition of ChargePoint, it sponsored Switchback II, which intends to search for target companies “in the broad energy transition or sustainability arena targeting industries that require innovative solutions to decarbonize, in order to meet critical emission reduction objectives.” That language wasn’t included in the original Switchback prospectus. Another NGP SPAC, Switchback III, has a similar language in itsS-1but has not yet gone public.Warburg Pincus sponsored two SPACs that went public in March. While no specific industry focus was discussed in the prospectuses, the documents did specifically state that “oil and gas companies are not anticipated to be the target.” This is consistent with Warburg’s recent transition away from investment in the oil & gas sector.Is SPAC Capital Available for Oil & Gas Companies?While most recent energy-focused SPACs are seeking business combinations in the energy transition space, there are a few remaining SPACs that may target more traditional oil & gas companies or assets.East Resources Acquisition Company went public in July 2020, raising $345 million. It is headed by Terry Pegula, who sold his previous company, Appalachian operator East Resources, Inc., to Shell for $4.7 billion in 2010. The SPAC’s prospectus states that “there is a unique and timely opportunity to achieve attractive returns by acquiring and exploiting oil and natural gas exploration and production (‘E&P’) assets in proven basins with extensive production history and limited geologic risk.”In November 2020, Breeze Holdings Acquisition Corp. raised $115 million. Managed by several former EXCO executives, the SPAC intends “to focus on assets used in exploring, developing, producing, transporting, storing, gathering, processing, fractionating, refining, distributing or marketing of natural gas, natural gas liquids, crude oil or refined products in North America.”Most recently, Flame Acquisition Corp. raised $287.5 million in February 2021. The SPAC intends to target“a business in the energy industry, primarily targeting the upstream exploration and production (‘E&P’) sector, midstream sector and companies focused on new advancing technologies that are transformative and provide the potential for and means to achieve greater profitability in the broader energy sector,” adding that “many businesses in the E&P industry or broader energy value chain could benefit from access to the public markets but have been unable to do so.” The company is headed by James Flores, the former CEO of Sable Permian. Gregory Pipkin, former head of Barclays’ upstream investment banking team, is a member of the board.It remains to be seen whether these SPACs will endure their oil & gas focus or try to capitalize on the trend towards renewables (like so many other energy-focused SPACs). However, with multiple SPACs targeting that space and increasing investor skepticism regarding lofty growth projections (as evidenced by the stock price performance of former SPACs Nikola, Hyliion, Romeo Power, and XL Fleet, among others), the acquisition of oil & gas assets at an attractive valuation may be well received by investors.ConclusionThe increasing popularity of SPACs helped push tremendous amounts of capital toward energy transition companies, with traditional oil & gas companies largely sitting on the sidelines. However, the tide may be turning, as SPAC IPOs have slowed and some energy transition company valuations have come crashing down from their previous (stratospheric) levels. While SPACs aren’t the complete solution to the dearth of capital available to oil & gas companies, a well-received transaction by one of the few remaining oil & gas-focused SPACs would certainly be a welcome development.Mercer Capital cannot help you sponsor a SPAC, though we have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

Multiple Expansion Drives 70%+ Returns for RIA Stocks Over Last Year

Over the last year, many publicly traded investment managers have seen their stock prices increase by 70% or more. This increase is not surprising, given the broader market recovery and rising fee base of most firms. With AUM for many firms at or near all time highs, trailing twelve month multiples have expanded significantly, reflecting the market’s expectation for higher profitability in the future. For more insight into what’s driving the increase in stock prices, we’ve decomposed the increase to show the relative impact of the various factors driving returns between March 31, 2020 and March 31, 2021 (see table below).Click here to expand the table aboveFor publicly traded investment managers with less than $100 billion in AUM, trailing twelve month (TTM) revenue for the year ended March 31, 2021 declined about 8% year-over-year. Due to the operating leverage in the RIA business model, the decline in revenue also resulted in a lower EBITDA margin. The net effect is that TTM EBITDA declined about 20% on average year-over-year for these firms. The fundamentals for the larger group (firms with AUM above $100 billion) fared better, with profitability generally increasing despite the market downturn during the year ending March 31, 2021. These firms saw positive revenue growth across the board, although in many cases the revenue growth was partially offset by margin compression.For both groups, expansion in the TTM EBITDA multiple was the primary driver of the stock price increases. The larger group (AUM above $100 billion) saw the median multiple increase 70%, while the smaller group (AUM below $100 billion) saw the median multiple more than double.The multiple expansion between March 31, 2020 and March 31, 2021, while extreme, is not surprising given the trajectory of the market over the last year. While EBITDA was down ~20% year-over-year for the smaller group (and up ~5% for the larger group), the market values these businesses based on expectations for the future, not on LTM performance. As of March 31, 2020, AUM (and run-rate profitability) was down significantly, and depressed market prices continued to impact revenue for 2-3 quarters for many firms. But the market recouped its losses relatively quicky and continued to trend upwards. Today, AUM for many firms is hovering at or near all time highs.What’s Your Firm’s Run-Rate? The multiple expansion seen in the publicly-traded investment managers over the last year illustrates the importance of expected future performance on RIA valuations. The baseline for estimating future performance is the firm’s run-rate performance today. RIAs are unique in that run-rate revenue can be computed on a day-to-day basis using the market value of AUM and the fee schedules for client accounts. After deducting the firm’s current level of fixed and variable costs, run-rate profitability can also be determined.Market participants tend to focus on the run-rate level of profitability because it’s the most up-to-date indication of a firm’s revenue and profitability and the baseline from which future performance is assessed. As AUM has increased for many RIAs, so too has the run-rate revenue and profitability. The significant improvement in run-rate revenue and profitability (and expectations for the same) is a driving factor behind the multiple expansion observed over the last year.Consider the financial results for a hypothetical firm (ABC Investment Management) shown below. While illustrative, the growth of this firm since March 31, 2020 is not unusual relative to that exhibited by publicly traded investment managers and many of our privately-held RIA clients. During the second quarter of 2020, ABC Investment Management billed on $1.75 billion in AUM at an effective realized fee of 65 basis points, resulting in revenue for the quarter of $2.8 million. After subtracting compensation expenses and overhead, ABC generated $660 thousand in EBITDA for the quarter. AUM grew rapidly as the market recovered, such that by the first quarter of 2021 the firm was billing on $2.8 billion in AUM at the same fee of 65 basis points. For the full year, ABC Investment Management generated $14.2 million in revenue and $4.6 million in EBITDA.As of March 31, 2021, however, the firm’s run-rate performance was significantly higher than its performance over the last twelve months. ABC’s $2.8 billion in AUM was generating $18.0 million in annualized revenue at the effective realized fee level of 65 basis points. Assuming the same level of fixed costs and the appropriate increase in variable costs to reflect the higher revenue, ABC was producing run-rate EBITDA of $7.3 million at the end of the first quarter. That’s a 57% increase relative to EBITDA over the last twelve months.Implications for Your RIAAs always, valuation is forward looking. In relatively stagnant markets, there might not be much of a difference between LTM and ongoing performance. But given the shape of the market recovery over the last year, the difference today can be material, as the example above illustrates. If you’re contemplating a transaction in your firm’s stock, it’s worth considering where your firm is at today, not just what it’s done over the last year.

Year-End 2020 Auto Dealer Industry Newsletter Release

We are pleased to release our latest issue of Value Focus: Auto Dealer Industry Newsletter. The newsletter features a commentary on industry data from year-end 2020.Additionally, this issue includes two timely articles. The first article discusses the seven factors of a highly effective Buy-Sell Agreement for auto dealerships. When present, these factors can help reduce the risk of litigation upon a triggering event or business divorce.The second article discusses the computer chip shortage, including how computer chips are used in the automotive industry, how the chip shortage came to fruition, how it is currently affecting the industry, and what it all might mean for auto dealers going forward.Click the link below to download this latest issue.Value Focus: Auto Dealer IndustryDownload the Year-End 2020 Newsletter

Prepping for a Potentially Big M&A Year in 2021

Barring another recession or material reduction in bank stock valuations in the public markets, M&A activity should improve as 2021 progresses.However, some boards that would like to sell may have a hard time accepting a lower price versus what was obtainable a couple of years ago.One way to bridge the bid-ask gap is to consider transactions with more rather than less consideration consisting of the buyer’s common shares. Cash deals “cash-out” shareholders who then reinvest after-tax proceeds. Stock deals allow the target’s shareholders to remain invested in a sector that still trades cheap to longer-term valuations.This session, presented as part of the 2021 Acquire or Be Acquired Conference sponsored by Bank Director, addresses these issues.Click here to view the video!

Out of the Crude Abyss

It has been almost a year since crude prices went into the abyss on last April 20th. What a day that was: OPEC’s shoe had already dropped, and the realities of COVID-19’s short term consequences panicked the global oil market into a historic backlog. Crude tankers were stranded on the seas, storage filled up, and for a short while production had nowhere to go.The havoc wreaked on markets was severe. Demand was projected to drop between 20% and 35% by some (consumption actually dropped about 22% per the EIA). Reserve lives for some major producers dropped by around 10 years and between them reported losses north of $60 billion in 2020. To be fair, there are a couple of ways to look at this: one is a market decline in interest in these commodities; another could be rooted in the demand from investors for more nimble balance sheets coupled with the growing ability to develop acreage relatively quickly. Beyond the decline of reserves, (both through production decline and economic characterization), the bankruptcy casualty counts also skyrocketed as I have discussed before. According to the latest Haynes & Boone data, the count was 35 new bankruptcies in the second and third quarters of 2020 and over $50 billion in total debt going into bankruptcy for the full year.What a difference a year makes.Recently WTI closed at over $63, and it has spent most of the past month at or above $60. Many analysts now predict oil to stay in the $60’s (or higher) for the rest of 2021 (EIA on the other hand projects the mid-$50’s). It appears that low prices may have been a cure for low prices. The Dallas Fed came out with their quarterly Energy Survey a few weeks ago and its results were quite shocking to many. Its business activity index was at its highest reading ever in the five-year history of the survey. Guarded optimism among industry players is creeping back into the picture: “We are optimistic that we will have a weaning of excess oil supply, and more importantly, suppliers of oil and gas, that will lead to a slightly higher sustainable price.” said a respondent to the Dallas Fed. The S&P’s SPDR Oil and Gas Production ETF which dropped to around $30 (split adjusted) in March 2020 is now trading around $80. Production and CapEx spending are emerging as well in response to rising demand. Global oil demand and supply are moving towards balance in the second half of this year, per the IEA’s latest monthly report. In fact, producers may then need to pump a further 2 million bbl/d to meet the demand. OPEC, which has been withholding supply in tandem with other producers including Russia, this week raised its forecast for global oil demand this year. OPEC expects demand to rise by 70,000 bbl/d from last month's forecast and global demand is likely to rise by 5.95 million bbl/d in 2021, it said. Upstream Economics: Back In BlackIt must be relieving to be “let loose from the noose” of low prices. A lot of producers should be singing AC/DC nowadays. It is now profitable to drill a lot more wells than a year ago. Heck, back then existing wells were not profitable, much less undrilled ones. In terms of reserve metrics, I have said before that value erosion usually starts at the bottom categories of a reserve report and moves upwards. Value accretion moves in reverse. The increased pricing is making larger swaths of reserves economic again. Even so, one thing that is different this time around may be the cautiousness of investors and producers to jump back on the drill bit right away. Investors have already been pulling valuations down as their standard tilted more towards shorter term returns as opposed to longer term reserves. Additionally, the Fed Survey was littered with comments expressing concern about the Biden administration’s policies being more aggressive towards regulation and ESG, thus promoting caution for aggressive drilling. In fact, the American Petroleum Institute (of all organizations) is now considering carbon pricing frameworks. Lastly, OPEC+ could yank the rug out from shale producers again if they are perceived as ramping up too quickly, according to Pioneer’s CEO. (It is notable though that Pioneer just bought West Texas producer DoublePoint for $6.4 billion. That’s approximately $30,000 per flowing barrel and $40,000 per undeveloped acre). Next StepsSo where does this leave us? Well, in a lot better place for producers and investors than last year – that’s to be sure. The companies that have hung in this past year and made it are starting to see some improvement. That’s also good because those that utilized PPP money have been in need of price help once the government subsidies ran out. In addition, with all of the attention towards electric vehicles replacing the combustion engine, we must remind ourselves that only 1% of the U.S. light fleet is EV and that light vehicles only make up 25% of crude oil use. Demand will not be chopped out from oil’s feet just yet.Markets are fast moving and unforgiving at times, but it appears with $60+ oil prices for 2021, that the upstream business can now start to slow down, look around, and evaluate what direction to go next.Originally appeared on Forbes.com.

Bull Markets Breed Complacency for Investors AND RIA Management Teams

Know Why Your Firm is Growing

Forty-three years ago, Mercedes Benz began offering anti-lock brakes as an option on its top-end S-class sedan. ABS had been the norm for commercial airliners and some commercial vehicles for years, but it took considerable development from supplier Bosch to make the feature “affordable” for passenger cars (equivalent to about $4500 today). Anti-lock brakes improved stopping distances in hard braking and wet conditions dramatically. Initially, however, it also increased the accident rate.As with “self-driving” or semi-autonomous features being developed today like automatic braking and lane-keeping, the early days of ABS found Mercedes owners a little too secure in the capabilities of their vehicles. Overconfidence leads to complacency, and complacency leads to accidents. Long before Tesla drivers were photographed asleep in their moving vehicles, Mercedes drivers were rear-ending cars (because they overestimated their brakes) and getting rear-ended (because they overestimated the brakes of the car behind them).The speed with which equity markets have recovered over the past year has the potential to lead to a similar level of complacency, and RIA management teams would be well advised to keep both hands on the wheel.The risk we not infrequently see is that lengthy periods of strong market performance necessarily lead to upward trends in AUM and revenue that mask underlying problems. Just as institutional asset management clients learned decades ago to evaluate portfolio performance on a relative basis, rather than absolute return, RIA management teams need to look a step or two beneath the surface to understand why their firm is growing.Gauging performance for an RIA is often thought of in terms of the portfolio, particularly for product companies that specialize in particular strategies. Even though performance, in theory, should drive AUM flows, capital markets are fickle, and so can be customer behavior. So, we prefer to start with a decomposition of AUM history, and then explore the “why” from there.Consider the following dashboard that breaks down the revenue growth of an example RIA. Over a five-year period, this RIA boasted aggregate revenue growth of nearly 40%, increasing from $3.7 million to $5.1 million. AUM growth was even more substantial, nearly doubling from $600 million to $1.1 billion. Revenue grew every year, which would lead one to have great confidence in the future of the firm.Looking deeper, though, we notice a couple of unsettling trends. The five-year period of measurement, 2016 through 2020, represents a bull market from which this RIA benefited substantially. Cumulative gains from market value were over $600 million, more than the total growth in AUM and masking the loss of clients over the period examined (net withdrawals and terminations of over $100 million). Markets cannot always be counted on for RIA growth, so client terminations, totaling $183 million over the five-year period, or nearly one-third that of beginning AUM in 2016, is cause for concern. This subject RIA only developed $35 million in new accounts over five years, and we notice what appears to be an accelerating trend of withdrawals from remaining clients.Further, there appears to be loss in value of the firm to the marketplace. Realized fees declined four basis points over five years. Had the fee scheduled been sustained, this RIA would have booked another $336 thousand in revenue in 2020, all of which might have dropped to the bottom line. Small changes in model dynamics have an outsized impact on profitability in investment management firms, thanks to the inherent operating leverage of the model. But the materiality of these “nuances” can be lost in more superficial analysis of changes in revenue or changes in total AUM.So, we would ask, what’s going on? Did this RIA simply ride a rising market while neglecting marketing? Are clients concerned about something that is causing them to leave? Does this RIA suffer from more elderly client demographics that accounts for the runoff in AUM? If the RIA handles large institutional clients, did some of those clients rebalance away from this strategy after a period of outperformance? Is their realized fee schedule actually declining, or is it not? Is the firm negotiating fees with new or existing clients to get the business? Did a particularly lucrative client leave? What is happening to the fee mix going forward?Decomposing changes in revenue for an investment management firm can prompt a lot of questions which say more about the performance of the firm than simply the growth in revenue or AUM. Yet when we ask for this information from new clients, it isn’t unusual for us to hear that they don’t compile that data. All should. Some drivers have too much confidence in new technology, and some RIA managers have too much faith in the upward lift of the market. The risk to both is the same: ending up in the ditch.

M&A Focus: The Pioneer-DoublePoint Deal

After what felt like an eternity of quiet transaction activity in the O&G industry, the M&A market in 2021 has been off to a more active start in 2021.According to S&P Global Market Intelligence, the industry announced 117 whole-company and minority stake deals in the first quarter of 2021, an increase of 28 transactions from the same period last year. The combined deal value has also increased from $3.86 billion to $26.4 billion, as supermajors like Exxon Mobil Corp., Royal Dutch Shell PLC and Equinor ASA divested assets and corporate consolidation continued. The trend continued early in the second quarter.In this post, we discuss the Pioneer-DoublePoint transaction (the “Transaction”) that could foreshadow for more M&A activity to come.Transaction Summary & Asset DetailsOn April 1, 2021, Double Eagle III Midco 2 LLC, wholly owned by DoublePoint Energy, LLC, announced that it entered a definitive purchase agreement to sell all leasehold interest, subsidiaries, and related assets to Pioneer Natural Resources Company (PXD) in a transaction valued at $6.4 billion. DoublePoint is a Fort Worth, Texas-based upstream oil and gas company that is backed by equity commitments from funds managed by affiliates of Apollo Global Management, Quantum Energy Partners, Magnetar Capital, and Blackstone Credit.According to Piconeer’s Investor Presentation, the Transaction adds approximately 100,000 Tier 1 Midland Basin net acres to Pioneer’s existing assets. The bolt-on acquisition will lead to the combined company owning approximately 920,000 net acres in the Midland Basin, making it the largest producer in that area. The deal is expected to close in the second quarter of 2021.The purchase price is comprised of the following:Approximately 27.2mm shares of Pioneer stock (PXD) based on Pioneer’s closing share price as of 4/1/2021 ($164.60). After closing, PXD shareholders will own approximately 89% of the combined company and existing DoublePoint owners will own approximately 11%.Cash of $1.0bnApproximately $0.9bn of liabilities that includes debt of $650mm at 7.75% and approximately $300mm of reserve-based lending and working capitalPer PXD Investor PresentationThe Transaction implies the following valuation metrics: Pioneer anticipates approximately $175 mm in annual synergies related to G&A, interest, and operations. The company expects to save approximately $15 mm in G&A by reducing DoublePoint’s expense by 60% in the second half of 2021. Pioneer also plans to refinance DoublePoint’s bonds after closing to save roughly $60mm. Last, the company projects about $100 mm in operational savings. According to Pioneer’s Investor Presentation, the acquired acreage is highly contiguous and largely undeveloped, adding greater than 1,200 high-return locations. Although the exact amount Pioneer attributed to PDPs and PUDs is unknown, this suggests that PXD most likely associated option value to the undeveloped acreage in their purchase consideration. Mixed Market Signals Investors responded relatively well the day of the announcement (prior to the press release), as PXD’s share price increased 3.64%, closing at $164.60 on April 1. However, the stock has since produced mixed signals. The next trading day, April 5, the stock closed at $152.18, a 7.55% decrease from the announcement. The stock closed at $147.10 on April 21, a 10.63% decrease from April 1. The company has still performed well in 2021, as PXD share price is up 29.63% year-to-date. PXD has followed similar trends to the broad E&P value index (as proxied by the SPDR S&P Oil & Gas Exploration & Production ETF, ticker XOP) since the beginning of year, so this decrease may be geared more towards industry sentiment rather than deal reaction. On April 5, 2021 Fitch Ratings released a statement that Pioneer’s ratings are unaffected by the company’s deal announcement with DoublePoint. On April 22, 2021 Fitch affirmed Pioneer’s long-term issuer default ratings and unsecured debt ratings at BBB. Fitch also assigned a BBB rating to Pioneer’s 364-day unsecured revolving credit facility. Fitch notes that their rating outlook for PXD is stable. Pioneer’s credit rating outlook is a testament to its strong balance sheet and 2021 estimated net debt / EBITDAX of 0.9x. ConclusionThe Pioneer-DoublePoint transaction could set the stage for an active M&A market relative to a quiet 2020. Also, Pioneer’s Fitch Rating could serve as a positive signal for utilizing leverage in future deals. It will also be interesting to monitor deal values as it relates to what buyers are willing to pay for specific producing and non-producing assets (to the extent that the information is disclosed). If an industry recovery is in sight, transaction activity could continue its healthy pace, but also has the potential to soften if uncertainty looms, causing the bid-ask spread to widen if buyers and sellers are not on the same page.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Dealership Working Capital

A Cautionary Tale Against Rigid Comparisons

We have previously written about six events that can trigger the need for a business valuation. In each of these examples, the valuation will consider the dealership as a going concern or a continuing operation. The valuation process considers normalization adjustments to both the balance sheet and the income statement, as we discussed in our whitepaper last summer. For the balance sheet, normalization adjustments establish the fair market value of the tangible assets of the dealership and also identify and bifurcate any excess or non-operating assets. Non-operating assets are anything of value owned by the company that is not required to generate earnings from the core operations of the dealership.Even if a dealer is considering a potential sale of the business, the other assets and liabilities not transferred in the proposed transaction still have value to the seller when they consider the total value of operations. These non-core assets would then be added back to the value of the dealership operations determined under the other valuation methods. Profitable dealerships will accrue cash on their balance sheets over time. While these profits tend to either be reinvested into the business or distributed to owners, we frequently find that auto dealerships will carry a cash balance in excess of the needs of the core operations which could but have not yet been distributed. This excess is considered a non-operating asset, and as we discuss in this post, there are numerous considerations in determining the extent that cash buildup may represent an excess.Working Capital on the Dealer Financial StatementCash (and contracts in transit) and inventory tend to be the two largest components of working capital (current assets minus current liabilities) for auto dealers. However, inventory is offset by floor-plan debt, requiring little actual upfront investment on the part of dealers. Still, there is a certain level of working capital required to maintain operations. Most factory dealer financial statements list the dealership’s actual working capital, along with the requirements or “guide” from the manufacturer on the face of the dealership financial statement, as seen in the graphic below. A proper business valuation should assess whether the dealership has adequate working capital, or perhaps an excess or deficiency. Comparisons to required working capital should not always be a rigid calculation. An understanding of the auto dealer’s historical operating philosophy can assist in determining whether there is an excess or deficiency as different sales strategies can require different levels of working capital, regardless of factory requirements. Often, the date of valuation coincides to a certain event and may not align to the dealership’s year-end. The balance sheet at the valuation date could represent an interim period and may reflect certain seasonality of operations. A proper assessment of the working capital should consider the sources and uses of cash including anticipated distributions, capital expenditures, accrued and off-balance sheet liabilities, etc. For many reasons, it may not be appropriate to simply take the $616,218 from above and call this amount a non-operating asset. Additional Challenges to Working Capital Assessment Caused by Industry ConditionsSince the start of the pandemic, the auto dealer industry has continued to rebound after initial declines caused by lockdowns and shelter in place orders. The industry has benefited from increased gross profit margins on new and used vehicles, reduced expenses in advertising, floor plan maintenance and staffing, and funds provided by the PPP. All have contributed to record performance for dealerships. The PPP funds pose additional challenges to assessing the working capital of a dealership; are the funds reported on the dealer’s financial statement or are they held in accounts not reflected on those financial statements? Is there a corresponding liability for the PPP loan on the balance sheet or has that loan been forgiven? The date of valuation and what was known/knowable as of that date frame the treatment of these and other items in business valuation. For dates of valuation later in 2020 and early 2021, the loan portion of the PPP funds may be written off to reflect either its actual or likely forgiveness, and the removal of the corresponding PPP loan can increase the dealership’s working capital.The increased profitability of dealerships can also be viewed in the rise of current ratios (current assets divided by current liabilities) over historical averages. According to the data provided by NADA, the average dealership’s current ratio has risen to 1.38, from prior averages around 1.24. Statistical data from 2014 through February 2021 can be seen below: So how should the working capital of an auto dealership be assessed? Let’s look to a case study of a recent project to determine the factors to consider. Certain figures have been modified to improve the discussion and protect client information. Case StudyConsider a dealership with a date of valuation of September 30, 2020 compared to their typical calendar year-end. In a review of historical financial statements and operational performance, the Company reported increasing cash totals as seen below. A quick review reveals that cash has increased by over $6 million in 2019 and $9 million from 2018 through the valuation date. Would the entirety of this increase represent excess working capital? Digging deeper, let’s examine the actual levels of working capital and working capital as a percentage of sales for the same company over the same historical period. As we can see above, working capital increased as a percentage of sales. A rigid comparison of the latest period’s working capital to the prior period might indicate excess working capital either on the order of $2.7 million or 1% of sales. We can also look at the manufacturer’s requirement. This particular dealership had a net worth requirement and the more traditional working capital requirement. These are simple figures indicating whether a dealership is properly capitalized considering both liquidity and solvency. All of these financial calculations and cursory level reviews of working capital and net worth fail to consider the specific assets and liabilities of the Company, the timing of the interim financial statements, and the anticipated uses of cash. It is critical to conduct an interview with management to discuss these items and the operating level of cash and working capital needed for ongoing operations. Importance of Management InterviewIn this example, management indicated that the ongoing cash needed to facilitate day-to-day operations would approximate $5 million. Deducting from the $14.7 million, would that indicate $9.0+ in excess cash based on comparison to the actual cash balance as of the date of valuation?Management also provided details of a related party note payable to one of its owners not readily identifiable on the dealer financial statement. The note was a demand note that was callable at any time and was expected to be paid in the short-term. This is considered a non-operating liability, offsetting the excess cash. Management also anticipated heightened capital expenditures for the fourth quarter in the amount of $325,000. This type of information would be nearly impossible to discern from just analyzing the financials as this expenditure is an off-balance sheet item.After learning this information, we chose to assess working capital utilizing three different methods. First, we assessed working capital in the context of net worth based upon the requirements from the manufacturer because the Company can’t distribute excess cash to the level that would reduce equity below this figure. This method resulted in an assessment of excess working capital of approximately $1.4 million as seen below: Next, we looked at the dealer’s working capital position compared to OEM requirements. This method showed closer to $2.4 million in excess working capital. While this shows the dealership may have ample liquidity to facilitate operations with less cash in the business, the excess cash cannot materially impair the required book value above. The final assessment of working capital focuses directly on the cash and equivalents. As discussed, management indicated that the Company had operational cash needs of $5 million. Additional uses of cash prior to year-end included the likely repayment of the related party demand note and the cash required for the capital expenditures. This method resulted in an assessment of working capital of approximately $1.3 million, compared to a rigid calculation of $9.6 million when only considering actual cash less operating level needs as seen below: Ultimately, we concluded the Company in this example had excess working capital in the form of approximately $1,350,000 in excess cash. While there was more cash on the balance sheet than historical periods, our other valuation methods assume appropriate investment in the business to sustain operations. As such, we would be double counting value to add back too much cash without considering necessary improvements to the business to generate profits in the future. This example highlighted a dealership with excess working capital that was reflected in excess cash. Occasionally, an analysis might indicate excess working capital, but the Company’s cash is not elevated above a sufficient level to fund operations. As discussed above, excess and non-operating assets are those that could theoretically be distributed while not affecting the core operations of the dealership. However, non-cash current assets, such as Accounts Receivable and Inventory, are either not readily distributable or doing so might jeopardize the core operations. For a valuation performed in March 2021, industry conditions would also impact these calculations. Many dealerships likely have excess cash from increased profitability caused by inventory shortages. While cash balances would be higher when compared to historical levels, overall working capital may not be too unchanged as dealers struggle to maintain adequate inventory. Extracting value in the form of excess cash in this environment would need to be balanced with appropriate consideration of ongoing sales abilities with constrained inventories. As we’ve shown throughout this case study, none of these figures can be viewed in isolation. ConclusionsWorking capital and other normalization adjustments to the balance sheet are critical to the valuation of an auto dealership. The identification and assessment of any excess or deficiency in working capital can lead directly to an increase or decrease in value. Valuable datapoints to measure working capital include the requirements by the manufacturer and the Company’s actual historical cash and working capital balances, along with its current ratio and working capital as a percentage of sales. None of these data points should be applied rigidly and should be viewed in the context of future sources and uses of cash, the presence of non-operating assets or liabilities, and the seasonality of an interim date of valuation. Additional challenges for current valuations can be posed by PPP funds and prevailing industry conditions including scarce inventory and heightened profitability.The professionals of Mercer Capital’s Auto Dealership Team provide valuations of auto dealers for a variety of purposes. Our valuations contemplate the necessary balance sheet and income statement adjustments and provide a broader view to determine the assumptions driving the valuation. For a valuation of your auto dealership, contact a professional at Mercer Capital today.

Dealership Working Capital

A Cautionary Tale Against Rigid Comparisons

Strong Gains in the Wealth Management Industry Propel RIA Aggregators to New Highs

Oh What a Difference a Year Makes…

Nearly all sectors of the stock market are up over the last year, but that’s especially true for the RIA industry. Even if most wealth management firms don’t employ any debt in their capital structure, their performance is very much levered to the stock market due to its direct effect on AUM balances, and the operating leverage inherent in the wealth management model. RIA aggregators are even more levered to market conditions, since they typically borrow money to purchase wealth management firms. It shouldn’t be too surprising that our aggregator index is up 140% over the last year. After a rough Q1 in 2020, wealth management firms have fared particularly well over the last year, with favorable market conditions and rising demand for financial advisory services. During times of excessive volatility and market turmoil, individual investors rely on their advisors to stay the course and rebalance portfolios in accordance with their investment objectives. Wealth management firms have capitalized on this reliance as the number of advisors charging financial planning fees on top of asset-based fees or commissions increased 72% in 2020. Despite steady gains over the last year, wealth management firms still face challenges pertaining to fee pressure, succession planning and connecting with millennials who are more interested in robo-advisors and fintech products than being counseled by their parents’ advisor. Additionally, the switch from in-person meetings to digital communication is viewed by many as another obstacle. According to a recent Schwab study, 35% of advisors viewed clients’ ability to connect virtually as one of the biggest challenges to their business in 2020. On the flip side, 37% of advisors view leveraging technology infrastructure to be able to seamlessly work remotely as one of the biggest opportunities to their business. Source: Schwab Advisor Services’ 2020 Independent Advisor Outlook StudyAnother near-term opportunity is the pending reversal of some or all of the Tax Cuts and Jobs Act of 2017, and the implications it has for estate planning in 2021. Biden’s current proposal cuts the Unified Tax Credit (the exemption on gift and estate taxes) in half from $23.2 million to $11.6 million for married couples and from $11.6 million to $5.8 million per individual. As a consequence, many high net worth families will have significant gift and estate planning needs from their advisors to avoid a substantial increase in their embedded estate tax liability next year.On balance, 2021 should prove to be another challenging but favorable year for wealth management firms that focus on their clients’ needs and take advantage of rising demand for financial planning services. Industry headwinds remain, but we’re confident that the industry will prosper, diversify, and expand.

Valuation Implications of a 28% Corporate Tax Rate on Blue Sky Multiples

Will Dealerships Become Less Valuable if Tax Rates Rise?

2017 Tax Cuts and Jobs ActTo get an idea of how Blue Sky multiples might change with an increase in the corporate tax rate, the simplest way may be to look at what happened the last time the rate changed. Fortunately for this analysis, we don’t have to go back too far. In December 2017, former President Trump signed the Tax Cuts and Jobs Act (“TCJA”) into law. Shortly after his inauguration, President Trump indicated a goal of “15 to 20%” for the federal corporate tax rate, down from 35% at the time. Fast forward to September 2017, the Trump administration and congressional Republican leaders announced a tax framework that included a 20% federal corporate tax rate, which eventually settled at 21% when the bill was signed into law on December 22, 2017.On a statutory basis, a dealer structured as a traditional C corporation making $1 million in pre-tax earnings went from net income of $650,000 to $790,000, or an increase in value of 21.5% assuming no change in the P/E multiple. While this generally comports with the returns of the S&P 500 in 2017 (which increased 19.4%), this increase happened gradually over time. While there are many other contributing factors, it is evident in the chart below that the market likely priced in any favorable tax changes gradually throughout the year. Because the market generally trended upwards in 2017, it would be difficult to point to any one period of rapid increase related to optimism surrounding lower corporate taxes. However, because the market has historically trended upwards, it can be more difficult to attribute the rise to specific policies. While this paints with more broader strokes for the market, let’s consider Blue Sky multiples. Blue Sky Multiples Before and After TCJAWhile after-tax earnings likely rose for most dealers due to the tax law change, pre-tax profits by definition would not be impacted. Theoretically as noted above, a buyer should be willing to pay more for a higher return, so the value should increase if earnings go up. With the earnings stream utilized in Blue Sky multiples unchanged, an increase in value should be seen in higher multiples.From Q3 2017 - Q1 2018, there were no changes in the range of multiples for any brands despite the material decrease in corporate tax rates. This begs the question: Why not?If dealership values had increased by 21.5%, the average Blue Sky multiple would have increased from 4.85x in Q3 2017 to 5.89x in Q4 2017. This change also could have been more gradual throughout the year. However, multiples were largely unchanged.From Q1 2017 to Q1 2018, only five brands saw a change in their Blue Sky multiples. Subaru multiples improved by one full turn of pre-tax profits in Q2 2017 (from 4x-5x to 5x-6x), while Toyota, Honda, Chevrolet, and Buick-GMC saw more modest increases in Q3 2017. From then until Q1 2018, there were no changes in the range of multiples for any brands despite this material decrease in corporate tax rates. This begs the question: Why not? Well, there are numerous potential reasons.State of the IndustryIn the Q4 2017 Haig Report, private dealership values were judged to have fallen by an estimated 2.6% from the year-end 2016 due to increased expenses. Despite generally favorable macroeconomic conditions in the U.S., auto sales and gross profit per vehicle retailed were starting to trend down at the same time that dealership expenses are increasing, reducing profits. With years of annual volumes above 17 million, there were concerns about declines. While volumes in 2018 and 2019 were below the 2016 peak, they remained above 17 million. SAAR for 2015 through 2019 is shown in the below graph for perspective. As the pandemic reminded us all, volumes do not directly correlate with profits. In order to gain a broader perspective of the auto dealer market conditions, we’ve considered the stock price returns of the S&P 500, the Russell 2000, and the publicly traded franchised dealers in 2017. The S&P 500 paced the group with the aforementioned 19.4% return. Lithia was just behind at 17.3% as it continued to buy up dealerships which the market viewed favorably. The return on the Russell 2000 was 13.1%, well above all other auto dealer stock prices whose returns ranged from 5.5% (AutoNation) to negative 19.4% (Sonic). The trend was particularly bad through the end of August with all non-Lithia dealers down between 6.7% and 23.0%. SAAR followed this general trajectory and caught a nice bounce in September, which coupled with optimism over favorable tax treatment potentially aiding in the rebound. Despite lower taxes increasing after-tax cash flows, it appears declining industry conditions offset gains, leading to minimal change in Blue Sky multiplesAfter the passage of the tax law and with some time to analyze any impacts, the Q1 2018 Haig Report noted positive and negative trends thusly:Positive Trends: “This remarkable era in auto retailing continues. We have enjoyed many years of low interest rates, cheap gas, and rising employment. Consumer confidence remains near its 17-year high and household wealth has never been greater. It’s true that dealership profits (and values) peaked a couple of years ago, but they remain close to record levels. The much-predicted downturn in sales has not yet happened. Congress even gave dealers a nice boost by lowering taxes and walking back pressure from the CFPB. Negative Trends: "While sales remain strong, there are some troubling vibrations coming from the disruptive influences of technology. Dealers continue to suffer from the degradation of gross profits due to the shift in pricing power from the retailer to the consumer thanks to various digital tools. And over the next five to ten years, electrification, ride sharing and autonomous vehicles loom as threats. Some well-respected industry leaders predict that the best days of auto retail are behind us, that profits will never return to current levels and that many dealerships will end up closing their doors.”Despite lower taxes increasing after-tax cash flows, it appears declining industry conditions offset these gains, leading to minimal change in Blue Sky multiples. To take the analysis a step further, we consider the specific tax structures of privately held dealerships and transaction considerations, rather than comparing it solely to publicly traded companies which are required to be structured as C corporations.Tax Structure of Largest Auto GroupsBlue Sky multiples are calculated on adjusted pre-tax profits. This enables comparison between dealerships subject to different income tax rates. Differences in total corporate income taxes paid are usually due to two reasons: state/local tax rates and ownership structure (C corporation vs pass-through). First, let’s address state/local tax rates. Language in the Haig report from editions before and after the tax law change note, “dealerships in states with no income tax usually bring premiums to dealerships in high tax states.” This means that for a given range, say 5x-6x, dealerships subject to lower taxes are more likely to receive a pre-tax multiple on the upper end of the range. While not all dealerships necessarily fit into this range, one can infer that local tax rate differences may not ultimately impact the multiple by more than one turn of pre-tax earnings.Dealerships in states with no income tax usually bring premiums to dealerships in high tax statesMany dealers may also structure their companies to be taxed at individual rates (S corporation, LLC, etc.) instead of corporate rates (C corporation). The pass-through tax structure has been popular because it avoids “double taxation” when a dealer pays corporate income taxes on profits then taxes on distributions from net income to dealers after the payment of corporate taxes. For a pass-through dealer, their marginal tax rates only declined from 39.6% to 37.0%. While the initial tax framework proposed by Republicans included a maximum 25% rate on pass-throughs, the TCJA instead offered a 20% deduction for Qualified Business Income (“QBI”). For dealers in the top marginal income tax bracket, this could mean a pass-through rate as low as 29.6% (37% x [1-20%]). Implied increases in values are demonstrated below: As noted above, Blue Sky multiples derived from private dealership transactions are applied to pre-tax earnings, enabling comparisons regardless of elected corporate structure. This is intuitive because a buyer is unlikely to be concerned with the corporate structure of the seller. While corporate taxes declined, many dealerships are structured in this way. Therefore, a negotiation between a buyer and seller is likely to balance favorable income tax treatment against other factors on pre-tax income. As discussed above, industry conditions were relatively stable if not modestly declining. Anticipated Impact of Increasing Corporate Tax RatesUnder the Biden plan, a 28% corporate tax rate would decrease after-tax earnings for C corporations by 8.9% all else equal. However, as we saw after the TCJA, not all else is equal. The reverse may be occurring in 2021 with rising taxes being offset by more favorable industry conditions as many auto dealers finished 2020 with record profits despite a global pandemic.In 2021, rising taxes may be offset by more favorable industry conditionsHeading into 2021, looming threats associated with scale continue to exist, though this is not exclusive to smaller dealers. With online-only used retailers attracting plenty of equity capital from the public markets, larger players in the industry are feeling the pressure to grow themselves. This levels the playing field as buyers are equally incentivized to grow as sellers might be to capitalize on high exit multiples, forgoing the need to make significant technological investments.ConclusionSo, what does the TCJA tell us about the proposed increase in corporate tax rates under the Biden administration? The short answer is it depends. Buyers and sellers are likely more focused on determining the run-rate, or core earnings of dealerships after record profits in 2020 than what rate may or may not apply to them. Fear of rising taxes may motivate sellers to cash in, which would weigh on value if there’s excess supply of dealerships for buyers to choose from. In 2017, the opposite was likely true as bolt-on acquisitions became more costly as dealers were less motivated to cash out as more income fell to their bottom line. As we’ve demonstrated, an increasing federal corporate tax rate may impact some dealers, but for most that are structured as pass-through entities, changes in the top marginal tax bracket for individuals is more likely to impact dealer principals. And while the corporate income tax rate is important for the future earnings of a dealership, sellers are likely to be more concerned about the taxes they would need to pay after selling their business.Mercer Capital provides business valuation and financial advisory services that consider the potential valuation implications of changes in legislation and how this impacts auto dealerships and their principals. We also help our dealer clients understand how their dealership may, or may not, fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to learn more about the value of your dealership.

Valuation Lessons from Credit Union & Bank Transactions

In recent years, credit unions have been increasingly active as acquirers in whole bank and branch transactions. This session focuses on the top considerations for credit unions when assessing and valuing bank and branch franchises in the current environment.For bankers, this session should enhance your knowledge regarding how credit unions identify potential targets, assess potential opportunities and risks of a bank or branch acquisition, and ultimately determine a valuation range for target banks and branches.This session, presented as part of the 2021 Acquire or Be Acquired Conference sponsored by Bank Director, addresses these issues.Click here to watch the video!

Solvency Opinions: Oil & Gas Considerations

The Key QuestionAs 2020 progressed, a record number of oil & gas operators and related oil field service companies filed for Chapter 11 bankruptcy, which provides for the reorganization of the firm as opposed to full liquidation (Chapter 7). In addition, consolidation by way of merger and acquisition (“M&A”) activity occurred, albeit such activity was at a 10-year low in 2020. Regardless of whether a company files for Chapter 11, is party to an M&A transaction, or executes some other form of capital restructuring – such as new equity funding rounds or dividend recaps – one fundamental question takes center stage: Will the company remain solvent?The Four TestsAs noted in our overview of solvency opinions last November, leveraged transactions that occurred pre-COVID-19 will continue to be scrutinized, with many bankruptcy courts considering the issue of solvency retroactively. Due to increased energy price volatility in the first and second quarter of 2020, many operational and dividend programs were suspended.As oil & gas prices have stabilized and appreciated over the past one to two quarters (in its April Short-Term-Energy Outlook report, EIA projects WTI and Brent to average $58.89 and $62.28 per barrel, respectively), a large number of oil & gas operators have significantly reduced their debt, and are considering or have resumed their operational plans and dividend programs, albeit perhaps not exactly as before their suspension.Emerging from the chaos of 2020 with lower leverage, leaner and more efficient operations, higher commodity prices, and the continued low interest rate environment, it is not unreasonable to think that oil & gas companies may consider increasing leverage again as operations continue to recover or expand and boards approve the return of capital to shareholders by way of resuming regular or even special dividends.Often, a board contemplating such actions will be required to obtain a solvency opinion at the direction of its lenders or corporate counsel to provide evidence that the board exercised its duty of care to make an informed decision should the decision later be challenged.A solvency opinion, typically performed by an independent financial advisor, addresses four questions:Does the fair value of the company’s assets exceed its liabilities after giving effect to the proposed action?Will the company be able to pay its debts (or refinance them) as they mature?Will the company be left with inadequate capital?Does the fair value of the company’s assets exceed its liabilities and capital surplus to fund the transaction?A solvency opinion addresses these questions using four primary tests:Test 1: The Balance Sheet Test – Does the fair value and present fair salable value of the Company’s total assets exceed the Company’s total liabilities, including all identified contingent liabilities? The balance sheet test takes the fair value of the subject firm on a total invested capital basis and subtracts its liabilities. Test 2: The Cash Flow Test – Will the Company be able to pay its liabilities, including any identified contingent liabilities, as they become due or mature? The cash flow test examines whether projected cash flows are sufficient for debt service. This is typically analyzed along three general dimensions, including the determination of the company’s revolving credit facility to manage cash flow needs over the forecast, the possible violation of any applicable covenants, and the likely ability to refinance any remaining debt balances at their maturity. Test 3: The Capital Adequacy Test – Does the Company have unreasonably small capital with which to operate the business in which it is engaged, as management has indicated such businesses are now conducted and as management has indicated such businesses are proposed to be conducted following the transaction? The capital adequacy test is related to the cash flow test and examines a company’s ability to service its debt with sufficient margin after giving effect to the proposed transaction. While there is no bright line test for defining “unreasonably small capital”, we typically evaluate this concept based upon pro forma and projected leverage multiples utilizing management’s projections as a baseline scenario and alternative downside scenarios to determine if there is “unreasonably small capital” under more stressed conditions. Test 4: The Capital Surplus Test – Does the fair value of the Company’s assets exceed the sum of (a) its total liabilities (including identified contingent liabilities) and (b) its capital (as calculated pursuant to Section 154 of the Delaware General Corporation Law) The capital surplus test replicates the valuation analysis prescribed under the balance sheet test, but includes the par value of the company’s stock (or entire consideration received for the stock if no par value is given), in the amount subtracted from the fair value of the company’s assets.Solvency Considerations within Oil & GasPerforming a solvency opinion requires careful consideration of numerous factors even when everything clearly appears to be more or less favorable in a proposed transaction that involves increasing leverage. It may be opportune to pursue a dividend recap as debt is cheap and the company is already exhibiting strong growth in an industry potentially starting to recover. A company may increase leverage despite already having sufficient cash on hand for a special distribution, but it wants to maintain flexibility to act on unexpected growth opportunities that may arise. Perhaps the company’s trajectory is so great that even its downside case(s) would be a lofty goal of the next closest competitor. Still, the independent financial advisor must maintain a critical eye, taking a medium- to long-term perspective with a skeptic lens, to determine that the company may reasonably remain solvent.Now, consider the oil & gas sector in 2020. Under the assumption that additional debt is needed just to survive, never mind paying special dividends, many additional questions to approaching the company’s baseline forecast and downside scenarios arise:If the fair value of the company’s assets is already greatly diminished in the current down cycle, how much should you temper – if at all – the downside future scenario(s) when conducting the capital adequacy test? An appropriate stress test scenario for a company at the top or mid-point of the business cycle may look far different from an appropriate stress at the bottom of the cycle.How will the balance sheet test fare given the concurrent decrease in asset fair value and increase in liabilities? Even if the capital adequacy and balance sheet tests do not raise any red flags on their own, the cash flow test may reveal significant concerns. Is there enough flexibility with the existing revolver to address cash flow needs over the forecast, or will it need to be increased? Could the revolver even be increased, if needed?Can the company financially perform well enough over the next three to five years that future (likely) higher interest rates won’t be overly burdensome if the company must refinance maturing debts?And while due diligence and financial feasibility studies are expected to be performed beforehand, what covenant violations are likely to occur and when (in the context of the forecast scenario)? Will the new debt be “covenant-light” and relatively toothless, or will the company find itself that much more constrained when the fangs sink in and the situation is already likely to be dire? While conversations regarding these questions and their implications may likely expose sensitive topics, these discussions must be candid if the independent advisor is to develop a well-founded and defensible opinion on the prospects of solvency. Mercer Capital renders solvency opinions on behalf of private equity firms, independent committees, lenders and other stakeholders that are contemplating a transaction in which a significant amount of debt is assumed to fund shareholder dividends, an LBO, acquisition or other such transaction that materially levers the company’s capital structure. For more information or if we can assist you, please contact us.

March 2021 SAAR

After a tumultuous February due to weather conditions, March SAAR has bounced back with a vengeance. March SAAR of 17.75 million units is the second-highest of all time for the month, just shy of March 2000. There are two main factors driving this increase. While the winter storms had a negative impact on February SAAR, it likely caused pent-up demand that helped drive sales in March. Beyond simple delays, flooding forced some to replace damaged vehicles. Secondly, the Biden administration passed a Covid-19 stimulus bill at the beginning of March, and $1,400 paychecks hit many Americans’ wallets. This influx of cash may have also spurred a massive increase in vehicle sales.Now more than 12 months into the Covid-19 pandemic, we don’t think that comparing March 2021 SAAR to March 2020 SAAR is prudent due to the change in the economic landscape (it’s a 56% increase for those of you who were curious). For the next couple of months, this year-over-year comparison will continue as spring 2020 SAAR values were horrendous as dealers scrambled to grapple with the challenging operating environment. We will instead try to show both a comparison to 2020 and 2019 levels. Even with this adjustment, March SAAR for 2021 was an increase of 44% compared to 2019.Driving March SAAR were sales of light trucks which accounted for 78.1% of all new vehicle sales in March 2021. This metric is a slight uptick from the 74% they accounted for in March 2020. Breakdown of SAAR by vehicle type as presented by NADA is below for March 2021:Inventory and Production ProblemsThe March record sales levels come at the same time as lean inventories and production problems plague the industry. Thomas King, president of data and analytics at J.D. Power, noted this:“At an aggregate industry level, Q1 inventories have been sufficient to meet consumer demand and delivered the opportunity for manufacturers and retailers to sell those vehicles with smaller discounts. Manufacturers who are experiencing supply chain challenges are prioritizing the production of their most profitable and desirable products, minimizing the net effect. There is no question that sales of specific models in specific geographies are being disrupted by low inventories, but consumers are nevertheless demonstrating their willingness to buy despite having fewer vehicles to choose from the in-retailer inventory.”It will be interesting to see how long inventory levels can meet demand, and if consumers will continue to be as flexible on car model choice. This factor likely hinges on the continuing chip shortage and how that impacts manufacturers during the rest of the year. We have discussed the chip shortage at length in a prior blog post, and it ultimately could pose a problem to the current growth trajectory.At the end of February, dealers had 2.7 million vehicles in stock or being shipped to stores, a 26% drop from the same month last year. The lack of availability has been more acute for crossovers and SUV models, including Jeep’s Wrangler and Chevrolet’s Tahoe, whose stock is running between 43-70% lower than last year. Pickup trucks are the most recent type to be impacted by the shortages, with dealers having about 414,000 trucks at the end of February, about half of what they had a year earlier. As a result, many consumers have had to order models from the factory or pick up vehicles in transit to dealerships.Long gone are the initial pandemic incentives to drive consumers to dealerships, and buyers are having a harder time finding bargains. According to JD Power, average incentive spending per unit is expected to total $3,527, a decrease of $888 and $262 relative to March 2020 and March 2019. High demand is driving record transaction prices, and reduced incentives are improving gross profit margins and overall profitability for dealers. JD Power notes that average transaction prices are expected to reach $37,286, just below the all-time record set in December 2020.Fleet SalesWhile new vehicle retail sales have been booming, fleet vehicle sales have not seen the same resurgence and remain depressed. According to NADA, manufacturers are prioritizing production of the most popular and profitable segments for retail customers. Fleet customers have had their orders pushed back or canceled for the 2021 model year in some cases. Fleet buyers typically get discounts for buying in bulk. Fleet sales have struggled mightily during the pandemic and have not seen the same type of rebound experienced by retail sales.JD Power notes that fleet sales are expected to total 180,200 units in March, down 33% from March 2020 and down 51% from March 2019 on a selling day adjusted basis. Fleet volume is expected to account for 12% of total light-vehicle sales, down from 26% a year ago. Fleet sales struggled inordinately compared to retail partially due to a decline in travel amid the pandemic. Although the introduction of a vaccine and more consumer confidence in travel should have been a bright spot for bringing back fleet sales, the reallocation of vehicles to retail due to the chip shortage is another blow to an already struggling segment of the industry. With supply low, OEMs are prioritizing buyers willing to pay top dollar, so fleet buyers are losing that allocation.ConclusionLooking toward the rest of the year, vehicle sales success is going to be contingent on being able to acquire inventory. Consumer demand is high, and if dealerships can navigate the chip shortage and lack of models, they may see more numbers like that posted in March. However, if the chip shortage worsens and dealerships are unable to acquire inventory, this may be a headwind.If you have any questions on SAAR and what it means in the broader context of a valuation of your dealership, please do not hesitate to reach out to any member of the Mercer Capital Auto Team.

Q1 2021 M&A Update

An RIA M&A Frenzy

Despite the hiatus in M&A beginning with the onset of COVID-19, 2020 was a strong year for RIA mergers and acquisitions, and 2021 is expected to be even stronger. Many of the same forces that have spurred M&A over the last five years drove deal activity in late 2020 and early 2021. Fee pressure in the asset management space and a lack of succession planning by wealth managers are still driving consolidation. But the increased availability of funding in the space, in tandem with more lenient financing terms, has also caused some of this uptick. There has been growing interest over the last few years from private equity and permanent capital providers who find investment managers’ recurring revenue streams and availability for operating leverage attractive. Investors, hungry for alpha in a low-yield environment, are driving up deal prices leading more firms to hang up a for-sale sign. Additionally, deal activity was bolstered by the low cost of credit and lenient financing terms by historical standards. As Jeff Davis, our bank guru, explains; “Loans in the commercial banking system declined for the first time in a decade in 2020 and for only the second time in 28 years while deposits remain historically high. In the current low-rate environment, revenue pressures are high for banks as cash and bonds yield little to nothing. Without a competitive alternative, banks and investors flush with capital are under pressure to compete for lending opportunities to produce a return while loan demand is weak as the U.S. market rounds what many believe to be the very beginnings of a new economic cycle.”There is a growing number of banks interested in lending to the space. Live Oak Bank pioneered an SBA vertical in lending to RIAs and investment advisor Oak Street Funding has played a role in a substantial portion of leveraged transactions in this space, and most recently SkyView began offering financing solutions for RIAs.Further, the Biden administration's efforts to increase the capital gains tax rate may also accelerate some M&A activity in the immediate short-term as sellers seek to position transactions to be taxed at current tax rates.What Does This Mean for Your RIA?If you are planning to grow through strategic acquisitions, the price may be higher, and the deal terms will likely favor the seller, leaving you more exposed to underperformance. In a market this competitive, acquirers need to distinguish themselves on more than price. Sellers are often looking for buyers who can help them achieve scale, reduce the load of managing a business, and/or expand their reach or distribution capability. If you are considering an internal transition, know there are more ways to finance the buy-out than there used to be. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and in some instances may still be the best option), but bank financing can provide the founding generation with more immediate liquidity and potentially offer the next-gen cheaper financing costs. If you are an RIA considering selling, there are many options, and it is important to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. A strategic buyer will likely be interested in acquiring a controlling position in your firm with some form of contingent consideration to incentivize the selling owners to transition the business smoothly after closing. Alternatively, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference.

RIA Industry Extends Its Bull Run Another Quarter

Publicly Traded Asset/Wealth Managers See Continued Momentum Through First Quarter as Market Backdrop Improves

It was about a year ago that share prices for publicly traded investment managers hit rock bottom, as investors reacted to the downside of having a revenue stream tied to the overall market. Since then, it’s been a straight-line recovery that’s continued through the first quarter of 2021, riding the wave of the larger bull market.Today, most individual stocks in our indices are hovering near 52-week highs. Aggregators have fared particularly well over the last twelve months on low borrowing costs and steady gains on their RIA acquisitions. Traditional investment managers have also performed well over this time on rising AUM balances with favorable market conditions. The upward trend in publicly traded asset and wealth manager share prices since March 2020 is promising for the industry, but it should be evaluated in the proper context. Pre-COVID, many of these public companies were already facing numerous headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. While the 11-year bull market run largely masked these issues, asset outflows and revenue pressure can be exacerbated in times of market pullbacks and volatility. The fourth quarter was also favorable for publicly traded RIAs of all sizes as shown below. As valuation analysts, we’re often interested in how earnings multiples have evolved over time, since these multiples can reflect market sentiment for the asset class. LTM earnings multiples for publicly traded asset and wealth management firms declined significantly during the first quarter last year—reflecting the market’s anticipation of lower earnings due to large decreases in client assets attributable to the overall market decline. Multiples have since recovered as prospects for earnings growth have improved with AUM balances. Implications for Your RIAThe value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with privately held RIAs should be made with caution. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds such as fee pressure and asset outflows to passive products. Many smaller, privately held RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.The market for privately held RIAs has remained strong as investors have flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer. Like the public companies, value likely declined during the first quarter of last year, but these were largely paper losses (not many transactions were completed based on value during the height of the downturn). Likely, not more than a quarter or two of billing was impacted last year by the market downturn. Since then, revenue and profitability have recovered rapidly, and value has likely improved as well similar to the publicly traded asset/wealth managers.Improving OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has generally improved with market conditions over the last several months. AUM has risen with the market over this time, and it’s likely that industry-wide revenue and earnings have as well. The first quarter was generally a good one for RIAs, but who knows where the rest of 2021 will take us.

Analyzing the Relationship of Rent and Real Estate Values in Dealership Acquisitions

The Opposite, Break-Even or Something In-Between?

My favorite TV show is Seinfeld. It's seemingly about nothing, but the situations and characters still resonate today.One of my favorite Seinfeld episodes is “The Opposite.” A brief (and incomplete) summary of the episode: George decides to turn his life around by doing the exact opposite of what he would usually do, and finally finds success, while Jerry keeps breaking even in life. Jerry marvels how things always just even out for him.What does this have to do with auto dealer valuations and the relationship of rent and real estate values in dealership acquisitions? In this post, we examine if the rent factor and value of the real estate all even out, just as Jerry Seinfeld’s character did in "The Opposite."The Impact of Rent and Real EstateOften dealership operations are organized in two entities: an entity holding the underlying real estate and an entity containing the dealership operations. We have chronicled the importance of normalization adjustments in the valuation process of the dealership operations including an assessment of rent. Since these entities are often owned by related parties, the level of rent should be examined.Dealers that own both the real estate entity and the dealership operations entity can control the amount of rent charged. Hypothetical buyers will assess the market rental rate and make adjustments to the valuation to keep this in line with the market.An ExampleWhy would dealers want to shift value and/or rental income to the real estate entity? Let’s examine this through an example highlighting increasing real estate values and one highlighting decreasing real estate values.Real estate is valued based upon a return of Net Operating Income. In our example, we assume a constant capitalization rate of 8% or a capitalization factor of 12.5x the rental income. In our example, this capitalization factor, or multiple, is higher for the real estate than the Blue Sky multiple of 6x, so the impact of the value of the real estate will have a greater impact on the overall acquisition value. Since Blue Sky multiples average around 6x, and range generally between 3-10x this will typically be the case. Fortunately or unfortunately, auto dealers cannot manipulate the underlying value of the real estate itself. Most, if not all auto dealership acquisitions will require a fair market value appraisal of the underlying real estate.Based on the assumptions above, the dealership operations would have a value of $3,000,000 (EBT of $500,000 times a Blue Sky multiple of 6x) and the real estate would have a value of $3,000,000 for a total acquisition value of $6,000,000 as seen below.Appreciating Real Estate ValuesIn times of appreciating real estate values, let’s assume the fair market value of the real estate increases by 15% to $3,450,000. If annual rent is kept at a constant capitalization rate of 8% with more of a long-term view, annual rent would increase to $276,000 and the resulting increase in rent would decrease normalized earnings to $464,000. While the real estate value climbs, the implied blue sky value for the dealership operations declines slightly since earnings are lower due to increased rent. However, the overall total acquisition value (operations + real estate) would increase by 4% ($6,234,000 vs. $6,000,000), despite the 7% decline in blue sky value as seen below.Depreciating Real Estate ValuesNow let’s examine the alternative where real estate values are declining. Let’s assume that the fair market value of the real estate declines by 15% to $2,550,000. If annual rent is kept at a constant capitalization rate of 8% with more of a long-term view, annual rent would decrease to $204,000 and the resulting decrease in rent would increase normalized earnings to $536,000. While the real estate value declines, the implied blue sky value for the dealership operations increases since earnings are higher due to decreased rent. However, the overall total acquisition (operations + real estate) would decrease by 4% ($5,766,000 vs. $6,000,000) despite the 7% increase in blue sky value seen below. For comparative purposes, we can also view this graphically: Seen differently, a 15% increase in FMV rent with no change in the cap rate of blue sky multiple shifts approximately 5% of the total value to the real estate. About the opposite is true for a 15% decline. ConclusionsThe relationship between rent and fair market value of the real estate has an impact on the components of an auto dealer acquisition. While the impacts may be opposite and felt on both sides of the two entities, the impact on the real estate can have a greater effect given lower capitalization rates and/or higher capitalization factors than most implied blue sky multiples.Back to the Seinfeld episode, does the rent factor and value of the real estate all even out? While a decrease in annual rent will materialize in a greater implied blue sky value all other things held constant, the total effect would not mitigate a corresponding decline in real estate values.While auto dealers that own both the dealership operations and the real estate can control the charged rental rates, they cannot influence the ultimate value of the real estate. Frequently, the rent paid by a dealership is either higher or lower than true market rent as dealers are more concerned with running the day-to-day operations of their business than trying to pinpoint rental cap rates. A proper valuation of the dealership operations will assess and adjust the charged rental rate to reflect the perceived fair market value of the real estate.To discuss the impact of the rental rate or for an assessment of the valuation of your dealership operations, contact a professional on Mercer Capital’s Auto Team.

Analyzing the Relationship of Rent and Real Estate Values in Dealership Acquisitions

The Opposite, Break-Even or Something In-Between?

Eagle Ford Benefits From Commodity Price Increases Despite Challenges

The economics of oil and gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. This quarter we take a closer look at the Eagle Ford.Production and Activity LevelsEstimated Eagle Ford production declined approximately 23% year-over-year through March. This is the most severe decline observed for all of Mercer Capital’s coverage areas, with production in the Bakken, Permian, and Appalachia down 19%, down 8%, and up 3%, respectively. In the immediate aftermath of the Saudi/Russian price war and historic rout in oil prices, the Eagle Ford’s production decline was less severe than what was seen in the Bakken, though the rebound in the Eagle Ford was also more muted. During the fourth quarter of 2020, Eagle Ford production trended downward once again and appears to have been materially impacted in February 2021 by the cold weather that disrupted power supplies throughout Texas. However, the Eagle Ford’s rig count has generally been rising over the past six months. Total rigs in the Eagle Ford stood at 31 as of March 26, down over 50% from the prior year, but more than 3x higher than the low of 9 rigs observed in September 2020. Bakken, Permian, and Appalachia rig counts were down 71%, 42%, and 19% year-over-year, though have all rebounded from the September lows (though not as dramatically as the Eagle Ford’s rise since then). While recent data has been noisy, and the Eagle Ford’s current rig count should keep production relatively flat, based on legacy production declines and new-well production per rig. Commodity Prices Stabilize, Though Uncertain Demand Dynamics RemainThe first quarter of 2021 was relatively good for commodity prices, though they exhibited more volatility than in recent quarters. Front-month WTI futures began the quarter at ~$48/bbl and increased to a peak of $66/bbl before ending the quarter at ~$59/bbl. Henry Hub natural gas front-month futures prices broke above $3/mmbtu in February 2021, though regional spot prices were much more volatile as cold weather disrupted gas production and transmission while also increasing demand for heat and electricity.Financial PerformanceThe Eagle Ford public comp group had a banner year for stock price performance over the past twelve months, with Penn Virginia, Silverbow, Mongolia, and EOG up 334%, 215%, 187%, and 102%, respectively. All except EOG outperformed the broader E&P sector, as proxied by XOP (which was up 157% during the past twelve months). However, that stock price performance is largely driven by the exceptionally low starting point in March 2020, as the Saudi/Russian price war and reduced demand due to COVID-19 lockdowns created significant concern among investors regarding the financial position of E&P companies, especially those with significant leverage. Stock prices for the four companies remain below all-time highs.EOG Doubles Down on “Double Premium” LocationsIn their Q4 2020 earnings call and presentation, EOG touted its inventory of “Double Premium” locations, which meet EOG’s new return hurdle of 60% Direct After-Tax Rate of Return (ATROR) at $40 oil and $2.50 natural gas. While not clearly defined, EOG describes Direct ATROR as including “the costs associated with drilling and completion operations and well site facilities.” All-In ATROR, which is more akin to a full-cycle calculation, “includes such costs as well as (i) the costs associated with other facilities, lease acquisitions, delay rentals and gathering and processing operations and (ii) geological and geophysical costs, exploration G&A costs, capitalized interest and other miscellaneous costs.” Per EOG’s presentation, roughly half of EOG’s 11,500 premium locations fit the underwriting criteria to be classified as “double premium.”However, E&P companies have long been criticized for touting well-level IRRs and other bespoke financial metrics that imply phenomenal economics, but don’t seem to result in corresponding corporate-level returns. We’ll see if EOG’s more stringent underwriting standards translate to shareholder returns.ConclusionThe Eagle Ford was among the regions hardest hit by low commodity prices. The recent increase in rig count bodes well for stemming production declines, though more rigs are likely needed for material production growth given natural declines in existing production. However, with investors and E&P management teams focused on returns rather than growth, current commodity prices may not lead to the expansion in the activity that’s been seen in previous cycles.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

E&P Second Quarter 2021

Permian Basin

Permian Basin // The second quarter of 2021 saw rising commodity prices across the board, with WTI and Henry Hub surpassing $70/bbl and $3.50/ mmbtu, respectively.

Transportation & Logistics Newsletter

Second Quarter 2021

Demand for services in the logistics industry is tied to the level of domestic industrial production.

Human Input in Investment Management Is a Feature, Not a Bug

In the mid-1970s, sports car racing requirements changed such that manufacturers could only race models that were also widely available through dealer networks. Porsche responded by developing the 930 Turbo, a 911 Carrera with upgraded suspension, larger brakes, and an uprated version of its six-cylinder boxer motor enhanced by a large diameter turbocharger. The 930 turbo became popular with enthusiasts as it was the fastest car built in Germany. For unskilled drivers, it was also quite dangerous. With a twitchy, short wheelbase prone to oversteer and non-linear gushes of power from the turbocharger, it was all too easy to spin – even in ideal conditions. As a consequence, the 930 Turbo earned the nickname that has stuck with it: the Widowmaker.To those who enjoy a direct connection with the road, the difficulty of controlling a vintage 930 Turbo at the limit is a feature, not a bug. The short wheelbase and rear-weight bias that produce oversteer make the car responsive, not dangerous. And the surge of power from the turbocharger makes the car undeniably fast – so long as it’s pointed in the right direction. If you can stay ahead of the car and master the capabilities of a 930 Turbo, you know you’re a good driver.Is human input in investment management a feature, or a bug? A generation of CFA charterholders have endured a curriculum that forcefully documents the futility of active management. The second decade of the millennium seemed to back this up, as anyone who owned anything other than a long-only position in an S&P 500 index fund probably regretted it. Even in an innovation economy, a cap-weighted index that favored big tech beat most alternatives. Thinking seemed overrated.Then the pandemic hit, and suddenly all asset pricing was non-linear. With a K-shaped recovery, an unsteady bond market, sagging dollar, a resurgence in value stocks, and talk of inflation, there’s no idiot-proof approach to investing.Does the market agree? Affiliated Managers Group share price sagged for years, dropping along with prospects for the active managers it acquired over the years. AMG hit bottom on March 20, 2020, closing under $50 per share. It’s approximately triple that today – back to levels it hasn’t seen since the summer of 2018. Franklin Resources’ shares are trading at double what they were a year ago, as are Silvercrest, Diamond Hill, Federated, and T. Rowe Price. Not every publicly traded asset manager has performed that well, but the turnaround in fortunes on many firms’ five-year charts is worth a look.Sometimes it seems like investment management is going to be entirely performed by one cloud server. We talk with many in the wealth management space who think active asset management has already been entirely supplanted by indexed products. And we know more than a few asset managers who think wealth management services could be performed just as well by robo-advisors. Our experience has been that human input finds unique solutions, secures and strengthens relationships, and ultimately provides clients with the best outcomes. Algorithms can be great tools, so long as their user has great skills.The capable but tricky 930 Turbo was not the start of a trend. Today, automakers are focused on building cars that will be self-parking, self-driving transportation vessels to mindlessly convey occupants in hermetically sealed cocoons. Even current iterations of the Porsche Turbo have all-wheel drive, traction control, automatic transmissions, and enough engine management systems to make them practically idiot-proof. But dumbing down driving doesn’t produce better drivers, any more than dumbing down investment management improves investment outcomes. Thinking still matters in this industry, thankfully. It’s also more fun.

What’s in a Multiple?

Blue Sky Multiples Improved in 2020 After a Rocky Start, and Buyers Weigh Multiple Years of Earnings

Multiples and Methodologies Moved Considerably Through 2020Prior to the tumultuous 2020, Blue Sky multiples for many brands could be relatively stable over numerous quarters. As seen in later charts, multiples don’t tend to shift dramatically on a quarterly basis. Multiples are dependent on numerous factors, though brand desirability is chief among them. This is usually tied to product lineup and the overall effectiveness of the OEM. However, the Covid-19 pandemic increased volatility in the economy to such a level that Blue Sky multiples reacted in a similar fashion regardless of brand. While multiples changed on a quarterly basis throughout 2020, notably, so did the earnings stream to which buyers applied the Blue Sky multiples.According to Haig Partners, buyers have historically focused on adjusted profits from the last twelve months, which has been viewed as the best indication of expectations for the next year. Throughout most of 2020, Haig’s reported Blue Sky multiples were applied to 2019 earnings as these were viewed as the best indication of a dealership’s “run rate” prior to any COVID impact. When profitability improved and uncertainty began to decline around June 2020, multiples applied on these 2019 earnings rebounded. Now into 2021, Haig reports that buyers are using a three-year average of adjusted profits from 2018 through 2020 as the best prediction of future profits. This comports better with the approach taken by Mercer Capital. Given the longer product life cycles, we have historically and continue to take a more long-term approach when assessing the ongoing earning power of an auto dealership.Given the longer product life cycles, we have historically and continue to take a more long-term approach when assessing the ongoing earning power of an auto dealership.Dealers will likely need to ramp back up staffing levels and advertising to support sales, but strong demand relative to constrained supply has led to higher gross profits for dealers. While dealers are optimistic that the cost savings will be “sticky,” we note ten years of slow, consistent growth since the Great Recession led dealers to such an environment where there were excesses that could be cut out of the cost structure. We see earnings and sales levels normalizing which only bolsters the need to consider earnings in a multi-period context.Illustrative Example: LexusTo show the variance in Blue Sky values in 2020, we’re going to take pre-tax earnings for average luxury dealerships as reported by NADA and apply them to the appropriate multiple. Since Lexus was one of the largest movers and has the widest range, we’re cherry picking them as the best illustrative example.In Q4 2019, Haig Partners reported a Blue Sky multiple range of 6.5x to 8.0x for Lexus dealerships. With 2019 pre-tax earnings of $2.2 million for the average luxury dealership, implied Blue Sky value for the average franchise would range between $14.5 million and $17.9 million. In Q1 2020, the multiple declined by 0.50x on the top and bottom end, dropping implied Blue Sky values to a range of $13.4 million to $16.7 million. By Q4 2020, multiples and earnings each increased significantly, and Lexus was up to a range of 8.0x to 10.0x as seen on the below graph. We note the range for Lexus dealerships has widened to two full turns of pre-tax earnings, or rather, two full years of profits. Applied to the three year average pre-tax earnings of the average luxury dealership, the difference in an 8x or 10x multiple represents a $5.3 million difference. High end multiple dealerships would have seen a value increase of $9.6 million ($16.7 million to $26.3 million) in that time, or 57.3%. While this appears high and all dealerships have their own unique characteristics, for context, the S&P 500 index was up 45.3% from March 31 to December 31. Without any context on the reported multiples (the red and green lines above), one might think that values were stagnant in Q4. However, the multiples reported by Haig are now being applied to 3-year average earnings instead of 2019 earnings. For the average luxury dealership, 2019 pre-tax earnings were $2.2 million, which were below 2018. Factoring in the higher earnings of $3.4 million in 2020, the 3-year average is $2.6 million. So, as seen on the graph, a dealership on the top end of the range saw their value increase by approximately $4 million as higher earnings are applied to multiples that held firm. Multiples reported by Haig are now being applied to 3-year average earnings instead of 2019 earnings.Deal Activity Can be Positively Correlated to MultiplesA multiple is a function of risk and growth, and certainly the outlook in March 2020 was higher risk than in in quarters prior to the pandemic. However, as seen below, very few transactions actually occurred during the initial economic decline as sellers were less interested in disposing of their most valuable asset at bargain prices. We note deal activity in 2020 was positively correlated with multiples, which makes intuitive sense and indicates a seller’s market in the back half of the year.Blue Sky MultiplesIn Q1, virtually every brand covered in the Haig Report saw a decline in their Blue Sky multiple. Fortunately, as SAAR rebounded, heightened levels of uncertainty abated, and dealers and the country at large embraced and adapted to the new normal, valuations partially recovered in Q2. With reduced uncertainty and higher profits, every brand except Volvo and VW received a higher blue sky multiple in Q3 2020 than Q4 2019 (pre-pandemic). In Q4 2020, the only multiple range that changed was that for Toyota which crept into the lead for mid-line imports.Luxury BrandsLuxury Blue Sky multiples followed the overall trend described above with drops in Q1, partial rebounds in Q2, then improved multiples in Q3, all relative to Q4 2019 multiples and earnings. Lexus saw the highest increase, from 6.0-7.5x in Q1 2020 to 8-10x in Q4. On the other end of the spectrum, Infiniti, Cadillac, and Lincoln continue to languish as brands without multiples, commanding a Blue Sky value range of up to $1.5 million. Each of these brands suffers from a myriad of issues, including costly facility upgrade requirements, which tend to weigh on Blue Sky values.Mid-Line Import BrandsMid-Line Imports multiples also followed the overall trend, as only VW’s Q4 wasn’t higher in 2020 than 2019 (each 3.0x – 4.0x). Nissan’s Blue Sky multiple in Q1 2020 declined to a paltry 1.5x on the low end, the lowest ever reported by Haig for any brand dating back to 2013. This was driven by troubles that began before the pandemic as corporate turmoil and an aging lineup weighed on dealer profits. At Q4 2020, this had rebounded to 3.0x – 4.0x, the highest for the brand since Q2 2018. Dealers that held on during the last few years have been rewarded. As noted previously, at the top end of mid-line imports, Toyota snuck its nose ahead of Honda, to pace the segment at 6.25x – 7.25x, on par with Jaguar/Land-Rover and Audi. Q2 and Q4 2020 were the only two quarters on record in which Toyota dealers have outpaced Honda, albeit only at a quarter turn multiple difference. Meanwhile, Subaru has caught up to Honda at 6.0x – 7.0x, a gap that has steadily narrowed since Subaru was closer to a 4.0x-5.0x multiple in 2016.Domestic BrandsDomestic franchises continue to move largely in lockstep with each other as Buick-GMC remains just below the others who command a 3.5x to 4.5x multiple. Domestics continue to outpace many of the mid-line imports, reminding everyone that vehicle pricing power is not the sole consideration in these multiples. Luxury vehicles frequently receive the highest multiples. However, three luxury brands continue to not even receive a multiple while Volvo and Acura are on par or below their domestic counterparts.ConclusionBlue Sky multiples provide a useful way to understand the intangible value of a dealership and its corresponding franchise rights. These multiples provide context for someone familiar with the auto dealer space but perhaps not the specific dealership in question. Buyers don’t directly determine the price they are willing to pay based on Blue Sky multiples; they analyze the dealership and determine their expectation for future earnings capacity (perhaps within the context of a pre-existing dealership where synergies may be present) as well as the risk and growth potential of said earnings stream. The resulting price they are willing to pay can then be communicated and evaluated through a Blue Sky multiple, and if a dealer feels they are being reasonably compensated, they may choose to sell.For dealers not yet looking to sell, Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze these key drivers of value. We also help our dealer clients understand how their dealership may, or may not, fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to learn more about the value of your dealership.

Eagle Ford M&A

Transaction Activity Slows Amid Challenges of 2020

Over the last year, deal activity in the Eagle Ford was relatively muted after the impact that the Saudi-Russian conflict and COVID-19 had on the price environment. M&A deals were largely halted in the second quarter of 2020 as companies turned to survival mode amid challenging realities. Frankly, transaction due diligence was most likely last on companies’ agendas. However, announced, and rumored transactions in the Eagle Ford picked up, relative to early 2020, towards the second half of the year as a price recovery began to take hold.Recent Transactions in the Eagle FordA table detailing E&P transaction activity in the Eagle Ford over the last twelve months is shown below. Relative to 2019, deal count decreased by four, and median deal size declined by approximately $74 million, however it is important to note the small sample of disclosed deal metrics.Chevron Adds to Eagle Ford Play and Global Portfolio with Noble AcquisitionOn July 20, 2020, Chevron announced that it was acquiring Noble Energy, Inc. in an all-stock transaction valued at $10.38 per Noble share, based on the price of Chevron’s stock before the announcement and an exchange ratio of 0.1191 Chevron shares per Noble share, representing an approximate premium of nearly 12% on a 10-day average based on the closing prices as of July 17, 2020. The total enterprise value of the deal (including debt) was pegged at $13 billion in the transaction press release. The deal closed on October 5, 2020, marking the completion of the first big-dollar energy deal since the market turmoil began in March 2020. The acquisition makes Chevron the second U.S. shale oil producer behind EOG Resources, Inc. Noble’s international plays also add 1 Bcf of international natural gas reserve to Chevron’s portfolio. Noble Energy’s domestic plays include the Permian Basin, Denver-Julesburg Basin, and the Eagle Ford.Ovintiv Further Deleverages with Eagle Ford Asset SaleOn March 24, 2021, Ovintiv Inc. agreed to sell its South Texas assets for $880 million to Validus Energy (portfolio company of Pontem Energy Capital), a privately owned operator. The transaction occurred roughly two weeks after sources rumored that Ovintiv was in advanced discussions to divest its Eagle Ford assets. The deal announcement comes shortly after Ovintiv’s debt reduction initiative outlined in February 2021, which includes generating approximately $1 billion by divesting certain domestic and international assets. In 2019, Ovintiv’s debt increased to nearly $7 billion after its purchase of Newfield Exploration. The company aims to reduce debt by 35% to about $4.5 billion by 2022 in order to gain investor confidence. The company announced that the transaction will allow them to reach the debt target by the middle of next year. Ovintiv has divested two geographic positions in consecutive quarters, with the first sale being their Duvernay position in Q4 2020. The company’s Eagle Ford position was purchased for $3.1 billion in 2014 from Freeport-McMoRan Inc. The company expects the deal to close in the second quarter of 2021.ConclusionM&A transaction activity in the Eagle Ford was fairly quiet throughout 2020 before Chevron’s $13 billion deal with Noble Energy. The Chevron-Noble Energy transaction and the Ovintiv-Validus deal could be foreshadowing a busier M&A market in 2021, whether companies try to bolt onto previous acreage, or are forced to divest to pay down debt.Mercer Capital has assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, we provide investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. Our Professionals also have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate, and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence

Six Events That Trigger the Need for a Valuation

Auto dealers, like most business owners, are focused on many aspects of their business: daily operations, strategic vision, competition, industry conditions, the state of the economy, etc. It is less common for auto dealers to be concerned if/when their business might need to be valued. Often, they are made aware of the need for these services by their trusted advisors including attorneys, financial planners, accountants, etc.What are common events that trigger the need for a valuation for an auto dealership?1. Estate Planning/Wealth TransferOver time, successful dealerships can accumulate tremendous value. Estate planning allows the first generation of a family to transfer wealth to the next generation through various mechanisms.Individuals and couples can take advantage of the lifetime exemption amounts by transferring value up to the current taxable exemption of $11.7 million for individuals or $23.4 million for couples over their lifetime.1 Gifting strategies can also utilize the annual exclusion amount of $15,000 per individual.Implementation of these strategies includes many different structures requiring the valuation of the auto dealership and the specific interest being transferred. A proper valuation assists in protecting the integrity of these transactions. Failure to support the concluded figures with a proper valuation can often lead to these transactions being challenged or audited, causing a later described litigation dispute.2. Death of a Dealer Principal/OwnerFor certain estates, an income tax return and Form-706 will have to be filed in a timely manner after the date of death. If the decedent is an owner of a business, or in this case an auto dealership, the value of the decedent’s interest will have to be valued. The valuation will need to be performed by a qualified business appraiser that can support the value of the dealership and specific ownership interest through accepted methodologies.3. Buy-Sell AgreementIn a prior blog post, we discussed the seven elements of a highly effective buy-sell agreement. This document, along with other corporate governance documents, describes the process and criteria for a business valuation and often requires an initial valuation to set the stock price for triggering events that will be governed by the document. Further, some buy-sell agreements require updated valuations at regular intervals or upon the occurrence of future triggering events. Following the provisions in these documents and maintaining regular valuations can aid in limiting or avoiding litigation disputes.4. Strategic PlanningBusiness valuations can also assist auto dealers with strategic planning. Not only can a valuation provide an indication of value at a specified point in time, but successive or regular valuations can track value over time. These valuations could be helpful for auto dealers contemplating incentive programs to reward ownership to key management. Auto dealers can also discover the value drivers of the current appraisal and set goals to enhance value through the improvement of those value drivers over time.5. Potential Sale of DealershipAt some point, successful dealers may reach the point where they contemplate a possible exit event. If there isn’t a viable second generation to continue the operations, a sale of the dealership may be the next best option.The auto dealer industry proved to be resilient and adaptable posting strong profitability for 2020 and continuing into 2021. Industry transaction activity also appears high for both public and private acquirors. Most auto dealers that have owned a dealership for a period of time have likely been contacted at one point or another with some interest either by phone or through the mail.If you have not had a recent business valuation, how can you evaluate any offers or know what your dealership is worth? A business valuation can inform you as to the value of the dealership and manage expectations to assess potential offers.6. Litigation DisputeThe next three events that we will describe all fall under the umbrella of litigation, but each is a unique event.Shareholder DisputesShareholder disputes can come in many forms: breach of contract, wrongful termination, damages, etc. In any of these scenarios, the value of the entire dealership and a specific ownership interest will be contested. A valuation and possibly testimony can assist the attorneys and/or triers of fact determine the outcome of the case. Certain components of an auto dealership’s value, such as Blue Sky Value, can also be critical to the case. Taxation DisputeIf a proper valuation was not utilized in an estate planning transfer or if the valuation is being challenged by the IRS, another form of litigation involving a taxation dispute could arise. These disputes require similar elements as in a shareholder dispute – valuation of the dealership, value of specific ownership interest, and possibly testimony. A unique element of taxation disputes is that generally an expert’s valuation report also serves as their direct testimony should the matter end up in trial. The valuation report must communicate the expert’s methodology and support for their conclusions for the value of the dealership and any applicable discounts such as lack of marketability, lack of voting rights, etc. Family Law DisputeWhile not a popular topic, dealers or their spouses in the midst of divorce would also be in need of a business valuation and potential expert witness services. In a divorce, all of the couple’s assets and liabilities need to be compiled and valued to assist the attorneys and trier of fact in the division of assets and other matters.Some assets, such as bank accounts and real estate, are easier to value. Other assets, such as business assets can be more difficult to value. In the auto dealer universe, these business assets can consist of more than one entity. Many dealerships are organized where the dealership operations and franchise agreements are contained in one entity, while the underlying real estate may be owned by a separate asset holding entity.In this example, both entities would need to be valued and the methodologies to value each are different. Some auto dealers may also own additional entities such as separate repair and body shops or re-insurance companies that also might require a business valuation.ConclusionBusiness valuations are triggered by numerous events. By knowing the events that dictate the need for a valuation, auto dealers can be more educated in the use of these services. As we have previously written, the auto dealer industry is unique to valuation in the methodologies employed, the terminology communicated, and the financial information utilized. When a valuation need arises, auto dealers are best served by someone who is both a valuation expert or an industry expert.Contact a professional at Mercer Capital to assist with you a business valuation or consultation of your auto dealership and related businesses for any of these events or others.1 The lifetime exemption amounts, estate income tax rates, and corporate income tax rates could all be subject to change with the new administration in the White House and change of control in the Legislative Branch. These changes could have a dramatic impact on business valuations and the need for related services.

Value Finally Outperforms Growth After Twelve Year Lull

Value Stocks Are Finally Besting Growth, But Is It Sustainable?

Growth-style investments have outpaced their value counterparts by a considerable margin since the Financial Crisis of 2008 and 2009. Propelled by an 11-year bull market from 2009 to 2020 and additional lift to tech stocks in a work-from-home environment, growth investing dominated value-oriented equities until just a few months ago. Now, the long-running trendline appears to be rolling over.With rapid vaccination rollouts and continued improvements in the global economy, value stocks, which were especially depressed by the pandemic this time last year, have soared relative to growth strategies over the last few months. If you believe in mean reversion, value’s comeback was inevitable and probably has some room to run. We’ve blogged about this before (Are Value Managers Undervalued?), and while we were a bit premature on the timing (we’re never wrong), it appears that this mean reversion is finally taking place. We don’t know how long this value resurgence will last, but given the duration and magnitude of growth’s prior reign (see first chart above), it’s not unreasonable to assume it could endure for a few more years at least. On the flip side, growth-oriented investment firms may finally have to deal with poor returns (relative to the market) in addition to prevailing industry headwinds like fee compression and asset outflows to passive products. Most value asset managers have already adapted to this double whammy, so growth firms should prepare for potential AUM losses if we’ve really hit another inflection point in the value versus growth rivalry. Value firms, on the other hand, are finally starting to shine. After years of outflows and subpar returns, publicly-traded value managers, Gabelli (GBL), Diamond Hill (DHIL), and Pzena (PZN) have significantly outperformed the S&P 500 (navy blue line below) since the vaccine announcement in early November. [caption id="attachment_36465" align="alignnone" width="800"]Source: S&P Global Market Intelligence[/caption] This recent outperformance suggests that value’s dominance could persist a few more years if the market is anticipating significantly higher inflows, AUM balances, and ultimately greater revenue and earnings figures in the coming quarters. Increased investor optimism surrounding the share prices of value firms is perhaps the best indication of a value resurgence even if we have only just started seeing that in the actual numbers. Value firms may finally be enjoying their heyday, but sector risks remain. Much of this resurgence is attributable to continued vaccination rollouts and a swift economic recovery, and any setbacks on either of these fronts could derail value’s recent momentum. Since most U.S. indices are trading close to an all-time high, the market doesn’t seem too worried about this, but last year has shown us how quickly investor sentiment can change. The quest for yield in a zero interest rate environment has also increased demand for value stock dividends, but the recent rise in Treasury yields could curb their relative advantage. It’s too early to call it a full recovery, given the decade-plus dominance of growth preceding this uptick, but recent progress is promising for the sector. We may again be premature in calling this, but we are taking note of what appears to be an important inflection point for the active management industry.

Chasing Waterfalls: How Volatile Equity Structures Are Changing Returns

Oil and gas asset values have experienced tremendous volatility over the past year. They have almost returned to where they started in 2020. However, most investors have experienced that unpredictable possibility differently than their assets have since they are not actually participating directly in assets. I am not just talking about debt leverage effects here either. Instead, people are investing in an entity that, in turn, owns and operates a group of assets. These equity and entity structures can change volatility exposure depending on how it is constructed. This includes what is known by multiple names, but generally called an equity distribution waterfall. Investopedia defines a distribution waterfall as “a way to allocate investment returns or capital gains among participants of a group or pooled investment.” The operative word there is “allocate.”Distribution waterfalls are mechanisms to allocate not only profit but also risk. Frequently found in joint venture arrangements and other financing structures such as DrillCos, distribution waterfalls have become a popular arrangement in recent years. The possibilities of an equity allocation are technically and practically endless yet generally negotiable. However, they often follow a typical framework. First, there is usually language in agreements for return of capital provisions, often followed by a preferred return provision. Lastly, residual returns are then usually subject to some form of payout split between investors. Some investors provide capital at the outset of the project which is a key economic factor for the distribution waterfall. Other investors provide non-capital contributions such as management expertise, technology, or assets in-kind. These different contributions can be beneficial to the entity by improving capital efficiency, synergizing expertise, creating optionality in varying respects or accelerating development timing.Things get interesting when contributions convert into distributions from a sale or liquidity event. Each investor can have different return profiles depending on the waterfall structure. Incentives can vary too. Sometimes they can be aligned, other times not so much. Take a hypothetical and simplified example; An upstream partnership is formed between an investor with mostly capital and a knowledgeable management team. $10 million of capital is provided to fund the assets in a domestic play with $9 million contributed by the investor and $1 million by the management team. No debt is procured. Each investor agrees that the distribution waterfall will begin with a return of each investor’s capital pro-rata, then secondly earn a 7% preferred return, lastly, residual cash flow is split 70/30. The management team runs the business and is reasonably compensated during this time. In five years, they sell the assets for $13.5 million.[caption id="attachment_36425" align="alignnone" width="777"]Hypothetical example of the waterfall analysis | Source: Mercer Capital[/caption] The returns for the partners might look something like this: [caption id="attachment_36429" align="alignnone" width="618"]Hypothetical example of the waterfall analysis | Source: Mercer Capital[/caption] At first glance, this appears pretty simple. The payout made it only through the first two tiers of the waterfall with no residual cash flow to split in the 70/30 tranche. Everyone makes out the same. However, look at what happens when the total equity returns notch up to say $20 million in that same five-year period in this structure: [caption id="attachment_36427" align="alignnone" width="640"]Hypothetical example of the waterfall analysis | Source: Mercer Capital[/caption] Both investors benefit in this scenario, but now the management team (general partner) has much higher relative return metrics relative to its original investment. In fact, they’ve more than doubled the limited partners’ returns from an IRR perspective and had over one turn better from a cash-on-cash perspective. That is great, however, this example assumes strong returns. That has not been the reality for most oil and gas ventures in the past year. What happens when asset values go down? First, holding periods are sometimes extended if they can be to attempt to ride out the storm. In addition, further investments, and capital expenditures typically get trimmed, which can conserve cash but this can also generate strain on business plans, growth and holding periods leading to disagreements between management and investors on which path to take. Take the same example and assume a $5 million total return pot: [caption id="attachment_36428" align="alignnone" width="614"]Hypothetical example of the waterfall analysis | Source: Mercer Capital[/caption] The limited partner in this example has lost 9x as much as the general partner management team because they had that much more to lose. Now, most parties prefer not to absorb that type of loss so what can also happen is the parties can extent holding periods in the hope that the time value optionality can prove fruitful to higher asset values later down the line. This can work, but not always. The math is relatively straightforward in a liquidity event. But what about transactions that occur prior to a liquidity event? How do you account for the different payoff structures for components of the capital stock? This is increasingly relevant as liquidity events have been deferred considering market conditions, and management teams are having difficult conversations with sponsors as portfolio companies are being consolidated (often referred to as “SmashCos”). NGP did this last year with some of its portfolio companies. Quantum Energy Partners did this for two of its Haynesville Midstream companies as well. This brings up a delicate issue of how to re-allocate management’s equity ownership. The payoff structure of the waterfall is critical, as the value of a capital component does not necessarily equal its value under a liquidation scenario today. Just like stock options, certain capital components have optionality that results in incremental value over what is implied by the company’s current value. I have dealt with these option pricing models and scenario analyses, and sometimes they can reflect significant value beyond what a simple waterfall allocation might imply. What is clear is that returns for the same asset can diverge quickly among different equity classes can end up being dramatically different over the course of an investment. Therefore, how they are set up can heavily influence the sometimes-delicate dance between equity holders. When asset values are high, then tensions among investors tend to ease, but in environments such as what we have seen recently, it can exacerbate them too. Originally appeared on Forbes.com on March 10, 2021.

Common Valuation Misconceptions About Your RIA

Old Rules of Thumb, Recent Headlines, and the Endowment Effect

As a financial analyst, a CFA charter holder, and a generally reasonable person, I know that Zillow isn’t accurate; but as a homeowner, I can’t help myself. When I am walking around my neighborhood, I always have the Zillow App open, and am speculating about how the “Z-estimate” for my house compares to my neighbors’. And, of course, my house always is better. Why? Because I own it. It’s called the endowment effect. I (as a homeowner) am emotionally biased to believe that something (my house) is valued higher than the market would ascribe, simply because I already own it.And you, the owner of an RIA, may believe your firm is valued higher than the market value too, and old rules of thumb and recent industry headlines amplify the problem.Old Rules of Thumb: Your RIA is Worth 2% of AUMWe have cautioned the use of AUM and Revenue-based multiples before, and an example has proven to be the best way to communicate the unreliability of such metrics. Consider, Firm A and Firm B, which both have the same AUM. Firm A has a higher realized fee than Firm B (100 bps vs 40 bps) and also operates more efficiently (25% EBITDA margin vs 10% EBITDA margin). The result is that Firm A generates $2.5 million in EBITDA versus Firm B’s $400 thousand despite both firms having the same AUM. The “2% of AUM” rule of thumb implies an EBITDA multiple of 8.0x for Firm A—a multiple that may or may not be reasonable for Firm A given current market conditions and Firm A’s risk and growth profile, but which is nevertheless within the historical range of what might be considered reasonable. The same “2% of AUM” rule of thumb applied to Firm B implies an EBITDA multiple of 50.0x—a multiple which is unlikely to be considered reasonable in any market conditions. Recent Headlines: Your RIA is Worth 10x EBITDADeal activity in the investment management space has been increasing over the last decade as consolidation has increased and outside investors realized the attractiveness of a recurring revenue stream paired with minimal capital investment. But the headlines touting impressive deal multiples really seemed to pick-up in 2019 with Goldman’s acquisition of United Capital. However, most of the acquisitions that warrant headlines are of larger investment managers, which due to their sheer scale, are less risky and therefore warrant a higher multiple.Mixing old rules of thumb, with recent headlines, and the endowment effect typically results in over valuing, which stems from an underestimation of non-systematic risk.Underestimating Non-Systematic RiskMost investment managers understand that their firm, like any publicly traded company in their clients’ portfolios, is exposed to systematic and non-systematic risks. And most seem to understand that investment management firms are subject to certain industry-wide risks such as the move from passive to active investment products and fee compression. But many investment management firms also have significant “firm-specific risks” that make their firm riskier than a much larger investment management firm. Many small to mid-sized investment management firms suffer from client concentrations, aging client bases, unclear succession plans, a lack of scale, and minimal asset growth (absent market appreciation).Unfortunately, understanding the value of your RIA is not as easy as applying a multiple to your AUM or run-rate EBITDA. Value is a factor of cash flow, growth, and risk. We’ve written a lot about investment management firm valuations:RIA Margins – How Does Your Firm’s Margin Affect Its Value?What Are RIA Valuations TodayValuing RIAs But, don’t hesitate to give us a call if we can be of assistance.

February 2021 SAAR

Several Factors Put Pressure on February SAAR, Contributing to a 5.4% Decline from January

As we previewed in our January 2021 SAAR post, February SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) declined as expected to 15.7 million from 16.6 million the previous month. This is a decline of 6.6% from the same period last year.However, given the circumstances with the winter storm that occurred this past month, many dealerships are most likely happy the decline wasn’t worse than it was. Furthermore, adjusting for calendar variances between this year and last also paints a different picture. February 2021 contained two fewer selling days and one fewer selling weekend than February 2020. When this is taken into consideration, JD Power reported retail sales actually increased 3.3% compared to the year prior. SAAR continues to be dragged down by lagging fleet performance.Inventory levels remain tight due to both strong retail demand and the current microchip shortage. According to NADA Marketbeat, the global semiconductor microchip shortage is expected to cause production losses in North America around 250,000 in the first quarter of 2021. Nearly all OEMs have been affected, and it continues to add pressure on already tight inventory levels. However, the shortages are anticipated to resolve by Q3 of this year.The tight inventory levels are having impacts on average vehicle days on the lots, manufacturer incentives, and transaction prices. As noted in JD Power’s February 2021 Automotive Forecast, the average number of days a new vehicle sits on a dealer’s lot before being sold is on pace to fall to 53 days, down 18 days from last year.For incentives, higher levels of vehicle turnover translates to manufacturers not feeling much pressure to offer discounts. The average manufacturer incentive is anticipated to be $3,562 per vehicle for February, a decrease of $614 from a year ago.Related to these declines in incentives, average transaction prices continue to be strong. Transaction prices are going up due to low supply most likely. Incentives go up when demand declines and they need to incentivize the purchases. JD Power notes that average transaction prices are expected to reach another monthly high, rising to 9.8% to $37,524, the highest ever for the month of February and nearly at the record set in December 2020.On the matter of the February SAAR, Thomas King, president of the data and analytics division at J.D. Power noted:"While the ongoing strength of the sales rate is impressive, the transaction prices and profitability of those sales is nothing short of remarkable. The combination of strong retail sales, higher transaction prices and smaller discounts means that February 2021 likely will be one of the most profitable Februarys ever for both retailers and manufacturers. As February results will show, while inventories are lean, there is still enough inventory to maintain positive sales growth in the near term. However, the lingering risk to the current retail sales pace for the balance of the year is supply chain disruption.”March ExpectationsAs we turn our attention to March, there are several positive tailwinds that could prove beneficial for SAAR, as well as potential headwinds.WeatherWith the winter storms that crippled Texas and much of the southeast behind us, there are hopes that March is going to bring back a sense of normalcy. Pent-up demand stemming from people being indoors due to the weather could prove to be a positive force for March SAAR. Anecdotally, daylight savings time always puts me in a good mood when it’s not dark outside at the end of the workday. We believe this will pair well with the below tailwinds.Government StimulusOn March 11, President Joe Biden signed a sweeping $1.9 trillion COVID-19 economic relief package into law.Key features of the plan include up to $1,400-per-person stimulus payments that will send money to about 90% of households, a $300 federal boost to weekly jobless benefits, an expansion of the child tax credit of up to $3,600 per child and $350 billion in state and local aid. Additionally, billions of dollars will be distributed among K-12 schools to help students return to the classroom, small businesses hard-hit by the pandemic, and vaccine research, development, and distribution.The overall influx of cash into the economy is bound to have a positive impact on dealerships as consumer’s disposable income levels get a boost.Vaccine DistributionSince vaccine distribution began in the U.S. on December 14th, more than 107 million doses have been administered, reaching 21% of the total U.S. population. The U.S. is currently administering over 2.3 million shots a day. Furthermore, President Biden has issued a statement that vaccines be available to all Americans by May 1st. As the population continues to get vaccinated, there will be more opportunities for people to return to their day-to-day lives and participate in more in-person activities. This may prove to be a positive tailwind for dealerships that rely on in-person customer visits to move vehicles. We are cautiously optimistic that we will be able to attend summer auto conferences.Chip ShortagesAs we have touched on previously, the chip shortage is going to be a problem for boosting inventory levels until at least Q3 of this year. However, once the bottleneck due to the shortage is relieved, dealers should expect to be able to build back up their inventories. It will be interesting to see how gross margins perform as these shortages are alleviated.A Final NoteIf you have any questions about SAAR and what it means in the broader context of a valuation of your dealership, reach out to a member of Mercer Capital's Auto Dealer Industry Team. We hope that you and your loved ones are continuing to stay safe and healthy during this time!

February 2021 SAAR

Several Factors Put Pressure on February SAAR, Contributing to a 5.4% Decline from January

Mineral Aggregator Valuation Multiples Analysis

Market Data as of March 12, 2021

Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly-traded minerals ownership.Due to a variety of corporate structures (including master limited partnerships and Up-Cs) and complex capital structures (including preferred equity and non-traded common units), mineral aggregator enterprise values pulled from databases are often missing meaningful components of value, leading to skewed valuation multiples.Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis. Download our report below. Mineral Aggregator Valuation MultiplesDownload Analysis

2021 RIA Practice Management Insights Conference Recap

We want to thank everyone who attended or participated in our inaugural RIA Practice Management Insightsconference last week. We set out last year to create a conference geared towards the back-of-house issues that are critical to success, but don’t get as much attention as themes like M&A and consolidation at many conferences. To that end, we were fortunate to be able to compile a speaker list full of well-known experts on various practice management topics like firm culture, marketing, managing your tech stack, and more.Our opening keynote was delivered by the legendary Jim Grant of Grant’s Interest Rate Observer, whose presentation traced the origins of central banking from Victorian England through present day, providing a unique perspective on current asset prices. To wrap up the event, we were pleased to have Peter Nesvold of Nesvold Capital Partners deliver our closing keynote focused on the state of the industry and predictions for the future of wealth management.Other speakers included the following:Louis Diamond of Diamond Consultants spoke on advisor recruitment and acquisitions, and how to craft a world-class value proposition and targeting strategies.Matt Crow and Taryn Burgess of Mercer Capital spoke on compensation strategies, and how to best structure your firm’s compensation to recruit and retain talent.Matt Sonnen of PFI Advisors hosted a live recording of the COO Roundtable Podcast featuring guests Kara Armstrong of CapSouth Wealth Management and Nick Maggiulli of Ritzholtz Wealth Management.Kristen Schmidt of RIA Oasis spoke about the importance of your entire tech ecosystem.Matt Crow moderated a panel discussion on creating a collaborative firm culture featuring Terry Igo of SanCap Group, Sonya Mughal of Bailard, and Colin Sharp, the former COO of Riverbridge and now co-founder of Knoxbarret.Megan Carpenter of FiComm Partners spoke on developing a “New Skool” marketing mindset to drive business growth.Brooks Hamner and Zach Milam of Mercer Capital spoke on succession planning for RIAs.Steve Sanduski of Belay Advisor moderated a panel discussion on delivering value that goes beyond products and planning featuring Julie Littlechild of Absolute Engagement and Seth Streeter of Mission Wealth. Thanks again to everyone who attended and to everyone who helped make the event a success. We plan to publish updates regarding next year's conference as they become available. So, stay tuned and we hope to see you next year!

Q4 2020 Earnings Calls

Sales Return Quicker than SG&A Expenses, But Inventories Continue to Lag Amid Chip Shortages

Fourth quarter earnings calls started similarly to the previous quarter, with significant increases in earnings per share as lower volumes were supported by higher margins and SG&A expense reductions related to personnel and ad spend continue to benefit dealers. Executives generally believe a portion, though not all, of this expense savings will be sustainable. Productivity has increased as employment levels have remained low despite improving activity.Long-term, however, low headcount and insufficient ad spend maybe a drag on incremental sales.February 2021 SAAR was already anticipated to be down from February 2020. February 2020 was the last month prior to the pandemic, did not have supply constraints related to chip shortages, and had a leap day fall on a Saturday.To compound problems, winter storms in certain areas of the country kept more people at home than mask mandates have in recent months. Most earnings calls occurred before the storms or there was little mention of them. AutoNation referenced January volumes in line with projections, affirming their forecast of approximately 16 million for 2021, though there was no discussion of the impact of the winter weather. Sonic indicated the storms closed some stores in their Texas, Birmingham, and Nashville markets, though they anticipate a quick rebound. Total volumes were down 12.6% in February 2021, but declines were closer to 5% after adjusting for selling days. However, we expect to see significant year-over-year improvements as we reach the one-year milestone of the pandemic.The proliferation of SPACs in 2020 and continuing into 2021 has been an interesting byproduct of the pandemic. While this has typically been for more speculative operations including EV startups, an article from Automotive News indicates some franchised dealers are mulling the possibility of accessing public capital markets through a SPAC. LMP Automotive, an ecommerce and facilities-based auto retailer already traded on the NASDAQ, closed on its first wave of auto dealerships on Friday, bringing the publicly traded group to seven. With these acquisitions, LMP will be considered in future earnings calls blogs.On the other hand, the number of public players could well decrease in 2021 as Lithia indicated consolidation amongst the public players may be the best way to ward off competition from used-only players like Carvana. Franchise agreements have long been seen as a hurdle for such significant consolidation, which was downplayed by Lithia. This prompted the question on future calls, and while many anticipate continued consolidation within the industry, Group 1 expressed doubts OEMs would approve such a deal, and AutoNation flat out rejected the notion as they are already the largest public auto dealer.Theme 1: Microchip shortages represent the latest hiccup in dealers’ quest to restore inventory levelsWe sat here a quarter ago and thought by the end of the first quarter days’ supply would be back up to normal. But because what's going on with the microchips and some other things, it's probably going to bleed well into the second quarter before inventories gets back. - David Hult, CEO, Asbury Automotive GroupWe're quite inventory constrained right now. As you know and we expect the new car inventory situation to continue to be constrained for probably the first half of the year. - Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 AutomotiveNew vehicle inventory levels remain constrained and we expect demand to exceed supply for an extended period. Given these dynamics, we remain focused on optimizing our business in the current operating environment. We expect industry sales to approach 16 million in 2021 with strong retail sales growth compared to last year. We have seen a solid growth in ‘21, with January trends in line with our annual forecast. - Mike Jackson, Chairman & CEO, AutoNationTheme 2: SG&A to gross profit anticipated to be structurally lower going forward after efficiencies gained during the pandemicSo we have to be below 70% [SG&A as a % of gross profit]. I think to be competitive. I think the world's moved on. So, yes so certainly we would expect to be significantly below a 70% level. As we've mentioned previously, although we do not expect this level to be sustainable, we do expect there to be significant improvement going forward versus pre-COVID levels. - Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 AutomotiveDuring 2020, we took targeted measures to improve operating efficiencies and manage expense throughout our entire organization, fundamentally improving our cost structure. As a result, we achieved all-time record adjusted SG&A expenses as a percentage of gross profit of 68.1% for the fourth quarter of 2020, down 560 basis points from 73.7% in the fourth quarter of 2019. Full year 2020 adjusted SG&A expenses as a percentage of gross profit were 72.9%, 400 basis points better than 2019. For 2021, we expect to continue to see a benefit of our permanent SG&A reductions. - Jeff Dyke, President, Sonic AutomotiveSG&A expense as a percentage of gross profit declined 940 basis points to 69.7% and declined 800 basis points on an adjusted basis to 71.1%. Our success in this area can be attributed to a reduction in T&E, advertising, vehicle maintenance, administrative, personnel and other fixed costs. We estimate that approximately 125 million to 150 million in SG&A costs have been eliminated across our various businesses. - Roger Penske, Chairman & CEO, Penske Automotive GroupWe also remain very active in managing expenses and we achieved SG&A as a percentage of gross profit of 61.4%. Our focus on gross profit and expense management once again produced a great quarter. […] We also changed our production per employee when the downturn hit, and we stayed disciplined with that. […] I think we'll certainly be in a much better position from an SG&A standpoint than we were pre-COVID. But where exactly […] I think there's too many variables to call that right now. “We sat here a quarter ago and thought by the end of the first quarter days’ supply would be back up to normal. But because what's going on with the microchips and some other things, it's probably going to bleed well into the second quarter before inventories gets back. - David Hult, CEO, Asbury Automotive GroupTheme 3: Lithia suggests public consolidation may be beneficial for entrenched franchised players seeking to ward off competition from rapidly growing used competitors. While other players doubt the likelihood of OEM support, industry-wide consolidation is anticipated to continueWe do believe that the best way to combat the entire industry is that the public should roll up, okay? And whether or not that can or can happen, we will tell you this, it's not restricted from framework agreements. We believe that we have strong relationships, and our national limitations in those 3 or 4 manufacturers that do have a ceiling established doesn't preclude us from buying any of the other public or joining forces. I do also like the fact that many of them appear to be replicating some of the strategies that we've been focused on over the last 3 years. And we're pleased to see that because I believe that the new car retailers, if we can cut off the stream of used vehicles to the used car new entrants in the space, and all they can really get is auction cars or late-model cars, the margins that we can make in the over 3- year-old cars are massive that the new car dealers could have a stronghold on the space for decades to come, even if electrification changes thing or connectivity or all the other things that are in all – in the back of all of our minds over the coming quarters, years and decades. - Bryan DeBoer, President, and CEO, Lithia MotorsI think there is a natural consolidation that needs to occur among the U.S. auto retail networks. There are simply too many dealers in many of the brands, not all of them, many of the brands to operate in efficient privately owned distribution network. […] And it's becoming more and more a big player game just because of capital investment and amortizing technology costs and the cost of developing people and things like that. So, I think that trend accelerates and that is the reason that there will be a lot of acquisition opportunities as they have been in the past few years […] And I think that will benefit the remaining larger retail groups. And I think it will benefit the OEMs. And so I think there, we're going to continue to move to an era of bigger partners for the OEMs. And - so I think that is very much a catalyst for these M&A opportunities. Now, the advantages of scale you know it would seem that we're not nearly as big as many other groups, yet we've been able to create a cost structure that's just about as competitive as any. So there is a diminishing point of return on scale, I think but there is a benefit to diversity of markets and brands that we can continue to benefit from. And there is potentially a widening of the gap between the ability to operate efficiently - for a smaller operator compared to a bigger operator. - Earl Hesterberg, President and CEO, Group 1 AutomotiveWhat I have experienced is that when you become as large as we are and you make an acquisition, takes a brand Z and you already own 25 brand Z stores and you want to buy number 26 and number 27, and the negotiation with the manufacturer, they will ask, okay, we will improve number 26 and number 27, but let me tell you what you have to do from store one through 25in order to get approval for the next increment. And if you really add that demand on to what you are acquiring, it really changes the return on investment and so the higher you climb the mountain the more difficult it becomes to keep climbing. […] So, the whole issue of consolidation whether two smaller public traded companies could come together, I can’t say, because I don’t have one of the smaller ones. But I can tell you as far as us acquiring one. I don’t see that’s just going to happen, because you immediately run into a problem of too much density in a given market that you are going to have to divest a significant part of what you just thought, at least that would be for us. So, overlap and too much density in the given market is a real genuine issue for us and so we will not be acquiring any other publicly traded company. I don’t see it pay off to the finish line. - Mike Jackson, Chairman & CEO, AutoNationConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These trends give insight to the market that may exist for a private dealership which informs our valuation engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Themes from Q4 2020 Earnings Calls

Mineral Aggregators

Last week, we reviewed the fourth-quarter earnings calls for a select group of E&P companies and briefly discussed the macroeconomic factors affecting the oil and gas industry. In this post, we focus on the key takeaways from mineral aggregators' fourth-quarter 2020 earnings calls.Status of M&A Activity Transaction activity was quiet for the majority of 2020 as commodity prices plummeted and companies entered survival mode. Aggregators explained that the bid-ask spread between buyers and sellers was wide throughout the year, but some believe that 2021 will offer a more active M&A environment due to their favorable outlook of an industry recovery.I think what we saw in late '19 and all of '20 is that the sellers, many of whom had acquired their assets in a different commodity environment and more active M&A environment, more expensive M&A environment, frankly. We're not looking to part with those assets in a cheaper, less expensive, less active M&A environment. And so, you just – you had a bit of a mismatch between sellers and buyers who had had their cost of capital beat up pretty hard. – Jeffrey Wood, President & CEO, Black Stone MineralsThe acquisition market was slow in 2020 as sellers did not want to part with assets at low prices, buyers were dealing with the high cost of capital and limited new capital availability and/or unwillingness to take on additional debt. – Tom Carter, CEO & Chairman of the Board, Black Stone MineralsWhen you look at the buyer and the seller, where you had an unsustainable, for example, commodity price period, it makes it more difficult for either the buyer or the seller to transact. And so that has been an impediment, but I think coming out on the other side of that cycle, having been at a more – a less volatile environment at a more constructive macro environment should be beneficial. – Bud Brigham, Founder & Executive Chairman, Brigham MineralsI think it’s all trending in a rational direction on the M&A front and I expect – not only us but also our other public peers to benefit from that. And then the other thing I’d say is people are getting used to selling for equity. We’re not going to lever up this business. – Davis Ravnaas, President, CFO & VP of Business Development, Kimbell Royalty PartnersRig Count & Production Recovery in SightAggregators were pleased to see a production and rig count recovery in sight. Production curtailments were put in place in response to the challenging price environment beginning in Q2, but many believe that the worst is behind the industry. Production levels remain down year-over-year, but companies are optimistic that they will continue to rise.In the fourth quarter, we began to see a strong recovery in drilling activity on our acreage, with a 30% increase in our rig count, coupled with good sequential improvements in commodity prices and revenue. We are optimistic about 2021 and the continuation of improvements in drilling activity, which is demonstrated by a 14% increase in the Baker Hughes Lower 48 rig count in February 2021 relative to year-end 2020. – Bob Ravnaas, Chairman & CEO, Kimbell Royalty PartnersAs of year-end, there were 38 rigs active on our acreage, and the count has grown to 50 rigs by the end of January. This is above the 29 rigs operating on us at the end of the third quarter, but it's down sharply from activity levels we saw a year ago. – Tom Carter, CEO & Chairman of the Board, Black Stone MineralsWe saw the rig count in those basins in the mid-500s in February of last year and then saw them decrease to around 150 rigs during the third quarter. In the fourth quarter, we saw a 40% rebound in the rig fleet, followed by a further 15% increase so far in the first quarter of 2021. As a result, we sit today up approximately 70% from the low point, but still around 300 rigs short of February a year ago. – Bud Brigham, Founder & Executive Chairman, Brigham MineralsViper also benefited from third-party operated well performance and timing of wells being turned to production outperforming our prior conservative expectations, which had been lowered due to the uncertainty presented by the volatile oil prices experienced early last year. – Travis Stice, CEO, Viper Energy PartnersAggregators Acting on Priorities Since mid-2020, a central theme of E&P companies and aggregators was to shore up balance sheets. Most aggregators delivered on their deleveraging agenda, whereas others, like Brigham Minerals, had no debt and were able to capitalize on the low-price environment. Aggregators are optimistic that their leverage levels will not be of concern entering the new year.Our first strategic priority was to further strengthen our liquidity and balance sheet position. We moved very early on in the year with aggressive actions to reduce our costs and reduce our debt. Over the course of the year, we paid down a total of $273 million of outstanding borrowings under our credit facility, funded by the proceeds from 2 asset sales that we completed in July, and from retained cash flow. – Tom Carter, CEO & Chairman of the Board, Black Stone MineralsThe company paid down $21 million of debt in 2020, and we plan to continue to allocate 25% of cash available for distribution to pay down a portion of our credit facility each quarter. – Bob Ravnaas, President, CFO & Chairman, Kimbell Royalty PartnersThe truly unique nature of Viper's business model is highlighted by the fact that during the fourth quarter alone, we were able to declare a $0.14 distribution, repurchase over 2 million units, and repay over $40 million in debt. Over the past nine months, we have now reduced total debt by $110 million or roughly 16% over this period. – Travis Stice, CEO, Viper Energy PartnersIn an entirely differentiated position, Brigham entered this disruption with no debt and flushed with cash. Having lived through tremendous volatility in the past, we were compelled to take bold action to compound value for our shareholders when others could not or did not want to. – Bud Brigham, Founder & Executive Chairman, Brigham MineralsConclusionBud Brigham, Founder and Executive Chairman of Brigham Minerals, summed up the last year in a nutshell on the company’s fourth-quarter earnings call, “The entirety of 2020 was filled with unprecedented volatility, triggered by the COVID-19 pandemic and the OPEC crisis from crude oil pricing to rig counts to frac crews as well as individual company performance. We started 2020 with $60 oil. Amazingly, it briefly went negative, and then oil spent most of the year around $40 to $45 per barrel. Markets have been healing. And today, we sit here with oil above $60 per barrel.” Aggregators seem ready to turn the page and enter 2021 with bullish hopes of a full industry recovery.Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly-traded minerals ownership. Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators. Contact a Mercer Capital professional to discuss your needs in confidence.

Mortgage Banking Lagniappe

2020 was a tough year for most of us. Schools and churches closed, sports were cancelled, and many lost their jobs. There were a select few, however, that thrived during 2020. Jeff Bezos and Elon Musk saw a meteoric rise in their personal net worth over the past 12 months. Mortgage bankers are another group showered with unexpected riches last year (and apparently this year).As shown in Figure 1, long-term U.S. Treasury and mortgage rates have been in a long-term secular decline for about four decades. Last year, long-term rates fell to all-time lows because of the COVID induced recession after having declined modestly in 2019 following too much Fed tightening in 2018. The surprise was not an uptick in refinancing activity, but that it was accompanied by a strong purchase market too. Housing was and still is hot; maybe too hot. Overlaid on the record volume (the Mortgage Bankers of America estimates $3.6 trillion of mortgages were originated in 2020 compared to $2.3 trillion in 2019 and $1.7 trillion in 2017 and 2018) was historically high gain on sale (“GOS”) margins. The industry was capacity constrained after cutting staff in 2018 when rates were then rising. Private equity and other owners of mortgage companies set their eyes on the public markets after many companies attempted to sell in 2018 with mixed success at best. During the second half of 2020, Rocket Mortgage ($RKT) and Guild Mortgage ($GHLD) made an initial public offering and began trading while seven other nonbank mortgage companies have either filed for an IPO or announced plans to do so. Also, United Wholesale Mortgage ($UWMC) went public by merging with a SPAC. The inability of several (or more) mortgage companies to undergo an IPO at a price that was acceptable to the sellers has an important message. The industry was accorded a low valuation by Wall Street on presumably peak earnings even though many mortgage companies will produce an ROE that easily exceeds 30%. The assumption is that earnings will decline because rates will rise and/or more capacity will reduce GOS margins. While it is likely 2020 will represent a cyclical peak, no one knows how steep (or gentle) the descent will be and how deep the trough will be. Mortgage companies may produce 20% or better ROEs for several years. One may question the multiple to place on 2020 earnings, but book value could double in three or four years if conditions remain reasonably favorable. Community and regional banks with mortgage operations have benefitted from the mortgage boom, too. Although various bank indices were negative for the year, it could have been much worse given investor fears surrounding credit losses and permanent impairment to net interest margins given the collapse in rates. In a sense, outsized mortgage banking revenues funded reserve builds for many banks and masked revenue weakness attributable to falling NIMs. The average NIM for banks in the U.S. with assets between $300 million and $1 billion as of September 30, 2020 is shown in Figure 2. The NIM fell 45bps from 3Q19 to 3Q20 due to multiple moving pieces but primarily reflected an increase in liquid assets because deposits flooded into the banking system and because the reduction in the yield on loans and securities was greater than the reduction in the cost of funds. Unless the Fed is able (and willing) to raise short-term policy rates in the next year or two, we suspect loan yields will grind lower as lenders compete heavily for assets with a coupon (i.e., loans) because liquidity yields nothing and bonds yield very little. Deposit costs will not offset because rates are or soon will be near a floor. Fee income and expense management are more critical than ever for banks to maintain acceptable profitability. When analyzing the same group of banks (assets $300M - $1B), banks with higher GOS revenues as a percentage of total revenue tended to be more profitable. As shown in Figure 3, median profitability was ~15% greater in the trailing twelve months for banks more engaged in mortgage activity than those that were not. Selling long-term fixed-rate mortgages for most banks is a given because the duration of the asset is too long, especially when rates are low. The decision is more nuanced for 15-year mortgages with an average life of perhaps 6-7 years. With loan demand weak and banks extremely liquid, most banks will retain all ARM production and perhaps some 15-year paper as an alternative to investing in MBS because yields on originated paper are much better. As for 30-year mortgages, net production profits for 3Q20 increased above 200bps according to the MBA for the first time since the MBA began tracking the data in 2008. Originating and selling long-term fixed rate mortgages has been exceptionally profitable in 2020. Mortgage banking in the form of originations is a highly cyclical business (vs servicing); however, it is a counter-cyclical business that tends to do well when the economy is struggling and therefore core bank profitability is under pressure. We have long been observers of the mortgage banking conundrum of “what is the earnings multiple?” It is a tougher question for an independent mortgage company compared to a bank where the earnings are part of a larger organization. Even when outsized mortgage banking earnings may weigh on a bank’s overall P/E, mortgage earnings can be highly accretive to capital. In the February issue of Bank Watch, we will explore how to value a mortgage company either as a stand-alone or as a subsidiary or part of a bank to understand in more detail the true valuation impacts of mortgage revenue. Originally appeared in Mercer Capital’s Bank Watch, January 2021.

Mortgage Banking Lagniappe (Part II)

The January Bank Watch provided an overview of the mortgage industry and its importance in boosting bank earnings in the current low-rate environment. As we discussed, mortgage volume is inversely correlated to interest rates and more volatile than net interest income. In this article, we discuss key considerations in valuing a mortgage company/subsidiary, including how the public markets price them.Valuation ApproachesSimilar to typical bank valuations, there are three approaches to consider when determining the value of a mortgage company/subsidiary: the asset approach, the market approach, and the income approach. However, since the composition of both the balance sheet and income statement differ from banks, several nuances arise.Asset ApproachAsset based valuation methods include those methods that write up (or down) or otherwise adjust the various tangible and/or intangible assets of an enterprise. For a mortgage company, these assets may include mortgage servicing rights (“MSR”). The fair value of the MSR book is the net present value of servicing revenue minus related expenses, giving consideration to prepayment speeds, float, and servicing advances. MSR fair value tends to move opposite to origination volume. For example, MSR values tend to increase in periods marked by low origination activity. Other key items to consider include any non-MSR intangible assets, proprietary technology, funding, relationships with originators and referral sources, and the existence of any excess equity.Market Approach Marketmethods include a variety of methods that compare the subject with transactions involving similar investments, including publicly traded guideline companies and sales involving controlling interests in public or private guideline companies. Historically, publicly traded pure-play mortgage companies were a rare breed; however, the COVID-19 mortgage boom has produced several IPOs, and others may follow. There are many publicly traded banks that derive significant revenues from mortgage operations, especially in this low-rate environment.The basic method utilized under the market approach is the guideline public company or guideline transactions method. The most commonly used version of the guideline company method develops a price/earnings (P/E) ratio with which to capitalize net income. If the public company group is sufficiently homogeneous with respect to the companies selected and their financial performance, an average or median P/E ratio may be calculated as representative of the group. Other activity-based valuation metrics for the mortgage industry include EBITDA, revenues, or originations.Another relevant indicator includes price/tangible book value as investors tend to treat tangible book value as a proxy for the institution’s earnings capabilities. The key to this method lies in finding comparable companies with a similar revenue mix (high fee income) and profitability.When examining the public markets, there are generally two types of companies that can be useful in gathering financial and valuation data: banks emphasizing mortgage activities and non-bank mortgage companies.Group 1: Banks with Mortgage Revenue EmphasisFigure 1 details the first step in identifying a group of banks with significant mortgage operations. First, financial data from the most recently available quarter (4Q20) regarding banks with assets between $1 billion and $20 billion were identified. Once that broad group of banks is identified, it is then important to segment the group further to identify those with significant gain on loan sales as a proportion of revenue and particularly those with higher than typical mortgage revenues/originations as opposed to SBA or PPP loan originations.Group 2: Non-Bank Mortgage CompaniesNon-bank mortgage companies found favor with the public markets in 2020 as beneficiaries of the sharp reduction in mortgage rates. In 2021 investor sentiment has faltered due to the impact of rising long-term rates on consensus earning estimates. Several companies undertook IPOs, while another company went public via merging with a SPAC. This expanded the group of non-bank mortgage companies from which to derive valuation multiples and benchmarking information. Figure 2 includes total return data for non-bank mortgage companies. Notable transactions include the following: Rocket Mortgage (NYSE: RKT) raised $1.8 billion via an IPO at an approximate $36 billion valuation in August; Guild Holdings (NASDAQ: GHLD) raised ~$98 million in a November IPO; United Wholesale Mortgage (NYSE: UWM) went public in the largest SPAC deal in history (~$16 billion) that closed in 2021; and Loan Depot (NYSE: LDI) went public during February by raising $54 million. Other pending IPOs based upon public S-1 filings include Caliber Home Loans and Better.com. Amerihome Mortgage Company had filed a registration statement but apparently obtained better pricing through an acquisition by Western Alliance Bancorp (NYSE: WAL) during February that was valued at ~ $1.0 billion at announcement, or about 1.4x the company’s tangible book value. While this activity is positive for mortgage companies, the IPOs were downsized in terms of the number of shares sold with pricing below the initial target range or at the low end of the range as investors hedged how far and how fast earnings could fall in a rising rate environment. For guideline M&A transactions, the data is often limited as there may only be a handful of transactions in a given year and even fewer with reported deal values and pricing multiples. However, meaningful data can sometimes be derived from announced transactions with transparent pricing and valuation metrics. After deriving the “core” earnings estimate for the mortgage company as well as reasonable valuation multiples, other key valuation elements to consider include: any excess equity, mortgage servicing rights, unique technology solutions that differentiate the company, origination mix (refi vs. purchase; retail vs. correspondent or wholesale), geographic footprint of originations/ locations, and risk profile of the balance sheet and originations (for example, agency vs. non-agency loans). Income ApproachValuation methods under the income approach include those methods that provide for the direct capitalization of earnings estimates, as well as valuation methods calling for the forecasting of future benefits (earnings or cash flows) and then discounting those benefits to the present at an appropriate discount rate. For banks, the discounted cash flow (“DCF”) method can be a useful indication of value due to the availability and reliability of bank forecast/capital plans. However, due to the volatile and unpredictable nature of mortgage earnings, this method faces challenges when applied to a mortgage company. In certain situations, the DCF method may not be utilized due to uncertainties regarding the earnings outlook. In others, the DCF method may be applied with the subject company’s level of mortgage origination activity tied to a forecast for overall industry originations and historical gain on sale margins.Given the potentially limited comparable company data and the difficulty associated with developing a long-term forecast for a DCF analysis, the single period income capitalization method may be useful.This method involves determining an ongoing level of earnings for the company, usually by estimating an ongoing level of mortgage origination activity and a pretax margin and capitalizing it with a “cap rate”. The cap rate is a function of a perpetual earnings growth rate and a discount rate that is correlated with the entity’s risk. Whereas we would likely use recent earnings in the market approach, in the income capitalization method it makes sense to normalize earnings using a longer-term average, which considers origination and margin levels over an entire mortgage operating cycle.Mortgage earnings and margins are cyclical. Due to the volatile nature of mortgage earnings, a higher discount rate is normally used. Therefore, a mortgage company’s earnings typically receive a lower multiple than a bank’s more stable earnings.ConclusionA mortgage subsidiary can be a beneficial tool for community banks to increase earnings and diversify revenue. This strategy, while clearly beneficial now, can be utilized throughout the business cycle. As rates fall and net interest income faces pressure, gains on the sale of loans should increase (and vice versa) to create counter-cyclical revenues. As we’ve discussed, the inherently volatile income from a mortgage subsidiary is not usually treated equally to net interest income in the public markets. Although, when it comes to price/tangible book value multiples, profitability is critical whether it is driven by mortgage activity or not. There are many factors to consider in valuing a mortgage company.If you are considering this line of business to diversify your bank or desire a valuation of a mortgage operation, feel free to reach out for further discussion.Originally appeared in Mercer Capital’s Bank Watch, February 2021.

Themes from Q4 2020 Earnings Calls

E&P Operators

As discussed in our recent blog post regarding tempered mineral and royalty valuations despite recent oil price gains, sentiment towards the oil & gas sector turned bullish as the fourth quarter progressed, with WTI crude spot prices surpassing $40/barrel and – more importantly – generally staying the course on an upward trajectory to close out the year. Over the fourth quarter, WTI spot prices rose 21% from $40.05/barrel at the close of September 30 to $48.35/barrel at December 31. Similarly, Brent spot prices increased 27% from $40.30/barrel to $51.22/barrel over the fourth quarter.One key factor supporting this price appreciation was OPEC’s decision to not flood the global market with crude oil. The election in November concluded with the election of Biden to the White House, a Democratic majority in the House, and uncertainty in the Senate as Georgia would have runoff elections in early January with its two seats – both held by Republican candidates – challenged by Democratic candidates.Despite little indication as to what, precisely, the legislative branch would look like following the Georgia Senate runoff elections, the national election results up to that point made it clear that the oil & gas industry would most likely face headwinds from Washington D.C. with respect to industry operations. Energy prices, however, did not seem to reflect a change in course either way. In this post, we capture the key takeaways from fourth quarter 2020 earnings calls from E&P operators.Heightened Caution Regarding Price VolatilityThroughout the earnings calls, the absence of COVID-19 as a factor of uncertainty was particularly striking. The majority of references to the pandemic were in passing, usually to provide context of the operational status in the fourth quarter 2020 relative to the same period in the prior year. Only one company executive, Harold Hamm of Continental, directly cited the role of public optimism regarding vaccinations as a driving factor behind the recent rebalancing of global crude oil inventories.It appears as though the impact of the COVID pandemic on energy demand is no longer considered as much of a wildcard in E&P operators’ forecasts as it was earlier in the year.While the pandemic is no longer a surprise, with operators fairly optimistic about short-term (1 to 3 years) projections, there is still the poignant memory of crude oil futures prices dipping into negative territory nearly a year ago. Yes, it has almost been a year already. The memory is indeed still very fresh, and operators are looking to protect themselves accordingly, whether via hedging or with greater conservatism regarding return of capital to shareholders by way of dividends.“Our hedge book really helps on just the comfort and confidence and what these cash flows look like for the next several years with approximately 90% [of volumes hedged] in 2021. We already have a material position in 2022. And then if you look at 2023 and 2024, it's getting close to almost being 50% hedged…”–Don Rush, CFO, CNX Resources Corp.“Historically, [Occidental Petroleum has not] regularly engaged in hedging, preferring to realize the prices over the cycle, that delivers the most buyer shareholders. But we did…take on an oil hedge in 2020 that had a collar in 2020, but then it also had a call provision in 2021.”–Rob Peterson, CFO, Occidental Petroleum Corp.“[We are] sticking with our priorities of managing capital expenditures supportive [of a] flatter production profile, then combined with protective hedges allows for maximum free cash flow generation, strong liquidity and debt reduction in long-term price recovery...”–Roger Jenkins, CEO, Murphy Oil Corp.“Our primary focus will be debt pay down, but we are also focused on the eventual reinstating of our dividend… At this time, we would like to build more protection against price volatility by paying down debt, but our management and the board are aligned in wanting to see the return of a sustainable and growing dividend sometime in the near future.”–John Hart, CFO, Continental Resources, Inc.Positive Free Cash Flow Despite the price volatility leading up to the fourth quarter, many operators either posted annual free cash flows well in advance of projections, or at least finished 2020 on a positive note.“2020 marked the most successful year we've seen as an E&P and, frankly, as a public company going back to the late 1990s, as measured by free cash flow…Our original guidance for 2020 free cash flow is around $135 million, compared to over the $356 million that we actually posted.”–Nick Deluliis, President & CEO, CNX Resources Corp.“Our fifth consecutive year of free cash flow, we said, we'd generate $200 million. We generated nearly 40% more, $275 million.”–William Berry, CEO, Continental Resources, Inc.“Even as activity levels increased in the fourth quarter and we returned to paying deferred dividends and cash, we still generated approximately $800 million of free cash flow…”–Rob Peterson, CFO, Occidental Petroleum Corp.“Free cash flow during the quarter was $155 million.” –Glen Warren, Jr., Antero Resources Corp.ESGCompared to our review of themes in the third quarter E&P earnings calls, the fourth quarter earnings calls had a bit more discussion concerning ESG initiatives, including plans of action beyond “we expect to publish our ESG plan soon.”“Our enhanced oil recovery projects [have] turned into an ability for us to create a new business that not only will add additional value for our shareholders over time but reduces emissions in the world. We'll be the leaders in helping to test direct air capture technology, put it in place, make it operational and commercial, and that will provide an opportunity for others to expand it in the world.”–Vicki Hollub, President & CEO, Occidental Petroleum Corp.“From a big picture perspective, if you look at sustainability and ESG…we translate what that means into really three crucial legs. One, you got to be transparent… Two, tangible, okay, these things, these targets, these metrics need to be measured. They need to be tangible. Like what did we actually deliver on? And then the third piece of this is actions, right. I think it's pretty simple across those three, but despite all the talk and the volume of stuff that's being bantered about across those metrics, I think those three things are lacking quite a bit. We want to be in the camp of, ‘Hey, here's what we're going to do, transparently. Here's what we're going to measure and accomplish tangibly. And then here's what our actions were that were consistent with those two things.’” –Nick Deluliis, President & CEO, CNX Resources Corp.“Our operations team continues work on minimizing our environmental impact such as building a new produced water handling system, as well as utilizing bi-fuel hydraulic frac spreads on all well completions in Canada, which results in considerable CO2 emissions reductions. While smaller changes individually, they add up to a larger impact over time.” –Roger Jenkins, CEO, Murphy Oil Corp.On the HorizonThroughout 2020, the oil and gas sector was rife with uncertainty regarding the COVID pandemic and its short- and long-term impacts on the energy markets. From some perspectives, there were 47 E&P operator bankruptcy filings in 2020. The worst year in the past 5 years in terms of the number of E&P operator bankruptcy filings was 2016, with 70 filings. However, some E&P operators proved that operational and capital discipline could still result in free cash flow sufficient to reduce debt and return capital to shareholders.Despite the upward trend in crude oil and natural gas strip prices in the fourth quarter and generally favorable sentiment that the trend would likely continue into and through 2021, there was very little commentary on expectations of increasing rig activity.Perhaps more surprisingly, and with the exception of Murphy Oil’s earnings call, there was also not much discussion regarding the Biden-Harris administration and its actions and intentions, which generally provide for stronger headwinds coming from Washington D.C. than what the industry has been used to over the prior four years.We expect a clearer picture of E&P operators’ perspectives regarding future changes in the “boots on the ground” and regulatory environment in our next review of first-quarter 2021 earnings call themes.For more information or to discuss a valuation or transaction issues in confidence, please contact us.

January 2021 SAAR

SAAR Hit Highest Levels Since the Pandemic Began, but Several Factors Could Hinder February’s Growth Prospects

January 2021 SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) increased to 16.6 million from 16.2 million in December. Though this is a decline of 1.4% from the same period last year, this is the highest that SAAR has been since the pandemic began. Light truck sales were behind this growth, as they captured 77.8% of all new vehicles sold in the past month. Below is a full breakdown of vehicles sold by type for the month. [caption id="attachment_36204" align="alignnone" width="940"]Source: NADA[/caption] The year began with some inventory constraints (down 20% from January 2020), and as such, manufacturers have not had to spend as much on incentives such as those that were offered at the beginning of the pandemic. According to JD Power, the average incentive from manufacturers on new vehicles is on pace to be $3,639 per vehicle, a decrease of $510 from a year ago. Furthermore, lean inventories mean that cars are spending less time on the lots.The average number of days a new vehicle sits on a dealer's lot before being sold is expected to fall to 51 days, down from 70 days from last year. Average transaction prices, according to JD Power, are expected to be up 8.4% compared with January 2020.Thomas King, president of the data and analytics division at JD Power noted this about January SAAR: “January continues the strong performance observed in Q4 of 2020 and points to a positive outlook for the balance of 2021. The growth in retail sales is encouraging, especially as it is being achieved with higher transaction prices and lower incentive levels. While retail demand remains strong, non-retail sales are still recovering, which is hampering total vehicle sales and SAAR.”As King noted, fleet sales are continuing to struggle as widespread travel is still down due to the COVID-19 pandemic. According to Ward Intelligence, retail sales are estimated to have increased by 7% from January 2020, as fleet sales dropped by 24%. Retail sales have been up year over year in four of the last five months, while fleet sales have declined for 13 straight months. For SAAR to fully recover, it might depend on a reverse in these declines. With vaccines being distributed, consumers may have renewed sense of confidence in their travels and could bring back demand.With February’s SAAR release coming in the next few days, there are already some insightful forecasts available for where the numbers will fall. Cox Automotive is anticipating February's sales pace to reach nearly 16.3 million, down from January’s 16.6 million pace. Despite this projected decline, the circumstances in February could have made things much worse. The two most significant events being the chip shortage and the winter storms through Texas and the South.Global Chip Shortage Continues As recently mentioned on this blog, the chip shortage is a pervasive issue for auto dealers going forward. According to LMC Automotive, the global chip shortage is expected to reduce North American production by some 230,000 units in the first quarter. For perspective, multiplying this by 4 for a simple annualization would reduce 2021 volumes by nearly 1 million. Consulting firm AlixPartners expects the shortage will cut $60.6 billion in revenue from the global automotive industry. Different manufacturers are anticipating different levels of impact (see table below). This is an unfortunate situation, as many dealerships were counting on inventory recovery in 2021 to help boost sales, and the full extent of the situation is still unknown. As we’ll note in next week’s post, public auto dealer execs continue to kick the inventory stabilization expectations can down the road now to mid-2021. With the February SAAR release on the horizon, those numbers may shed more light on this ongoing situation. Storms Ahead for February SAAR (Literally)The event that might have the most immediate impact on February SAAR is the winter storm that went through Texas and the South between February 13–17. I’m based in Mercer Capital’s Dallas office and during that time we had no choice but to work remotely (the pandemic has given us lots of practice with remote working). Some of my coworkers were without power and water for days, sending videos of water pipes bursting in apartment buildings around them. Luckily, I only lost water for one day and my biggest tribulation of the week was forgetting to buy groceries before the storm and as a result, walking 2 miles to an open taco store and buying 15 to last me for a few days. Many were not so lucky, and we hope that everyone is recovering and getting back to normal from that time period.As a result of the storm, the concerns of most people across the state were around making sure they had food, water, and energy, and probably not trying to get out and buy a new car. This week of “shut down” may have an impact on overall February SAAR. However, as Texas and the rest of the south continues to thaw, the industry is anticipated to recover, though, in some areas, infrastructure damage and continuing water scarcity could depress some Texas markets for days to come.However, there may be a silver lining for Ford dealerships. Ford confirmed that it had seen an 18% spike in online searches for the F-150 during the power and water crisis in Texas. What could be driving these searches? News broke that Texas truck owners were using the generators on F-150s to heat homes. As one 2021 F-150 hybrid owner stated, “You’re living your life normally, and all of a sudden, you’re thrust into the dark… I think it got around 9 degrees. It’s been in mid-20s and low 30s. You don’t expect that in south Texas. You don’t expect to lose power when we have nuclear, natural gas, wind, and solar power. The truck gave us light at night, TV access to catch the news and weather. It helped give us a little bit of heat and a good pot of coffee.”Furthermore, Ford sent letters to its Texas dealers encouraging them to use the hybrid trucks as needed. "Due to the urgent and unprecedented weather situation in Texas, a number of our local dealers are using all-new Ford 150s equipped with Pro Power Onboard to help in their communities. Approximately 415 trucks fall within this effort. We're proud to pitch in to help Texas in this time of need." Mike Levine, Ford North American product communications manager said.We hope that this post finds everyone affected by the winter storms safe and with power and water, and that March has better weather in store. If you have any questions about SAAR and what it might mean for your dealership, feel free to contact any of the professionals on the auto dealer team at Mercer Capital.

Conference Speakers Will Shed Light on a New Day in the RIA Industry

Catching Up with the Future at the RIA Practice Management Insights Conference

One year ago this week I was in New York on what I didn’t know would be my last business trip for a long time. I could have never imagined how the year to come would both disrupt and accelerate business plans for us and for our clients, but it’s been strangely great and awful all at the same time.Many of our clients have been unusually reflective about practice management issues over the past year, and that effort has been rewardedMany of our clients have been unusually reflective about practice management issues over the past year, and that effort has been rewarded. After a brief gasp and pause in the second quarter of 2020, we saw many clients accelerate leadership transitions, look for transaction opportunities, shift product and service offerings, rewrite fee schedules, refine marketing approaches, and rethink what it means to be a firm – all while working remotely. As our annual projects came through the shop this winter, we tallied the results: more growth and greater efficiency. 2020 was a good year, at least on paper.Still, for the industry as a whole, focus on practice management is relatively new and, for many, relatively foreboding. Most firms grow from the talents of individuals who enjoy some or many aspects of managing money. They partner with like-minded individuals, start gathering client assets, and when momentum kicks in and the market cooperates, they become a profit-making machine. That formula worked for a long time.The deficiency in the growth story of many RIAs is they employed lots of people to work “in” the business, but not enough to work “on” the business. It’s not unusual for heads of multi-billion dollar firms to still manage client relationships, serve on investment committees, and be the principal in charge of major human resource decisions.Strategic thinking about practice management is a necessity in an industry that has been catapulted into the futureToday, the investment management industry doesn’t have the same growth drivers it enjoyed for a long time, and defending margins has become an active discussion. As a consequence of those forces, and a year where the industry had time to rethink everything from custodial relationships to custom indexing, investment management is becoming subject to creative forces that were very recently as unimaginable as a year without business travel.We have had a great time putting together the conference for this week, but I think we’re only scratching the surface. Strategic thinking about practice management is a necessity in an industry that has been catapulted into the future.Practice management is resource-intensive, but enduring the cost of catching up to the future is prohibitive.Just don’t tell that to the post office, which recently unveiled a new fleet of delivery trucks. The Postmaster General noted that only 10% of the new vehicles would be battery powered, because that would cost extra. The gasoline powered motors could, however, be converted to electric during the vehicles’ estimated 20-year life. Given the pace of innovation at the postal service (Mercer Capital shares its hometown with FedEx, so we’re biased), this fleet plan tells me that the age of the internal combustion engine is rapidly coming to a close.On the other end of the spectrum, McLaren just announced a new sports car, the Artura (pictured above). With a high-performance hybrid engine and an ultra-light carbon fiber monocoque architecture, the Artura is a testament to a future that is beautiful and exciting. We look forward to sharing that future with you at the RIA Practice Management Insights conference this week.RIA Practice Management Insights Is Only 2 Days Away!We are excited to bring this virtual conference to you. The focus is on OPERATIONS – strategy, staffing, technology, firm culture, marketing, and so much more. If you’ve been too busy working in your business to work on your business, this conference is for you!It's NOT too late to register!Use code 30%OFFto save 30% off conference registration This 30% special conference discount is only good until Tuesday, 3:00pm ET. After that, the registration fee returns to $250, so act now and save $75! In the meantime, want to see the conference in a nutshell? Check out the video below to learn more.

Failing to Plan Is Planning to Fail

Just Because Everyone Else Is Doing It, Doesn’t Mean You Should Ignore Succession Planning

Next week, during the inaugural RIA Practice Management Insights conference, we will set aside some time to answer your questions about succession planning. Roughly two-thirds of RIAs are still owned by their founders, and only a quarter of those have non-founding shareholders. We won’t solve all the pieces to the succession planning puzzle in our session, but we’ll address succession planning strategies, and what works best under different circumstances.We’ll cover some of these in more detail next week, but here’s a preview of our thinking about various succession planning (and exit) options.Sale to a Strategic BuyerIn all likelihood, the strategic buyer is another RIA, but it could be any financial institution hoping to realize certain efficiencies after the deal. They will typically pay top dollar for a controlling interest position with some form of earn-out designed to incentivize the selling owners to transition the business smoothly after closing. This scenario sometimes makes the most economic sense, but it does not afford selling principals much control over what happens to their employees or to the company’s name.Sale to a Consolidator or Roll-up FirmThese acquirers typically offer some combination of initial and contingent consideration to join their network of advisory firms. The deals are usually debt-financed and typically structured with cash and stock upfront and an earn-out based on prospective earnings or cash flow. Consolidators and roll-up firms usually don’t acquire or pay as much as strategic buyers, but they often allow the seller more autonomy over future operations. While there are currently only a handful of consolidators, their share of sector deal making has increased dramatically in recent years.Sale to a Financial Buyer This scenario typically involves a private equity firm paying all-cash for a controlling interest position. PE firms will usually want the founder to stick around for a couple of years after the deal but expect him or her to exit the business before they flip it to a new owner. Selling principals typically get more upfront from PE firms than consolidators but sacrifice most of their control and ownership at closing.Patient (or Permanent) CapitalMost permanent capital investors are family offices, or investment firms backed by insurance companies, that make minority investments in RIAs either as a common equity stake or revenue share. They typically allow the sellers to retain their independence and usually don’t interfere much with future operations. While this option is not always as financially lucrative as the ones above, it is often an ideal path for owners seeking short term liquidity and continued involvement in this business.Internal Transition to the Next Generation of Firm Leadership Another way to maintain independence is by transitioning ownership internally to key staff members. This process often takes a lot of time and at least some seller-financing as it’s unlikely that the next generation is able or willing to assume 100% ownership in one transaction. Bank and/or seller financing is often required, and the full transition can take 10-20 years depending on the size of the firm and interest transacted. This option typically requires the most preparation and patience but allows the founding shareholders to handpick their successors and future leadership.Combo DealMany sellers choose a combination of these options to achieve their desired level of liquidity and control. Founding shareholders have different needs and capabilities at different stages of their life, so a patient capital infusion, for instance, may make more sense before ultimately selling to a strategic or financial buyer. Proper succession planning needs to be tailored, and all these options should be considered.If you’re a founding partner or selling principal, you have a lot of exit options, and it’s never too soon to start thinking about succession planning. Let us know what questions you have at the conference next week.Only 1 WEEK until the RIA Practice Management Insights conference begins!Mercer Capital has organized a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.Join us and speakers like Jim Grant, Peter Nesvold, Matt Sonnen, and Meg Carpenter, among others, at the RIA Practice Management Insights, a conference unlike any other in the industry.Have you registered yet?

Held by Production

Oftentimes differences are a matter of perspective. Put another way – one person’s loss can be another person’s gain. One of the thematic differences between producers and mineral owners is their perspective on “Held By Production.” It elicits very different reactions depending on what side of the term one is on, and has a leverageable impact on value. With rig counts dropping to around half of last year’s count, how much acreage will be available for re-leasing this year? In this post, we decided to spend some time exploring this concept and its impact on the energy industry.What Is Held By Production?Held By Production (“HBP”) is a mineral lease provision that extends the right to operate a lease as long as the property produces a minimum quantity of oil and gas. The definition of HBP varies contractually by every lease it governs which is often misunderstood. We have had discussions with several people, including peers (as well as knowledgeable industry participants) who did not have a clear grasp of HBP and its exact meaning. Some people thought HBP was governed by state law, regulatory agencies, or even accounting rules. However, the truth is that the facts and circumstances that shape a lease as it pertains to HBP, are all negotiable. Therefore, by extension, the outcome of lease negotiations can have a spectrum of results: from being deemed balanced, to favoring the lessor (i.e., the mineral owner) or the lessee (i.e., the producer). A large percentage of public company leases are HBP. In prior management calls, management teams have noted that the Permian Basin was about 95% HBP due to decades of prior drilling. Why might someone be more attracted to an operator’s stock that has a large percentage of leases HBP? Investopedia puts it this way:The “held by production” provision enables energy companies to avoid renegotiating leases upon the expiry of the initial term. This results in considerable savings to them, particularly in geographical areas that have become “hot” due to prolific output from oil and gas wells. With property prices in such areas generally on an upward trend, leaseholders would demand significantly higher prices to renegotiate leases.What Does the Term "Held By Production” Mean to Mineral Owners (Lessors)?Mineral owners should have an understanding of how their lease terms impact drilling activity (and by extension – royalty payments) on their properties. Lessors are challenging operators’ decisions not to drill on their land, even if prospects appear to be good. As a result, mineral owners are more interested in how certain clauses and term structures function in their leases.Therefore, it is important for mineral owners to understand two lynchpin concepts as they pertain to defining HBP: the Pugh Clause and the Implied Covenant to Develop.Pugh ClauseThe Pugh Clause is named after Lawrence Pugh, a Crowley, Louisiana attorney who developed the clause in 1947, apparently in response to the Hunter v. Shell Oil Co., 211 La. 893 (1947). In this case, the Louisiana Supreme Court held that production from a unit, including a portion of a leased tract, will maintain the lease in force as to all lands covered by the lease even if they are not contiguous. This clause is most often cited today in pooling for horizontal wells. There have been situations (depending on the clause’s language) whereby one well might maintain a large area (thousands of acres) defined as HBP. This is to an operator’s advantage and a mineral holder’s chagrin. However, this can be negotiated in the mineral holder’s favor – particularly in active markets and basins. For example, a few years ago Mercer Capital had a client that had a large tract of land in the Eagle Ford Shale and was being courted by many eager operators. Ultimately, they negotiated a lease with an operator who contractually obligated the company to drill three wells per year on the property for the duration of the lease. Not too long after the lease was negotiated, the price of oil dropped in half and the operator was much less enthusiastic about having to drill three wells per year. There are several nuances and factors to Pugh clauses (and similar lease clauses) that we won’t explore here, but suffice to say, it is a critical factor to defining a property as HBP or not.Implied Covenant to DevelopAnother aspect of lease law is centered around the concept called “Implied Covenant to Develop.” Sometimes a lessors’ alternative is to attempt to find remedy through the implied obligation that the lessee failed to develop and operate the property as a reasonably prudent operator. Forcing an implied obligation generally occurs through a lawsuit and is difficult to prove. However, implied covenants have been addressed by courts from all producing states as well as the Supreme Court of the United States.There are several potential examples. One example is discussed in this Gas & Oil Law blog.Consider an oil and gas lease taken on 200 acres. Let’s say that thirty years ago one well was drilled on the 200-acre lease and that this well unit only included 40 acres. Under the implied covenant to reasonably develop, a judge may very well cancel the lease to the remaining, unused 160 acres (200 acres – 40 acres = 160 acres). How could a judge do that? The basic question that needs to be answered is whether or not the oil and gas producer has behaved as a reasonable oil and gas producer would in similar circumstances. If any reasonable producer would have drilled more than one well on the 200-acre lease, then a reviewing judge might void the lease to the remaining 160 acres. However, if the existing well was not a very good well, then it might be that the producer did behave reasonably when they decided not to drill additional wells.ConclusionDepending on which side of the negotiation one is on, HBP can be a favorable (or unfavorable) contributor to value. As such, it is crucial to have an analyst who possesses knowledge from all sides of industry negotiations.Mercer Capital has over 20 years of experience valuing assets and companies in the oil and gas industry. We have valued companies and minority interests in companies servicing the E&P industry and assisted clients with various valuation and cash flow issues regarding royalty interests. Contact one of our oil and gas professionals today to discuss your needs in confidence.

Seven Factors of a Highly Effective Buy-Sell Agreement for Auto Dealerships

A Roadmap to the Valuation Process

A few of our recent auto dealership valuation engagements have involved disagreements among family members and the next generation or what might otherwise be termed a business divorce. Inevitably, one of the first questions I always ask "Is there a buy-sell agreement or governance document that will provide a roadmap into the valuation of the business and the respective subject interests?" Often the answer is "I’m not sure, I don’t know, or maybe but we haven’t reviewed it in some time."We’ve also encountered plenty of examples where these documents exist, but they are either poorly written, do not contain the necessary information, or have not been contemplated in many years since the drafting of the document. In Stephen Covey’s popular management book, he discussed the seven habits of highly effective people. In this post, we cover seven factors of a highly effective buy-sell agreement for auto dealerships and also touch on several other considerations.1) Standard of ValueThe standard of value establishes the parameters for how the auto dealership will be valued. It should be clearly defined and give clear indications for how the participants in a hypothetical transaction should be viewed: buyer, seller, motivations, knowledge of facts, etc. The most common standard of value is fair market value and is generally defined as a hypothetical buyer and a hypothetical seller both having reasonable knowledge of the business and all relevant factors and neither being under any compulsion to buy or sell.The other most common standard of value in buy-sell agreements is fair value. Simply put, fair value is fair market value without consideration of any applicable discounts for lack of control and lack of marketability for the subject interest. Fair value is often used in legal proceedings. The difference between these two standards of value and the lack of clarity in defining which standard is governed by a company’s buy-sell agreement is often the impetus to litigation.2) Level of Value Level of value is a valuation concept describing the differences between various “levels” of a company’s value. Levels of value can include financial control, strategic control, marketable minority interest, and non-marketable minority interest. Each level has a distinct difference in the amount of control one can exhibit over the operations of a business and/or their ability to sell an interest in that business. For the layperson, the levels of value ultimately dictate whether premiums or discounts would be applied to the subject interest being valued.3) Define Triggering Events If the goal of a buy-sell agreement or governance document is to provide a roadmap for the valuation, then it’s important for these documents to define the events that will be governed under their parameters. These events are often referred to as triggering events and can include the death of an owner, termination of an owner, divorce, change of control, etc. By defining the triggering events, it will be clear when the document will be enacted and enforced and when it will not apply. For example, selling or gifting a minority interest in the business to future generations is not likely to be a triggering event in this context and almost certainly would not be valued at anything besides the nonmarketable minority level of value.These events can also have unique ramifications on auto dealerships. For example, each franchised dealer has a dealer principal that has to be approved by the manufacturer. The death or divorce of a dealer principal can also pose challenges as the transferability of that interest and title of dealer principal is not guaranteed and cannot occur without approval from the manufacturer.4) Avoid Formula Pricing Often these documents contain a formula or a methodology to value the business. The formula might consist of the applicable financial information to consider and the multiple to apply to those metrics to determine the value. At the time of the drafting of the buy-sell, these formulas might establish the shareholder's perceived value of the business. If considerable time has passed between the drafting of the document and the triggering event, these formulas and concluded values could be stale and outdated. As we’ve previously discussed in this space, the auto dealership industry is unique from a valuation perspective. Traditional formulas such as EBITDA multiples often utilized in other industries are not as informative in this industry. The drafting attorney may not be as familiar with the nuances of auto dealership valuation. Even if an industry-appropriate metric, such as a Blue Sky multiple or formula is used, it is likely be dated in a short period of time. National auto brokers (Haig Partners and Kerrigan Advisors) publish and update these Blue Sky multiples by manufacturer quarterly. As we’ve seen during the COVID-19 pandemic, operational conditions and perceived franchise values can change both quarterly and over a longer time horizon. Additionally, dealerships could evolve over time and acquire or divest of different franchises that could drastically change their operations and perceived value.Finally, what adjustments are to be considered? Even if a buy-sell agreement has language providing for a multiple to be updated with the current market environment, significant one-time or non-recurring income or expense items can inflate or depress value.5) Specify Valuation DateThe buy-sell agreement should explicitly define the date to be used for the valuation. Typically, the date of valuation would be at or near the triggering event depending on its proximity to the timing and availability of current and reliable financial information. A proper valuation should consider what is reasonably known or knowable as of the date of valuation. Any ambiguity in defining the valuation date or the financial information to be used could have a significant impact on value. Since franchised auto dealers must submit monthly financial statements to the manufacturer, an appropriate valuation date might be set to be the month-end prior to the triggering event.6) Defining Appraiser Requirements Who should perform the valuation? Often buy-sell agreements will utilize language such as a “qualified appraiser” and may even include certain valuation credentials such as an Accredited Senior Appraiser (ASA), someone who is Accredited in Business Valuation (ABV), or a Certified Valuation Analyst (CVA) from national valuation accrediting organizations. Since the auto dealership industry is so unique, these credentials may not be enough. Should your buy-sell agreement also require that the appraiser have specific industry experience? Finally, independence is key. We recommend selecting a third-party valuation firm with experience in valuing auto dealerships so that the appraiser will be qualified and unbiased.7) Make It a Living Document How often does a company have a buy-sell agreement or governance document drafted only to be placed in an electronic file, a desk drawer, or a file cabinet and never reviewed or contemplated again? The value of an effective buy-sell agreement is to provide a roadmap for how to value the dealership at a triggering event. If the document was never used since drafting, can it be reliable?Effective buy-sell agreements are not only drafted, but they are utilized. Some require ongoing valuations at annual anniversaries or other timeframes to provide the owners with a value indication that could be used for strategic planning or contemplation of an upcoming triggering event.If the document didn’t clearly contain the items in this post and was never used since drafting, it could create confusion leading to litigation or the buy-sell agreement could be ignored in an eventual litigation. Frequent use or at least consideration of the terms considered in the document are likely to be much more relevant in a litigation context.Conclusion and ConsiderationsAn effective buy-sell agreement can provide a roadmap to defining the valuation process through many challenging events during the lifetime of an auto dealership. As we’ve discussed, the document should contain and clearly define these seven elements, among others, to accomplish that goal.Other considerations to contemplate are the premise of value, funding mechanisms for repurchase, and managing expectations. The premise of value will establish whether to determine the value of the dealership if it continues as a going-concern business as opposed to liquidation. Funding mechanisms and repurchase requirements can also dictate the mechanical treatment of certain assumptions in the valuation such as the impact of recognizing life insurance proceeds at the death of an owner to establishing a market for the subject interest that could possibly impact the applicable discount for lack of marketability.Does your auto dealership have a buy-sell agreement or governance document? When was it drafted? Who drafted it? Does it contain and discuss these seven key items? If it contains formula pricing, would buyers and sellers find the methodology employed reasonable today? These are all items that need to be considered.To discuss the impact of your buy-sell agreement, assist you and your attorney in drafting an effective buy-sell agreement, or determine the valuation of your auto dealership at a triggering event, contact a professional at Mercer Capital today.

Personal Goodwill: An Illustrative Example of an Auto Dealership

This article discusses important concepts of personal goodwill in divorce litigation engagements. The discussion relates directly to several divorce litigation cases involving owners of automobile dealerships. These real life examples display the depth of analysis that is critical to identifying the presence of personal goodwill and then estimating or allocating the associated value with the personal goodwill. The issues discussed here pertain specifically to considerations utilized in auto dealer valuations, but the overall concepts can be applied to most service-based industries.It is important that the appraiser understands the industry and performs a thorough analysis of all relevant industry factors. It is also important to determine how each state treats personal goodwill. Some states consider personal goodwill to be a separate asset, and some do not make a specific distinction for it and include it in the marital assets.Personal goodwill was an issue in several of our recent litigated divorce engagements. It is more prevalent in certain industries than others and varies from matter to matter. However, although there are several accepted methodologies to determine personal goodwill, there is not a textbook that discusses where it exists and where it doesn’t. Before any attempts to measure and quantify it, an important question to ask is “Does it exist?” Often with ambiguous concepts like personal goodwill, the adage “you know it when you see it” is most appropriate. In this article, we examine personal and enterprise goodwill using a specific fact pattern unique to the auto dealership industry. Beyond this illustrative example, the analyses can be applied in other industries, but must be considered carefully for the unique facts and circumstances of each matter.What Is Personal Goodwill?Personal goodwill is value stemming from an individual’s personal service to a business and is an asset that tends to be owned by the individual, not the business itself. Personal goodwill is part of the larger bucket of an intangible asset known as goodwill. The other portion of goodwill, referred to as enterprise or business goodwill, relates to the intangible asset involved and owned by the business itself.1Commercial and family law litigation cases aren’t typically governed by case law resulting from Tax Court matters and can differ by jurisdiction, but Tax Court decisions offer more insight into defining the conditions and questions that should be asked in an evaluation of personal goodwill. One seminal Tax Court case on personal goodwill is Martin Ice Cream vs. Commissioner.2 Among the Court’s discussions and questions to review were the following:Do personal relationships exist between customers/suppliers and the owner of a business?Do these relationships persist in the absence of formal contractual relationships?Does an owner’s personal reputation and/or perception in the industry provide intangible benefit to the business?Are practices of the owner innovative or distinguishable in his or her industry, such as the owner having added value to the particular industry?Another angle with which to evaluate the presence of personal goodwill, specifically to professional practices, is provided in Lopez v. Lopez.3 Lopez suggests several factors that should be considered in the valuation of professional (personal) goodwill as:The age and health of the individual;The individual’s demonstrated earning power;The individual’s reputation in the community for judgement, skill, and knowledge;The individual’s comparative professional successThe nature and duration of the professional’s practice as a sole proprietor or as a contributing member of a partnership or professional corporation.Why Is Personal Goodwill Important?Many states identify and distinguish between personal goodwill and enterprise goodwill. Further, numerous states do NOT consider the personal goodwill of a business to be a marital asset for family law cases. For example, a business could have a value of $1 million, but a certain portion of the value is attributable and allocated to personal goodwill. In this example, the value of the business would be reduced for personal goodwill for family law cases and the marital value of the business would be considered at something less than the $1 million value.How Applicable/Prevalent Is Personal Goodwill in the Auto Dealer Industry?In litigation matters, we always try to avoid the absolutes: always and never. The concept of personal goodwill is easier identified and more prevalent in service industries such as law practices, accounting firms, and smaller physician practices. Does that mean it doesn’t apply to more traditional retail and manufacturing industries? In each case, the fundamental question that should be first answered is “Is this an industry or company where personal goodwill could be present?”For the auto dealer industry, the principal product, outside of the service department, is a tangible product – new and used vehicles. In order for personal goodwill to be present in this industry, the owner/dealer principal would have to exhibit a unique set of skills that specifically translates to the heightened performance of their business.We are all familiar with regional dealerships possessing the name of the owner/dealer principal in the name of the business. However, just having the name on a business doesn’t signify the presence of personal goodwill. An examination of the customer base would be needed to justify personal goodwill. It would be more difficult to argue that customers are purchasing vehicles from a particular dealership only for the name on the door, rather than the more obvious factors of brands offered, availability of inventory, convenience, etc. An extreme example might be having a recognized celebrity as the name/face of the dealership, but even then, it would be debated how materially that affects sales and success.Auto dealers attempt to track performance and customer satisfaction through surveys, which could provide an avenue to determine this value (if, for example, factors that influenced the decision to buy listed Joe Dealer as being their primary motivation) though this is still unlikely and would be subject to debate.Another consideration of the impact of a dealer’s name on the success/value of the business would be how actively involved the owner/dealer principal is and how directly have they been involved with the customer in the selling process. Simply put, there should be higher bars to clear than just having the name in the dealership for personal goodwill to be present. In more obvious examples of personal goodwill in professional practices, the customer usually interacts directly with the owner/professional such as with the attorney or doctor in our previous examples. How often does the customer of an auto dealership come into contact or deal directly with the owner/dealer principal, or do they generally engage with the salespeople, service manager, or the general manger?Another factor that often helps identify the existence of personal goodwill is the presence of an employment agreement and/or non-compete agreement. The prevailing thought is that an owner of a business without these items would theoretically be able to exit the business and open a similar business and compete directly with the prior business. Neither of these items typically exist with an owner of an auto dealership. However, owners of auto dealerships must be approved as dealer principals by the manufacturer.The transferability of a dealer principal relationship is not guaranteed, and certainly an existing dealer principal would not be able to obtain an additional franchise to directly compete with an existing franchise location of the same manufacturer for obvious area of responsibility (AOR) constraints. So, does the fact that most dealer principals don’t have an employment or non-compete agreement signify that personal goodwill must be present? Not necessarily. Again it relates back to the central questions of whether an owner/dealer principal is directly involved in the business, has a unique set of skills that contributed to a heightened success of the business, and does that owner/dealer principal have a direct impact on attracting customers to their particular dealership that could not be replicated by another individual.ConclusionPersonal goodwill in an auto dealership, and in any industry, can become a contested item in a litigation case because it can reduce the enterprise value consideration, reduced by the amount allocated to personal goodwill. As much as the allocation, quantification, and methodology used to determine the amount of personal goodwill will come into question, several central questions should be examined and answered before simply jumping to the conclusion that personal goodwill exists. Instead of arguing whether the value of an auto dealership should be reduced by some percentage, the real debate should center around the examination of whether personal goodwill exists in the first place. The difference in reports from valuation for experts in litigation matters generally falls within the examination and support of the assumptions (that lead to differences in conclusions). If present, personal goodwill for an auto dealership, or any company in any industry for that matter, must exist beyond just having the owner’s name in the title of the business.1 In the auto dealer industry, goodwill and other intangible assets are referred to as Blue Sky value. 2 Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (1998). 3 In re Marriage of Lopez, 113 Cal. Rptr. 58 (38 Cal. App. 3d 1044 (1974).

How RIA Owners Can Rethink Compensation

Money Talks

Salary and bonus discussions are some of the most stressful conversations business owners have each year, and RIA principals are no exception. Since personnel costs are by far the largest expense item on an RIA’s income statement, it is understandable that these principals frequently question (and are questioned about) their compensation decisions. While there is no one-size-fits-all formula for compensation, we have discovered three ways to ease some of the anxiety around these discussions.1) Define the Philosophy of Your Compensation ModelCompensation can do more than simply reimburse your employees for their time, but only if it is well planned and communicated. A good compensation model can help your company attract, retain, and motivate talent. We often think about compensation in four buckets.2) Pay Bonuses More FrequentlyOne benefit of a recurring revenue business is that a firm’s performance can be calculated on a more frequent basis. Paying bonuses quarterly, or even bi-annually, can take away some of the stress that annual bonus discussions bring. Additionally, quarterly bonus discussions provide an opportunity to deliver meaningful feedback to your employees on a more regular basis. Employees do their best work when they feel valued; why not remind them of that more than once a year?3) Compare Your Margins to PeersWhile there is significant variation in how RIA owners think about compensating their employees (and themselves), there is some uniformity across the industry as to how much RIAs should pay out in total compensation. As shown below, publicly traded RIAs with under $100 billion in AUM pay out roughly half of revenue as compensation. Considering this metric along with typical operating margins for RIAs (usually 20% to 30% depending on size, type, and location) can help you gauge whether your compensation expenses are in sync with the market. To learn more about more on common compensation questions join us atRIA Practice Management Insights, as Matt Crow and I spend a half-hour answering your question about RIA compensation practices. Only 2 WEEKS until the RIA Practice Management Insights conference begins!Mercer Capital has organized a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.Join us and speakers like Jim Grant, Peter Nesvold, Matt Sonnen, and Meg Carpenter, among others, at the RIA Practice Management Insights, a conference unlike any other in the industry.Have you registered yet?

What Is a Fairness Opinion And What Triggers the Need for One?

Based on available public data from S&P Global’s Market Intelligence platform, there were 25 merger and acquisition announcements in 2020 related to oil and gas companies at the entity level (including natural gas midstream and utility companies). These 25 announcements represented at least $16.2 billion in total deal value, notwithstanding three deals where the value was not publicly disclosed. On a quarterly basis, there were eight announcements in Q1 2020, eight in Q2 and Q3 combined, and nine in Q4.While the trend in the quarterly announcements is not very surprising, one phrase, in particular, creeps up with increasing frequency when reviewing transaction details as 2020 progressed: “Fairness Opinion.”In Q1, only one of the eight transactions was reported to have had a Fairness Opinion conducted. None of the two transactions announced in Q2 had Fairness Opinions, but two of the six announced deals in Q3 did. As the Oil and Gas industry began to get somewhat comfortable again, Q4 finished out strong with nine announced deals. However, nearly half of them were accompanied by Fairness Opinions. We examine this trend from a monthly perspective in the following chart: Irrespective of what industry or sector a company may operate in, a fundamental question arises as mergers and acquisitions persist and company boards and management teams survey their options when a proposed transaction is put on the table: is it fair to all direct stakeholders? What Is a Fairness Opinion?A Fairness Opinion involves a comprehensive review of a transaction from a financial point of view and is typically provided by an independent financial advisor to the board of directors of the buyer or seller. The financial advisor must look at pricing, terms, and consideration received in the context of the market for similar companies. The advisor then opines that the transaction is fair, from a financial point of view and from the perspective of the seller’s minority shareholders. In cases where the transaction is considered to be material for the acquiring company, a second Fairness Opinion from a separate financial advisor on behalf of the buyer may be pursued. On this point, we note that among the six deals announced in 2020 where a Fairness Opinion was conducted, only one of the six had Fairness Opinions conducted on behalf of both the buyer and the seller; the opinions performed for the other five deals were solely on behalf of the sellers in those transactions.Why Is a Fairness Opinion Important?Why is a Fairness Opinion important? There are no specific guidelines as to when to obtain a Fairness Opinion, yet it is important to recognize that the board of directors is endeavoring to demonstrate that it is acting in the best interest of all the shareholders by seeking outside assurance that its actions are prudent.One answer to this question is that good intention(s) without proper diligence may still give rise to potential liability. In its ruling in the landmark case Smith v. Van Gorkom, (Trans Union), (488 A. 2d Del. 1985), the Delaware Supreme Court effectively made the issuance of Fairness Opinions de rigueur in M&A and other significant corporate transactions. The backstory to this case is the Trans Union board approved an LBO that was engineered by the CEO without hiring a financial advisor to vet a transaction that was presented to them without any supporting materials. Regardless of any specific factors that may have led the Trans Union board to approve the transaction without extensive review, the Delaware Supreme Court found that the board was grossly negligent in approving the offer despite acting in good faith. Good intentions, but lack of proper diligence.The facts and circumstances of any particular transaction can lead reasonable (or unreasonable) parties to conclude that a number of perhaps preferable alternatives are present. A Fairness Opinion from a qualified financial advisor can minimize the risks of disagreement among shareholders and misunderstandings about a deal. They can also serve to limit the possibilities of litigation which could kill the deal. Perhaps just as important as being qualified, a Fairness Opinion may be further fortified if conducted by a financial advisor who is independent of the transaction. In other words, a financial advisor hired solely to evaluate the transaction, as opposed to the banker who is paid a success fee in addition to receiving a fee for issuing a Fairness Opinion.When Should You Obtain a Fairness Opinion?While the following is not a complete list, consideration should be given to obtaining a Fairness Opinion if one or more of these situations are present:Competing bids have been received that are different in price or structure, leading to potential disagreements in the adequacy and/or interpretation of the terms being offered, and which offer may be “best”; Conversely, when there is only one bid for the company, and competing bids have not been solicited.The offer is hostile or unsolicited.Insiders or other affiliated parties are involved in the transaction, giving rise to potential or perceived conflicts of interest.There is concern that the shareholders fully understand that considerable efforts were expended to assure fairness to all parties.What Does a Fairness Opinion Cover?A Fairness Opinion involves a review of a transaction from a financial point of view that considers value (as a range concept) and the process the board followed in reaching a decision to consummate a transaction. The financial advisor must look at pricing, terms, and consideration received in the context of the market. The advisor then opines that the consideration to be received (sell-side) or paid (buy-side) is fair from a financial point of view of shareholders, especially minority shareholders in particular, provided the advisor’s analysis leads to such a conclusion.While the Fairness Opinion itself may be conveyed in a short document, most typically as a simple letter, the supporting work behind the Fairness Opinion letter is substantial. This analysis may be provided and presented in a separate fairness memorandum or equivalent document.A well-developed Fairness Opinion will be based upon the following considerations that are expounded upon in the accompanying opinion memorandum:A review of the proposed transaction, including terms and price and the process the board followed to reach an agreement.The subject company’s capital table/structure.Financial performance and factors impacting earnings.Management’s current year budget and multi-year forecast.Valuation analysis that considers multiple methods that provide the basis to develop a range of value to compare with the proposed transaction price.The investment characteristics of the shares to be received (or issued), including the pro-forma impact on the buyer’s capital structure, regulatory capital ratios, earnings capacity, and the accretion/dilution to earnings per share, tangible book value per share, dividends per share, or other pertinent value metrics.Address the source of funds for the buyer.What Is Not Covered in a Fairness Opinion?It is important to note what a Fairness Opinion does not prescribe, including:The highest obtainable price.The advisability of the action the board is taking versus an alternative.Where a company’s shares may trade in the future.How shareholders should vote a prox.yThe reasonableness of compensation that may be paid to executives as a result of the transaction. Due diligence work is crucial to the development of the Fairness Opinion because there is no bright-line test that consideration to be received or paid is fair or not. The financial advisor must take steps to develop an opinion of the value of the selling company and the investment prospects of the buyer (when selling stock).ConclusionThe Professionals at Mercer Capital may not be able to predict the future, but we have nearly four decades of experience in helping boards assess transactions as qualified and independent financial advisors. Sometimes paths and fairness from a financial point of view seem clear; other times they do not.Please give us a call if we can assist your company in evaluating a transaction.

Public Auto Dealer Profiles: Lithia Motors

From 1996 to 2002, six new vehicle retailers became publicly traded companies. While these companies have expanded their footprint, there have not been any more publicly traded new vehicle retailers since. Online used vehicle retailers have recently IPO’d and EV startups have used SPACs to come to market during the pandemic, but these are not comparable to privately held franchised dealerships that can sell new vehicles.This is the first in a series of profiles of these six public new vehicle dealerships. The goal of these profiles is to provide a reference point for private dealers.Dealers may benefit in benchmarking to public players, particularly those that are significantly larger with numerous rooftops. Smaller or single point franchises will find better peers in the average information reported by NADA in their dealership financial profiles. Public auto dealers also provide insight as to how the market prices their earnings.We’re starting with Lithia Motors (LAD) because of their targeted annual acquisitions of $3-5 billion in revenue, which will require plenty of deals with private dealerships, representing a potential exit strategy. Lithia has also already reported their 2020 earnings, so the early bird gets the worm.Lithia Motors Locations and BrandsBased in Medford, Oregon, Lithia has over 200 locations throughout the U.S. largely focused on the West Coast, Texas, and the Northeast. Management indicated 100% of consumers in the U.S. were within a 400-mile radius of the company’s fulfillment network, with this density shrinking to 100 miles in the northwest and 200 miles in the Southwest, South Central, and Northeast. According to the Automotive News Top 150, Lithia sold the third most new retail units in 2019 at just over 180 thousand, trailing only AutoNation and Penske Automotive Group. Lithia added seven dealerships in 2019, making it the most acquisitive dealership in the country that year, a trend they carried into 2020 and is anticipated to go forward. As seen in the table below, nearly 45% of Lithia’s revenues in the last quarter came from Toyota, Honda, and Chrysler. While just under 30% of the company’s revenue came from luxury vehicles (8% BMW/Mini), luxury volumes made up only about 22% of unit sales. Lithia is relatively balanced, seemingly agnostic to brand and segment. Historical Financial PerformanceAs we’ve discussed frequently, there are numerous hurdles to clear when comparing a privately held dealership to a publicly traded retailer. Scale and access to capital make the business models different, even if store and unit-level economics remain similar. With numerous acquisitions and industry-wide improving gross margins in 2020, Lithia’s revenue and gross profit have grown at an annualized rate of 9.2% and 13.7% in the past three years. Lithia’s 10K’s and Q’s look different than the dealer financial statements produced by our dealer clients. For example, “Other income” items such as doc fees and dealer incentives can significantly impact profitability for privately held dealers. For dealers that sacrifice upfront gross margins to get volume-based incentive fees, operating income can be negative for dealers before accounting for these profits. For Lithia, other income (excluding interest expense) amounts to only 7.4% of pre-tax profits due in part to differences in reporting.Implied Blue Sky MultipleIn this blog, we’ve discussed how Blue Sky multiples reported by Haig Partners and Kerrigan Advisors represent one way to consider the market for private dealerships. Below, we attempt to quantify the implied Blue Sky multiple investors place on Lithia Motors. If we assume that the difference between stock price and tangible book value per share is made up exclusively by franchise rights, then Lithia’s Blue Sky value per share is approximately $228. With pre-tax earnings per share of approximately $26.8, Lithia’s implied Blue Sky multiple is 8.53x. Luxury franchises trade for multiples in this ballpark, but luxury makes up only approximately 30% of Lithia’s sales. For comparison, domestic brands make up a similar percentage for Lithia with multiples closer to 4x. Still, the scale of Lithia’s operations and significant growth profile lend it to higher multiples, and there would certainly be intangible assets other than franchise values. Primary Pitch to Investors: Growth and “Driveway”Seeking to meet the market’s insatiable demand for growth, Lithia unveiled its five year growth plan halfway through 2020. The company is targeting annualized revenue growth of 31% for the next five years with a goal of $50 billion in revenue (from $13 billion in 2020). Lithia describes itself as the largest participant in a fragmented $2 trillion revenue industry, combining both the traditional new franchise retailers and the used-only auto retailers.Lithia has emphasized and invested in its omnichannel efforts called “Driveway.” This is an eCommerce solution the company compares to Carvana and Carmax. Lithia notes a higher gross margin than Carvana, and the company’s long-term strategic advantage lies in the combination of an eCommerce option for consumers supported by a larger network of traditional retail locations, which increases options for online shoppers in adjacent markets. Lithia sources 60% of its inventory from trade-ins, giving it robust offerings in the online used vehicle space.In 2018, Lithia also invested $54 million in a partnership with Shift Technologies, which competes with Driveway, Carvana, Carmax, and Vroom. According to the most recently available filing, Lithia owns 13.8 million shares of Shift, which went public via SPAC in October, worth approximately $140 million based on last close.The company’s recent investor presentation showed the company added $3.5 billion in annualized steady-state revenue, though it does not specify the impact of the pandemic on this estimate. Lithia’s acquisitions also required an intangible investment of 25% of annualized revenues indicating the company may have paid greater Blue Sky values in 2020 as Haig Partners and Kerrigan Advisors each indicated market multiples increased in 2020 despite declining revenues.Seeking to acquire strong brands and grow profits, Lithia highlights five keys when acquiring dealerships:New Vehicle Market Share: Lithia looks to improve dealerships that are underachieving the OEM’s market share performance goals. They target improvement from 75% of the OEM target to 125%.Used Vehicle Units: The company seeks to triple the number of used vehicles sold per store per month.F&I Profit: By focusing on cross-selling F&I, Lithia seeks to improve GPUs from $700 to over $1,450.Service & Parts: Similar to improving market share targets, the company seeks to improve CSI scores. In addition to improving relations with customers, this focus positively influences relationships with manufacturers.SG&A Reduction: Lithia seeks to use its scale to reduce SG&A expense to below 65% from approximately 90% for its targets pre-acquisition. In summation, Lithia aims to improve pre-tax margins of its targets from under 1% of revenues to above 3%. To quote the CEO, Bryan DeBoer, on the recent earnings call, “Lithia’s model has always been to buy value-based investments that underperform.” Targeting dealerships with thin profit margins also allows Lithia to grow revenues and increase its distribution network while potentially reducing the amount of Blue Sky paid. However, as noted in the Haig report, lower margin dealerships can often attain higher Blue Sky multiples, resulting in favorable returns for sellers as well.ConclusionLithia’s aggressive growth strategy may pay off if they don’t overspend on dealerships over the next five years. Depending on which markets they target, they’ll also need to be strategic to avoid cannibalizing their current sales as they expand. Investors may well reward them if they hit their growth targets, but private dealerships also stand to benefit from an aggressive buyer in the market. This will be particularly true if Lithia falls behind its growth targets, as private dealers looking to exit may be able to extract more blue sky value out of the deal. Dealers in markets competing with Lithia may also see a shift in their pricing strategy, as the company touts 43% of its transactions with customers as “negotiation free,” potentially implying more competitive (read: lower) prices.At Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. Surveying the operating performance and strategic investment initiatives of the public new vehicle retailers gives us insight into the market that may exist for a private dealership. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Labor Shortage in Trucking Industry Leading to a Rise in Consumer Pricing

A truck driver’s lifestyle is typically portrayed as being lackluster due to exhausting work hours and countless days away from home. As a result of the work environment for a driver, prospects debating entering the labor force in this career field ponder whether driving would be an enjoyable lifestyle. Due to the notion that the younger generation typically finds a career path in trucking unappealing, the demographics of this industry lean towards older males with 27% of truck drivers being over the age of 55 and the median age being 46.

The Chip Shortage Is Making It Feel Like 2020 All Over Again

Last year, many of our blog posts touched on the subject of inventory shortages due to plant closures from the pandemic. However, after stay-at-home orders were relaxed and plants got up and running again, there were high hopes among the major public dealers that inventory levels would return to pre-COVID levels in 2021 and dealerships could meet consumer pent up demand. However, manufacturers are facing a new obstacle on the production line that is a threat to reaching these inventory goals. All over the world, automakers (and other industries) are grappling with a shortage of computer chips.In this blog post, we discuss the necessity of chips in the auto making process, how the chip shortage came to fruition, how it is affecting the industry, and what all this might mean for auto dealers going forward.Small But MightyWhen considering all of the different digital products that you might use on a day to day basis, there is likely one specific thing that they all have in common: computer chips. While cars might not be the first thing to pop in your head when you’re thinking about digital technologies, they also rely on them for many different functions.A mainstream car has more than 100 microprocessors.As OEMs continue to innovate and more features become standard, consumers have benefitted from an enhanced experience while vehicle prices have increased. These advances have also increased the reliance on semiconductors, which have become a crucial part of the supply chain. Car companies can use them to power the modern-day technology in their vehicles, such as the engine, Bluetooth capabilities, seat systems, collision and blind-spot detection, transmissions, Wi-Fi, and video displays.As Kristin Dziczek, a senior industry analyst with the Center for Automotive Research (CAR) notes, “Today’s automobiles use a huge number of computer chips, chips in the engine, chips in the seat, chips in everything, but they’re in tight supply right now.” A mainstream car has more than 100 microprocessors.How It StartedLike many other production struggles that have occurred in the past year, the COVID-19 pandemic is at the root of the shortage of chips. With the new normal of being indoors, demand for electronics increased substantially, boosting demand for microchips. Xbox and Playstation also released their latest consoles in mid-November. The last consoles brought to market by these companies was in 2013, so the timing of this launch exacerbated these issues.While demand for electronics was increasing at the beginning of the pandemic, demand for cars had waned, and thus, automakers like General Motors, Toyota, and Subaru, were forced to close factories at the onset of the pandemic. In accordance, this caused overly conservative demand estimates to be made. However, once the plants reopened, demand was much higher than anticipated, and the chips necessary to fulfill the demand just were not there.Chipmakers tend to favor consumer electronics because their orders are larger than those of automakers. The annual smartphone market is more than a billion devices compared with fewer than 100 million cars. Automaking is also a lower-margin business, leaving manufacturers unwilling to bid up chip prices to avoid risking profitability. Automakers in China were the first to feel the impacts of the shortage, primarily due to it being the world’s biggest auto market recovering from the pandemic, but now the shortage has spread to auto manufacturers across the globe.Current ImpactsMajor auto manufacturers are already starting to react to the chip shortage. Ford is the latest, cutting production of its top money maker, the F-150 pickup truck, due to the chip shortages. The impact could be significant, as the Ford CFO John Lawler notes, “Right now, estimates from [chip] suppliers could suggest losing 10% to 20% of our planned first-quarter production.” This could mean a loss of profit of $1 to $2.5 billion in 2021. Ford is proactively trying to mitigate risk in other parts of their vehicles subject to supply chain disruption, and has hinted that they might be investing in battery production to avoid a similar issue on that front.With not enough chips in supply, the automaking industry stands to lose $61 billion in 2021.Ford is not alone in production cuts though, as it joins General Motors, Nissan, Volkswagen, Toyota, Mazda, and Subaru in cutting output due to the semiconductor shortage. With not enough chips in supply, the automaking industry stands to lose $61 billion in 2021, as reported by consulting firm Alix Partners as Bloomberg reported.As of right now, there is no clear answer for when the chip shortage will be alleviated. Macquarie Capital expects auto production to be affected until mid-2021, as chipmakers up their production, while data firm HIS Markit said the shortage could last until the third quarter this year. As the shortage has worsened in the past week, 15 senators have asked President Joe Biden to secure the funding necessary to implement clauses related to chips in the National Defense Authorization Act, in the hopes it could spur production in the U.S.Potential Impacts for Auto DealersOverall dealership supply is most likely going to be impacted by the chip shortage, and for shoppers who have the money to buy new cars and are expecting deals, they may be disappointed by the selection available. This is a major blow to auto dealers, especially after the public companies on their last earnings call were anticipating inventories to stabilize in 2021. Stay tuned for our upcoming earnings call blog post to hear what public dealers prospects on the matter.All else equal, shortages could squeeze profits for OEMs if they are all vying for the same limited amount of chips. These costs would likely trickle down to dealers who would attempt to pass them on to consumers. However, it is a bit too early to say for certain what the overall impact will be on dealership profitability. A lot of it may depend on how significant the disruption ends up being and how long until things normalize once again.Regardless, it is not the optimistic news that many were hoping to kick off 2021 and signals continuing struggles as the industry tries to shake off the effects of this pandemic. Though the current circumstances are uncertain, the COVID-19 vaccine offers some hope that things will begin to stabilize soon. The current microchip shortage may not be ideal in the current circumstances for inventory levels and dealership profitability, but the impacts will not last forever.If you are interested in learning more about how this may impact the value of your dealership, feel free to reach out to any of us on the auto dealer team. We hope everyone is continuing to stay healthy during this time!

Seven Considerations for Your RIA’s Buy-Sell Agreement

Working on your RIA’s buy-sell agreement may seem like a distraction, but the distraction is minor compared to the disputes that can occur if your agreement isn’t structured appropriately. Crafting an agreement that functions well is a relatively easy step to promote the long-term continuity of ownership of your firm, which ultimately provides the best economic opportunity for you and your partners, your employees, and your clients.If you haven’t looked at your RIA’s buy-sell agreement in a while, we recommend dusting it off and reading it in conjunction with the discussion below.1) Decide what’s fair.In our experience, buy-sell agreements tend to function well when they attempt to strike a balance between the interests of the various stakeholders in an investment management firm, including the founding partners, next-gen management, employees, clients, and the firm itself. By balancing the interests of the various stakeholders, a well-structured buy-sell agreement can be a competitive advantage by facilitating a smooth transition between founding partners and next-gen management. Ultimately, this enhances value for everyone.2) Define the standard of value.Standard of value is an abstraction of the circumstances giving rise to a particular transaction. It imagines the type of buyer, the type of seller, their relative knowledge of the subject asset, and their motivations or compulsions. We wouldn’t recommend getting creative here. Unconventional standards of value can and do lead to different interpretations that can result in wildly different conclusions of value. For most purposes, using one of the more common definitions of Fair Market Value is advisable. Fair Market Value contemplates a hypothetical willing seller and willing buyer, both of whom have reasonable knowledge of the subject asset and neither of whom are under any compulsion to buy or sell. This standard has an almost universally agreed-upon definition and is well established and understood in the valuation and legal communities, all of which helps to remove uncertainty as to its valuation implications.3) Define the level of value.Valuation theory suggests that there are various “levels” of value applicable to a business or business ownership interest. For example, a non-marketable minority interest may be worth less than an otherwise identical controlling interest. From a practical perspective, the “level of value” determines whether any discounts or premiums are applied to a baseline marketable minority level of value. Naturally, sellers would prefer a premium and buyers a discount, but it helps to keep in mind that today’s buyers are tomorrow’s sellers, and today’s sellers are yesterday’s buyers. When transactions are done on a consistent basis over time, it helps to promote a sustainable marketplace for the company’s shares.4) Avoid formula pricing.We often see buy-sell agreements that use a formula to determine value (usually a fixed multiple of a historical performance metric). These formulas often reflect what the principals of the firm thought the business was worth at the time the buy-sell agreement was drafted. As market conditions and the business’ economics change, formula prices can quickly diverge from market value, but the ink on the page remains.When it comes time to buy or sell, perhaps years or decades after the buy-sell agreement was drafted, the formula price will inevitably be benchmarked against the actual buyer and seller’s perceptions on the current market value of the interest. If the formula value is greater than the perceived value, then the selling shareholder may find there are no willing buyers or no reasonable way to finance the sale. If the formula value is less than the perceived value, then the selling shareholder may be incentivized to hold on to their ownership longer than is optimal from the perspectives of the firm, next-gen management, and clients.5) Specify the valuation date.A buy-sell agreement should be explicit about the “as of” date of the valuation. Typically, valuations will consider only what is known or reasonably knowable as of this date. As a result, a difference of just a few days can have a significant impact on the valuation if an unexpected event occurs at the firm. Consider, for example, the death of a key executive. Such an event will often trigger buy-sell agreement provisions, and whether or not the event factors into the valuation will depend in part on the valuation date specified by the agreement. For firms with larger shareholder bases and relatively frequent transactions, it often makes sense to specify an annual valuation date that then applies to transactions throughout the year.6) Decide who will perform the valuation. We recommend selecting a reputable third-party valuation firm with experience valuing investment management firms.7) Manage expectations. Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled. Testing your buy-sell agreement now by having a valuation prepared can help to center or reconcile those expectations and might even lead to some productive revisions to your buy-sell agreement.For more information on RIA practice management issues, register for our upcoming conference, RIA Practice Management Insights. More information can be found below.Early Bird Pricing for the Upcoming RIA Practice Management Insights Conference Ends in 7 DaysMercer Capital has organized a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.Join us and speakers like Jim Grant, Peter Nesvold, Matt Sonnen, and Meg Carpenter, among others, at the RIA Practice Management Insights, a conference unlike any other in the industry.Take advantage of early bird pricing to receive $100 off conference registration. Offer ends next week.Have you registered yet?

Mineral And Royalty Valuations Remain Low Amid Recent Oil Price Gains

The recent rise of oil prices returning to over $50 per barrel is a welcome sign to mineral and royalty holders across the board. There are inklings of bullish expectations for oil and gas prices in the coming year. However, climbing back up the valuation cliff that these assets fell from in March 2020 is still daunting. There are a lot of factors keeping this asset class from rebounding such as rig counts, capex budgets and supply chain issues. It has slowed royalty acquisitions and divestitures to a crawl and pushed undeveloped acreage values in many areas to multi-year lows.On the other hand, these same factors have led to a rush of estate planning transaction activity. The combination of depressed E&P valuations, the potential for future tax changes and the ability for mineral and royalty holding entities to utilize minority interest and marketability discounts have kept many tax advisors busy in recent months. These low valuations may not last for much longer if some recent bullish sentiment comes to fruition though. In the meantime, let us expound a bit on these forces keeping mineral and royalty valuations in their existing state.Low Upstream ValuationsThere is no need to explain how 2020 was a tough year, though the pain was dire for many upstream companies. Recovery appears to be gaining ground, but the momentum is tentative and some changes in travel habits might become permanent. While E&P company values (as proxied by the SPDR S&P Oil & Gas Exploration & Production ETF $XOP) have recovered from their lows in March, the index remains down year-over-year, having declined 38% during 2020.[caption id="attachment_35814" align="alignnone" width="668"] SPDR S&P Oil & Gas Exploration & Production ETF (XOP) | Source: CAPITAL IQ[/caption] The recent flurry of E&P bankruptcies also is indicative of a challenging operating environment and reduced equity valuations. There are exceptions with assets and situations of highly economic Tier 1 production, and/or acreage that can maintain or have proportionally small value decreases during this downturn, but most E&P companies have suffered alongside commodity prices. One of the significant outcomes from this is that rig counts remain less than half what they were pre-pandemic. This lack of activity is contributing to current oil inventory issues and price gains but is also keeping raw and undeveloped acreage valuations particularly depressed due to the slowdown in prospective development timelines. Potential For Future Tax ChangesPresident Biden’s tax plan calls for some major changes to the current gift & estate tax regime. Most notably, the estate tax exemption could be reduced from today’s $11.7 million (unified) to $3.5 million (estate) and $1.0 million (gift), and the tax rate could increase from 40% to 45%. The prospects for tax reform likely increased after Georgia’s Senate run-off elections on January 5th which put the Democrats in control of both houses of Congress.While new tax legislation could potentially be made retroactive to January 1, many tax policy experts see that as unlikely.Acreage Values Remain DepressedThese dynamics are keeping values low. Cash flow values are coming back, but not much else. Few are paying for undrilled acreage unless it is extremely high quality. Freehold’s recent $58 million royalty package acquisition demonstrates this. The deal announced in early January included 400,000 gross acres of mineral title and overriding royalty interests across 12 basins and eight states. It traded for about 58x months of prospective cash flow, but the incremental acreage value was minimal (if anything).[caption id="attachment_35815" align="alignnone" width="700"] Royalty/Mineral Transaction Activity | Sources: Energy Net, EIA, and Hart Energy[/caption] This characteristic is also apparent in mineral aggregators’ stock prices, which remain significantly lower even though oil and gas prices are in a similar spot as a year ago. [caption id="attachment_35816" align="alignnone" width="700"] Mineral Aggregator Stock Performance: 2020-2021 | Source: Capital IQ[/caption] Until The Drill Bit Turns…Many things remain uncertain, but for investors in mineral and royalty assets, prices above $50 per barrel again is a start. The more restrictive regulatory environment will likely also buoy prices. However, until production ramps up and future drilling inventory comes into focus, expect that mineral and royalty values will still have a steep cliff to climb.Originally appeared on Forbes.com on January 29, 2021.

Being Human: The Secret to Authentic Advisor Videos

Guest Post by Megan Carpenter of FiComm Partners

Over the years, we have repeatedly said that the wealth management side of the investment management business is healthier than the asset management side. Unlike asset managers whose clients are likely to jump ship after a few bad quarters, wealth management is based on client relationships and a manager’s ability to inspire confidence in his or her clients. Wealth managers spent their careers perfecting in-person communications to connect with clients. 2020’s transition to WFH made most of these communications virtual. In this post, Megan Carpenter provides tips to improve your Zoom communication skills with clients.Megan Carpenter helps RIA firms and advisors connect, communicate, and engage effectively with their target audiences She will be speaking about the role of marketing in delivering commercial outcomes at our upcoming RIA Practice Management Insights conference to be held March 3-4. Register now to hear more Megan Carpenter along with keynotes from James Grant, founder and editor of Grant’s Interest Rate Observer, and industry veteran Peter Nesvold, Managing Director of Nesvold Capital Partners.The year 2020 knocked a lot of old traditions off their pedestals—including the ways people connect with each other. Now, you don’t even need to be in the same room to sustain a relationship anymore. A video app is enough.The problem is, you spent years becoming a superstar at in-person communications—learning to press the flesh, read a room and translate body language. Can you learn to translate those skills to a screen, and be just as engaging on video?Fortunately, the answer is yes. But first, you need to commit to doing three things: Be vulnerable. Practice hard. And learn from your peers. Be vulnerable: It’s what makes you human.On video, it’s easy to spot the difference between honesty and pretense. A newbie might sit bolt upright at his desk in a suit and tie like a sportscaster, leaving the audience wondering if he forgot he’s at home. Someone more comfortable might lean to the side and smile, welcoming you into her living room like she’s about to serve tea.What you say is even more important than how you look. If you’re guarded, everything sounds like corporate happy-talk. For example, we run video DIY workshops for advisors. For one assignment, we asked attendees to make videos about working from home. Most were predictable, boasting about successful transitions or a smooth client process. Out of nowhere, one advisor said, “I realized I’ve never given myself permission to work from home, even though I’m more productive here. I’ve put all of that on myself.” That one crack of honesty in the wall opened up a flood of deeper conversation.Some concrete tips for bringing vulnerability into your communications include:Don’t overproduce; be humanSpeak to one person, not an imaginary audienceKeep your background simple but relatableIf you forget to mention something while speaking, don’t start again. Just say “Oh, I forgot,” as if you were talking to a friendShare your thought process, and explain how your thinking has matured Practice hard: Being “natural” takes work.It's an oxymoron, but it’s true: If you want to be yourself on camera, you have to learn how. And not just learn it, but practice it. It’s taken you a lifetime to master the art of walking confidently into a room and building a human connection. You’re can’t expect to master doing it on video overnight. These skills aren’t intuitive; they have to be rehearsed. Shoot video regularly, get feedback, recalibrate and try again. If you want more guidance and support, consider signing up for workshops or coaching sessions. Learn from other advisors: You don’t have to go it alone.In fact, you can’t go at it alone. You need give-and-take to learn how to connect remotely. The good news is, being vulnerable is a lot less scary when you see your peers doing the same thing. There’s comfort in watching other advisors emerge from their shells, support each other, and feel supported in return. That’s another reason why workshops are ideal for learning video skills.It’s a new world out there. Old voices are losing influence, and new leaders in branding and communications are emerging. If you want to become a video superstar, you have to commit yourself to learning and growing. You don’t have to be perfect. You just have to be willing to break down old habits, listen to others, and stick with your journey.Originally published in WM.com Midyear OutlookAbout the AuthorMegan is CEO and Co-Founder of FiComm Partners, an award-winning agency for RIA firms and financial advisors.Recently named to the Investment News "40 Under 40" list, Meg’s expertise spans over 15 years of helping RIA firms and advisors connect, communicate and engage effectively with their target audiences. Her passion to promote the industry is demonstrated through her involvement with the CFP Board Center for Financial Planning Workforce Development Advisory Group. We’re excited to have Megan speak at our inaugural RIA Practice Management Insights conference.

Optional Insights on Valuing PUDs and Unproven Reserves

One of the primary challenges for industry participants when valuing and pricing oil and gas reserves is addressing proven undeveloped reserves (PUDs) and unproven reserves, particularly in today’s volatile price environment. The onslaught of COVID-19 and the Russian-Saudi price war caused significant operational implications with arguably all E&P companies. Companies’ forecasts were no longer reasonable. Drilling stopped and the market took a dive. The implication of these events had impacts on the valuations of PUDs and unproven reserves valuations. While the market approach can sometimes be used to understand the value of PUDs and unproven reserves, every transaction is unique. Why then, and under what circumstances, might the PUDs and unproven reserves have significant value?Public transactions do not disclose the value associated with PUDs and unproven reserves, but instead, they indicate an aggregate value for a bundle of assets. The allocation of that value across the various assets acquired is up for debate. Recent transaction sheds some light on asset pricing in the current environment.Optionality ValueThe answer lies within the optionality of a property’s future DCF values. In particular, if the acquirer has a long time to drill, one of two forces come into play: either the PUDs potential for development can be altered by fluctuations in the current price outlook for a resource, or as seen with the rise of hydraulic fracturing, drilling technology can drive significant increases in the DCF value of the unproven reserves.This optionality premium or valuation increment is often most pronounced in unconventional resource play reserves, such as coal bed methane gas, heavy oil, or foreign reserves. This is especially apparent when the PUDs and unproven reserves are reliant on future production. These types of reserves do not require investment within a fixed short timeframe.PUDs are typically valued using the same discounted cash flow (DCF) model as proven producing reserves after adding in an estimate for the capital costs (capital expenditures) to drill. Then the pricing level is adjusted for the incremental risk and the uncertainty of drilling “success,” i.e., commercial volumes, life, risk of excessive water volumes, etc. This incremental risk could be accounted for with either a higher discount rate in the DCF or a reserve adjustment factor (RAF). Historically, in lower oil price environments like we face today, a raw DCF would suggest little to no value for PUDs or unproven reserves in several plays and basins.In practice, undeveloped acreage ownership functions as an option for reserve owners; they can hold the asset and wait until the market improves to start production. Therefore, an option pricing model can be a realistic way to guide a prospective acquirer or valuation expert to the appropriate segment of market pricing for undeveloped acreage.Adaptation of Black Scholes Option ModelThe PUD and unproved valuation model is typically seen as an adaptation of the Black Scholes option model. The Black Scholes option model is widely used to develop the value of European-style options. The adaptation is most accurate and useful when the owners of the PUDs have the opportunity, but not the requirement, to drill the PUD and unproven wells and the time periods are long, (i.e., five to ten years). The value of the PUDs thus includes both a DCF value, if applicable, plus the optionality of the upside, driven by potentially higher future commodity prices and other factors. The comparative inputs, viewed as a real option, are shown in the table below. When these inputs are used in an option pricing model, the resulting value of the PUDs reflects the unpredictable nature of the oil and gas market. This application of option modeling becomes most relevant near the lower end of historic cycles for a commodity. In a high oil price environment, adding this consideration to a DCF will have little impact as development is scheduled for the near future and the chances for future fluctuations have little impact on the timing of cash flows. At low points, on the other hand, PUDs and unproved reserves may not generate positive returns and thus will not be exploited immediately. If the right to drill is postponed for an extended period, (i.e., five to ten years), those reserves still have value based on the likelihood they will become positive investments when the market shifts at some point. In the language of options, the time value of the out-of-the-money drilling opportunities can have significant worth. This worth is not strictly theoretical, either, or only applicable to reorganization negotiations. Market transactions with little or no proven producing reserves have demonstrated significant value attributable to non-producing reserves, demonstrating the recognition by the pool of buyers of this optionality upside. ConclusionWe caution, however, that there can be limitations in the model’s effectiveness, as we describe in Bridging Valuation Gaps Part 3. Specific and careful applications of assumptions are needed, and even then, Black Sholes’ inputs do not always capture some of the inherent risks that must be considered in proper valuation efforts. Nevertheless, option pricing can be a valuable tool if wielded with knowledge, skill, and good information, providing an additional lens to peer into a sometimes-murky marketplace. Today’s marketplace is particularly uncertain, and a quality appraisal is extremely valuable since establishing reasonable and supportable evidence for PUD, probable, and possible reserve values may assist in a reorganization process that determines the survival of a company, the return profile for a potential investment, or simply standing up to third-party scrutiny. Given these conditions, we feel that the benefits of using option pricing far outweigh its challenges.

What Does “The Market” Say Your RIA Is Worth?

GameStop Theory in a Consolidating Industry

Long before Reddit investors discovered that you could Occupy Wall Street more effectively with out of the money call options than you can with tents, Porsche briefly turned itself into a hedge fund and used a similar tactic to try to take over Volkswagen. The story sheds some light on how market pricing does, and does not, reveal the value of a business. Benchmarking the value of an RIA off the behavior of a few aggressive consolidators has similar limitations.Barbarians from BavariaAround 2005, a niche automaker from Stuttgart revealed that it intended to become the largest shareholder of the largest automaker in Germany. At the time, VW Group sold more cars each week than Porsche sold annually, but its share price lagged its industrial scale. Porsche had a CFO with larger ambitions and developed a strategy to use market manipulation to do what seemed impossible. Within a year of its announcement, Porsche’s stake in VW reached 25%, and then 30% by March 2007. Porsche denied mounting a full takeover intent, instead suggesting that it was protecting VW from hostile suitors (an accusation that turned out to be a confession). [caption id="attachment_35773" align="aligncenter" width="690"]For a brief moment, VW had the largest market capitalization of any company on earth, with a closing price on October 28, 2008, of over $1,100 per share, or over 5x its current share price (data from Bloomberg, L.P.)[/caption] By late 2008, Porsche’s ownership stake had climbed to over 40%, and it held options to purchase another 31.5%. The burgeoning stock price for VW was recorded as a gain at Porsche – profits that exceeded what Porsche made from selling cars. At the peak, VW was trading for more than 20 times where it was before Porsche started accumulating shares. If Porsche could’ve gained control of 75% of Volkswagen’s stock, it would trigger a change of control, and Porsche could strip VW’s balance sheet with 8 billion euros. Alas, the credit crisis intervened on VW’s behalf and Porsche’s self-inflicted wounds created insolvency that could only be remedied with a sale to, you guessed it, Volkswagen.GameStop TheoryBy now you’ve read plenty about the short squeeze on GameStop and other heavily shorted financial instruments and commodities (today it’s silver). It seems like it was only a few months ago that cryptocurrencies were exciting. We won’t bite at the opportunity to weigh in on whether or not loosely organized hordes of retail investors at aptly-named Robinhood should be allowed to out-manipulate billionaire hedgies.We will, however, consider the valuation implications of unusual market behavior. The investment management industry hasn’t been the target of vigilante options traders, and we’re not aware of any sub-billion-dollar managers launching a leveraged effort to take over, say, Focus Financial. But the RIA press is fond of breathless speculation about ever-higher prices being paid for firms. One of the absolute truths of the current environment for buying and selling investment management firms is that there has never been a larger number of capital providers offering a greater variety of transaction terms.The question is, what does it mean to you and the value of your firm?The Rules of the GameSome things haven’t changed. Valuation operates in an alternative returns world. In other words, the value of any given investment opportunity depends on the rate of return it generates compared to other opportunities with a similar risk and growth profile.Value is a function of cash flow, rate of return (relative risk), and growth. Assuming cash flow is a constant, for valuations to increase, either cash flow growth expectations must be higher or the expected rate of return must be lower – or both.It is through this lens that we have to view the news about industry consolidation. When a particular buyer makes an eye-watering bid for an RIA, one or more of these three basic elements is in play.The buyer has a unique circumstance that allows them to extract more profitability from the target firm than other bidders or than the firm could extract on its own.There is ample reason to be skeptical of this expectation. Investment management is labor intensive, and clients don’t like their relationship or investment people turning over. While there are some back office efficiencies that come from some transactions, it usually isn’t enough to be meaningful. In our experience, most buyers are genuinely interested in the talent-acquisition angle of an acquisition, because good and experienced industry veterans are rarely available.The buyer has a unique expectation of the growth opportunities inherent in an acquisition. Organic firm growth comes from market tailwinds and marketing discipline. It’s hard to forecast market tailwinds, especially in this environment, and marketing discipline can be built more cheaply than it can be acquired.The buyer is willing to accept a lower rate of return than competing bidders. This is the technical definition of winner’s curse. When Goldman Sachs paid up for United Capital, it wasn’t a big enough deal in the overall GSAM universe to dilute earnings, and it sped up Goldman’s foray into serving the mass-affluent. So even though Goldman accepted a lower return on the deal from a closed-form perspective, it had larger implications for the company that justified getting it done. Just because I found an exception doesn’t make it the rule. All else equal, the highest multiple is the lowest earnings yield, so the buyer is just willing to get less out of the deal.Just Because You Can, Doesn’t Mean You ShouldOne of the pioneers of the RIA industry was a smallcap manager who also happens to be the father of a friend of mine. One choice piece of wisdom that he passed on to his kids: “just because you can, doesn’t mean you should.”You can rationalize valuing RIAs higher today because interest rates are low and the space offers one of the few growth-and-income plays that has worked well for several decades. Time will tell, but interest rates are probably low because economic growth is low. If the market is leveraged to the economy, and RIAs are leveraged to the market, the rules of valuation suggest that low rates don’t necessarily defend higher multiples.Investment management firms used to be considered a value investment. If that’s no longer true, will internal transactions be possible? Will firms be compelled to sell into complex financial engineering schemes that cut every analytical corner in an effort to buy high and sell higher? The NPV of financial engineering, over time, is zero (before fees). No SPAC is going to change that.Does the high bidder set the market? On paper, yes. But the market for RIAs consists of tens of thousands of active participants, many of whom are quietly willing to sit out if financial returns aren’t high enough. Full stop.A Plug for Mercer Capital’s Upcoming RIA Practice Management Insights ConferenceMercer Capital has organized a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.Join us and speakers like Jim Grant, Peter Nesvold, Matt Sonnen, and Meg Carpenter, among others, at the RIA Practice Management Insights, a conference unlike any other in the industry.Have you registered yet?

Changing Advertising Trends for Sunday's Big Game

How the Auto Industry Is Spending Advertising Dollars

So it’s the week of the big game. What are you most looking forward to? The game? The food – appetizers and snacks? The halftime show? Or maybe the commercials? Inevitably, all of us probably have this same list of things in some particular order. The festivities will probably look entirely different this year with smaller gatherings and pandemic protocols affecting travel and public viewing at restaurants and sports bars. But what will this year's commercial line up look like?The big game has historically been a showcase for national companies and advertisers to try and leave a lasting impression on a mass audience. Each of us probably has a running short list of the most iconic and memorable ads from prior games: the Budweiser frogs, Wendy’s “where’s the beef?” or Coca-Cola and mean Joe Green tossing his jersey to the childhood fan. But, these advertisements aren’t for the faint of heart – they are very costly. 2021 is no different with Viacom/CBS having an asking price of about $5.5 million for each 30-second spot. The price tag serves as a barrier to entry for all but larger national brands or those few each year trying to splash onto the scene.The auto industry, specifically the OEMs, are no strangers to advertising during this annual football holiday. Looking back over the last five years, an average of seven auto manufacturers have participated with a high of nine advertisers during the February 2016 game and a low of five at the February 2019 game. The chart below displays the number of advertisements in each of the past five games, plus this year’s game. What’s different in this year’s game? Well for starters, the pandemic has adversely affected television ratings and the public’s consumption of sporting events. The Fox Network, which broadcast last year’s game, had sold out its commercial inventory by Thanksgiving of the prior year. This year’s broadcast partner, CBS/Viacom, only recently sold out its commercial inventory in the past week. Traditional national brands and advertising participants (such as Coca-Cola, Anheuser-Busch/Budweiser, PepsiCo, and Avocados From Mexico) are sitting out this year from running in-game advertisements. How will the auto industry participate? As of this week, only three automotive companies/brands are scheduled to run in-game advertisements which would mark the lowest number of participants in the last five years. In addition to the lower number of auto spots, the messaging choice is also a reflection of trends in the auto industry over the past year: electric vehicles and online/remote retail sales. There are three companies participating in this year’s game. General Motors – advertisement focusing on their ultium battery technology for use in electric vehicles.Cadillac – advertisement focusing on their lyriq electric crossover vehicle.Vroom – advertisement parodying the pains of the dealership buying experience to highlight their safely delivered, contact-free online buying experience. Will this year serve to be an aberration or is it a reflection of advertising changes impacting the auto industry and auto dealerships?Auto Dealership Advertising Trends and SpendingAs we have previously discussed, three expense categories that declined in 2020 that helped auto dealerships maintain profitability despite declining retail sales were advertising, personnel, and inventory costs. Let’s examine some of the trends within advertising spending.The auto industry has historically placed heavy reliance on television and print advertising. According to Zenith Media, television is the second largest advertising channel for auto advertisers and as a whole, auto advertisers spend nearly 32% of their advertising budgets on television, whereas the average brands only spend 27% of their advertising budgets on television advertising.How are auto dealerships and auto advertisers adapting? First, consider several statistics revealed by LocaliQ in their Automotive Social Media Marketing strategy article.72% of Americans use at least one form of social media.78% of all car buyers consider social media in choosing their next vehicle.47% of car buyers spend time on Facebook Marketplace according to their study. Over the past year, the pandemic forced many auto dealerships to shift to offering more online and remote retail services. While overall advertising spending was expected to decline in 2020, the automotive industry had already been spending more advertising dollars on digital media. The chart below shows the total automotive industry’s digital spending in the U.S. for 2017 through 2019, along with anticipated figures for 2020 and predicted figures for 2021. While advertising spending had been increasing in digital channels prior to 2020 and is predicted to return to prior levels in 2021, the digital component to the overall advertising budget still remains a small percentage. In another view of digital spending, Zenith Media found that auto brands lagged behind average brands in this category also, with only 42% of budgets for the auto brands dedicated to digital channels in 2019 as compared to 49% by average brands. Where are individual auto dealerships spending more advertising dollars in 2020? One channel highlighted by the studies discussed previously is Facebook. Facebook and Google are the two premier places companies across a variety of industries advertise and according to a study by Dealers United, the average dealership spent nearly $2,300/month in June 2020 as compared to only $1,600/month at the start of the year. These numbers were only expected to maintain those levels or climb higher as the year came to a close. Digital media advertising allows auto dealerships to optimize the way car users search and shop using mobile devices. These outlets offer the dealership better tools to track their customers, interact with them, and offer a means of customer feedback and improved customer service. The costs for some digital channels can be a fraction of the cost of traditional television and print advertising. Combine lower costs and more targeted advertising, and online strategies seem like a no brainer. Maybe this plays a role in the decline in advertisements at this year’s Big Game. While the three commercials this year also highlight trends we’ve seen this year with EVs and online sales, there’s another trend among the advertisers. Digital ads may be more targeted and have higher conversion rates/ROI, but there is no substitute for national TV advertising for events like the Big Game if you want to get a big message out to as many people as possible. We see this in politics, which really heats up around election day. Vroom, GM, and Cadillac are all looking to make big statements. For the traditional brands, GM and Cadillac want to be known as going in on EVs. They aren’t going to be gas-guzzling forever, and they don’t want consumers to view them as the old guard that can’t adapt to new technology. GM recently announced its intention to be fully electric by 2035; advertising an EV during the game is just another way of amplifying this message. Vroom is also trying to get their name out there. While their IPO may have generated some buzz last year, it seems like just about every IPO this year saw huge gains, so the typical branding advantage of such a jump was probably more muted. Consumers are more likely to have heard of Carvana, as it has a few more years on Vroom, and its car "vending machines" are well known by now. For a company like Vroom to compete, they have to spend considerable advertising dollars on getting their name out there and drive traffic to their site. So far, Carvana seems to be winning this battle, so an ad during this year's game just might help Vroom catch up. ConclusionThe auto industry and particularly the manufacturers will always maintain some level of national television advertising. Over the last several years and specifically the last year, auto dealerships have shown the ability to adapt their operations including how and where they choose to spend their advertising dollars.As you watch the big game this weekend, pay attention not only to the memorable commercials but which brands are advertising this year and which brands are not. Also, look at their messaging. If you’re an operator of an automobile dealership, how are you choosing to spend your advertising dollars and how has that changed in the last year? What is your message?To discuss how these trends are affecting your dealership and their impact on the value of your dealership, contact a professional at Mercer Capital today.

Personal Goodwill: An Illustrative Example of an Auto Dealership

Headwinds and Tailwinds for Auto Dealers

Your Flight Itinerary for 2021

If you’ve ever been on a flight, you know that the pilot and plane itself can only do so much in determining how quickly you get to your destination. A key factor is which way the wind is blowing. If the pilot announces that there are headwinds, you can expect your flight time to be on the longer side. The opposite is true with tailwinds, and you can expect to arrive at your destination more quickly under these circumstances.Similarly for auto dealers, sometimes it doesn’t matter what the dealership’s management is like or how good the dealership itself is, as certain headwinds and tailwinds can make it harder or easier to achieve its goals. Below, we have considered some headwinds and tailwinds heading into 2021.Headwinds for Auto DealersRegulations in the Industry As we mentioned in the blog post which looked into how each presidential candidate’s policies would impact the auto industry, the end of the Trump administration most likely points to an end in regulatory rollbacks in the industry.In 2012, the Environmental Protection Agency and the National Highway Traffic Safety Administration issued regulations that would increase average fleet-wide fuel economy standards to 54.5 miles per gallon by 2025. Though President Trump had pushed back on the regulations, the Biden administration has indicated that they are in favor of these regulations and fuel economy and emission standards set by the Obama administration. Although the administration change could prove beneficial to EV manufacturers, especially in terms of Biden’s plan for providing further government assistance for these companies, an increase in regulations could make cars more expensive, which are already historically expensive.Though higher prices due to inventory shortages during the pandemic have helped margins for dealers, further increases in vehicle prices could dissuade consumers from purchasing vehicles. Dealers will have to hope they are able to continue to pass such costs along to consumers, which may prove more difficult with the proliferation of internet shopping, which brings us to our next headwind for traditional franchised dealers.Consumer Confidence IndexWhen consumers are more confident, they are more willing to make large purchases (i.e. vehicles). This makes it an important indicator for determining headwinds and tailwinds for auto dealers. Unfortunately, between the COVID-19 pandemic, unemployment rate jumps, and uncertainties regarding the election, there was a decline in the Consumer Sentiment Index, as seen in the graph below. As the pandemic rages on and unemployment rates remain high, it’s tough to tell when consumer confidence will return to pre-COVID levels. However, the Biden administration’s plan for a $1.9 trillion stimulus bill could have a positive impact if it is passed. Internet-Based SalesInternet-based sales for vehicles have had their moment in 2020 with the COVID-19 pandemic. Most notably in this industry was the Vroom IPO, whose success has shown investors are confident that internet-based sales for vehicles will be a larger part of the industry going forward. However, internet-based sales strategies can increase revenue at the detriment of margins as increased price transparency further decreases gross margins, posing a potential headwind for the industry going forward. Vroom and others have been able to undercut prices with significant inflows of capital. However, Vroom’s stock price is down a bit over 40% from August highs. If investors sour on the viability of the online used car sellers, this headwind could turn into a tailwind for traditional franchised dealers.Tailwinds for Auto DealersAverage Age of Vehicle FleetA study from IHS Markit found that the average age of vehicles on the road rose to 11.9 years this year, one month older than in 2019. This increase can be partially attributed to declines in new vehicle purchases as a result of the pandemic. Furthermore, vehicles, in general, are lasting longer and increases in prices have dissuaded some consumers from purchasing new vehicles.While new vehicles made up 6.1% of vehicles on the road last year, IHS Markit predicts the final data for 2020 will be closer to 5%. This increase in the overall vehicle age represents pent-up demand for new vehicles. To the extent the pandemic has persuaded would-be buyers on the margin to forego purchases, increasing vehicle age portends greater demand for parts and service operations, which is a positive tailwind for the industry.InventoryAs we mentioned in our New Year’s Resolutions blog post, inventory is the name of the game in 2021 as production has ramped back up, and many of the public dealerships anticipate their inventory levels to fully recover. Because of the inventory shortages caused by manufacturing shutdowns in 2020, many shoppers who were looking for specific models, especially trucks, might not have been able to find what they were looking for. With inventory recovery on the horizon, many dealerships are hopeful this will no longer be a problem. The stabilization of inventory levels presents arguably one of the largest tailwinds for the industry going into 2021. However, it is important to note that a computer chip shortage that has been garnering attention at the beginning of this year poses a threat to this inventory resurgence.Interest Rates With interest rates near zero and the Federal Reserve chairman Jerome Powell indicating that will continue for the near future, auto dealers stand to gain. Lower interest rates make cars and trucks more affordable for consumers financing these large purchases. If interest rates stay low as they are expected to, most consumers will be able to finance vehicles at affordable rates. This should help to offset our headwind above with rising prices.Public Transportation SentimentWhile the COVID-19 pandemic has been devastating for public transportation, auto dealers may be able to gain a new customer base or expand their current one as a result. With Americans relying further on personal vehicles to avoid being in public areas, cars have become more important than ever to many Americans trying to limit exposure as much as possible. Furthermore, with more companies bringing their employees back into the office, this could have a positive impact on car sales as well.The graphs below show both public transit unlinked trips and vehicle miles traveled. While vehicle miles traveled has almost recovered from pre-pandemic levels and are down only 9% in October 2020 compared to October 2019, public transit ridership has fared much worse, down 62% in the same time period. This decline in consumer sentiment for public transit presents a positive tailwind for the industry.ConclusionWe hope that this post is helpful; however, as 2020 made painfully clear, these are only predictions based on current trends. It’s impossible to know exactly what lies ahead. For now, we can all just hope that the ride won’t be as bumpy as 2020 was.If you’re interested in how these trends may affect your dealership or would like to discuss a valuation issue in confidence, feel free to reach out to Mercer Capital's Auto Dealer team.

RIA Industry Extends Its Bull Run Another Quarter

Continuation of Market Rebound Drives All Categories of Publicly Traded RIAs Higher in Q4 2020

Share prices for publicly traded investment managers have trended upward with the market since March’s collapse. Aggregators fared particularly well over the last nine months on low borrowing costs and steady gains on their RIA acquisitions. Traditional asset and wealth managers have also performed well over this time on rising AUM balances with favorable market conditions.[caption id="attachment_35650" align="alignnone" width="959"]Source: S&P Market Intelligence[/caption] The upward trend in publicly traded asset and wealth manager share prices since March is promising for the industry, but it should be evaluated in the proper context. Pre-COVID, the industry was already facing numerous headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. While the 11-year bull market run largely masked these issues, asset outflows and revenue pressure can be exacerbated in times of market pullbacks and volatility. The fourth quarter was also favorable for publicly traded RIAs of all sizes except the under $10 billion in AUM category. This underperformance is largely attributable to the lack of diversification in this index and one company’s (Hennessy Advisors) earnings misses rather than any indication that smaller RIAs have struggled over the last few months. [caption id="attachment_35651" align="alignnone" width="862"]Source: S&P Market Intelligence[/caption] As valuation analysts, we’re often interested in how earnings multiples have evolved over time, since these multiples reflect market sentiment for the asset class. LTM earnings multiples for publicly traded asset and wealth management firms declined significantly during the first quarter—reflecting the market’s anticipation of lower earnings due to large decreases in client assets attributable to COVID-19’s impact on the market. Multiples were inflated in Q2, as prices recovered and earnings lagged—but have metrics have since normalized as prospects for earnings growth have improved with AUM balances. [caption id="attachment_35652" align="aligncenter" width="518"]Source: S&P Market Intelligence[/caption] Implications for Your RIADuring such volatile market conditions, the value of your RIA is sensitive to the valuation date or date of measurement. In all likelihood, the value declined with the market in the first quarter and has now recovered most or all of that loss. We’ve been doing a lot of valuation updates amidst this volatility, and there are several factors we observe in determining an appropriate amount of appreciation or impairment.One is the overall market for RIA stocks, which was down significantly in the first quarter but has since recovered to above where it was a year ago (see chart above). The P/E multiple is another reference point, which has followed a similar path. We apply this multiple to a subject RIA’s earnings, so we also have to assess how much that company’s annual AUM, revenue, and cash flow have increased or diminished since the last valuation, while being careful not to count good or bad news twice.While the market for publicly traded companies is one data point that informs private RIA valuations, that’s not to say that privately held RIAs have followed the same trajectory as their larger public counterparts. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds discussed above. Many smaller, privately-held RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.We also evaluate how our subject company is performing relative to the industry as a whole. Fixed income managers, for instance, held up reasonably well compared to their equity counterparts in the first quarter of 2020. We also look at how much of a subject company’s change in AUM is due to market conditions versus new business development net of lost accounts. Investment performance and the pipeline for new customers are also key differentiators that we keep a close eye on.You also need to consider the implications of the recent election and Georgia run-off on your clients’ estate planning needs in the face of higher taxes and lower exemptions (What RIAs Need to Know About Current Estate Planning Opportunities) that could go into effect next year. And you should always be thinking about practice management issues (RIA Practice Management Insights) and how your firm can thrive in a chaotic market environment.Improving OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has generally improved with market conditions over the last several months. AUM has risen with the market over this time, and it’s likely that industry-wide revenue and earnings have as well. The fourth quarter was generally a good one for RIAs, but who knows where 2021 will take us following a wild year for RIA valuations and market conditions.A Plug for Mercer Capital’s Upcoming RIA Practice Management Insights ConferenceMercer Capital has organized a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.Join us and speakers like Jim Grant, Peter Nesvold, Matt Sonnen, and Meg Carpenter, among others, at the RIA Practice Management Insights, a conference unlike any other in the industry.Have you registered yet?

Playing the Match Game: Finding the Perfect Fit Between Buyers and Sellers

Guest Post by Louis Diamond of Diamond Consultants

For most independent RIAs, a future M&A transaction is inevitable. The impetus behind the transaction could be the partners’ desire to retire, gain scale, accelerate growth, meet liquidity needs, reduce the time burden of non-client facing tasks, or some other motive. Whatever the reason, picking the right partner is critical for the success of the transaction. For both buyers and sellers, knowing where your firm fits into the RIA M&A landscape is an important first step towards identifying compatible transaction partners. The universe of RIA sellers can be categorized based on firm culture, the motive behind the transaction, management’s expectations for post-transaction roles, liquidity needs, the status of next-generation management, and the like. As RIA transactions have proliferated in recent years, several different buyer profiles have emerged that address the concerns of these different seller types. In this week’s guest post, Louis Diamond of Diamond Consultants identifies four common buyer profiles and the types of sellers that fit well with each.Louis Diamond will be speaking on the topic of advisor recruitment and acquisitions at our upcoming RIA Practice Management Insights conference, to be held March 3-4. Register now to hear more from Louis Diamond along with keynotes from James Grant, founder and editor of Grant’s Interest Rate Observer, and industry veteran Peter Nesvold, Managing Director of Nesvold Capital Partners.Most acquirers have traits within one of four categories—each offering a unique value to sellers. And having the “right” persona can make all the difference in attracting the right acquisition partners.Many independent firms reach a point in their business lifecycle where they can no longer sufficiently grow or compete on their own. It’s when discussions around finding a way to gain scale and solve for succession hit a wall that firms often consider a merger or acquisition opportunity. Yet finding the right M&A partner isn’t all that easy.As a firm that represents both buyers and sellers, it’s our job to keep a finger on the pulse of the market and listen to many value propositions from prospective buyers. That said, only a handful of firms are truly poised to be meaningful acquirers in this hyper-competitive marketplace. Attributes such as being well-capitalized (given that most sellers expect a decent portion of the purchase price at closing), having a repeatable and battle-tested M&A process, a unique value proposition, and strong leadership are now table stakes in this environment.Buyers and sellers alike often fail to recognize what a marriage between firms can mean for ongoing control, growth and quality of life. Therefore, it is paramount that firm owners are strategic in how they present their value to prospective sellers—and sellers come to the table prepared with clearly identified expectations of the new affiliation.One key area that many buyers often lose sight of – which helps to focus targeting, due diligence efforts and proper alignment – is being clear and honest about what “type of acquirer profile” your firm represents to a prospective seller. It’s equally important to recognize that remaining consistent in this regard is critical; that is, once a firm persona is established, any variances can lead an organization astray of its core competencies and culture, ultimately suppressing enterprise value. And for sellers, recognizing their goals and matching those with one of the four profiles will ultimately translate into a more strategic and focused sale process.The Four Acquirer ProfilesWe find that most acquirers have traits within the following four categories—each of which offer a unique value to sellers.1) Standalone RIAsThese firms are exemplified by a “one brand, one firm, one investment” approach. The most successful acquirers in this group manage more than $1B in assets and have a similar culture, operating structure, and approach as the firms they acquire. They tend to do a small number of deals, so they are typically more strategic in nature than financial. These firms may sometimes allow the seller to maintain an active voice in steering the ship and become a relatively significant equity holder, if so desired. Additionally, all back office and business operations will be taken off the seller’s plate.Another important distinction for those who become an equity owner: There is still the possibility of a significant liquidity event down the road if they take on an investor or sell the firm.Examples: Numerous RIAs have completed a handful of deals and are embarking upon M&A for the first time.Most attractive sellers: Principals who have a longer runway to retirement and are still looking to retain some managerial duties, and those who are primarily focused on a good cultural or local fit. Or an advisor close to retirement who identifies an ideal hand picked successor already at the acquiring firm.Least attractive sellers: Those who value maximum upfront money since these firms are not backed by deep-pocketed investors; those wanting more of a national footprint or brand; or anyone looking to remain fully in charge of operations, since to an extent, investment management and financial planning are standardized across the firm. Also, sellers looking to get a deal done quickly might steer clear of acquirers in this category as these standalone firms tend to be less-experienced deal makers.2) Aggregators or RollupsFirms that are very well-capitalized, prolific deal makers are frequently referred to as aggregators or rollups. They excel at operations, streamlining businesses, standardizing processes, and maintaining strong communities of like-minded advisors. They will take over the entire investment management program, as well as the financial planning process—essentially everything aside from client service. Many firms in this category have cracked the code on organic growth so may have a dedicated business development team, a well-oiled digital marketing or seminar-based lead development system, or be active in the various custodial referral programs.Examples: Mercer Advisors, Beacon Pointe, Mariner, Allworth, and Buckingham.Most attractive sellers: Firms that believe the acquirer has built a “better mousetrap” and are in complete lockstep with the acquirer’s values (i.e., a hard-core focus on financial planning). Also, a good fit those seeking an exit strategy or to gain considerable scale and vastly accelerate organic growth, as well as those who want to step away from the day-to-day operations and just focus on clients.Least attractive sellers: Any principal who is not ready to give up full control.3) Platform AcquirersThese are organizations with many different types of businesses under one roof, but with common middle- and back-office infrastructures. They want sellers to leverage their platform and scale, yet they are all about letting businesses continue to operate in silos.Examples: HighTower Advisors, Kestra Financial (Bluespring Wealth), Stratos Wealth Partners, Sanctuary Wealth PartnersMost attractive sellers: Those who are seeking a partial liquidity event or looking to step back from business ownership, yet still value being involved with portfolio management, financial planning, maintaining their brand, prospecting, and even running their own P&L.Least attractive sellers: Advisors who are close to retirement, yet do not have a succession plan; those who are seeking dedicated resources to fully take on planning, investment management, and day to day client facing responsibilities; and those who are no longer interested in managing a business.4) Financial Buyers or InvestorsThere’s no shortage of capital chasing the independent wealth space as countless private equity firms, family offices, sovereign wealth funds, and diversified financial services companies have made passive investments in larger scale firms. These firms offer prospective sellers the ability to take significant chips off the table by selling a portion of their business. They serve as a strategic growth partner to assist in the sourcing, structuring, and financing of sub-acquisitions, as well as provide the opportunity to retain brand and the client service model.Examples: Focus Financial Partners, Wealth Partners Capital Group, Emigrant Partners, Merchant Investment Management, CI FinancialMost attractive sellers: Those who value maximum upfront cash, retaining day-to-day control of the business, minimizing change, and growing by way of acquisition.Least attractive sellers: Advisors looking to offload the non-client service and business development processes, a firm without an internal succession plan, firms that struggle with profitability and scale, those less interested in focusing on organic and inorganic growth. A merger or acquisition can benefit both parties involved, provided each are equally motivated with compatible needs and goals. By identifying the unique needs and requirements of each party (prior to engaging in an M&A project), the process of meeting the right match can be far more efficient and lead to a successful marriage. About the AuthorLouis has guided many of the top teams in the industry as they’ve transitioned to another employee-model firm or launched RIA firms. And as a next generation leader himself, Louis has a passion for representing complex multi-generational teams.A George Washington University magna cum laude graduate with a BBA degree in Finance and International Business, Louis began his career with some of the biggest names in the financial services industry. His time working as a consultant at Ernst & Young, and in wealth management at Morgan Stanley and UBS, well prepared him to understand the financial world from a client’s perspective.We're excited to have Louis speak at our inaugural RIA Practice Management Insightsconference.

2021 Is Still an Optimal Time for Gifting Interests in E&P Companies

Factors That Led to a Rush of Estate Planning Activity in 2020 Largely Remain

December was a busy month at Mercer Capital, and at business valuation firms across the country. Clients sought to make gifts and perform other estate planning transactions ahead of year-end. But the changing of the calendar does not mean that the window for gifting is over. The factors that led to a rush of estate planning transaction activity during 2020 largely remain. The combination of depressed E&P valuations, the potential for future tax changes, and the ability to utilize minority interest and marketability discounts are still present in 2021.Depressed E&P Valuations2020 was a difficult year for many companies, though the pain was acute for E&P companies that were faced with unprecedented demand destruction that led to negative oil prices. Recovery appears to be taking hold, but the pace is uncertain and some changes in commuting and business travel habits might be permanent.While E&P company values (as proxied by the SPDR S&P Oil & Gas Exploration & Production ETF) have recovered from their lows in March, the index remains down year-over-year, having declined 38% during 2020.[caption id="attachment_35371" align="aligncenter" width="645"]Source: Capital IQ[/caption] The recent spate of E&P bankruptcies also is indicative of a challenging operating environment and reduced equity valuations. There are exceptions with assets and situations of highly economic Tier 1 production, and/or acreage that can maintain or have proportionally small value decreases during this downturn, but most E&P companies have suffered alongside commodity prices. While unpleasant from a net worth perspective, this (hopefully temporary) reduction in value can be a boon for estate planning purposes, allowing taxpayers to gift larger interests, while utilizing less of their gift & estate tax exemption (or paying less in taxes on the gifted interest). Potential for Future Tax ChangesPresident-elect Biden’s tax plan calls for some major changes to the current gift & estate tax regime. Most notably, the estate tax exemption could be reduced from today’s $11.7 million (unified) to $3.5 million (estate) and $1.0 million (gift), and the tax rate could increase from 40% to 45%. The prospects for tax reform likely increased after Georgia’s Senate run-off elections on January 5th put the Democrats in control of both houses of Congress.While new tax legislation could potentially be made retroactive to January 1, many tax policy experts see that as unlikely. Mercer Capital’s Atticus Frank has a great blog post with additional reading for anyone interested in estate planning for 2021.Consider taking advantage of the current gift & estate tax exemptions in 2021 before they potentially go away.Minority Interest and Marketability DiscountsBy gifting minority interests to heirs, taxpayers can potentially utilize minority interest and marketability discounts to reduce the value of the gifted interest and ease gift & estate tax burdens. These discounts are highly dependent on facts and circumstances surrounding the subject interest. Mercer Capital has successfully defended its minority interest and marketability discounts to the IRS and in other litigated contexts.By gifting minority interests, one does not only benefit from the application of minority interest and marketability discounts during the gifting process. If done as a part of a thoughtfully executed estate planning strategy, gifting can result in a non-controlling ownership interest in an estate, allowing for the potential application of discounts for estate tax purposes as well.Mercer Capital’s Travis Harms has an insightful blog post about this issue. In the post, he runs hypothetical math showing the difference in potential tax liabilities under various gifting scenarios. A thoughtful gifting strategy as part of a broader estate plan can have a significant impact on the proceeds heirs receive from an estate.ConclusionDespite what one might think, the window for gifting transactions has not closed. Mercer Capital provides valuation and other financial advisory services to families seeking to optimize their estate plans. Give one of our professionals a call to discuss how we can help you in the current environment.

Small/Mid-Sized Asset Managers Can Stay Relevant

Asset Management Industry Outlook

Over the last decade, investors have generally earned a higher net return by investing in passive vehicles rather than actively managed funds. Heather Brilliant, CFA (CEO of Diamond Hill), says the growth of passive investing has allowed “investors to access beta at a much lower price.”However, the strong performance of large cap indices like the S&P 500 between the 2008-2009 recession and February of this year has also contributed to outflows from actively managed products. In March of last year, when the stock market fell due to COVID-19, many of our clients thought this would lead to a reversal in the trend. Active managers could once again shine.When the market quickly recovered and performance was largely driven by a handful of sizeable tech companies, however, active managers continued to struggle to deliver alpha (net of fees). U.S. trailing twelve month fund flows as of November 2020 were negative for all classes of actively managed equity investments and positive for all passive products. Passive market share is now greater for U.S. equity investing than active, a first. While large asset managers (i.e. BlackRock), are protected by sheer scale, how do small/mid-sized asset managers stay relevant in this environment? As we noted last week, the multiples observed for publicly traded asset managers are often lower than multiples observed in acquisitions of wealth management franchises. Asset managers are still facing numerous headwinds, as outlined below, and this higher risk profile and lower opportunity for growth is the cause for lower multiples. Industry HeadwindHow to Stay RelevantUnderperformance Drives Outflows An asset manager’s clients are more likely to jump ship after short term underperformance than clients of wealth managers. A 2016 State Street Study found that 89% of clients will look elsewhere after just 2 years of underperformance. But outperformance can also drive asset attrition from rebalancing.Educate your Clients Investors who truly understand the risk/ return profile of their investment portfolio are more likely to tolerate short term underperformance. Most asset managers have a style that will work better in some markets than others. Asset Management Industry Barbell Many asset managers are too small to achieve scale yet too big for the investment team to create highly researched and distinguished funds. Some of these firms are capitulating to consolidation, but there are other options.Commit to Capacity Limits The CEO of Diamond Hill Capital Management, Heather Brilliant, CFA, took the stance in a recent podcast that active management is not a scale game. While many consider this to be a shortcoming of the industry, acknowledging that your firm cannot work for everyone, but can deliver great returns for fewer investors, is key. Her advice lines up with the recent growth of the OCIO industry, which commits more time and energy to individual clients’ needs. Fee Pressure As we have written numerous times before, fee pressure in the asset management space has increased over the last decade, as low-to-no-cost products have proliferated and actively managed products have underperformed.Differentiate Products and Trim Expenses There are two ways to increase the bottom line: 1) increase revenue and 2) reduce expenses. Asset managers can combat fee pressure by differentiating their products by taking a new approach to branding or by considering specialized investment classes such as sustainable investing. But, without buttressing your fees, the only way to save your margin is to clean up the “back of the house.” Investment management techniques and products have developed tremendously and there is a growing focus to match this development in the back office.A Plug for Mercer Capital's Upcoming RIA Practice Management Insights ConferenceWe’ve decided to put together a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.The topic list is unlike that of any other investment management firm forum. We’ve attended and spoken at plenty of great conferences that cover investment products and M&A, so we’re not going to plow that ground ourselves. Instead, we have gathered an impressive list of thought leaders who have built careers out of professionalizing the “back of the house” to support the best investment management products and services.Please join us to get their wisdom on how your firm can evolve to become a more sustainable, profitable, valuable enterprise.Have you registered for the RIA Practice Management Insightsconference yet?

December 2020 SAAR

2021 Predictions for Auto Dealers

Coming into 2020, vehicle volumes in the U.S. were anticipated to dip below 17 million light vehicles sold. The industry had eclipsed this mark in each year since 2014, though 2019 cut it close. Like most industries, automotive retail got off to a strong start in 2020. While SAAR was just below the 17.0 million mark at 16.9 in January and 16.8 million in February, the boost of a leap year falling on a Saturday had total volumes at just shy of 2.5 million, up 4.5% from 2019. While dealers were hopeful volumes would remain high, we all know what happened next in March and April, which put to rest any notion of 17 million vehicles sold. In the U.S., 14.46 million units were sold in 2020 representing a 14.7% decline and the lowest total since 2012. Normalizing only March and April to their 2019 levels, volumes in 2020 would have been 15.7 million, showing nearly half the 2020 decline occurred in just those two months.The decline can also be attributed to a significant reduction in fleet sales as the COVID-19 pandemic’s impact on travel caused several major rental car companies to cancel orders. In December 2020, monthly retail sales appear to have actually improved 0.5% from 2019, compared to a 33% decline in fleet volumes. Viewed another way, fleet sales represented only about 14.3% of total volumes in 2020, compared to a 19.6% share in 2019. We touched on the impact of retail vs total SAAR last month.The pandemic had a material impact on the sales process in March/April and the sales mix from fleet to retail, predictions from before the pandemic about sales volumes weren’t that far off the mark once stay at home orders were relaxed and dealers figured out how to navigate the new protocols. By September, SAAR had returned above 16 million. However, no month in 2020 reached seasonally adjusted volumes of 17 million, a mark reached seven times in 2019 and every month but two in 2018. So, while nobody could have predicted the depths of the pandemic, we see that the initial expectation of a lower run rate may have been correct.Eisenhower once said, “Plans are worthless, but planning is indispensable.” According to Scott Galloway, Professor at NYU Stern School of Business, “the same is true for predictions – they matter for the strategy and data behind them. Predictions are useless, but scenario planning is invaluable.” I find this quote to be even more telling as it appeared in a piece about predictions for 2020, which just about everyone missed.Heading into 2021, we’re going to make some predictions. While they may or may not prove true in 2021, we believe this exercise is beneficial for auto dealers who should be looking forward to what the year might bring and prepare themselves should these trends materialize. While nobody could have predicted their need for Clorox and face masks, the pivot to digital offerings and more targeted advertising was already in motion prior to the pandemic. Intentional planning can help prepare for what lies ahead, whether or not things actually unfold as you project. It’s the preparation itself that’s meaningful.Inventory Constraints Lessen and Fixed Operations ReturnsThis prediction is based on the trends seen at the end of 2020 continuing through 2021. As vaccine distribution ramps up, auto manufacturing should continue as well. The speed of each of these will likely be a significant factor in total volumes in 2021. Fixed operations, particularly collision, were diminished in 2020 with fewer road miles driven. Due to inventory constraints and potential affordability concerns, among other reasons, consumers shifted towards used vehicles. We anticipate normalizing inventories and an improving economy should both tilt the mix back towards more new vehicles. However, the recent increase in used vehicle sales should increase the average age of vehicles on the road, which tends to spur more business for dealers’ service and parts departments. Since this is the highest margin business for auto dealers, we see tailwinds in terms of total profitability. While higher volumes can bring in more bonus money to dealers on the backend, at the end of the day, profitability is what drives value for auto dealers.Crossovers Remain Popular as Low Gas Prices and High EV Battery Costs Don’t Make the Trade-Off Worth It to the Bulk of Consumers, Yet.Pickup trucks accounted for 19.7% of market share, higher than all cars combined (small, midsized, and large) excluding luxury. Combined with crossovers (43.3%), SUVs (8.7%), and vans (4.7%), light trucks accounted for 76.4% of all sales, up from 72.1% in 2019 and 69.2% in 2018. Larger vehicles have become increasingly popular with consumers, and low gas prices and improved MPGs reduce the costs of the trade-up in size. Even inventory shortages and reduced incentives haven’t deterred demand in this segment. Incentives in December 2020 were down 12.7% from 2019, which along with the continued shift to higher priced vehicles, pushed average transaction prices to all-time highs of just over $38 thousand per vehicle.Nearly 96% of vehicles sold in 2020 were gas or diesel-powered, with EVs making up only 1.4% of the market. While there has been significant investment in this space, and an incoming Democratic administration portends a shift towards sustainable fuels, we do not anticipate this to materially accelerate in 2021. Instead, most of the EV progress anticipated in 2021 is more likely to be along the lines of infrastructure investment, legislative assistance, and vehicle improvements. While many manufacturers such as Volvo have made claims their cars will be all-electric by 2030, we see that progress being back-ended. While Elon Musk claimed EV battery costs could be cut in half, but this will still be years from now. Ultimately, until the sticker price can meaningfully compete, EV’s won’t reach the majority of consumers.SAAR of 16 Million (Above NADA’s Forecasted Figure of 15.5 Million)NADA is forecasting a SAAR of 15.5 million in 2021, making our prediction slightly on the bullish side. While the industry appears set for a second straight year below 17 million, improved margins could leave dealers with higher gross profits, which would be a welcomed trade in the industry. According to NADA, headwinds for the vehicle market in 2021 include continued increases in COVID-19 cases, which could lead to production disruptions along the vehicle supply chain. They further noted a global shortage of semiconductor microchips used in many facets of auto production and tight inventory on dealer lots, particularly for pickup trucks. Alternatively, tailwinds for 2021 include a potential economic boom in the second half of the year once a coronavirus vaccination is widely available, and Americans return to work from WFH. Auto retailers also stand to benefit if consumers continue to prefer personal vehicle ownership over rideshare services and public transportation. Finally, low interest rates keep cars affordable, and the Fed has indicated it intends to continue to be accommodative, which should support vehicle demand.Conclusion As auto dealers know, SAAR is a decent gauge on the industry, but it tells us very little on its own. While we believe it’s important to track, we recognize the inherent limitations of just volumes. In the proper context of incentive spending, profitability, and other key metrics, SAAR can be helpful. While dealers can see how their volumes compare to wider industry trends, dealers need to focus on the underlying trends within their local markets to contextualize performance to make sure they are staying ahead of the curve.For an in-depth analysis of how your dealership fits in the auto dealer marketplace, contact a member of Mercer Capital’s Auto Dealer team today.

Silver Linings: Using Crisis to Improve Your RIA’s Health

Guest Post by Matt Sonnen of PFI Advisors

Early in the COVID pandemic, PFI Advisors published an article outlining how RIAs could perform an “Operational Diagnostic” to improve their profitability. Matt Sonnen wrote, “For now, advisors are focusing on exactly what they should be doing – guiding their clients through this turmoil and keeping them calm and focused on their long-term financial goals. When the time is right, however, I’ll forward this article to our clients so they can begin the work of focusing on the bottom line…”Nine months later, most RIAs and their clients have recovered from the market volatility and ended up having a very good year, at least on paper. Now’s the time for RIA principals to consider how they can advance their firms to be ready to meet the next challenge with greater ease.We’re featuring Matt Sonnen’s wisdom on operational best practices and business strategy in our upcoming conference, RIA Practice Management Insights, on March 3 and 4. Registration is open. This article is being published a bit early, I realize that. When you go to the doctor with clogged sinuses, a splitting headache, and body aches like you’ve never had, you just want some antibiotics that will get you back on your feet as quickly as possible – you aren’t in the mood to hear a lengthy admonishment over your lack of exercise and eating habits. “Doc – if I survive this thing, I promise I’ll go on a diet and exercise in order to prevent this from happening again, but you’ve just got to help me get out of bed tomorrow, first!” we all say. The recent pullback in the market is putting stress on RIAs from coast to coast. Revenues are estimated to be down 10 – 15% for the year, putting pressure on profit margins and causing some RIA owners to fret about the viability of their businesses and what cuts they’ll need to endure in the coming months. We’ve written about the need to focus on profits before (What RIAs Should Learn From Uber and Lyft and The Age-Old Debate: Profit vs. Growth – What’s More Valuable?), and much has been published in the past few weeks about the need to focus on profitability in order to survive this downturn. Lecturing RIAs about their profit margins right now is a bit like the doctor lecturing you about your eating habits when you are just trying not to pass out from exhaustion, and your body furiously fights off a bacterial infection. But at some point, it is prudent for you to look at preventative measures that can help you avoid that pain in the future. For now, advisors are focusing on exactly what they should be doing – guiding their clients through this turmoil and keeping them calm and focused on their long-term financial goals. When the time is right, however, I’ll forward this article to our clients so they can begin the work of focusing on the bottom line… Why are profits so vitally critical now, you ask? A recent Financial Advisor IQ article quoted the Boston Consulting Group’s finding that “profits in absolute terms at wealth management companies have yet to reach pre-2008 crisis levels.” BCG says, “Even when allowing for some profit growth during 2019, the average firm thus has a much lower buffer to absorb shocks.” Philip Palaveev recently stated in a Financial Advisor Magazine article, “Much like the [corona]virus, if someone has health issues, they are very vulnerable and perhaps they need to be looking ahead and taking even more precautions.” He continued, “Those firms with less than 25% profit margins have less room to wiggle without going to compensation reduction and layoffs.” Brandon Kawal of Advisor Growth Strategies agrees with Palaveev’s 25% profitability hurdle, stating in a recent RIAIntel article, “A healthy operating margin – net of owner and employee compensation costs – is generally between 25% and 30%. Less profitable firms could potentially face drastic declines in compensation and even resort to cost cutting.” Kawal continued, “I imagine a lot of owners are sort of stuck in the here and now [tending to clients]. As we go through the coming weeks, it’s going to be time to take a step back and really take a look at the business holistically.” In his recent article, Don’t Waste This Crisis, Matt Crow of Mercer Capital points out, “The value of RIAs and the future of transactions in the industry ultimately comes down to the health of the individual firms. Fortunately, there is a relatively straightforward way to assess the financial well-being of your firm, and ways of taking corrective action if your firm’s future is threatened.” Crow recommends RIAs take a look at their ongoing revenue and expenses. Starting with expenses, he advises, “Take your last month’s P&L. Your biggest expense is labor and benefits; it’s not unusual to see labor costs comprising two-thirds or more of an RIA’s total operating costs.” For a simpler calculation, he says to leave out discretionary bonuses and just focus on salaries and benefits. “Once you’ve quantified total personnel costs, look at other fixed costs like rent, research, compliance, technology, systems, etc. Adding all that together will derive your annualized expense base.” Now it’s time to calculate your adjusted revenue, given the pullback in the markets. Crow points out, “The beauty of the RIA model is that you can know, on any given day, what annualized revenue is. Take your closing AUM as of the most recent trading day, filter it through your fee schedule, and you can tell, based on that day’s market pricing of your client assets under management, what annualized revenue is.” He concludes, “With annualized revenue and expenses calculated, you know whether or not you’re profitable, and by how much.” As every episode of G.I. Joe concluded in the 1980’s, “Knowing is Half the Battle.” The next big question is, “What the heck are we going to do about it?” There are only two sides to the profitability equation that you can manipulate in order to boost profitability: you can increase revenue, or you can decrease expenses. Given the fact that no one knows how the current economic uncertainty is going to play out and the effect it will have on RIA revenue, it is most logical to focus on expenses. There are hard costs to examine – “Where can we spend less money?” and there are productivity costs to review – “Where are we under allocating resources that we could be more productive and service our clients more efficiently?” In our opinion, the best way to perform this analysis is through an Operational Diagnostic, where you review each of your core back office systems and workflows and ask yourself a few key questions, detailed below. Maybe you are spending money on systems that your firm is not fully utilizing, and there is a less expensive system that could be implemented without causing any decrease in client service. Maybe you have underspent in certain areas, which is causing too many man hours to be spent on basic tasks. The Operational Diagnostic process should reveal these areas and allow you to more efficiently provide high-touch service to your clients. Another area to focus on would be Client Segmentation. The goal of any client segmentation exercise is to determine the proper resources to allocate across your client base. Are you profitably servicing every client, based on the complexity of the relationship and the fees they are paying you? Here are some ideas around a Client Segmentation exercise:One last area worth evaluating is what services are you outsourcing vs. conducting in-house? We recently wrote an article expressing our thoughts around building vs. buying your RIA’s client portal. Other areas you may want to consider outsourcing are:PFI Advisors has helped many RIAs think through profitability since our launch in 2015 – whether we are asked, “How do I run my firm more profitably?” or “How do I launch an RIA that will be designed to maximize profitability?” or “How do I successful execute a merger in the most profitable fashion?” We are always here to help RIAs think through these issues, but this analysis can be done in-house as well, following the guides included below.We’ll make it through this, just like we’ve made it through other economic downturns in the past. Matt Crow points out, “The current [environment] threatens our physical health as well as our financial health, so it wears on our psychology much more than most economic downturns.” This one is tough, on many levels. But when the dust settles, and our physical health is assured, use this wake-up call to focus on the health of your business. As management guru and former CEO of Intel, Andy Grove, stated, “Bad companies are destroyed by crisis. Good companies survive them. Great companies are improved by them.”Originally published in April 2020.About the AuthorMatt founded PFI Advisors to help existing RIAs tackle the various operational and strategic issues that arise as they continue to grow, and to help billion-dollar breakaway teams start their own RIAs. He left Focus Financial Partners in 2015 to launch PFI with his wife and business partner to help RIAs become more successful. Matt understands the importance of efficient systems, as he carried out two full system replacements while COO/CCO of Luminous Capital. He has 20 years of industry knowledge and experience to help your firm reach its full potential.For the past two years, Matt has been hosting a monthly podcast, The COO Roundtable. Through interviews with top operations leaders from around the country, the podcast highlights the incredibly important work COOs perform on a daily basis. We are excited to have Matt conduct a live interview at the RIA Practice Management Insights Conferencewith two operations professionals to discuss best practices and general business strategy for the RIA industry. With all the disruptions caused by COVID-19, operations professionals have more leverage with RIA owners than possibly any time in our industry’s history. This is bound to be an insightful discussion. To learn more about The COO Roundtable, click here.

Q4 2020 RIA Transaction Update

Deal Activity Rebounds After Brief Lull; Deal Terms and Multiples Remain Robust

After a brief lull during the second quarter of last year, RIA deal activity surged in the fourth quarter, rounding out a record year in terms of reported deal volume. Concerns about the pandemic and market conditions were quickly shrugged off, as deal terms and the pace of deal activity returned to 2019 levels after the brief pause at the peak of the shutdown.The strong fourth quarter deal activity reflects a continuation of the upward trajectory seen over the last several years. Fourth quarter deal activity was further accelerated by the backlog of deals that had stalled earlier in the year and by the expectation for increases to capital gains tax rates when the new administration takes over. The total reported deal volume in 2020 increased 28% from 2019 levels, and while deal count declined 15% from 2019 levels, the decline was almost entirely attributable to the brief slowdown in the second and third quarters. The average deal count in the first and fourth quarters exceeded the 2019 quarterly average.Deal Terms Remain Robust Deal terms and multiples showed remarkable resilience in 2020.Deal terms and multiples for wealth management franchises showed remarkable resilience in 2020. While the height of the market downturn caused some buyers to exercise caution regarding multiples and deal terms, the effect was short-lived. As equity markets rebounded and the uncertainty diminished, deal terms and multiples quickly returned to 2019 levels, with attractive RIA sellers seeing high single digit multiples of EBITDA and meaningful portions of the purchase price paid in cash at closing.The strength of deal terms is not surprising given the influx of new buyers in recent years. RIA aggregators, strategic acquirers, banks, and private equity have all been elbowing their way to the table, which suggests a continued seller’s market.Consolidators Drive Deal ActivityRIA consolidators and larger RIA strategic acquirers continued to be a driving force behind deal activity. Wealth Enhancement Group, Focus Financial, Hightower, Creative Planning, CAPTRUST, and CI Financial each acquired multiple RIAs in 2020. These firms sustained deal activity during the peak of the pandemic distraction, while smaller acquirers without dedicated deal teams were forced to delay or abandon planned transactions. Consolidators and large strategic acquirers remain an attractive option for many RIA sellers due in part to the lower execution risk resulting from consolidators’ experience in closing transactions.Mega-DealsWhile consolidators accounted for a large percentage of deal activity, these deals are typically relatively small. The uptick in total deal value during the year was driven by several mega-deals among publicly traded asset managers and discount brokerages. Back in February, Franklin Templeton agreed to buy rival asset manager Legg Mason for $6.5 billion, and Morgan Stanley purchased online broker E-Trade for $13 billion just a few days later. In October, Morgan Stanley agreed to buy asset manager Eaton Vance for $7 billion. In December, Macquarie Group (a diversified Australian financial services company) agreed to buy asset and wealth manager Waddell & Reed for $1.7 billion.The differences between these larger transactions and the smaller wealth management firm transactions are noteworthy. The recent mega-deals in the industry between public companies have been focused on sectors of the industry that many analysts believe are declining—asset management and discount brokerage. These sectors have seen significant fee and margin compression in recent years, and as a result, these deals are largely defensive in nature and motivated by cost savings and increased scale to protect margins.In contrast, buyers of independent wealth management firms are typically attracted by recurring revenue, a sticky client base, relatively high margins, and attractive growth prospects due to market appreciation and demographic trends. As a result of these differing motivations and outlooks, the multiples seen for wealth management franchises are often higher than their publicly traded asset management-focused counterparts. In the case of the Waddell & Reed transaction, the multiple paid for the asset management component of the business may have been as low as 5x (see our post, Did Macquarie Pay 11x EBITDA for Waddell & Reed? Yes and No), well below what an attractive wealth management business can expect in the current environment.Internal TransactionsMany of our RIA clients have taken time over the last year to work on back-of-house issues like succession planning. It’s no secret that succession planning is a major issue for the industry, and one of the questions RIA principals must answer when succession planning is whether to engage in an internal or external transaction. Although there has been a proliferation of external buyers and deal terms remain strong, internal transactions can be an attractive option for a variety of reasons. Compared to the stringent structure that an outside buyer might impose, internal transactions can offer greater flexibility for retiring partners. They also sidestep one of the largest issues in RIA transactions—cultural compatibility—since no new parties are introduced and forced to work together.It’s no secret that succession planning is a major issue for the industry.One of the downsides of internal transactions is that the buyers, typically younger firm employees, often don’t have the financial resources to purchase a significant interest outright. The good news is that capital options to facilitate these transactions have expanded significantly in recent years, with various banks, private equity, and minority investors increasing their focus on the sector.Another challenge with internal transactions is that they require a strong next-gen management team to be in place. Without a strong bench, external transactions may be the only option for a founding partner seeking to exit the business. For firms that lack the next-gen management to run the business and turn to external buyers to solve their succession planning problem, it may be difficult to realize full value.We’ll be addressing succession planning along with other operational, back of the house RIA issues at our upcoming conference, RIA Practice Management Insights, to be held virtually on March 3-4, 2021.

Valuation Considerations for Auto Dealership Entities with Multiple Franchises

The valuation of an auto dealership can be a challenging and complicated process. The structure of most auto dealerships consists of an entity holding the actual dealership operations and a separate entity owning the real estate and building. Often the latter is a related party entity that charges the dealership rent for use of the land and building. Occasionally, the real estate and the dealership operations are contained in the same entity.We are all used to the local dealership in our town: Bill Jones Honda, Steve Smith Chevrolet. But what about the larger auto groups that have multiple franchises organized in the same entity? How are they valued and what special valuation considerations apply to them?Financial ReportingFranchised auto dealerships submit dealer financial statements to the manufacturer on a monthly basis. These dealer financials contain valuable information about the various departments, including profitability by department, overall number of new and used vehicle sold, individual models sold, etc. How does that differ for entities that contain multiple franchises under one structure? In our experience, those dealerships submit a combined dealer financial statement to each manufacturer. For example, if an entity owned a Chevrolet and a Honda franchise, they would submit an identical dealer financial statement displaying the combined operations to Chevrolet and to Honda. This can make it difficult to assess the individual financial performance of each franchise.Most dealership financial packages will contain various support schedules that can provide additional insight. There should be a breakdown of new vehicle sales and gross profits by manufacturer provided or the auto dealer would maintain that data.With this information, a valuation analyst can determine the contribution of each franchise to the combined operations by percentage of revenues, gross profit, or new or total units sold. Generally, these combined statements do not allocate the selling, general and administrative expenses by franchise, so individual franchise income statements are typically not available. We will later discuss how to incorporate this information into the valuation of an entity with multiple franchises.Profitability and BenchmarkingEstablishing the ongoing earnings of a dealership is critical to its determination of value under both the income approach and the market or Blue Sky approach. If individual profitability of each franchise isn’t discernable in a combined entity, how do you evaluate the profitability of the dealership?We have previously discussed in this space the use of industry benchmarking tools to assess a dealership’s profitability. One such tool is NADA's Dealership Financial Profiles. These benchmark studies are released monthly and are categorized by the type of dealership including Overall Average, Domestic, Import, Luxury, and Mass Market. An analyst can use these tools to determine a blended overall industry profitability figure for the dealership based on the composition of each franchise to total operations and the specific category of dealership that each franchise represents.The table below lists the average pre-tax income margins for the dealership categories for 2018 and 2019: For example, let’s say you had a fictitious combined entity with a Chevrolet and a Honda franchise and that each comprised 50% of the total combined operations of the entity. As a guide, you could compile a blended profitability measure of 2.80% for 2019 to account for the domestic franchise (3.10% x 50%) and the import franchise (2.50% x 50%). These comparisons to industry profitability margins are not rigid but do provide a framework to assess the subject dealership's performance against its peers. Since Chevrolet and Honda also would both fall under the “Average” category, one might be tempted to simply pull the average figure. However, as we see in our example, this may lead to a lower benchmark than is ultimately appropriate. Franchise and Blue Sky Values Multi-franchised entities can also pose a challenge since each franchise has inherent value and all franchise values are not created equally. The perceived franchise value is often reflected in a multiple of pre-tax income referred to as Blue Sky Value. Leading national firms that specialize in auto dealer transactions, such as Haig Partners and Kerrigan Advisors, publish their observed Blue Sky multiples by franchise each quarter.Examples of Haig’s published Blue Sky multiples for the second and third quarters of 2020 based upon dealership category appears in the table below: Using our previous example of a combined fictitious entity with a Chevrolet and Honda franchise, it’s clear from these Blue Sky multiples that it would be inappropriate to value the entire entity just based on Honda’s perceived value (6.00-7.00X) or Chevrolet’s perceived value (3.50-4.50x) alone. One technique that can be utilized is to establish a blended Blue Sky multiple for the two franchises based on the composition of each to the total combined operations. As we discussed earlier, this can be estimated based upon revenue or units sold composition of the two franchises in the subject dealership. Based on a 50/50 composition of each of these two, it would be reasonable to estimate a blended Blue Sky multiple of 4.75X on the low end and 5.75X on the high end using Haig’s Q3 2020 multiples. (Note: The valuation requires more in-depth analysis than just a high-low average.) A blended Blue Sky multiple would incorporate the inherent difference in values of the two franchises so as to not undervalue or overvalue the combined subject dealership in our example if either an exclusive Chevrolet or Honda multiple were considered. After a direct valuation of the entity is performed, the corresponding Blue Sky value could be measured against this blended multiple. For example, if the conclusion of value for this example implied a 9x Blue Sky, this exercise would illustrate that the valuation conclusion or some of the underlying assumptions were flawed. Recent Acquisitions and DivestituresMost valuations of auto dealerships require the analysis of prior years’ performance and results. The golden period for valuation analysts seems to be reviewing five full historical years. In our projects involving entities owning multiple franchises, we often see activity within those franchises owned in those prior five years. It can be valuable to ask if there have been any acquisitions or divestitures of franchises during that historical period of reviewed financials. First, the analyst wants to establish that the comparison of historical years to one another are apples to apples. If an entity had sold off or discontinued a franchise, the earnings related to that particular entity should not be considered in any current value of the subject dealership. In the case of a divested franchise, the impact of those sales and earnings should be removed from prior year results as much as possible. This won’t always be possible for the same reason we can’t construct individual P&L statements by franchise. Again, this is due to the lack of itemized SG&A expenses by the franchise.Conversely, if the subject dealership had recently acquired or added an additional franchise to its operations during the reviewed period, the value of that franchise should also be captured. If the franchise is recently acquired, information regarding the acquisition price and/or consideration paid for Blue Sky could be considered in the valuation analysis, especially if the operating results haven’t fully reflected the integration of the new franchise. Franchise value paid for acquisitions in historical periods can also be helpful information. For example, if a dealership acquired a particular franchise for a Blue Sky value of $10M but the dealership’s performance and earnings from that franchise had suffered in the years following the acquisition, the concluded value of that franchise might be lower today. In this example, the original $10M Blue Sky value for that franchise would have been helpful as a sanity check to the concluded value for that franchise today.ConclusionEntities owning multiple franchises pose unique challenges to valuation compared to a single-franchised dealership. While the conclusion of value for the entity is contained in a single value, we have discussed the importance of evaluating the individual value of the franchises involved or at least examining the concluded value in the context of the earnings and blue sky value inherent within each franchise.Contact a professional at Mercer Capital to discuss the value of your multi-franchised or single-franchised auto dealership.

Announcing the Inaugural RIA Practice Management Insights Conference

Professionalizing the Business of Investment Management

After World War II, British automakers launched a valiant attempt to sell products beyond the Empire. Several U.K. marques introduced themselves to the U.S. with cute, tiny roadsters that stood out from the chrome-bedazzled land yachts from Detroit. Just imagine the 11 foot long, 1,455-pound Austin-Healey pictured above parked next to a 23 foot, two and a half ton Cadillac Eldorado of the same vintage.While the British invasion from Austin-Healey, Morris Garage, Triumph, and Jensen (among others) won a few sales, most ultimately surrendered, retreating to their island home. The problem was that their products, though eye-catching, were unreliable. Oil leaks, busted clutches, and faulty electronics were typical. A car buyer in the 60s had to face certain tradeoffs: be stylishly stranded on the side of the road, or just drive a Ford like everyone else.If the Brits had developed their mechanical prowess to the same level as their styling, we would all be driving MGs today. As it happened, the Brits failed to evolve, and the Japanese replaced them with practical and reliable transportation that ultimately challenged the U.S. auto industry in a way the British could not, further one-upping the Brits with their own ragtop – the Mazda Miata.RIA Practice Management InsightsSince the start of the American experience with the pandemic, we’ve noticed our clients spending more time working “on” their business as opposed to simply working “in” their business. No doubt the work-from-anywhere model has given many people a perspective on their firms that wouldn’t have happened otherwise. We see changes afoot in the industry as a consequence which we believe will outlast WFH.Our clients are spending more time working “on” their business as opposed to simply working “in” their business.Consolidation gets most of the headlines in the RIA press, but too many examples of consolidation are really capitulation – selling out is a path to sidestep lingering practice management issues like sustainability or succession.Despite what you read, not everyone wants to sell. Over the past year or so, many of our clients have used the “pause” in their normal work lives to reassess their marketing plans, compensation schemes, leadership issues, technology integration, and ownership. Most aren’t simply playing practice management whack-a-mole but are looking at these issues in a holistic and strategic way to strengthen the internal mechanisms of their firms and build a more sustainable platform.RIAs need to grow their systems, processes, policies, and infrastructure just as fast as their AUM.We’re seeing a subtle, but growing, emphasis on professionalizing the independent investment management industry. RIAs are no longer an assortment of small, scrappy practices for lone wolfs who don’t want to work at wirehouses or bank trust departments. As the decades wear on and the billions under management accumulate, many RIAs have become real businesses. These businesses need to grow their systems, processes, policies, and infrastructure just as fast as their AUM. And there are threats paired to opportunity: with fee schedules and margins under pressure, many firms who have avoided confronting change can no longer afford to do so.A New ConferenceIn this spirit, we’ve decided to put together a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.A virtual conference for RIAs focused entirely on operational issues – from staffing to branding to technology to cultureThe topic list is unlike that of any other investment management firm forum. We’ve attended and spoken at plenty of great conferences that cover investment products and M&A, so we’re not going to plow that ground ourselves. Instead, we have gathered an impressive list of thought leaders who have built careers out of professionalizing the “back of the house” to support the best investment management products and services.Please join us to get their wisdom on how your firm can evolve to become a more sustainable, profitable, valuable enterprise.

The “Best” of 2020

Energy Valuation Insights’ Top Blog Posts

As we hope for a better 2021, we look back at 2020 to see what was popular with you – our readers. Below is a list of some of our top posts of 2020.Energy Valuations: Freefall Into Bankruptcy Or Is This Time Different?2020’s challenges were apparent early in the year. In this post, Bryce Erickson discusses whether the headwinds are a temporary blip, or whether these issues portend a wave of bankruptcies for the industry.Saudi Arabia, Russia, or the United States – Did One of the Players Blink?This post from April discusses some of the initial fallout from the Saudi / Russian price war, and came just days before the historic decline of WTI into negative territory.Royalties and Minerals: A New Market Is Emerging2020 delivered some jarring blows to players in the mineral and royalty space. Although this asset class enjoys certain benefits relative to oil and gas producers, its value is still connected to commodity prices. The recent swing downward has staggered market participants and quickly changed several assumptions regarding a sense of normalcy. In this post, Bryce Erickson discusses the sector with Chris Atherton, the CEO of EnergyNet, which is one of the largest private mineral transaction platforms in the market.Impairment Testing of Oil & Gas ReservesThe oil & gas market and the energy sector as a whole took a beating during 2020 and experienced unprecedented events due to the global impacts from the pandemic and international price wars. Companies are having to question and consider the need for interim impairment testing on reserves. This post will help oil & gas companies discern whether they may need to make interim impairment assessments and to understand the impairment testing process.Oil Frackers Are Breaking Records Again – In Bankruptcy CourtIn an unfortunate answer to the first post featured above, it was not different. In this post, Bryce Erickson discusses the volume of E&P bankruptcies observed during 2020.Conclusion2020 was a challenging year in the energy space that most are eager to leave behind. We look forward to 2021 and appreciate your interest in this blog. May you and your family enjoy a happy and prosperous year!

2021 New Year's Resolutions for Auto Dealers

At the start of a new year, many people, including myself, try to establish resolutions to get the year started off on the right foot. This is especially prevalent this year with most people welcoming 2021 with open arms after the disaster of a year that was 2020. When considering the auto industry in 2020 and predictions for 2021, making some “resolutions” for your dealership to prepare for the year ahead could prove to be helpful. With that being said, here are a few common “New Year’s Resolutions” that can be applied to your auto dealership.Resolution #1 – Keep Up With the TimesAuto dealers that choose to embrace technology could find themselves faring better than those that don’t in an era of e-commerce explosion.As we have discussed previously, the COVID-19 pandemic has pushed auto dealers into the 21st century as they relied more on technology to reach their audience. In March 2020 as the pandemic was beginning, U.S. search interests in “dealerships near me” dropped more than 20% from the prior month. Furthermore, as stay-at-home orders swept across the country, many people could not visit dealerships even if they wanted to. In order to continue to reach customers, offering at least portions of the buying process online became necessary. As the year continued and the pandemic trudged on, consumers dramatically shifted their shopping habits to online, as e-commerce sales are projected to increase by 40.3% in 2020 from the prior year. For dealerships, specifically, 90% of car shoppers prefer a dealership where they can start the buying process online. Although dealerships most likely can’t and won’t reach the digital offering scale of a Carvana, having sleek offerings online is important.Now as we begin the new year, there is some evidence that consumers won’t revert to pre-COVID buying habits. A research paper from McKinsey in early 2020 said trends in China suggest that between three and six percentage points of market share gained by online channels will be "sticky." What does this mean for your dealership? With overall buying habits having shifted, consumers are going to be more familiar with the online purchasing process. Furthermore, experts anticipate the pandemic to continue into 2021. Making an effort to invest in digital technology for your dealership to reach customers could reap dividends as the year goes on.Resolution #2 - Invest in YourselfInvestment in facilities to achieve image compliance could lead to a bump in your dealership’s value.Despite fewer people visiting physical dealerships because of COVID, it could still be worthwhile to consider giving your dealership an upgrade in 2021. As reported in Kerrigan’s Q3 Blue Sky Report:“Image compliant dealerships with low rent command higher multiples. Up-to-date dealerships are more attractive to buyers because they require no additional investment. Dealers also command better pricing when they have an attractive rent factor, lowering fixed expenses. In our experience, dealers frequently own the real estate or hold it in a separate but related entity. But as dealers know, rent factors include other factors include utilities, property taxes, interest, and other hard costs of ownership. Dealerships that can reduce this expense or have a favorable lease if owned by an unrelated third party, stand to have higher earnings, and potentially a higher multiple with lower risk. In general, if a dealership is image compliant and its rent-to-gross profit is below 10%, it is considered to have low rent.”Resolution #3 - Shed Some PoundsAuto dealerships can benefit from becoming leaner and meaner by streamlining SG&A costs to promote a healthier bottom line.A prevalent 2020 trend was cutting SG&A costs. As we mentioned in our Q3 2020 earnings calls post, advertising and personnel costs that were taken out at the beginning of the pandemic haven’t come back as dealers try to determine how best they can run lean and improve productivity. This decrease in overall SG&A has helped support many auto dealer’s bottom lines as SAAR has been running below 2019 levels.Looking into 2021 and a continuing pandemic, improving the bottom line is going to continue to be important. Advertising costs can be alleviated by choosing alternative and more efficient channels such as social media, as we mentioned previously. Furthermore, with consumers doing more of the car shopping process online, personnel expenses that used to be necessary are no longer so. Auto dealers can take full advantage of this to streamline costs. While many of these costs have already been cut to the bone, dealers will need to be judicious about adding in costs. We had clients coming out of the Great Recession saying they ran leaner than they have previously thought was possible. Ten years of slow and steady economic growth may have led to excess expenses that naturally get trimmed in a downturn. Dealers need to determine which expenses can be removed and which may need to return in order to boost sales, particularly when new vehicle inventory becomes less tight.Resolution #4 - Make GainsWith vehicle manufacturing revving up, it could prove beneficial to offer consumers wider varieties of models.If you have been reading our blog over the course of the year, one of the big takeaways that we have been hammering home is that inventory shortages have plagued the industry all year due to lag from shutdowns. Dealers won’t have needed to read a single word we’ve written to know that for themselves. However, with plants back up and running, many dealerships are expecting inventory levels to normalize in 2021; therefore, there might be pent up consumer demand so dealerships will be working to get the right inventory. While consumers have been more patient in light of the pandemic, that patience won't last forever.As the pandemic continues on, many people are still wary of using public transportation and ride-sharing. In fact, a survey conducted by Google found that 93% of people say they are using personal vehicles more. Furthermore, a recent Cars.com survey reported that 20% of respondents who didn’t own their car were considering purchasing one. Dealerships in 2021 could continue to find new customers trying to shift from public transportation to a personal vehicle.ConclusionThe Auto Dealership team at Mercer Capital wishes you a happy and safe new year! If you have any questions about what your dealership may be worth, please feel free to reach out to us.

E&P First Quarter 2021

Eagle Ford

Eagle Ford // The first quarter of 2021 saw generally increasing commodity prices, a welcome change from the volatile price environment seen during 2020.

Transportation & Logistics Newsletter

First Quarter 2021

What Is a Reserve Report?

A reserve report is a fascinating disclosure of information. This is, in part, because the disclosures reveal the strategies and financial confidence an E&P company believes about itself in the near future. Strategies include capital budgeting decisions, future investment decisions, and cash flow expectations.For investors, these disclosures assist in comparing projects across different reserve plays and perhaps where the economics are better for returns on investment than others.However, not all the information in a reserve report is forward-looking, nor is it representative of Fair Value or Fair Market Value. For a public company, disclosures are made under a certain set of reporting parameters to promote comparability across different reserve reports. Disclosures do not take into account certain important future expectations that many investors would consider to estimate Fair Value or Fair Market Value.What Is a Reserve Report?Simply put, a reserve report is a report of remaining quantities of minerals which can be recoverable over a period of time. The current rules define these remaining quantities of mineral as reserves. The calculation of reserves can be very subjective, therefore the SEC has provided, among these rules, the following definitions, rules, and guidance for estimating oil and gas reserves:Reserves are “the estimated remaining quantities of oil and gas and related substances anticipated to be economically producible;The estimate is “as of a given date”; andThe reserve “is formed by application of development projects to known accumulations”. In other words, production must exist in or around the current project.“In addition, there must exist, or there must be a reasonable expectation that there will exist, the legal right to produce or a revenue interest in the production of oil and gas”There also must be “installed means of delivering oil and gas or related substances to market, and all permits and financing required to implement the project.”Therefore, a reserve report details the information and assumptions used to calculate a company’s cash flow from specific projects which extract minerals from the ground and deliver to the market in a legal manner. In short, for an E&P company, a reserve report is a project-specific forecast. If the project is large enough, it can, for all intents and purposes, become a company forecast.What Is the Purpose of a Reserve Report?Many companies create forecasts. Forecasts create an internal vision, a plan for the near future and a goal for employees to strive to obtain. Internal reserve reports are no different from forecasts in most respects, except they are focused on specific projects.Externally, reserve reports are primarily done to satisfy disclosure requirements related to financial transactions. These would include capital financing, due diligence requirements, public disclosure requirements, etc.Publicly traded companies generally hire an independent petroleum engineering firm to update their reserve reports each year and are generally included as part of an annual report. Like an audit report for GAAP financial statements, independent petroleum engineers provide certification reserve reports.Investors can learn much about the outlook for the future production and development plans based upon the details contained in reserve reports. Remember, these reserve reports are project-specific forecasts. Forecasts are used to plan and encourage a company goal.How Are Reserve Reports Prepared?Reserve reports can be prepared many different ways. However, for the reports to be deemed certified, they must be prepared in a certain manner. Similar to generally accepted accounting principles (GAAP) for financial statements, the SEC has prepared reporting guidance for reserve reports with the intended purpose of providing “investors with a more meaningful and comprehensive understanding of oil and gas reserves, which should help investors evaluate the relative value of oil and gas companies." Therefore, the purpose of SEC reporting guidelines is to assist with project comparability between oil and gas companies.What Is in a Reserve Report?Reserve reports contain the predictable and reasonably estimable revenue, expense, and capital investment factors that impact cash flow for a given project. This includes the following:Current well production: Wells currently producing reserves.Future well production: Wells that will be drilled and have a high degree of certainty that they will be producing within five years.Working interest assumption: The ownership percentage the Company has within each well and project.Royalty interest assumptions: The royalty interest paid to the land owner to produce on their property.Five-year production plan: All the wells the Company plans to drill and have the financial capacity to drill in the next five years.Production decline rates: The rate of decline in producing minerals as time passes. Minerals are a depleting asset when producing them and over time the production rate declines without reinvestment to stimulate more production. This is also known as a decline curve.Mineral price deck: The price at which the minerals are assumed to be sold in the market place. SEC rules state companies should use the average of the first day of the month price for the previous 12 months. Essentially, reserve reports use historical prices to project future revenue.Production taxes: Some states charge taxes for the production of minerals. The rates vary based on the state and county, as well as the type of mineral produced.Operating expenses for the wells: This includes all expenses anticipated to operate the project. This does not include corporate overhead expenses. Generally, these are asset-specific operating expenses.Capital expenditures: Cash that will be needed to fund new wells, stimulate or repair existing wells, infrastructure builds to move minerals to market and cost of plugging and abandoning wells that are not economical.Pre-tax cash flow: After calculating the projected revenues and subtracting the projected expenses and capital expenditures, the result is a pre-tax cash flow, by year, for the project.Present value factor: The annual pre-tax cash flows are then adjusted to present dollars through a present value calculation. The discount rate used in the calculation is 10%. This discount rate is an SEC rule, commonly known as PV 10. The overall assumption in preparing a reserve report is that the company has the financial ability to execute the plan presented in the reserve report. They have the approval of company executives, they have secured the talent and capabilities to operate the project, and have the financial capacity to complete it. Without the existence of these expectations, a reserve report could not be certified by an independent reserve engineer.A Plug for Mercer CapitalMercer Capital has significant experience valuing assets and companies in the energy industry. Because drilling economics vary by region it is imperative that your valuation specialist understands the local economics faced by your E&P company. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

‘Twas the Blog Before Christmas…

2020 Mercer Capital RIA Holiday Quiz

‘Twas the blog before Christmas, when all through the house Every laptop was purring, every keyboard and mouse; The stockings were hung by the chimney with care, So that backgrounds on Zoom calls wouldn’t look quite so bare;When out on the squawk there arose such a clatter, I refreshed my Bloomberg to check on the matter. Then what to my wondering eyes did appear, But a global growth manager outperforming its peer.With a ghostly old PM so lively and quick, I listened, engaged, to his every stock pick. More rapid than eagles his recommends came, And he whistled, and shouted, and called them by name:“Buy Bitcoin! Buy Apple! Buy Tesla and Google! ’Cause shorting the future will always prove futile! To the top of the charts, for the big money haul, Go long like you’ve never had a bad margin call!”As I drew down my cash, and was turning around, Down the chimney John Templeton came with a bound. He was dressed like he owned just a few private jets, Which compared favorably to my “work at home” sweats.A bundle of hundreds he had flung on his back, Like an entrepreneur with a new public SPAC. He spoke not a word, but went straight to his work, And filled all my orders, then added a perk:His eyes - how they twinkled! His dimples, how merry! As he talked a new strat that would guarantee carry! And out-money calls bought to cover the shorts, Bringing untold riches to long-only sorts.A wink of his eye and a twist of his head, Made me want to get all of his thoughts on the Fed – And vaccines and rates and bullion and more, But he rose and I followed him out my front door.A magical Gulfstream waited there in my yard, And up the air-stairs sprang the RIA bard. But I heard Sir John claim, as he flew out of sight - "Let your best winners run, and all will be right!"...(function(t,e,s,n){var o,a,c;t.SMCX=t.SMCX||[],e.getElementById(n)||(o=e.getElementsByTagName(s),a=o[o.length-1],c=e.createElement(s),c.type="text/javascript",c.async=!0,c.id=n,c.src="https://widget.surveymonkey.com/collect/website/js/tRaiETqnLgj758hTBazgd7CsENq4E17zRc3oaUw9n_2BzGVsq_2BQvhuHonnFZr_2BMGJt.js",a.parentNode.insertBefore(c,a))})(window,document,"script","smcx-sdk"); Create your own user feedback survey If you're having trouble viewing the survey below, click here.

Weather Report for Auto Dealers

Q3 Climate for Blue Sky Multiples, Transaction Activity, and Other Trends

Ever wonder why the local news teases the weather report in the first five minutes of each broadcast before returning to it later in the show? Because everyone wants to know the weather forecast so they can plan ahead.In this post, we provide the weather report for the auto dealer industry with a review of the three recently released industry reviews.Haig Partners and Kerrigan Advisors have released their Third Quarter Blue Sky Reports and J.D. Power just released its U.S. Sales Satisfaction Index. These reports are timely and informative of not only where the auto dealer industry is today, but where it is headed.Transaction Volume Transaction volume often defines the health of the industry. After a turbulent spring and slow climb during the summer, auto dealer transactions are on the rise in the third quarter. According to Haig Partners, transactions for the third quarter topped 95, representing a 9% increase over the same quarter for 2019. As seen in the graph below, public auto dealers have capitalized on their increasing market values, acquiring 21 dealerships in Q3 compared to only 6 in Q3 2019. The monthly average number of dealerships being acquired is currently about 30, compared to 5 or fewer per month in April/May. [caption id="attachment_35044" align="aligncenter" width="277"]Source: Haig Partners[/caption] Kerrigan noted the increase in multi-dealership transactions. The much publicized acquisitions of luxury dealerships by Lithia Motors and Asbury Automotive was evidence of this trend. Other contributors include the formation of many special purpose acquisition companies (or SPACs) and investment companies, which we have previously written about. Many dealerships are on the back side of the family ownership life span, and high multiples are making exits more intriguing. Specifically, Kerrigan notes that multi-dealership transactions are up from 33 to 46, or an increase of 25% from the first nine months of 2019. Q3 2020 is tied for the second most multi-dealership transactions for the same time period in the past 5 years. [caption id="attachment_35054" align="alignnone" width="702"]Source: Kerrigan Advisors[/caption] ProfitabilityTwo weeks ago, we discussed the record level Gross Profit Margins per Unit (GPUs) in new and used vehicles and their contribution to the overall profitability of dealerships through October 2020. These metrics only tell part of the profitability story. Auto dealers have also been successfully minimizing their operating expenses during these unprecedented times and Haig points to three specific expense areas: advertising, labor, and floor plan.As we have discussed several times throughout the year, new vehicle supply has been constrained as manufacturing plants have faced temporary shutdowns and other challenges. Dealers have had fewer new vehicles to sell, and consequently, have chosen to spend less on advertising. This lower level of inventory has reduced the cost to maintain the inventory, or floor-plan interest. Lower interest rates have further lowered these costs. As a result, auto dealers’ floor plan costs are currently much less than in a normal operating environment.Finally, personnel or labor costs have been drastically reduced across many dealerships. The lack of foot traffic in showrooms and temporary shutdowns across the country have forced many auto dealers to reduce their staff. Kerrigan notes that few buyers they have spoken to expect dealers to return to pre-COVID staffing levels and are instead choosing to optimize digital sales platforms to help support operations with reduced staff.Blue Sky MultiplesSo far, 2020 has been the tale of three quarters in terms of Blue Sky multiples. Q1 saw a decline in virtually every brand covered by the Haig Report. While Q2 showed some recovery in Blue Sky multiples coinciding with a steady climb in SAAR, Haig has raised the Blue Sky multiple range for nearly every brand in Q3. The only brands not to see an increased rating by Haig for Q3, are Infiniti, Cadillac, and Lincoln. However, Haig has recently reported franchise value ranges for these brands in lieu of Blue Sky multiples for several quarters due to operational struggles.Kerrigan’s Blue Sky multiples have mostly been held steady in Q3 except for a reported increase in three brands: Chevrolet, Buick/GMC, and Volvo. The difference in perspective of these multiples can be explained in the pricing of transactions. With unparalleled profitability experienced by many auto dealers in 2020 due to increased GPUs and decreased operating expenses, buyers must ponder the sustainability of each of these measures, as well as overall profitability. Historically, according to Haig and Kerrigan, auto dealer transactions were often priced based upon the latest year’s earnings. Buyers now need to evaluate the expected level of earnings for the dealerships into the future, a metric that the auto dealer industry has never relied on much. According to Kerrigan, buyers are pricing transactions off of a modified/sustainable 2020 earnings stream. In other words, buyers are adjusting or discounting actual 2020 earnings from elevated levels to a future expectation.Similarly, Haig Partners discusses buyers' pricing transactions based on previous 2019 level of earnings, rather than the heightened/unsustainable 2020 levels.Sales Satisfaction IndexIn addition to transaction volume, profitability, and blue sky multiples, the Customer Service Index (CSI) and Sales Satisfaction Index (SSI) results provide another lens when considering auto dealership valuations. J.D. Power recently released its 2020 SSI report. The results for Luxury Brands are displayed below.[caption id="attachment_35040" align="alignnone" width="696"]Source: J.D. Power[/caption] It’s interesting to note that the three brands without a reported Blue Sky multiple from Haig (Lincoln, Cadillac, and Infiniti) all scored in the upper half of the results from the SSI for luxury brands. While SSI is clearly important, observing other factors is necessary when considering a brand’s overall perception and value proposition. Each of these three has struggled with some combination of aging models/inventory, introduction of new models, and entrance into the electric vehicle market. The results for the Mass Market Brands are as follows. [caption id="attachment_35043" align="alignnone" width="653"]Source: J.D. Power[/caption] Conclusion The current forecast for the auto dealer industry looks bright heading into 2021. Both Haig Partners and Kerrigan Advisors predict Blue Skies ahead for auto dealers, though dealers will certainly recall the rainy days of March and April. Even the successful private auto dealers that have been able to navigate the challenges of 2020 face decisions regarding the future of their dealerships.Conversations regarding profitability and expense levels and their sustainability are prevalent in all auto dealer valuation projects. Contact a professional at Mercer Capital to discuss these questions or to find out the value of your auto dealership.

November 2020 SAAR

SAAR Declined to 15.6 million, Primarily Driven by a Decline in the Number of Selling Days for the Month

After steady increases, SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) experienced its first notable decline since April, dropping to 15.6 million from 16.3 million in October. November 2020 is down by 8.4% compared to the same period in 2019, and through 11 months of the year, new light-vehicle sales are down 16.7% compared to the same period last year. The calendar differences are important to note for this month with November 2020 only having 23 selling days relative to 26 days in November 2019. As Thomas King, president of data and analytics division at JD Power notes:November 2020 is a prime example of why accounting for selling day differences is important in measuring comparable sales performance. After two consecutive months of year-over-year retail sales gains, a quirk in the November sales calendar will result in new-vehicle retail sales appearing to fall 12%. This year, November has three fewer selling days and one less selling weekend compared with 2019. When these calendar quirks are accounted for, new-vehicle retail sales are expected to almost match 2019 levels. While the sales results illustrate the continued strength of consumer demand, that strength is further reinforced by transaction prices hitting another record high, even as manufacturers and retailers continue to remain disciplined on new-vehicle incentives and discounts.While adjusting for calendar differences is important in determining true trends that are occurring in the industry, it is also necessary to consider retail SAAR vs. total SAAR.While retail SAAR includes the daily selling rate for retail auto sales to individual customers, total SAAR also includes fleet sales to businesses, government, and daily rental companies. Because of this distinction, considering just total SAAR alone may not indicate actual consumer purchase trends. This has been especially notable for this year as fleet vehicle sales and rental companies have been inordinately affected by the pandemic compared to auto dealer sales.Though dealerships experienced a decline when they had to shut down due to stay-at-home orders, business picked back up once they could reopen. Fleet sales, on the other hand, are suffering from changes in consumer trends due to the pandemic, rather than government mandates. For example, many businesses have adopted a work from home model to keep employees healthy during the pandemic. As such, rental car needs for business purposes have declined. Furthermore, overall travel, in general, is down as people have been wary to fly, further impacting this market. May was the toughest month with rental units declining 91%, and Hertz announcing their bankruptcy. From March through September 2020, fleet sales have seen an average monthly decline of 53% with November fairing slightly better with a 25% decline from the same time last year.Observing the implications numerically can be helpful to further illustrate this point. As you can see in the chart produced by JD Power, while total SAAR is down 7.6% (unadjusted for calendar dates), retail SAAR is only down 5.1% (also unadjusted). These numbers reflect the brunt of economic difficulty that fleet sales have faced relative to retail sales. An important note is that this graph is primarily for illustrative purposes with both of these SAAR numbers being predictive rather than actual. Average incentive spending per unit is expected to top $3,800, marking the third straight month of incentives below $4,000, which reflects strong vehicle demand supporting sales. The average new-vehicle retail transaction price in November is expected to reach a record $37,099, topping the previous record last month of $36,755. While tight inventory constraints have plagued the industry all year, there are signs that things are improving. According to Cox Automotive Senior Economist Charlie Chesbrough, “The tight inventory situation, where available products at dealerships were drawn down to very low levels, reached a peak in late summer. However, factory production has improved while sales pace has slowed, and the combination is allowing dealerships to replenish somewhat. Overall, supply still remains far below last year's levels, and holiday sales may slow if buyers can't find what they want." With factories now operating at pre-pandemic levels, production has not been the hurdle it was through mid-year. It is important to note potential tailwinds to SAAR going into the end of the year, specifically in terms of the COVID-19 pandemic and ongoing U.S. politics. As of writing this blog post, coronavirus cases are surging throughout the country as a result of colder weather and indoor gatherings to celebrate the holidays. With restrictions being put back in place throughout the country, dealerships may see less foot traffic as people try to limit exposure as much as possible. However, with promising news on the vaccine front in the past month, hopes are high that there may be a return to normalcy on the horizon. The political climate continues to pose challenges for auto dealerships as a new stimulus continues to be stuck in a divided Congress. Weekly unemployment claims might be starting to be affected by the lack of stimulus with more than 947,000 workers filing new claims for state unemployment benefits the first week of December. Applications have risen three times in the last four weeks and are up nearly a quarter of a million since the first week of November. This is evident when looking at the chart below produced by the New York Times.Conclusion While we think it’s far too early to suggest we might be falling into a second decline, the downturn in SAAR this month shows we are not yet out of this pandemic. An effective and distributable vaccine should boost economic activity and support employment figures and in turn boost consumer spending on items such as vehicles. However, we note that reduced business travel may have long-term impacts on rental businesses, and fleet sales may not return to pre-pandemic levels as a second order impact. We will continue to monitor these trends as I’m sure you and all of our auto dealer clients will.If you want to discuss how SAAR (total and retail) and the greater macroeconomic environment may impact your dealership, contact a member of the Mercer Capital Auto Dealer team today.

Seeking the Value of SEACOR

On December 7, 2020, publicly traded SEACOR Holdings announced that it had entered into an agreement with American Industrial Partners (AIP) to go private. The cash transaction, estimated to be worth slightly over $1 billion, is expected to close during the first quarter of 2021. Other transportation companies in AIP’s portfolio include EnTrans International, LLC (bulk and energy transportation) and Rand Logistics (bulk freight shipping).

How to Use an EV/Production Multiple

Oil and gas analysts use many different metrics to explain and compare the value of an oil and gas company, specifically an exploration and production (E&P) company. The most popular metrics (at least according to our eyeballs) include (1) EV/Production; (2) EV/Reserves; (3) EV/Acreage; and (4) EV/EBITDA(X). Enterprise Value (EV) may also be termed Market Value of Invested Capital (MVIC) and is calculated by the market capitalization of a public company plus debt on the balance sheet less cash on the balance sheet. In this post, we will dive into one of these four metrics, the EV/Production metric, and explore the most popular uses of it.DefinitionEV/Production is a commonly used valuation multiple in the oil and gas industry which measures the value of a company as a function of the total number of barrels of oil equivalent, or mcf equivalent, produced per day. When using this multiple, it is important to remember that it does not explicitly account for future production or undeveloped fields.Common UsesWhile the above definition was provided by Investopedia, the source goes on to explain the meaning of the multiple in the following way:All oil and gas companies report production in BOE. If the multiple is high compared to the firm's peers, it is trading at a premium, and if the multiple is low amongst its peers it is trading at a discount. However, as good as this metric is, it does not take into account the potential production from undeveloped fields. Investors should also determine the cost of developing new fields to get a better idea of an oil company's financial health.While some of the above explanation may appear true; the detail, analysis, and reason is lacking. Let’s more fully investigate the above notes:BOE or MCFE. Not all oil and gas companies report in barrel of oil equivalent per day (BOEPD). Those that are primarily dry gas producers will choose to report in MCF equivalent per day (MCFEPD). On the other hand, majority oil producers will report in BOEPD. One take away analysis to consider is that many times the metric a company uses to report production communicates the core production activity of the company (i.e. a company that reports in BOE wants to communicate they primarily target oil, while a company that reports in MCFE wants to communicate they primarily target gas).Premium or Discount. If the multiple is higher compared to its peers, it only appears to trade at a premium, but it does not mean the market value of the company is at a premium or more expensive than its peers. If it trades at a discount to its peers, the same is also true; it does not automatically mean the MVIC of a company is cheaper than its peers. To draw that conclusion, one assumes each of its peers has the exact same future production outlook, the exact same well locations and the exact same management team, just to name a few. Making this assumption in isolation is in error. Instead, analysis should be performed to understand the why behind a perceived “premium” or “discount.”Current or Future Production. The metric uses current production as an indication of value for the company. When using this metric, it could be assumed that (1) the current oil/gas/natural gas liquids mix will stay the same; (2) the current production level will continue on its previously experienced decline rate; and (3) the equivalency formula to translate gas production into oil production (typically 6.1 mcf = 1 barrel of oil equivalent) will not change. This metric fails to account for visibility into future production. When analyzing an E&P company, future production should always be considered.ExperienceWhile this multiple is useful, it also has its shortfalls. As with all multiples, it should never be used as the sole indicator of value. As an example, using this multiple in isolation would give zero value for an E&P flush with acreage and no production.We had a client with investments in an oil and gas company that was facing a transfer of ownership decision. During negotiations certain parties involved were convinced the only way to value, and therefore the only way they would pay for, an E&P was to utilize an EV/Production multiple and nothing else. They backed their position with their transaction experience of buying oil and gas assets as well as their knowledge of industry participants. We believed utilizing that particular method significantly undervalued our client. While the company had very little production, the acreage rights were significant as well as the PV 10 reserve report. We assisted our client through the transaction process by utilizing multiple valuation approaches, not solely the one a potential suitor strongly suggested.Multiples such as EV/Production can provide context for market pricing in the form of a range. We would never recommend using one market multiple as the only value indication for a subject company, particularly a non-publicly traded company. Ideally, market multiples should be used as one of many value indicators during analysis. While there may be facts and circumstances that prohibit the use of multiple value indicators, it is always advisable to (1) understand the implications of using a specific multiple; (2) understand its weaknesses; and (3) use other value indications together. When observing the EV/Production multiple, reconcile the observations with other valuation multiples and valuation indications for a reasonable analysis. For assistance in the process or other valuation analysis for an energy company, contact a member of our oil and gas team to discuss your needs in confidence.

Estate Planning When Bank Stocks Are Depressed

Maybe not for the best of reasons, the stars have aligned for bank investors who have significant interests in banks to undertake robust estate planning this year. Bank stock valuations are depressed as a result of the recession that developed from the COVID-19 policy responses, including a return to a zero interest rate policy (“ZIRP”) that is now known as the effective lower bound (“ELB”). The result is severe compression in net interest margins (“NIMs”), while the extent of credit losses will not be known until 2021 or perhaps even 2022.As shown in Figure 1, bank stocks have produced a negative total return that ranges from -27% for the twelve months ended September 25, 2020 for the SNL Large Cap Bank Index to -36% for the SNL Mid Cap Bank Index. At the other extreme are tech stocks. The NASDAQ Composite has produced a one-year total return of 35%–a 70% spread between the two sectors.Valuations for banks are depressed and are comparable to lows observed on March 24, 2020 when market panic and forced selling by levered investors peaked and March 9, 2009 when investors feared a possible nationalization of the large banks. Price-to-tangible book value (“P/TBV”) multiples are presented in Figure 2, while price-to-earnings (“P/E”) ratios based upon the last 12-month (“LTM”) earnings are presented in Figure 3.(Note—while P/TBV multiples are little changed from March 24, 2020, P/E ratios have increased because reserve building and reduced NIMs have reduced LTM earnings).No one knows the future, but assuming reversion to the mean eventually occurs bank stocks could rally as earnings improve once credit costs decline even if NIMs remain depressed, resulting in higher earnings and multiple expansion. Relative to ten-year average multiples based upon daily observations, banks are 30-40% cheap to their post-Great Financial Crisis trading history. In effect, current gifting and other estate planning could lock in significant tax benefits assuming a Japan and Europe scenario does not develop in the U.S. where banks are “re-rated” and underperform for decades.A second reason to consider significant estate planning transactions this year is the potential change in Washington if 2021 sees a Biden Administration backstopped with a Democrat-controlled Senate and House.Vice President Biden’s proposed estate tax changes include the elimination of basis step-up, significant reductions to the unified credit (the amount of wealth that passes tax-free from estate to beneficiary) and gift tax exemption, and increasing current capital gains tax rates to ordinary income levels for high earning households.The cumulative effect of these changes is a substantial increase in high net worth clients’ estate tax liabilities if Biden’s current proposals become law.Basis step-up is a subtle but important feature of tax law.Unusual among industrialized nations, in the United States the assets in an estate pass to heirs at a tax value established at death (or at an alternate valuation date).Even though no tax is collected on the first $11.6 million per person, the tax basis for the heir is “stepped-up” to the new value established at death.Other countries handle this issue differently, and Biden favors eliminating the step-up in tax basis.Further, he prefers taxing the embedded capital gain at death.Canada, for example, does this – treating a bequest as any other transfer and assessing capital gains taxes to the estate of the decedent.Fortunately, there are several things bank shareholders can do now to minimize exposure to these potential tax law changes.Taking advantage of the current high-level of gift tax exemptions ($11.58 million per individual or $23.16 million per married couple) could save millions in taxes if Biden’s proposed lower exemption of $3.5 million per individual becomes law. Other options include the formation of trusts or asset holding entities to transfer wealth to the next generation in a tax-efficient manner.Proper estate planning can mitigate the adverse effects of higher taxes on wealth transfers, but the window to do so may be closing if we have a regime change later this year. Further, the demand (and associated cost) for estate planning services may go up significantly in November, so you need to apprise your clients of these potential changes before it’s too late.In the 1990s, the unified credit (the amount of wealth that passes tax-free from estate to beneficiary) was only $650 thousand, or $1.3 million for a married couple.The unified credit was not indexed for inflation, and the threshold for owing taxes was so low that many families we now consider “mass-affluent” engaged in sophisticated estate tax planning techniques to minimize their liability.Then in 2000, George W. Bush was elected President, and estate taxes were to be phased out.Over the past decade, the law has changed several times, but mostly to the benefit of wealthier estates.That $650 thousand exemption from estate taxes is now $11.6 million.A married couple would need a net worth of almost $25 million before owing any estate tax, such that now only a sliver of bank stock investors require heavy duty tax planning.That may all be about to change. Vice President Biden has more than gestured that he plans to increase estate taxes by lowering the unified credit, raising rates, and potentially eliminating the step-up in basis that has long been a feature of tax law in the United States.Talk is cheap. But investors take heed; now may be the time to execute rather than plan. Originally appeared in Mercer Capital’s Bank Watch, September 2020.

Four Reasons to Consider a Stock Repurchase Program

Bank stocks rallied in the first few weeks of November 2020 as the market’s Thanksgiving dinner came early, and it digested several issues including positive news on the COVID-19 vaccine candidates.While significant uncertainty still exists on credit conditions, COVID-19, and the economic outlook, bank valuations and earnings expectations also benefitted from the yield curve steepening as evidenced by the 10-year Treasury moving up from ~50 bps in early August to ~85 bps in mid-November. Despite the recent rise in bank stock pricing, bank stock valuations are still depressed relative to pre-COVID levels as a result of the recession that developed from the pandemic and ensuing policy responses.A primary headwind for banks is the potential compression in net interest margins (“NIMs”) following a return to a zero interest rate policy (“ZIRP”) that is now known as the effective lower bound (“ELB”).Additionally, credit risk remains heightened for the sector compared to pre-pandemic levels as the extent of credit losses resulting from the pandemic and economic slowdown will not be known until 2021 or perhaps even 2022. Amidst this backdrop, many banks and their directors are evaluating strategic options and ways to create value for shareholders.While the Federal Reserve has prohibited the largest U.S. banks from share repurchases, the current environment has prompted many community banks to announce share buyback plans. According to S&P Global Market Intelligence, more than forty U.S. community banks announced buyback plans in the third quarter and the trend has continued in the fourth quarter with another 36 buyback announcements, including new plans, extensions of existing plans, and reinstatements of previously suspended plans, in October.In our view, there are four primary reasons that many community and regional banks are announcing or expanding share repurchase programs in the current environment.1) Valuations are Lower Relative to Historical LevelsSince the onset of the COVID-19 pandemic, the banking sector has underperformed the broader market due to concerns on credit quality and a prolonged low-interest rate environment.Despite the November rally, bank stocks are still trading at lower multiples than observed in recent years.Furthermore, many banks are finding themselves with excess liquidity in light of weaker loan demand and growing deposits. In a depressed price environment, share repurchases can be a favorable use of capital, particularly when pricing is at a discount to book value and is accretive to book value per share.As shown in the chart below, the average P/TBV multiple has declined for all of the SNL market capitalization bank indices since the beginning of 2020.The decline has been most pronounced for the Micro Cap index, with the average P/TBV multiple for banks with a total market capitalization of less than $250 million falling from 133% to 102%. 2) Favorable Tax Environment for Shareholders Seeking LiquidityCapital gains tax rates are low relative to historical levels and the potential for higher capital gains tax rates has risen under President-elect Biden. As part of his tax plan, Biden has proposed increasing the top tax rate for capital gains for the highest earners from 23.8% to 39.6% (akin to ordinary income levels), which would be the largest increase in capital gains rates in history.While the ability for Biden’s tax plan to become reality is uncertain, many community banks have an aging shareholder base with long-term capital gains and it is an issue worth watching and planning for as poor planning can leave significant tax consequences for the shareholder or his or her heirs.A share repurchase program can provide liquidity to shareholders who may be apt to take advantage of the current capital gains rates that are low by historical standards and lower than the rates proposed by President-elect Biden.3) Relatively Low Borrowing Costs and Sufficient Capital for Many Community BanksDespite the unique issues brought about by the pandemic and the uncertain economic outlook, many community banks are well capitalized and have “excess” capital at the bank level and perhaps even an unleveraged holding company.We have written previously about the idea of robust stress testing and capital planning given the economic environment but note that a recent survey indicated that most bankers believe capital levels are sufficient to weather the economic downturn.Our research also indicates that rates on subordinated debt issuances issued in September of 2020 averaged ~5% compared to ~6% average for 2018 and 2019.These lower borrowing costs and ample capital for many banks in combination with lower share prices enhance the potential internal rate of return for share repurchases when compared to other strategic alternative uses of capital.4) Enhancing Shareholder Value and Liquidity Board members and management teams face the strategic decision of allocating capital in a way that creates value for shareholders.Potential options include growing the balance sheet organically or through acquisition (perhaps a whole bank or branch), payment of dividends, or a stock repurchase program.While M&A has been a constant theme, activity has slowed during the COVID-19 pandemic and Bank Director’s 2021 Bank M&A Survey noted that only ~33% say their institution is likely to purchase a bank by the end of 2021, which was down from the prior year’s survey (at ~44%).Key challenges to M&A in the current environment include conducting due diligence and evaluating a seller’s loan portfolio in light of COVID-19 impacts and economic uncertainty. Organic loan growth expectations have also been muted for many banks in light of the economic slowdown resulting from COVID-19.With organic and acquisitive balance sheet growth appearing less attractive for many banks in the current environment, dividends and share repurchases have climbed up the strategic option list for many banks.A share repurchase program can have the added benefit of enhancing liquidity and marketability of illiquid shares, which potentially enhances the valuation of a minority interest in the bank’s stock.ConclusionIf your bank’s board does implement a share repurchase program, it is critical for the board to set the purchase price based upon a reasonable valuation of the shares.While ~5,000 banks exist, the industry is very diverse and differences exist in financial performance, risk appetite, growth trajectory, and future performance/outlook in light of the shifting landscape.Valuations should understand the common issues faced by all banks – such as the interest rate environment, credit risk, or technological trends – but also the entity-specific factors bearing on financial performance, risk, and growth that lead to the differentiation in value observed in both the public and M&A markets.At Mercer Capital, valuations are more than a mere quantitative exercise. Integrating a bank’s growth prospects and risk characteristics into a valuation analysis requires understanding the bank’s history, business plans, market opportunities, response to emerging technological issues, staff experience, and the like. For those banks considering a share repurchase program, Mercer Capital has the experience to provide an independent valuation of the stock that can serve to assist the Board in setting the purchase price for the share repurchase program. Originally appeared in Mercer Capital’s Bank Watch, November 2020.

Did Macquarie Pay 11x EBITDA for Waddell & Reed? Yes and No

Catching a Falling (Butter) Knife

Last week, Macquarie Group announced its acquisition of Waddell & Reed (WDR) for $1.7 billion. Waddell & Reed is one of the oldest mutual fund and asset management firms in the U.S. with a range of investment styles and insurance products. Waddell and Reed’s asset management division will expand Macquarie’s investment solutions, boost Macquarie’s annuity earnings, and push Macquarie’s U.S. AUM to $276 billion, making it one of the top 25 active managers in the U.S.The transaction marks a shift in Macquarie’s past acquisition strategy, which has historically followed the old saying, “The time to buy is when there’s blood in the street.” The firm’s last large acquisition was in 2010 when it acquired Delaware Funds (with $135 billion AUM) for $428 million. Instead, Macquarie is moving when the market is at an all-time high and paying nearly a 50% premium to WDR’s share price.Not only does this mark a shift in Macquarie’s deal strategy, but it is also the first acquisition by Macquarie’s new CEO. Shemara Wikramanayake, who has been called the most powerful woman in Australian finance, is now dealing with skeptics who ask why she paid such a premium for a business whose AUM has halved over the last six years.Transaction OverviewAt first glance, the AUM and revenue multiples paid by Macquarie Group appear fairly normal for an asset manager, but maybe not for a firm with a 14% EBITDA margin and years of declining AUM.While EBITDA multiples over 11.0x are not unheard of in this space, one would likely expect an impressive growth trajectory to accompany it. To understand the deal multiples implied by Macquarie’s acquisition of Waddell and Reed, we must dig into the details of the transaction.WDR has historically held lots of cash and investments on its balance sheet, for which Macquarie likely paid dollar for dollar. Typically, RIAs hold between 6-8 weeks of operating expenses on its balance sheet as working capital, or approximately 10% to 15% of revenue. With an estimated $437 million of excess working capital on its balance sheet, the price for the operating business is approximately $1.26 billion, which implies multiples more in line with the typical range observed in the legacy asset management space. Additionally, upon completion of the deal, Macquarie Group will sell WDR’s wealth management division to LPL Financial (a U.S. retail investment advisory firm, BD, and RIA custodian) for $300 million. The adjusted transaction price as a multiple of WDR’s asset management division’s AUM is 1.42%. However, determining the post transaction revenue and EBITDA requires a good bit of speculation. With AUM of approximately $68 billion and pro forma effective fees of around 65 bps, the post-transaction business will likely generate about $450 million of investment income. A little under 90% of WDR’s underwriting revenue was generated through its advisor network. Post-transaction, Macquarie will be one of LPL’s top strategic asset management partners, which suggests that Macquarie will not lose all revenue associated with its advisor network. As such, we have estimated WDR’s underwriting revenue stream could fall by approximately 80%. There will be expense savings generated by selling this business and additional synergies from merging with Macquarie. However, buyers don’t often pay for something they bring to the table, so WDR was likely only compensated for the cost reductions associated with selling its wealth management business. Thus, we have modeled a range of scenarios with between 50% to 60% cost savings. Even if Waddell and Reed’s AUM has been falling year-over-year, scale is valuable in the asset management space and we doubt that Macquarie was able to pick up WDR’s asset management business for a 5.0x EBITDA multiple. But the 7x-11x range seems reasonable. Macquarie’s acquisition of Waddell and Reed highlights how the success of legacy asset managers is currently dependent upon achieving scale. While the $25 per share purchase price represents a healthy premium to the latest pricing, the market has been down on investment managers since March’s sell-off. Paying a premium does not necessarily mean that Wikramanayake overpaid. Some may say that Macquarie is catching a falling knife by buying a business whose assets have been on the slide, but maybe it was just a butter knife…

Measuring Up: Evaluating Your Auto Dealership Against Benchmark Metrics

In a strange year of oddities, 2020 has all of us constantly evaluating life’s basic truths. Market conditions vary drastically across all industries and even geographically within the same industry due to local government restrictions. It’s critical for auto dealers to continually analyze all aspects of their business and be ready to capitalize on industry trends. We previously discussed the use of the NADA dealership profiles as a useful tool to examine timely monthly data based on averages or dealership type. Three specific metrics in the data have reached their highest level since the data was originally published in 2012: new vehicle retail gross profit per unit, used vehicle retail gross profit per unit, and used-to-new vehicle unit ratio.Retail Gross Profit Per New VehicleThis metric considers numerous factors. The numerator is gross profit achieved on the retail sale of new vehicles and is measured by the retail selling price less the cost paid to the manufacturer for the dealership to acquire the vehicle. Industry professionals also often refer to this metric as "front-end margin" meaning front of the showroom and not including elements of fixed operations. The denominator is the total number of vehicles retailed, or new vehicles sold less fleet sales which, as we’ll discuss in a future post, is subject to different operating environments. Over time, auto dealers’ new vehicle gross margins have been compressed as a percentage of retail sales price as consumers have become more knowledgeable about manufacturer costs and sticker prices in the information age. Dealerships aim to create long-term value by placing more new vehicle units on the road in hopes of the continuing service revenue that results from miles driven. These fixed operations tend to be higher margin, which aids the overall gross margin of the dealership. Though as noted above, this is not captured in new vehicle gross margin.As of October 2020, retail gross profit per new vehicle or new vehicle gross profit per unit ("GPU") climbed to $2,355 for the average dealerships as defined by NADA. This eclipses a previous high of $2,226 achieved in 2012. The year-to-date figure represents a nearly $280/unit increase over the average figure of $2,076 from 2012 through 2019. The chart below displays the annual new vehicle gross margin from 2012 through the current year-to-date.Retail Gross Profit Per Used VehicleLike new vehicle GPU, this metric refers to the gross margin achieved on the retail sale of a used vehicle and is measured by the retail selling price less the cost paid to acquire the vehicle divided by total units retailed. Similar to the new vehicles retailed which excludes fleet sales, it should be noted that this metric refers to retail sales only and does not include used vehicles for wholesale. Like its new vehicle gross profit counterpart, this metric has also climbed to its highest point in the observed period, currently at $2,678 per unit. We have previously written about several factors driving this metric including the heightened performance of the used vehicle market in the pandemic due to production shortages and shipment delays for new vehicles as manufacturers have experienced partial shutdowns. Low supply leads to higher prices, and dealers have been able to capture their share of this margin. The year-to-date figure represents a nearly $300/unit increase over the average figure of $2,386 from 2012 through 2019. With rising profitability over lower volumes, it’s clear why this figure is reaching all-time highs. The chart below displays the annual used vehicle gross margin from 2012 through the current year-to-date.Used-to-New Vehicle Unit RatioWith near-record levels of gross profit per new and used vehicles, how has that affected the product mix of vehicles sold by dealerships? The used-to-new vehicle unit ratio measures the amount of used retail units divided by new retail units. This ratio or product mix held fairly stable from 2012 through 2018 ranging from approximately 75% - 80%. Over the last year and a half, this ratio has climbed to 84.8% at the end of 2019 and peaked at 96.3% for October 2020. Used vehicles have become more profitable and have been more available to dealers at times in 2020. This ratio has reached an almost 1:1 relationship. The figure below displays the annual used-to-new vehicle unit ratio from 2012 through the current year-to-date. There are elements of both supply and demand in this figure. As noted in the previous charts, dealers earn more gross profit per used vehicle retailed than new vehicles. That means dealers get more bang for their buck when the used-to-new ratio approaches 1:1. However, customers are historically attracted to franchised dealerships because they want a specific make or model. With the reduction in new vehicle supply, it appears dealers have effectively pivoted their customers from new vehicles to used vehicles rather than losing the sale when their preferred option isn’t in stock. Another factor is likely in play, however. While supply is shifting towards used, demand is as well. With spikes in unemployment this year and the uncertainty surrounding job security for many, consumers are less likely to be able to afford the higher sticker prices of new vehicles, substituting to used as a more reasonable alternative.Potential Impacts and ConclusionHow is your dealership measuring up to these metrics and what impact could they have on the value of your dealership? As always, comparison with industry data should be viewed with some caution as it may not pertain directly to your dealership or the economic conditions experienced in your area. Nonetheless, the levels of these three metrics reflect the auto dealer industry’s ability to adapt to the challenges of 2020.The more important question for these metrics and for the valuation of your dealership, is how sustainable are these metrics for the long-term? The historical graphical information for each suggests that these figures will revert back to previous levels at some point. A majority of our projects for litigation and corporate valuations involve evaluating the expected annual earnings of the dealership for the future. Often, we examine these various metrics and the overall profitability and performance of the dealership over a longer historical period of time than just the latest year to determine the sustainability and future expectation. Just like dealers wouldn’t want to sell their business after a down year, valuations can become too lofty if an outlier year is effectively forecasted as the new normal.For an understanding of how your dealership is performing along with an indication of what your dealership is worth, contact a professional at Mercer Capital to perform a valuation or analysis.

The Role of Earn-Outs in RIA Transactions (Part Three)

In last week’s blog post, we covered five considerations for designing earn-outs. To recap, these considerations are as follows:Defining the continuing business that will be the subject of the earn-outDetermining the appropriate period for the earn-outDetermining to what extent the buyer will assist or impede the seller’s performance during the earn-out periodDefining what performance metrics will control the earn-out payment(s)Determining other earn-out features (caps on payments, clawbacks, etc.) While there is no one set of rules for structuring an earn-out, keeping these conceptual issues in mind can help anchor the negotiation. This week, we look at an example RIA transaction to illustrate how these considerations come into play when buyers and sellers are working out deal pricing and structure.RIA Transaction ExampleConsider the example of a depository institution, Hypothetical Savings Bank (HSB). HSB has a substantial lending platform, but it also has a trust department that operates as something of an afterthought. HSB’s senior executives consider options for closing or somehow spinning off the trust operation, but because of customer overlap, lengthy trust officer tenure with the bank, and concerns by major shareholders who need fiduciary services, HSB instead hopes to bolster the profitability of trust operations by acquiring an RIA.Following a search, HSB settles on Typical Wealth Management (TWM). TWM has 35 advisors and combined discretionary assets under management of $2.6 billion (an average of $75 million per advisor). TWM has a fifteen-year track record of consistent growth, but with the founding generation nearing retirement age, the firm needs a new home for its clients and advisors.The Seller’s PerspectiveTWM’s founders are motivated, but not compelled, to sell the firm. TWM generates 90 basis points of realized fees per dollar of AUM and a 30% EBITDA margin. Even after paying executives and advisors, TWM makes $7MM of EBITDA per year, and the founders know that profitability has significant financial value to HSB, in addition to providing strategic cover to shore up the trust department.Further, Typical Wealth Management has experienced considerable growth in recent years, and believes it can credibly extend that growth into the future, adding advisors, clients, and taking advantage of the upward drift in financial markets to improve revenue and enhance margins. Given what it represents to be very conservative projections, and which don’t take into account any cross-selling from the bank or potential fee enhancements (TWM believes it charges below-market fees to some clients), the seller wants 12x run rate EBITDA, or about $85 million, noting that this is only about 10x forward EBITDA, and less than 7x EBITDA three years hence. The Buyer’s PerspectiveThe commercial bankers at HSB are not overly familiar with the wealth management industry, but they know banks rarely double profitability in three years and suspect they’ll have a tough time convincing their board to pay top dollar for something without tangible book value.Bank culture and investment management do not always mix well, and HSB worries whether TWM’s clients will stay if TWM’s senior staff starts to retire. Further, they wonder if TWM’s fee schedule is sustainable in an era of ETFs and robo-advisors. They create a much less sanguine projection to model their possible downside. Based on this, HSB management wants to offer about $40 million for TWM, which is about six times run rate EBITDA. This pricing gives the seller some credit for the recurring nature of the revenue stream, but doesn’t pay for growth that may or may not happen following a change of control transaction. The CompromiseWith a bid/ask spread of $45 million, the advisors for both buyer and seller know that a deal isn’t possible unless one or both parties is willing to move off of their expectations significantly (unlikely) or a mechanism is devised to reward the seller in the event of excellent performance and protect the buyer if performance is lackluster. Even though the buyer is cautious about overpaying, they eventually agree to a stronger multiple on current performance and offer $50 million up front for TWM. The rest of the payment, if any, will come from an earn-out. Contingent consideration of as much as $30 million is negotiated with the following features:TWM will be rebranded as Hypothetical Wealth Management, but the enterprise will be run as a separate division of the bank during the term of the earn-out. This division will not pay any overhead charge to the bank, except as specifically designated for marketing projects through the bank that are managed by the senior principals of the wealth management division. As a consequence, the sellers will be able to maintain control over their performance and their overhead structure during the term of the earn-out.The earn-out period is negotiated to the last three years. Both buyer and seller agree that, in a three year period, the value delivered to the seller will become evident.Buyer and seller agree to modest credits if, for example, the RIA recommends a client develop a fiduciary relationship with the bank’s trust department, or if the bank’s trust department refers a wealth management prospect to the RIA. Nevertheless, in order to keep matters simple during the term of the earn-out, both parties agree to manage their operations separately while the bank determines whether or not the wealth management division can continue to market and grow as an extension of the bank’s brand.To keep performance tracking straightforward, HSB negotiates to pay five times the high-water mark for any annual EBITDA generated by TWM during a three year earn-out period in excess of the $7 million run-rate established during the negotiation. It is an unusual earn-out arrangement, but the seller is compensated if AUM is significantly enhanced after the transaction, whether by steady marketing appeal or strong market returns. The buyer is protected, at least somewhat, from the potentially temporary nature of any upswing in profitability by paying a lower multiple for the increase than might normally be paid for an RIA. As long as the management of TWM can produce at least $6 million more in EBITDA in any one of the three years following the transaction date, the buyer will pay the full earn-out. Any lesser increase in EBITDA is to be pro-rated and paid based on the same 5x multiple.The earn-out agreement is executed in conjunction with a purchase agreement, operating agreement, and non-competition/non-solicitation agreements which specify compensation practices, reporting structures, and other elements to govern post-transaction behavior between the bank and the wealth manager. These various agreements are done to minimize misunderstandings and ensure that both the buyer and sellers are enthusiastic participants in the joint success of the enterprise. As the earn-out is negotiated, buyer and seller run scenarios of likely performance paths for TWM after the transaction to see what the payout structure will look like per the agreement. This enables both parties to value the deal based on a variety of outcomes and decide whether pricing and terms are truly satisfactory.Conclusion: Earn-Outs are Interactive With the Value of RIAsRisk is an unavoidable part of investing. While we might all desire clairvoyance, it would only work if we were the sole investors who could see the future perfectly. If everyone’s forecasts were proven accurate, assets would all be priced at something akin to the risk free rate with no premium return attached. Uncertainty creates opportunity for investors, because opportunity is always a two way street.Pricing uncertainty is another matter altogether. Not everyone “believes” in CAPM, or at least maybe not the concept of beta, but most agree that the equity risk premium exists to reconcile the degree of un-likelihood for the performance of a given asset with the value of that security. In an ideal world, a reasonable cash flow projection and a reasonable cost of capital will yield a reasonable indication of value.In the vacuum-sealed world of fair market value, we can reconcile discordant outlooks with different cash flow projections. The differing projections can then be yoked together into one conclusion of value by weighing them relative to probability. The discount rate used in the different projection models captures some of the risk inherent in the cash flow, and the probability weights capture the remainder of the uncertainty. In a real world transaction, however, buyers want to be paid based on their expectations if proven right, and sellers also want to be paid if outcomes comport with their projections. With no clear way to consider the relative likelihood of each party’s expectations, no one transaction price will facilitate a transaction. Risk and opportunity can often be reconciled by contract, however, by way of contingent consideration.

Issue No. 7 | Data as of Year-End 2020

Seven Factors of a Highly Effective Buy-Sell Agreement for Auto Dealerships and The Chip Shortage Is Making It Feel Like 2020 All Over Again

Themes from Q3 2020 Earnings Calls

Part 2: Mineral Aggregators

Last week, we reviewed the third quarter earnings calls from a select group of E&P companies and briefly discussed the macroeconomic factors affecting the oil and gas industry. In this post, we focus on the key takeaways from the mineral aggregator third quarter 2020 earnings calls.Theme 1: M&A Activity Is Heating UpThe mineral aggregator space seems to be following the same M&A pattern as E&P operators as of late. Relative to the first half of 2020, consolidation efforts are increasing as aggregators are focusing on potential acquisition opportunities. Industry participants, however, continue to notice a wide bid-ask spread as sellers are often unwilling to sell at current prices.“I would say that, in terms of overall deal flow, we're seeing a tremendous amount of deal flow. If anything, our deal teams are busier now than they ever have. What I would say is that the competition today isn't necessarily with other mineral companies, but in often instances, we refer to kind of reservation price and that's the seller's willingness to part with those minerals.” – Robert Roosa, Founder & CEO, Brigham Minerals“We've been active on the M&A front. We'll still look at acquisitions. We're still working around the clock on acquisitions or submitting bids. It's just more challenging. I mean I think that sellers in this environment need to adjust expectations when the public companies, they're supposed to be the lowest cost of capital trade down so dramatically, us and our peers, that should trickle down to the sellers.” – Davis Ravnaas, President, CFO & VP of Business Development, Kimbell Royalty Partners“There's billions of dollars of minerals held within private equity firms as well as family offices. But in places where they're not meant to be held over the long term. And I think you will see consolidation in the space. And I think there's an opportunity for value creation as a result of that.” – Daniel Herz, President & CEO, Falcon MineralsTheme 2: Curtailment Situation Affects Aggregators Differently Production curtailments continued in some basins, like the Bakken, in the third quarter, while other well curtailments were reversed and put back online in the Permian and Eagle Ford. Some aggregators had the benefit of being active in certain basins where the curtailments were lifted, and others were not so fortunate but remained optimistic that their wells would be back online by the end of the year.“We believe, as of the end of September, all of the curtailed wells are back online and are producing to our benefit, with the barrels of oil selling at substantially higher prices that existed during the curtailment period. Very good news for us all. While the third quarter had limited wells turned online, which is consistent with what we had expected and previously discussed, activity has begun to pick up.” – Daniel Herz, President & CEO, Falcon Minerals“Production curtailments, which were put in place by many operators during the height of the pandemic earlier this year, were largely reversed in the Permian and Eagle Ford during the quarter. However, curtailments were still largely in place on our Bakken assets during the third quarter. We are hopeful that these will reverse in Q4 of 2020 due to improved differentials in commodity prices.” – Bob Ravnaas, President, CFO & Chairman, Kimbell Royalty PartnersTheme 3: Natural Gas Continues to Spark InterestNatural gas has shown its ability to remain somewhat stable during a difficult price environment. The commodity’s price stability along with the favorable outlook has aggregators interested. The participants recognize natural gas as an important asset in their portfolio and express their optimism in gas prices moving into 2021.“There's already some optimism in natural gas with '21 forward prices over $3 in MMbtu. And the recent underinvestment in oil projects, both domestically and abroad, combined with the lessening influence of OPEC is setting the stage for an oil rally once demand recovers.” – Tom Carter, CEO & Chairman of the Board, Black Stone Minerals“In addition to our gas weighted daily production, we also have a significant amount of future drilling inventory located across the major natural gas basins in the U.S. with a concentration in the core areas of the Haynesville and Marcellus.” – Bob Ravnaas, President, CFO & Chairman, Kimbell Royalty Partners“As Bob laid out a few moments ago, natural gas price futures are projected to be up approximately 50% in the next 12 months as compared to the average prices over the last 12 months, which could generate a significant improvement in cash flow for the company.” – Davis Ravnaas, President, CFO & VP of Business Development, Kimbell Royalty Partners“And just when we thought gas was dead, of course, natural gas prices are above $3 and that's a great call option for us. And we have two rigs running across our acreage position. And we have a nice amount of gas.” – Daniel Herz, President & CEO, Falcon MineralsTheme 4: Banks and Balance SheetsBanks seem to be uneasy with E&P companies’ lending situations, which trickles down to the aggregator space. A continuing trend among E&P operators and mineral aggregators is the effort to shore up the balance sheet to create a healthier company and maintain positive bank relationships during the current uncertainty.“In addition, the balance sheets of many operators are strained and as we go through the fall borrowing base redetermination season. Bank and equity markets remain closed for most E&P companies. This plus a renewed focus on cash returns instead of simply production growth, has limited new drilling capital across Lower-48, which obviously impacts our production levels.” – Tom Carter, CEO & Chairman of the Board, Black Stone Minerals“I mean, you've seen obviously, the banks have had a tough time with energy companies through this down cycle. We want to be as low touch as possible with those banks.” – Kaes Van’t Hof, President, Viper Energy Partners“We're not interested in using cash in this environment just given the fact that we're really focused on cleaning up the balance sheet as much as we can and we don't want to do an equity raise at an unpalatable discount right now to raise the cash.” – Davis Ravnaas, President, CFO & VP of Business Development, Kimbell Royalty Partners

Valuation Assumptions Influence Auto Dealer Valuation Conclusions

How to Understand the Reasonableness of Individual Assumptions and Conclusions

There are several life events (large and small) that require an owner of an auto dealership to seek a business valuation – estate planning, a potential sale, shareholder dispute/litigation, divorce, death of an owner, etc. Often the owner of the dealership and their advisors may only view a handful of business valuations during their careers. It is not unusual for the valuation conclusions of appraisers to differ significantly, with one significantly lower or higher than the other.Valuation also involves proving the overall reasonableness of an appraiser’s conclusion.What is an owner or their advisor to think when significantly different valuation conclusions are present? The answer to the reasonableness of the conclusion lies in the reasonableness of the appraiser’s assumptions. However, valuation is more than “proving” that each and every assumption is reasonable. Valuation also involves proving the overall reasonableness of an appraiser’s conclusion.A short example will illustrate this point and then we can address the issue of individual assumptions. In the following example, we see three potential discount rates and resulting price/earnings (“P/E”) multiples. The discount rate or rate of return is a key component in determining the value of an auto dealership under an income approach. While other methods, including Blue Sky multiples are more often used, determining the rate of return applicable to an auto dealership is also an important step in a business valuation.In the table below, we look at the theoretical assumptions used by appraisers to “build” discount rates. We show differing assumptions regarding four of the components, and none of the differing assumptions seems to be too far from the others. So, we vary what is called the equity risk premium (“ERP”), the beta statistic, which is a measure of riskiness, the small stock premium (“SSP”), and specific company risk (“SCR”).The left column (showing the low discount rate of 12.0% and a high P/E multiple of 11.1x) would yield the highest valuation conclusion. The right column (showing the high discount rate of 23.5% and the low P/E of 4.9x) would yield a substantially lower conclusion. That range is substantial and results in widely differing conclusions.In either case, appraisers might have made a seemingly convincing argument that each of their assumptions were reasonable and, therefore, that their conclusions were reasonable. However, the proof is in the pudding. Perhaps, neither the low nor the high examples would yield reasonable conclusions when viewed in light of available market evidence of the particular franchise, and location and profitability of the subject dealership.So, as we discuss how to understand the reasonableness of individual valuation assumptions in business appraisals of auto dealerships, know also that the valuation conclusions must themselves be proven to be reasonable. That’s why we place a “test of reasonableness” in every Mercer Capital valuation report that reaches a valuation conclusion.Auto Dealership Valuation AssumptionsNow, we turn to individual assumptions utilized in an auto dealership valuation.Growth RatesGrowth rates can impact a valuation in several ways. First, growth rates can explain historical or future changes in revenues, earnings, profitability, etc. A long-term growth rate is also a key assumption in determining a discount rate and resulting capitalization rate under the income approach.A long-term growth rate is also a key assumption in determining a discount rate and resulting capitalization rate under the income approach.Growth rates, as a measure of historical or future change in performance, should be explained by the events that have occurred or are expected to occur. In other words, an appraiser should be able to explain the specific events that led to a certain growth rate, in terms of total and departmental revenue and profitability. Auto dealerships experiencing large growth rates from one year to the next should be able to explain the trends that led to the large changes, whether it is new customers, new vehicle models being offered, loss/additional of a competitor, or other pertinent factors. Large growth rates for an extended period of time should always be questioned by the appraiser as to their sustainability at those heightened levels. This is particularly true for auto dealers, which as dealer principals know, experience ebbs and flows of the business cycle.A long-term growth rate is an assumption utilized by all appraisers in a capitalization rate. The long-term growth rate should estimate the annual, sustainable growth that the dealership expects to achieve. Typically, this assumption is based on a long-term inflation factor plus/minus a few percentage points. Be mindful of any very small, negative, or large long-term growth rate assumptions. If confronted with one, what are the specific reasons for those extreme assumptions?AnnualizationIn the course of a business valuation, appraisers normally examine the financial performance of the auto dealership for a historical period of around five years, if available. Since business valuations are point-in-time estimates, the date of the valuation may not always coincide with the auto dealership’s annual reporting period.Dealerships should be able to provide factory financial statements for the year-to-date period coinciding with the valuation date for the current and preceding year. A business appraiser can compile a trailing twelve month (“TTM”) financial statement from those two interim factory statements and the most recent 13th month year-end factory statement. A TTM financial statement allows an appraiser to examine a full-year business cycle and is not as influenced by seasonality or cyclicality of operations and performance during partial fiscal years. The balance sheet may still reflect some seasonality or cyclicality.Be cautious of appraisers that annualize a short portion of a fiscal year to estimate an annual result. This practice could result in inflating or deflating expected results if there is significant seasonality or cyclicality present. At the very least, the annualized results should be compared with historical and expected future results in terms of implied margins and growth.Dealer principals are well aware of monthly volumes of light vehicles sold in the U.S. that are annualized and referred to as “SAAR.” Due to the number of selling days and the inherent seasonality throughout the calendar year, properly determining the TTM financials should reduce the need to consider a complex formula such as that employed in the calculation of SAAR that almost certainly is not used if an appraiser simply annualizes by scaling up a stub period to 12 months.Litigation Recession “Litigation recession” is a term to describe a phenomenon that sometimes occurs when an owner portrays doom and gloom in their industry and for the current and future financial performance of the dealership. As with other assumptions, an appraiser should not blindly accept this outlook.A quality appraiser will compare the performance of the dealership against its historical trends, future outlook, and the condition of the industry and economy, among other factors. Be cautious of an appraisal where the current year or ongoing expectations are substantially lower, or higher for that matter, than historical performance without a tangible explanation as to why.Industry Conditions Most formal business valuations should include a narrative describing the current and expected future conditions of the auto dealer industry. An important discussion is how those factors specifically affect the dealership being valued. There could be reasons why the dealership’s market is experiencing things differently than the national industry. Industry conditions can provide qualitative reasons why and how the quantitative numbers for the dealership are changing. Look carefully at business valuations that do not discuss industry conditions or those where the industry conditions are contrary to the dealership’s trends. Current valuations in 2020 should include a discussion of the local industry conditions and their impact on a dealership’s performance as the effects of the pandemic have varied across states and regions.Valuation Techniques Specific to the Auto Dealer IndustryAs we have previously written, the valuation methods utilized in the auto dealer industry are unique and include an asset-based approach, an income approach, and a modified market approach incorporating concepts of Blue Sky value. It may be difficult for a layperson reviewing a business valuation to know whether the methods employed are general or industry-specific techniques. An auto dealer or their advisor should ask the appraiser how much experience they have performing valuations in the auto dealer industry.Risk Factors Risk factors are all of the qualitative and quantitative factors that affect the expected future performance of the auto dealership. Simply put, a business valuation combines the expected financial performance of the dealership (earnings and growth) and its risk factors. Risk factors show up as part of the discount rate utilized in the income approach of the business valuation.Like growth rates, there is no textbook that lists the appropriate risk factors for the auto dealer industry. However, there is a reasonable range for this assumption.Be careful of appraisers that have an extreme figure for risk factors. Make sure there is a clear explanation for the lowered or heightened risk. Otherwise, this is an easy area to influence a lower or higher valuation of the dealership.Blue Sky Multiples Another typical component of an auto dealer valuation is the use of Blue Sky multiples and the reflection of the concluded value as a measure of Blue Sky. As we have discussed, there are several national business brokers that publish these multiples quarterly by the manufacturer. Be wary of appraisers that do not reference Blue Sky multiples or explain their concluded values as a measure of Blue Sky. Also, be wary of appraisers that apply Blue Sky multiples to used vehicles or other metrics that are not widely recognized by the auto dealer industry.Another critique could be the range of Blue Sky multiples examined and how they are applied to the subject dealership. Take note of an appraiser that applies the extreme bottom or top end of the range of multiples, or perhaps even a multiple not in the range. Be prepared to discuss the multiple selected or implied and how the dealership compares to the range of multiples in terms of the local market (location and urban vs. rural), level of competition, historical profitability, etc.... we believe Blue Sky multiples are very helpful, at least for explaining value.In our review of appraisals performed by other firms, particularly those without considerable auto dealer experience, we see Blue Sky multiples either won’t be rigorously analyzed or may not even be mentioned. While this may not be a red flag to a layperson, we believe Blue Sky multiples are very helpful, at least for explaining value. To confirm the reasonableness of an appraisal that does not mention Blue Sky multiples, dealer principals can calculate it themselves. Blue Sky value is measured/calculated as the excess equity value over the tangible net assets of the dealership. If the implied multiple from an appraisal is unreasonable in the context of multiples seen for the relevant franchise(s), the overall reasonableness of the conclusion should be questioned.Time Periods Considered Earlier we stated that a typical appraiser examines the prior five years of the dealership’s financial performance, if available. Be cautious of appraisers that simply choose to use a small sample size, i.e. the latest year’s results, as an estimate of the dealership’s ongoing earnings potential. The number of years examined should be discussed and an explanation as to why certain years were considered or not considered should be offered.Some industries, like the auto dealer industry, have multi-year cycles, not just annually (further evidence of the importance of a discussion of industry conditions and consideration of recognized industry-specific techniques in the appraisal).The examination of one year or a few years (instead of five years) can result in a much higher or lower valuation conclusion. If this is the case, it should be explained.ConclusionBusiness valuations of auto dealerships are a technical analysis of methodologies used to arrive at a conclusion of value for the subject dealership. It can be difficult for an auto dealer or their advisors to understand the impact of certain individual assumptions and whether or not those assumptions are reasonable. In addition to a review of individual assumptions, the valuation conclusion should be reasonable.Mercer Capital performs numerous business valuations of auto dealers annually for a variety of purposes. Contact a professional at Mercer Capital to discuss your next business valuation.

Themes from Q3 2020 Earnings Calls

Part 1: E&P Operators

As discussed in our quarterly overview, the oil & gas sector experienced a relatively stable price environment as compared to the volatile energy prices seen in the first half of the year. The third quarter saw the WTI range narrow and hover around $40 per barrel, in line with industry participant expectations of nominally higher prices than in the second quarter.However, the concurrent overlapping impact of (i) discord created by the OPEC/Russian rift and resulting supply surge; and (ii) the drop in demand due to COVID-19 related issues was historic and continued to play a role in the third quarter. As if COVID-19 and the Russian-Saudi price rift wasn’t eventful enough, the regulatory shakeup expected to come from the Biden administration following the November election will add to the mix for what seems to be an already pressing and critical time for the industry. The unfortunate, overlapping timing of these events has made the bankruptcy courts busy with no indication of that trend coming to a halt.In this post, we capture the key takeaways from E&P operator third quarter 2020 earnings calls.Theme 1: Continued Cost Reductions Lower Break-Even PricesOne recurring theme among E&P operators in our prior E&P operator earnings calls was the continued focus on reducing operating costs and capital expenditures in the pursuit of increased efficiencies. All six E&P operators we tracked in our current quarterly overview saw gains along these lines, evident by positive free cash flow in Q3 due to a decline in break-even prices.“Yes, we do see the break-even is roughly $32 next year. I don’t think that’s too dissimilar from where we were before we were indicating kind of in the mid-30s. But it depends on the capital program at any given time and where you’re putting those assets and the productivity.” – William Berry, CEO, Continental Resources, Inc.“Our pro forma maintenance capital corporate breakeven is at a very, very attractive low -- in the low 30s WTI, including the base dividend.” – Scott Sheffield, CEO, Pioneer Natural Resources Company“Impressive downside resilience as evidenced by our low-cost structure and enterprise free cash flow breakeven, approximately $35 per barrel WTI breakeven in 2021, including our dividend…” – Lee Tillman, President & CEO, Marathon Oil Company“Due to sustainable cost reductions achieved this year, maintenance capital and the current dividend can now be funded with oil in the mid-30s.” – Lloyd Helms, COO, EOG Resources, Inc.Theme 2: Continued Emphasis on Debt Reduction and Shareholder DividendsAnother recurring theme in our prior quarterly analysis was the focus by E&P operators on reducing debt and reinforcing dividends. The panel of operators we tracked in this quarterly earnings call review was split almost evenly among those who were still focused on debt reduction and those who put the return of capital to shareholders as their top priority.“The cornerstone of our 2021 plan is maximizing free cash flow to pay down debt… While our dividend has been suspended, but not terminated, both our shareholders and our board are very supportive of bringing the dividend back at the appropriate time after our debt is reduced.” – William Berry, CEO, Continental Resources, Inc.“We are well aware that some of our larger peers are planning to return cash to shareholders. But as we have repeatedly stated, our plan is to apply our free cash flow, alongside our monetization proceeds, towards meaningful debt reduction, until we have significantly lowered our total debt balance.” – Jim Ulm, Chief Financial Officer, Callon Petroleum Company“[With respect to the prioritization of allocating free cash flow] the base dividend will be first. And then second, will be a combination of balance sheet and variable dividend.” – Scott Sheffield, CEO, Pioneer Natural Resources Company“Put very simply, our forward capital allocation philosophy has not changed. We will protect our dividend, spend maintenance capital at most and use excess free cash flow to pay down debt. If our expected free cash flow will not cover our dividend, then we will cut capital to ensure our dividend is protected.” – Travis Stice, CEO, Diamondback Energy, Inc.“[W]e are putting this free cash flow to good use. Advancing our dual objectives of returning capital to our shareholders through our base dividend reinstatement and improving our balance sheet through … gross debt reduction while cutting our 2022 maturity tower in half. Importantly, both the fourth quarter dividend reinstatement and gross debt reduction were fully funded by actual third quarter free cash flow.” – Lee Tillman, President & CEO, Marathon Oil Company“We remain committed to pursuing our objective to strengthen our balance sheet further during upturns. Beyond the regular dividend and debt reduction we regularly review performance scenarios that may present options for additional cash return to shareholders. We haven't ruled out buybacks or a variable or special dividend and we'll consider all options for additional return of cash to shareholders when the opportunity presents itself.” – Tim Driggers, CFO, EOG Resources, Inc.Theme 3: Uncertainty Lies AheadDespite the relative stability of oil and gas prices in the third quarter, E&P operators continue to project significant uncertainty for their industry. The critical near-term factors affecting their forward outlook include regulatory changes for the oil and gas industry as put forth by the Biden administration, an upcoming meeting of OPEC+ producers in December, and the potential timeline of effective and available vaccines to curb the energy demand shock brought on by the COVID-19 pandemic.“There's certainly some significant headwinds on the commodity space right now. I mean we've got the election uncertainty and looming policy changes… We've got COVID that we're still struggling how to contain that. And is there going to be a vaccine anytime soon, and what does that mean to the supply demand recovery? We've got OPEC+ meeting in December to talk about whether they maintain cuts or start easing those cuts, and then we've got a global inventory overhang that's still there. All of those are macro issues that I can't control, and we can't influence.” – Travis Stice, CEO, Diamondback Energy, Inc.“There are still several unknowns that we will continue to evaluate during our budgeting process. The impact of the election, the timing of COVID-19 vaccine and in turn, the return and stabilization of oil demand, especially what OPEC decides to do in during the mid-November to December 1 OPEC meetings.” – Scott Sheffield, CEO, Pioneer Natural Resources CompanyOn the HorizonBroadly speaking, the E&P operator earnings calls suggest an uneasy calm. The question is, has the oil and gas industry emerged from the first major quake and should it expect relatively minor aftershocks, or is it in the eye of the storm, experiencing a brief respite before the tempest picks up again? Overall, it is clear that oil and gas operators can not only weather the storm, but still produce free cash flow that is significant enough to shore up the balance sheet and return capital to shareholders while concurrently maintaining lean operational and capital programs. This modus operandi, however, comes at the cost of highly subdued expectations for growth (with one noted exception among the six E&P operators we monitor).Throughout the earnings calls, we noted that management outlooks that included flat or even slight production declines over the near-term horizon were not considered to be “downside” scenarios, but evidence of, if nothing else, at least sustainable ongoing operations. Additionally, we noted that at least half the E&P operators discussed continued efforts to support and advance various ESG initiatives, including proactively reducing emissions, and imparting stronger positive impacts on the local communities in which the companies operate.Regarding M&A activity, there was not much commentary regarding overall industry trends, but the overriding thesis was brought up in a number of calls that the focus of any such activity should be on “not necessarily bigger, but better.”

Avoiding Buyer’s Remorse

The Role of Earn-Outs in RIA Transactions (Part Two)

One November day in the late 1970s my dad noticed an ad on the bulletin board at work that caught his attention: someone had a Jensen Healey MkII for sale. The MkII was arguably the best product Jensen Healey ever made: a lightweight two seat convertible with a Lotus four-cylinder double overhead cam engine with dual Stromberg carburetors. The Jensen my dad was looking at was far from perfect – it was covered with a couple of years worth of dust and had a crease running down the middle of the fragile aluminum hood because someone hadn’t been careful closing it. It needed a tune up and who knows what else (British sports cars aren’t known for reliability). But at 2,400 pounds and 140hp, when it ran, it ran fast. Dad brought the Jensen home for the long Thanksgiving weekend and we drove it around Miami (due diligence) to decide whether or not to take the plunge.Part Two of Our Series on Earn-OutsLast week, we offered an example, ACME Private Buys Fictional Financial, to shed light on several issues presented by the use of earn-outs in RIA transactions. As explained, gathering comprehensive data on ultimate deal value in investment management transactions is problematic as most post-deal performance doesn’t get reported other than AUM disclosures in public filings. And, if the acquired entity is folded into another RIA, you can’t even judge a deal by that. Sometimes bad deals can be saved by good markets, but hope is not a strategy. Consequently, earn-outs are the norm in RIA transactions, and anyone expecting to be on the buy-side or sell-side of a deal needs to have a better-than-working knowledge of them.Earn-Out FunctionAs noted above, RIA transactions usually feature earn-out payments as a substantial portion of total consideration because so much of the seller’s value is bound up in post-closing performance. Earn-outs (i.e. contingent consideration) perform the function of incentives for the seller and insurance for the buyer, preserving upside for the former and protecting against potential losses for the latter. In investment manager transactions, earn-outs are both compensation, focusing on the performance of key individuals, and deal consideration, being allocated to the selling shareholders pro rata. And even though earn-out payments are triggered based on meeting performance metrics which are ultimately under the control of staff, they become part of overall deal consideration and frame the transaction value of the enterprise.For all of these reasons, we view contingent consideration as a hybrid instrument, combining elements of equity consideration and compensation, and binding the future expectations of buyer and seller in a contractual understanding.Earn-Out ParametersContingent consideration makes deals possible that otherwise would not be. When a seller wants twice what a buyer is willing to pay, one way to mediate that difference in expectations is to pay part of the price upfront (usually equal to the amount a buyer believes can safely be paid) and the remainder based on the post-closing performance of the business. In theory, earn-outs can simultaneously offer a buyer some downside protection in the event that the acquired business doesn’t perform as advertised, and the seller can get paid for some of the upside he or she is foregoing by giving up ownership. While there is no one set of rules for structuring an earn-out, there are a few conceptual issues that can help anchor the negotiation.Define the Continuing Business Acquired That Will be the Subject of the Earn-Out.Deciding what business’s performance is to be measured after the closing is easy enough if an RIA is being acquired by, say, a bank that doesn’t currently offer investment management services. In that case, the acquired company will likely be operated as a stand-alone enterprise with division level financial statements that make measuring performance fairly easy.If an RIA is being rolled into an existing (and similar) investment management platform, then keeping stand-alone records after the transaction closes may be difficult. Overhead allocations, staff additions and subtractions, expansion opportunities, and cross selling will all have some impact on the value of the acquired business to the acquirer. Often these issues are not foreseen or even considered until after the transaction closes. It then comes down to the personalities involved to “work it out” or be “fair.” As a friend’s father used to say: “fair is just another four-letter word.”Determine the Appropriate Period for the Earn-Out.We have seen earn-out periods (the term over which performance is measured and the contingent consideration is paid) as short as one year and as long as five years. There is no magic period that fits all situations, but a term based on specific strategic considerations like proving out a business model, defining investment performance objectives, or the decision cycle of key clients are all reasons to develop an earn-out timeframe.There is no magic period that fits all situations.The buyer wants the term to be long enough to find out what the true transferred value of the business is, and the seller (who otherwise wants to be paid as quickly as possible) may want the earn-out term to be long enough to generate the performance that will achieve the maximum payment. Generally, buyer-seller relations can become strained during an earn-out measurement period, and when it is over, no one wishes the term had been longer.We tend to discourage terms for contingent consideration lasting longer than three years. In most cases, three years is plenty to “discover” the value of the acquired firm, organize a merged enterprise, and generate a reliable stream of returns for the buyer. If the measurement period is longer than three years, the “earn-out” starts to look more like bonus compensation, or some other kind of performance incentive to generate run-rate performance at the business. Earn-outs can be interactive with compensation plans for managers at an acquired enterprise, and buyers and sellers are well-advised to consider the entirety of the financial relationship between the parties after the transaction, not just equity payments on a stand-alone basis.Determine to What Extent the Buyer Will Assist or Impede the Seller’s Performance During the Earn-Out.Was the seller attracted to the deal by guarantees of improved technology, new product options, back-office support, and marketing? Did the buyer promise the seller the chance to operate their business unit without being micromanaged after the transaction? These are all great reasons for an investment management firm to agree to be absorbed by a larger platform, and they may also help determine whether or not the acquired firm meets performance objectives required to receive contingent consideration.While bad deals can be saved by good markets, counting on overpromises is not a sound deal strategy. Instead, buyers and sellers should think through their post-close working relationships well in advance of signing a deal, deciding who works for whom, and defining the mutual obligations required to achieve shared success. If things don’t go well after the transaction – and about half the time they don’t – the first person who says “I thought you were going to…” didn’t get the appropriate commitments from his or her counterparty on the front end.Define What Performance Measurements Will Control the Earn-Out Payments.It is obvious that you will have to do this, but in our experience buyers and sellers don’t always think through the optimal strategy for measuring post-closing performance.Buyers ultimately are paying for the future profit contribution from the seller, so a measure of cash flow seems like the obvious performance metric to measure the acquired investment management operation’s success. However, there are at least two problems with using cash flow to benchmark contingent consideration.Returns from markets don’t determine long-term success nearly as much as returns from marketing.First, profitability is at the bottom of the P&L and is, therefore, (potentially) subject to manipulation. To generate a dollar of profit at an RIA, you need some measure of client AUM, market performance, a fee schedule, investment management staff, office space, marketing expense, technology and compliance, capital structure considerations, parent overhead allocations, and any number of other items, some of which may be outside of the sellers’ control. Will the sellers accuse the buyer of impeding their success? Can the factors influencing that success be sufficiently isolated and defined in an earn-out agreement? It is often more difficult than it seems.Second, much of the post-transaction profitability of the acquired business will depend on the returns of the financial markets, over which nobody has control. If a rising tide indeed lifts all boats, should the buyer be required to compensate the seller for beneficial markets? By the same token, if a deal is struck on the eve of another financial crisis, does the seller want to be held accountable for huge market dislocations? In our experience, returns from markets don’t determine long-term success nearly as much as returns from marketing. Consider structuring an earn-out based on net client AUM (assets added net of assets withdrawn), given a certain aggregate fee schedule (so business won’t be given away just to pad AUM).Name Specific Considerations That Determine Payment Terms.Is the earn-out capped at a given level of performance or does it have unlimited upside? Can it be earned cumulatively or must each measurement period stand alone? Will there be a clawback if later years underperform an initial year? Will there simply be one bullet payment if a given level of performance is reached? To what extent should the earn-out be based on “best efforts” and “good faith?”Earn-outs manage uncertainty; they don’t create certainty.Because these specific considerations are unique to a given transaction between a specific buyer and seller, there are too many to list here. Nevertheless, we have formulated a couple insights about earn-outs over the years: 1) Transaction values implied by earn-out structures are often hard to extrapolate to other transactions. 2) An earn-out can ease the concerns and fulfill the hopes of parties to a transaction about the future – but it cannot guarantee the future. Earn-outs manage uncertainty; they don’t create certainty.Above all, contingent consideration should be based on the particular needs of buyers and sellers as they pertain to the specific investment management business being transacted. There is no one-size-fits-all earn-out in any industry, much less the RIA community. If an earn-out is truly going to bridge the difference between buyer and seller expectations, then it must be designed with the specific buyer and seller in mind.Earn-Outs Are Like WarrantiesWhat happened to the Jensen Healey? Over that fall weekend in Miami, we detailed and waxed the car. My dad was able to get the crease out of the aluminum hood by reshaping it with his bare hands. It was a beautiful car and sounded great under power, but even a five-year-old British sports car in the 1970s was cause for concern, and they don’t come with warranties. My dad had lived with an old Jaguar in his 20s and didn’t mind getting grease under his fingernails, but one evening we were diving the Jensen home from dinner and it ran out of gas. The fuel gauge didn’t work; likely one of a string of problems that would lead my father to a level of buyer’s remorse that he had experienced with other cars and didn’t want to deal with again. He didn’t buy it.Like old sports cars, acquisitions don’t come with warranties, so protecting yourself against buyer’s remorse is critical. Even with escrows and punitive terms, you can’t guarantee that you’ll get what you pay for in an acquisition; but, with a properly structured earn-out, you can at least pay for what you get.

October 2020 SAAR

October lightweight vehicle sales had their second month in a row above 16 million, coming in at an annualized rate of 16.2 million for the month. Though this is down 0.6% from the September SAAR of 16.3 units, it is still a positive sign for the industry that sales have shown notable improvement since the start of the pandemic. As Thomas King, president of data and analytics at J.D. Power noted:“Two consecutive months of year-over-year retail sales increases demonstrates that consumer demand is showing remarkable strength. The strong sales pace is occurring despite tight inventories. The combination of strong demand and lean inventories is enabling manufacturers to reduce new-vehicle incentives and is allowing retailers to reduce the discounts they typically offer on new vehicles.”SAAR for October 2020 is off by 3% from that of October 2019. Light trucks are continuing to bolster sales, coming in at 77% of new vehicles sold in October and 76% of new vehicles sold this year.The average new vehicle turnover from lots to consumers has fallen to 49 days, the first time it has fallen below 50 days in more eight years. 20% of vehicles are being sold after being on a dealer lot for only five days or less.As we mentioned in our Q3 earnings call blog post, public auto dealers noted how vehicle demand has been outstripping supply as manufacturers struggle to get new vehicles to dealers. Among the major public dealerships, there is consensus that this inventory shortage will continue through year-end before beginning to normalize in 2021. However, tighter inventory has contributed to higher gross margins and higher selling prices. In October, these prices are expected to reach another all-time high, rising 7.3% from last year to $36,755. More expensive trucks and SUVs have been drivers of this average transaction increase.Looking toward the rest of the year, not much is anticipated to change unless there is an unexpected relief to the inventory constraints. The sales calendar for November 2020 is shorter than that of 2019 (28 days in 2020 vs. 32 in 2019), so slightly deflated SAAR is expected.Dealership Valuations Looking UpWhen considering the year that auto dealerships have experienced, an outside observer would likely assume that dealership values are down. However, more dealerships are bullish on their valuations over the next twelve months according to a Kerrigan Advisors survey of dealers. The second annual survey found that 33% of dealers expect the value of their stores to rise in the next year, up from 26% in 2019. Another 53% expect values to remain the same, while 14% think their values will be lower. This is a change from 2019 where 60% expected values to remain the same and 14% to expect a decrease. Erin Kerrigan, managing director of the firm, noted "The rebound in auto sales coupled with reduced dealership expenses and higher vehicle margins will result in record industry earnings in 2020.” As seen in the table above, Subaru, Toyota, Porsche, Honda, and Mercedes-Benz have the highest expected valuation gains. These trends are in line with Blue Sky multiple increases as well, as Subaru’s blue sky multiple has seen an increase to 5.0x – 6.0x, while dealerships such as Infiniti and Cadillac continue to be below blue sky multiple levels. Some CaveatsThough dealers being bullish on their valuations is a good sign in terms of the recovery of the industry, every dealership is different. While there are many factors that need to be considered when determining the value of a dealership, here are three that are critical, especially when considering the operating in a pandemic.LocationWhile 38% of Subaru dealerships surveyed anticipate valuation growth this year, that percentage is unlikely to be consistent across the country.When determining the value of a dealership, it’s important to consider the local economy where the dealership operates, especially considering stay-at-home orders and business restrictions stemming from the pandemic.In March and April, dealers in the northeast were harder hit by the stay-at-home orders than the dealerships elsewhere. As of today, with the virus surging across the country, looking at the impacts in each specific region is important to determining dealership values.SalesWhile many dealerships are seeing earnings growth in Q2 and Q3, what is the quality of that earnings growth and how do dealerships’ earnings compare to that of prior years?If earnings have only increased due to operation cuts, that growth should be scrutinized a bit. Cutting costs can improve the bottom line in the short run, but it may not contribute to overall company growth over the long-term. We’ve had clients remark how the Great Recession taught them just how lean they could operate. Since then it’s likely that dealers have added back some expenses but the pandemic has again forced cost cutting. The sustainability of earnings in 2020 will depend on how many of those expenses can continue to stay low and how gross profits look once inventories become less scarce.Earnings growth must also be evaluated in the context of pre-pandemic levels, not just improvement from the bottom. The recent pattern in GDP growth is a good example of this. In Q3, GDP increased an impressive 33.1%, after having fallen 31.4% in Q2. While 33.1% is greater than 31.4%, we can see in the graph below that GDP has not fully recovered.OperationsIn an increasingly technological environment due to the pandemic, a dealership’s digital presence can contribute to their overall valuation. A dealership that has invested in their digital offerings has set themselves on a platform for growth.ConclusionThe valuation outlook for many dealerships is positive but dealerships are not created equal. The individual characteristics and performance of each dealership has to be analyzed in any valuation process.Feel free to reach out to us for more information about how current economic conditions may affect your dealership’s valuation or to discuss a specific valuation need in confidence.

The Role of Earn-Outs in RIA Transactions (Part One)

Earn-outs are as common to investment management firm transactions as they are misunderstood. Despite the relatively high level of financial sophistication among RIA buyers and sellers, and broad knowledge that substantial portions of value transacted depends on rewarding post-closing performance, contingent consideration remains a mystery to many industry participants. Yet understanding earn-outs and the role they play in RIA deals is fundamental to understanding the value of these businesses, as well as how to represent oneself as a buyer or seller in a transaction. Contingent consideration remains a mystery to many industry participantsThis blog series is not offered as transaction advice or a legal primer on contingent consideration. The former is unique to individual needs in particular transactions, and the latter is beyond our expertise as financial advisors to the investment management industry. Instead, we offer these posts to explore the basic economics of contingent consideration and the role it plays in negotiating RIA transactions.Earn-Outs Are Fundamental to RIA TransactionsAs the saying goes (which has been attributed to at least a dozen famous figures): "It’s difficult to make predictions, especially about the future." This reality is the single most difficult part of negotiating a transaction in the investment management industry. The value of an RIA acquisition target is subject not only to a large number of variables but also a wide range of possible outcomes:Performance of financial markets (standard deviation varies)Skill of the investment management staff (difficult to measure)Sustainability of the acquired firm’s fee schedule (not as much a given as in the past)Retention of key staff at the acquired firm (absolutely necessary)Retention of key staff at the acquiring firm (absolutely necessary)Motivation of key staff (absolutely necessary)Retention of client assets (depends on third party behavior)Marketing strength of the merged enterprise (tough to predict) Without faith in the upward drift of financial markets, favorable margins in investment management, and the attractiveness of the recurring revenue model, no one would ascribe material value to an RIA. But actually, buying an investment management firm is making a bet on all of the above, and most people don’t have the stomach.Only by way of an earn-out can most investment management firm transactions overcome so much uncertaintyReaders of this blog understand that only by way of an earn-out can most investment management firm transactions overcome so much uncertainty. Nevertheless, in our experience, few industry executives have more than an elementary grasp of the role contingent consideration plays in an RIA transaction, the design of an earn-out agreement, and ultimately the impact that these pay-for-performance structures have on valuation.If nothing else, earn-outs make for great stories. Some of them go well, and others go like this.From Earn-Out to Burn-Out: ACME Private Buys Fictional FinancialOn January 1, 20xx, ACME Private Capital announces it has agreed to purchase Fictional Financial, a wealth management firm with 50 advisors and $4.0 billion in AUM. Word gets out that ACME paid over $100 million for Fictional, including contingent consideration. The RIA community dives into the deal, figures Fictional earns a 25% to 30% margin on a fee schedule that is close to but not quite 100 basis points of AUM, and declares that ACME paid at least 10x EBITDA. A double-digit multiple brings other potential deals to ACME, and crowns the sellers at Fictional as “shrewd.” Headlines are divided as to whether Fictional was “well sold” or that ACME was showing “real commitment” to the wealth management space, but either way the deal is lauded. The rest of the investment management world assume their firm is at least as good as Fictional, so they’re probably worth 12x EBITDA. To the outside world, everybody associated with the deal is happy.The reality is not quite so sanguine. ACME structures the deal to pay half of the transaction value up front with the rest to be paid based on profit growth at Fictional Financial in a three year earn-out. Disagreements after the deal closes cause a group of advisors to leave Fictional, and a market downturn further cuts into AUM. The inherent operating leverage of an investment management firm causes profits to sink faster than revenue, and only one third of the earn-out is ultimately paid. In the end, Fictional Financial sold for about 6.5x EBITDA, much less than what the selling partners wanted for the business. Other potential acquisition targets are disappointed when ACME, stung with disappointment from the Fictional transaction, is not willing to offer them a double-digit multiple. ACME thought they had a platform opportunity in Fictional, but it turns out to be more of an investment cul-de-sac.The market doesn’t realize what went wrong, and ACME doesn’t publish Fictional’s financial performance. Ironically, the deal announcement sets the precedent for interpretation of the transaction, and industry observers and valuation analysts build an expectation that wealth management practices are worth about 10x EBITDA, because that’s what they believe ACME paid for Fictional Financial.ConclusionThis example highlights the difference in headline deal values (total consideration) and what actually gets paid after the earn-out payment. Sometimes they’re the same but often only a portion of the contingent consideration is realized, which makes total consideration multiples difficult to interpret. We’ll touch on this a bit more in next week’s post on transaction strategies and earn-out parameters.

Mineral Aggregator Valuation Multiples Analysis

Market Data as of November 10, 2020

Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly-traded minerals ownership.Due to a variety of corporate structures (including master limited partnerships and Up-Cs) and complex capital structures (including preferred equity and non-traded common units), mineral aggregator enterprise values pulled from databases are often missing meaningful components of value, leading to skewed valuation multiples.Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis. Download our report below. Mineral Aggregator Valuation MultiplesDownload Analysis

Solvency Opinions Explained

What a Solvency Opinion Is and What It Addresses

What Is a Solvency Opinion?With the rise of corporate bankruptcies, a lot of leveraged transactions that occurred pre-COVID are going to be scrutinized. The musings here consider solvency opinions conceptually, but many bankruptcy courts, such as the one that oversaw the restructuring of Neiman Marcus, will consider the issue retroactively and may ask stockholders to return distributions that were deemed to have been obtained via fraudulent conveyance.The Business Judgement RuleThe Business Judgement Rule, an English case law doctrine followed in the U.S. and Canada, provides directors with great latitude in running the affairs of a corporation provided directors do not breach their fiduciary duties to act in good faith, loyalty, and due care. However, there are instances when state law prohibits certain actions including the fraudulent transfer of assets to stockholders that would leave a company insolvent.This straightforward statutory prescription has taken on more meaning over the past decade because corporate America has significantly increased its use of debt given very low interest rates. Investors have been willing to fund the increase because negligible rates on “safe” assets have pushed individuals and institutions out of the risk curve to produce income.Transactions that may meaningfully alter the capitalization of a company include leveraged dividend recapitalizations, leveraged buyouts, significant share repurchases, and special dividends funded with existing assets. Often a board contemplating such actions will be required to obtain a solvency opinion at the direction of its lenders or corporate counsel to provide evidence that the board exercised its duty of care to make an informed decision should the decision later be challenged.Four QuestionsA solvency opinion addresses four questions:Does the fair value of the company’s assets exceed its liabilities after giving effect to the proposed action?Will the company be able to pay its debts (or refinance them) as they mature?Will the company be left with inadequate capital?Does the fair value of the company’s assets exceed its liabilities and surplus to fund the transaction? A solvency opinion is typically performed by a financial advisor who is independent, meaning the advisor has not arranged financing or provided other services related to the contemplated transaction. The opinion is based upon financial analysis to address the valuation of the corporation and its cash flow potential to assess its debt service capacity. Also, the opinion is just that—it is an informed opinion. It is not a pseudo-statement of fact predicated upon the “known” future performance of the company. It provides a reasonable perspective concerning the future performance of the company while neither promising to stakeholders that those projections will be met, nor obligating the company to meet those projections.Test 1: The Balance Sheet TestThe balance sheet test asks: Does the fair value and present fair saleable value of the company’s total assets exceed the company’s total liabilities, including all identified contingent liabilities? The balance sheet test is a valuation test in which the value of the company’s liabilities are subtracted not from the assets recorded on the balance sheet, but rather the fair market value of the company on a total invested capital basis. The value of the company on a debt-free basis is estimated via traditional valuation methodologies, including Discounted Cash Flow (“DCF”), Guideline Public Company, and Guideline Transactions (M&A) Methods. In some instances, the Net Asset Value (“NAV”) Method may be appropriate for certain types of holding companies in which assets can be marked-to-market.Test 2: The Cash Flow TestWill the company be able to pay its liabilities, including any identified contingent liabilities, as they become due or mature? This question addresses whether projected cash flows are sufficient for debt service. A more nuanced view evaluates the question along three general dimensions:Revolver Capacity: If financial results approximate the forecast, does the company have sufficient capacity, relying upon its revolving credit facility if necessary, to manage cash flow needs through each year?Covenant Violations: Does the projected financial performance imply that the company will violate covenants of the credit or loan agreement, or the terms of any other credit facility currently in place or under consideration as part of the subject transaction?Ability to Refinance: Is it likely that the company will be able to refinance any remaining balance at maturity?Test 3: The Capital Adequacy TestDoes the company have unreasonably small capital with which to operate the business in which it is engaged, as management has indicated such businesses are now conducted and as management has indicated such businesses are proposed to be conducted following the transaction? The capital adequacy test is related to the cash flow test. A company may be projected to service its debt as it comes due, but a proposed transaction may leave the margin to do so too thin – something many companies discovered this year in which they were able to operate with high leverage as long as business conditions were good. There is no bright line test for what “unreasonably small capital” means. We typically evaluate this concept based upon pro forma and projected leverage multiples (Debt/EBITDA and EBITDA/Interest Expense) relative to public market comps and rating agency benchmarks. While management’s projections represent a baseline scenario, alternative downside scenarios are constructed to asses the “unreasonably small capital” question in the same way downside scenario analyses are constructed to address the question of whether debts can be paid or refinanced when they come due.Test 4: The Capital Surplus TestThe capital surplus test asks: Does the fair value of the company’s assets exceed the sum of (a) its total liabilities (including identified contingent liabilities) and (b) its capital (as such capital is calculated pursuant to Section 154 of the Delaware General Corporation Law)? The capital surplus test replicates the valuation analysis prescribed under the balance sheet test, but also includes the company’s capital in the subtrahend (Hey! There is a word we haven’t seen since early primary school. The subtrahend is the value being subtracted.) Section 154 of the Delaware General Corporation Law defines statutory capital as (a) the par value of the stock; or in instances when there is no par value as (b) the entire consideration received for the issuance of the stock. "Capital" as defined here is nuanced. Often it may be a small amount if par is some nominal amount such as a penny a share, but that may not always be the case. What is excluded is retained earnings (or deficit) from the equity account.The Mosaic of SolvencyThe tests described above are straightforward. Sometimes proposed transactions are straightforward regarding solvency, but often it is less clear—especially when the subject company operates in a cyclical industry. Every solvency analysis is unique to the subject transaction and company under review and requires an objective perspective to address the solvency issue.Mercer Capital renders solvency opinions on behalf of private equity, independent committees, lenders and other stakeholders that are contemplating a transaction in which a significant amount of debt is assumed to fund shareholder dividends, an LBO, acquisition or other such transaction that materially levers the company’s capital structure. For more information or if we can assist you, please contact us.

Q3 2020 Earnings Calls

Low Supply and SG&A Reductions Lead to Record Earnings

Third quarter earnings calls started with an optimistic tone, with just about every call reporting record earnings despite revenue headwinds. Advertising and personnel costs that were taken out at the beginning of the pandemic haven’t come back as dealers try to determine how best they can run lean and improve productivity. Tight inventories continue to plague new vehicle volumes, which isn’t expected to get better until the turn of the year. To compensate for this volume decline, dealers have strategically priced the models they did have in stock. Executives noted some points in the quarter where certain models were completely out of stock. Trucks and crossovers have been particularly hot, representing over 75% of vehicles sold.Speaking of crossovers, many executives discussed the point of the transaction where consumers cross over from digital to in-person. During significant shelter-in-place restrictions that caused April lows, dealers were thrust into their online strategies and there were many prognostications about the potential long-term impacts. As the pandemic has persisted, consumers appear to have indicated a preference to beginning the process online, but the desire to test drive the vehicle or discuss the financing has limited the amount of fully online transactions.While Carvana is the new kid on the block in terms of public auto retailing, it’s their used-online operations that franchised dealers are looking to mirror. Across many calls, Carvana’s name was invoked as the key comparative tool to measure how digital offerings match up. While executives all project confidence about their used platforms, it appears clear that the well capitalized online used retailer has an advantage in this area. Still, franchised dealers have their own advantages with access to new vehicles and fixed operations.With consumers still spending a significant amount of time in their homes, the collision business has seen an impact as miles driven has decreased. While miles driven would appear to be the most direct indication of demand for autos, interestingly, executives have noted another trend. With the decrease in rental business and ridesharing, it looks like auto retailing may be regaining market share, which would benefit the industry if this trend continues as the number of miles driven rebounds.The recent Hummer EV unveiling also drew the attention of analysts and executives. The consensus was the hype surrounding the relaunch of a brand that was defunct since the financial crisis was a positive sign for GM, and the shift to electrification will continue. However, many noted the importance of quality models in this shift as consumers won’t be willing to pay up for vehicles (or expensive batteries) that don’t stand up on their own just because they’re electric. This is particularly true with low prevailing fuel costs. While the Hummer EV’s price point allows for good margins, it means volumes will be much lower and ultimately will have less of an impact on dealership profitability.Theme 1:Dealers made significant investments in digital offerings to compete under strict stay-at-home orders. As the pandemic persists, executives believe digital will continue to play a role particularly at the beginning of the shopping experience, though it is unlikely car buying moves fully online.[I]n this day and age 95% of the people are looking online first. – David Hult, CEO, Asbury Automotive Group[I]f a consumer wants to, which is less than 2% of the population right now[,] they can go online, buy a car from end-to-end, no touchpoints […] I think about 15% to 16%, 17% of our customer base right now is completing some percentage of the transaction online before they come to the store to pick it up. […] The consumers are telling us that they want to be able to search our inventory online, but they want to come to a store, sit with an associate that’s got experience dealing with the car that they’re looking at. They want to test drive from a big inventory before they buy a car and make that decision. Our goal in our hybrid approach from A to Z is to allow them, if they want to go A to J or they want to go A to Z, our system is going to allow that to happen. – Jeff Dyke, President, Sonic AutomotiveAbout 80% of our consumers use digital forms in some way during the process. We actually only sell about 1.5% of our cars today on a truly digital end-to-end type of solution. – Bryan DeBoer, President, and CEO, Lithia MotorsTheme 2:Demand continues to outstrip supply as manufacturers struggle to get new vehicles to dealers. Consensus appears to be 2021 before this begins to normalize. Tight inventories have led to higher gross margins.We’ve had of course running conversations with the manufacturers since the spring, and every target has been missed. What we’ve been told we would be shipped, it simply did not happen. I don’t see any change in the fourth quarter from what I understand is coming through, and so now we’re into the first quarter, best case. When I see that they’re able to consistently achieve their shipping targets, then we can talk about what you can sell new. The demand is there at retail. I’m not worried about the demand. […] we’ll either get it through the volume or we’ll get it through pricing. – Mike Jackson, Chairman & CEO, AutoNationAvailability is coming back. I think we’ve got or 1,000 or 1,200 more cars on the ground at this point than we did last month at this time. And that just keeps improving every month. Manufacturing is doing a great job getting inventory back in our hands. The demand is there, and I think we’ll all be back and rolling as we move into the first and second quarter of next year as supplies build. From a used car perspective, […] the supply is endless. – Jeff Dyke, President, Sonic AutomotiveThe substantial improvements in gross profit of over $1,000 per unit compared to third quarter of 2019 are largely attributed to high level of incentives from our OEM partners and a perceived inventory shortage in the country. –Bryan DeBoer, Presiden, and CEO, Lithia MotorsOperators are very savvy, when they cannot replace a vehicle. They don't sell it as cheaply. I mean, that's the simple thing. They know whether they can trade with another dealer, and if they can replace it. So that's driving these high margins throughout the industry. And the ramp up in supply from the OEMs has been far below what anyone in our sector would have expected. We're just now starting to receive a few more vehicles and we're retailing every month. But our new vehicle inventory year-over-year, one point drop something like 12,000 units. So we were still nowhere near back to normal levels. And I'm sure, we're not the only one. So while the reduction in margins going forward will be proportionate to the increase in inventory, there still appears to be a long way to go before the industry is back to normal move vehicle and inventory levels. – Earl Hesterberg, President and CEO, Group 1 AutomotiveAs we sit here today that we’re still benefitting in our GPUs from the lower inventory and we anticipate at this point to benefit throughout the quarter. The virus is starting to heat, but backed up as we all know, assuming factories don't shut down at all, we anticipated some point in the first quarter to get inventory levels somewhat back to normal, and at that point you would assume you would feel it into margins, but we don’t see that happening in Q4. – David Hult, CEO, Asbury Automotive GroupTheme 3:While working from home has led to a decline in miles driven which has negatively impacted collision, other areas of parts and service have come back. Despite fewer miles driven, some executives also believe there is a structural change in demand wherein consumers want their own vehicles.In our products and service numbers that we disclosed collisions in there. Collision for us is running, for 12% to 15%, back, depending upon the market. So that's pulling back our CP numbers. We've been positive for the last few months in service specifically, as it relates to customer pay in warranty. – David Hult, CEO, Asbury Automotive GroupI think we got to think a little bit socially what's really happening, with a vehicle market and personal mobility. […] Personal mobility […] should create some more demand and use cars and also new cars now, not high luxury cars. But I mean, cars that we would use on a daily basis if you needed transportation, because I think combined transportation where two or three people are together, whether it's in a transit, public transit, whether it's a rental car, whether it's Uber or Lyft, I think there's some softness in those businesses, which will drive more automotive sales for us both in new and used. So I think these are things that personal use, will be help us drive a bigger part of the share of the auto business in the future. And I could be wrong. But there's definitely a flight to safety. – Roger Penske, Chairman & CEO, Penske Automotive GroupThere has been a significant shift towards individual mobility as a result of the pandemic and shelter-in-place. This has increased demand across the board from pre-owned through new in every segment. This individual retail demand is lasting and will continue for the next several years. – Mike Jackson, Chairman & CEO, AutoNationConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

RIA Margins – How Does Your Firm’s Margin Affect Its Value?

An RIA’s margin is a simple, easily observable figure that encompasses a range of underlying considerations about a firm that are more difficult to measure, resulting in a convenient shorthand for how well the firm is doing. Does a firm have the right people in the right roles? Is the firm charging enough for the services it is providing? Does the firm have enough–but not too much—overhead for its size? The answers to all of these questions (and more) are condensed into the firm’s margin.What Is a “Typical Margin?”We’ve seen a wide range of margins for RIAs. Smaller firms with too much overhead and not enough scale might see no profitability or even negative margins. On the other hand, an asset manager with rapidly growing AUM and largely fixed compensation expenses might see margins of 50% or more. The “typical” margin for RIAs depends on the context. As the chart below illustrates, different segments of the investment management industry typically have different margins based on the risk of the business model (among other factors).At one end of the spectrum are hedge funds, venture capital firms, and private equity managers. The high fees these companies generate per dollar invested can support very high margins, but the risk of client concentrations, underperformance, and key staff dependence is significant.Traditional institutional asset managers are somewhere in the middle of the spectrum. When these companies get it right, institutional money can flock in rapidly. A successful institutional asset manager may find themselves managing billions more in assets while staffing remains virtually unchanged. The additional fees flow straight to the bottom line, and margins can be quite healthy as a result. But the risks are significant. Institutional money can leave just as quickly as it came if the manager’s asset class falls out of favor or if performance suffers.At the lower end of the spectrum are more labor-intensive disciplines like wealth management and independent trust companies. For these businesses, bringing on additional clients translates directly into increased workload for staff, which will ultimately translate into higher staffing levels and compensation expense as the business grows. While margins are lower, the risk is less. Key-person risk is less because an individual’s impact is generally limited to the clients they manage, and not the entire firm’s investment strategy. Client concentration is less because wealth management firms tend to have a large number of HNW clients rather than a few large institutional clients. Performance risk is generally less of a concern as well.Does a Firm’s Margin Affect What Its Worth?A high margin conveys that a firm is doing something right. But what really matters from a buyer’s perspective is not what the margin is now, but what it will be in the future. Consider the three scenarios below. In Scenario A, the EBITDA margin starts relatively low (15%), but improves over time. In Scenario B, the margin starts at a higher level (25%) but remains constant. In Scenario C, the margin starts at 35% but declines over time.The sensitivity table below shows the buyer’s IRR in each scenario as a function of the multiple paid.1 For a given multiple, the IRR is highest in Scenario A (margins low but expanding) and lowest in Scenario C (margins high but declining). In Scenario A, the buyer can afford to pay a higher multiple and still generate an attractive rate of return (a 9.0x multiple results in an IRR of 23.4%). In Scenarios B and C, however, the buyer must pay a lower multiple in order to generate the same IRR, even though the initial margin is higher.The implication of the analysis above is that the prospect for future margins is much more important than the current margin when determining the appropriate multiple for an RIA. The market for different segments of the investment management industry tends to reflect this. Institutional asset managers, while they can have very high margins, tend to command lower multiples than HNW wealth managers, which often have lower margins. The reasons for this are many: asset managers are more exposed to fee pressure, trends towards passive investing, and client concentrations, among other factors. These factors suggest an increased likelihood for lower margins in the future for asset managers. HNW wealth managers, on the other hand, often have lower but more robust margins due to their relatively sticky client base, growing client demographic (HNW individuals), and insulation from fee pressure that has affected other areas of the industry.Margin and Value High margins are great, but what really matters to a buyer how durable those margins are. There are a variety of factors that affect this, some of which are within the firm’s control and some of which or not. Where the firm operates within the investment management industry (asset manager, HNW wealth manager, PE fund, etc.) is one factor that can affect revenue and margin variability.While a firm can’t easily change which segment of the industry it operates in, there are other steps that these businesses can take to protect their margins. For example, designing the firm’s compensation structure such that it varies with revenue/profitability is one way to protect margins in the event that revenue declines. See How Growing RIAs Should Structure Their Income Statement (Part I and Part II). Firms can also critically evaluate their growth efforts to ensure that additional infrastructure and overhead investments don’t outweigh gains in revenue. By structuring the expense base in a way that protects the firm’s margin if revenue falls and developing growth initiatives designed to support profitable growth, many RIAs can generate stable to improving margins in most market environments—and realize higher multiples when the firm is eventually sold.1 For simplicity, other projection assumptions are omitted.

GM and Nikola Partnership: What Went Wrong and Where Does it Stand?

Even with Halloween, we doubt your weekend was as scary as the past few months have been for Nikola...As we have discussed previously, electric vehicles (EVs) are all the rage with new start-ups trying to capture a slice of the pie that Tesla has been helping grow for years. In response, traditional manufacturers have begun to create EV options of their own. However, the entry path into the EV space has its drawbacks. For start-ups entering the industry, they may have the technology or innovative idea but lack the scale and access to capital necessary to gain market share and keep up with established competitors. Legacy manufacturers face the opposite problem: while they have the scale and capital, diverting resources into R&D for electric in a rapidly progressing space can lead to minimal tangible gain while it’s established products languish. To solve this mismatch, a new trend has emerged as manufacturers seek start-ups for their technology in a mutually beneficial relationship, perhaps best exemplified by GM and Nikola’s plan for a partnership. In this post, we look at the original deal, ensuing issues, and current plans. We will also look at what this trend could mean for dealerships going forward, and the importance of the valuation date.The Initial DealIn early September, Nikola stock got a massive boost after announcing a partnership with General Motors. Under the agreement, GM would engineer and build Nikola’s pickup truck named the Badger. In return, GM would take an 11% stake in Nikola and have rights to nominate one person on the board of the startup. This $2 billion equity stake won’t be in the form of cash however, but instead will be in “in-kind” contributions. These contributions include access to General Motors’ global safety-tested and validated parts and components. In regards to the deal, Nikola Founder and Executive Chairman Trevor Milton had this to say:Nikola is one of the most innovative companies in the world. General Motors is one of the top engineering and manufacturing companies in the world. You couldn’t dream of a better partnership than this […]. By joining together, we get access to their validated parts for all of our programs, General Motors’ Ultium battery technology and a multi-billion dollar fuel cell program ready for production. Nikola immediately gets decades of supplier and manufacturing knowledge, validated and tested production-ready EV propulsion, world-class engineering and investor confidence. Most importantly, General Motors has a vested interest to see Nikola succeed. We made three promises to our stakeholders and have now fulfilled two out of three promises ahead of schedule. What an exciting announcement.General Motors Chairman and CEO Mary Barra shared similar sentiments about the deal:This strategic partnership with Nikola, an industry leading disrupter, continues the broader deployment of General Motors’ all-new Ultium battery and Hydrotec fuel cell systems […]. We are growing our presence in multiple high-volume EV segments while building scale to lower battery and fuel cell costs and increase profitability. In addition, applying General Motors’ electrified technology solutions to the heavy-duty class of commercial vehicles is another important step in fulfilling our vision of a zero-emissions future.While Nikola would utilize GM’s fuel cell technology for the Badger, they would still be responsible for the sales and marketing, and the Badger would remain under the Nikola brand name. Though the Badger was first announced on February 10, 2020, production was not expected to occur until late 2022.What Went Wrong?Although the deal was initially anticipated to close on September 30, 2020, Nikola experienced troubles over the weeks prior that led to delays as their value has dropped sharply. Behind this decline in value and trouble sorting out the deal is a litany of allegations. Things began to fall apart just two days after the announcement when short-seller Hindenburg Research released a study claiming Nikola was based on “intricate fraud built on dozens of lies.” Included in these fraudulent claims is an allegation of Nikola staging a 2018 video of its hydrogen fuel-cell truck driving. Hindenburg alleges that the semi-truck was not actually driving, but instead, rolling down a long gentle slope. In response, Nikola stated it never claimed that the car was propelling itself. They also noted the careful wording employed at the time of the vehicle “being in motion” did not necessarily indicate that it was moving on its own accord. This technicality didn’t do much to assuage investors.Another misrepresentation that was alleged is Nikola’s efforts to develop a new kind of battery for use in electric vehicles. In November 2019, Milton claimed that Nikola would unveil “the biggest advancement we have seen in the battery world,” with these claims based on the planned acquisition of ZapGo. However, the acquisition never went through after Nikola stated that ZapGo had nothing more than interesting research with no ability to commercialize it. Despite pulling out of the deal, Nikola’s message about the new advancement in battery technology remained the same, putting into question if there is actually this battery technology in the works at all. This was not the only problem for Nikola in the past month, however, as the Department of Justice and SEC are reportedly probing Hindenburg’s allegations and two women in Utah filed sexual abuse charges against Milton. Ultimately, all of this culminated into a mountain of insurmountable issues for Trevor Milton, who resigned from his position as Executive Chairman of Nikola on September 20th. Post resignation, Nikola stock dropped 17% to $28.35 after already being down almost 27%. As of November 2nd, Nikola’s stock price stood at $18.84. This is a 76.4% decline from the stock’s peak as of June 9th and down 62.3% since the GM announcement spike.What Now?With all of this being said, it’s clear why GM and Nikola haven’t been able to close their $2 billion deal. The question now seems to be under what terms a “new deal” may come, or if there should even be a deal at all. According to several sources, GM is considering revisions to the deal and may seek a higher stake in the startup after its valuation fell due to the allegations. Though there are some new considerations that need to come into play for the deal to occur, some analysts see it still as a viable possibility. J.P Morgan analyst Paul Coster thinks that a new deal could be signed by early December, as he notes, “Nikola needs access to GM’s supply-chain, engineering resource, the Ultium battery, and Hydrotec fuel cells to de-risk the Class 8 truck initiative.” The analyst wrote in a Monday research report, “GM needs to realize a return on billions of dollars of investment in hydrogen fuel cells, and Nikola might be the best available option." He believes that the price target for Nikola is still around that $41 September value and that the stock is currently undervalued. However, with the December 3rd deadline of renegotiations looming, November is going to be critical to getting something put together.TakeawaysThough the GM and Nikola deal is in limbo, we believe more partnerships like this may materialize in the future. With increased emphasis on energy-efficient vehicles going forward, traditional manufacturers are going to need to find ways to meet consumer demand and fuel efficiency regulations. Furthermore, the looming election and the potential for a leadership transition might pave the way for EVs to carve out a more significant spot in the market (if you haven't already, read our blog post on Trump and Biden’s potential policy impacts on the auto industry). Manufacturers may seek partnerships and acquisitions in lieu of creating their own electric vehicle technology. Ultimately, only time will tell, but the struggles of GM and Nikola to close this deal might not be a reflection that these deals are doomed, and instead, a hiccup before other auto manufacturers try to create their own deals with EV start-ups.This GM and Nikola deal sheds light not only on the current EV industry, but also on how important the valuation date is in determining value for deals such as this. In the initial deal, Nikola was going to give 47,698,545 shares of its common stock to GM Holdings in exchange for in-kind contributions. These shares were valued at $2 billion based on the average price per share of $41.93 as of the September 8th Nikola filing with the SEC. When considering this, does it make sense for GM to assume $41 per share, established at the September valuation date, when allegations have led to scrutiny of this number? Especially when the public market has reacted and the stock price has plummeted to under $20 per share? Your answer is most likely no. They should try to get a new valuation closer to the deal close date in order to more accurately determine Nikola’s current value.The same considerations should be made if you are considering buying and selling an auto dealership. Though it can be more difficult to determine value without the assistance of the public market as in the case of Nikola, there are still certain signs that a previous valuation may no longer be applicable. The most common this year has been due to the economic volatility of the COVID-19 pandemic and the ensuing recession. Because of these factors, the fair value of a dealership has most likely fluctuated depending on how they were able to navigate the past year. Proceeding with a deal considering a February valuation could lead to one party paying unfairly. With this being said, due diligence in regard to having a proper and timely valuation is critical to making sure that a buyer and seller both agree to a fair price.If you are interested in how the past year may have affected the value of your dealership, feel free to reach out to us.

What a Biden or Trump Presidency Might Mean for the Oil & Gas Industry

With the presidential election less than a week away, we believe it is timely to identify the potential domestic and international implications of each candidates’ agendas as they relate to the oil and gas industry. The election comes at a pressing time in the industry, with the next four years of U.S. oil and gas policy at stake. Uncertainty continues to build as the election awaits and as two contrasting platforms face off. As if COVID-19 and the Saudi-Russian price rift weren’t impactful enough to the industry, an election year adds to the eventful list. In this post, we discuss each candidate’s political platform for the oil and gas industry. The major topics and issues at stake include domestic production, infrastructure plans, OPEC+ engagements, and international sanctions.U.S. UpstreamPrior to the COVID-19 demand destruction, U.S. oil production increased 3.9 million b/d from Trump’s inauguration in January 2017. President Trump’s production initiative aims to increase domestic output to pre-COVID levels, aligning with his historical policies to maximize U.S. energy production while constraining the supply of international players. The industry has a general consensus on what the next four years may look like under a Trump administration. The last four years have been filled with unrestricted oil production and relaxed crude export barriers. The greatest domestic impact could come from Joe Biden’s initiative to oppose fracking on federal lands and waters. Biden denied claims that he would ban fracking outright, instead stating that his platform would favor a ban on new fracking on federal lands and waters. According to S&P Global Platts Analytics, eliminating the issuance of drilling permits for federal lands has the potential to shrink U.S. oil production by up to 2 million b/d by 2025, primarily from the Delaware Basin and the Gulf of Mexico. During the final presidential debate, Joe Biden called for the U.S. to transition away from oil to address the environmental harm of climate change. A Biden administration would look to re-enter the Paris Climate Agreement, which Trump pulled out of during his term, in order to prioritize the movement away from fossil fuel energy sources. The push towards alternative energy sources could hinder domestic oil production compared to Trump’s vision for the industry, which supports fracking initiatives.Source: S&P GlobalInfrastructure During his term, President Trump signed executive orders, making efforts to ease permitting for pipelines, ports, and other energy infrastructure projects. His actions were challenged by many state governments and projects continue to face legal obstacles. If Joe Biden is elected, he would likely raise the bar for infrastructure project permits by considering climate impacts. For example, it is possible that Biden may deny the 570,000 b/d Dakota Access Pipeline a new permit, a move initiated by the Obama administration, leaving Bakken producers without capacity to transport roughly 300,000 b/d to market. U.S. crude exports that rely on certain pipelines will be affected by these future build-out decisions. Infrastructure orders that are initiated by either candidate will face pushback as it is common for state and local authorities to get involved.OPEC+According to the Dallas Federal Energy Survey, 74% of industry executives believe that OPEC will play a bigger role in the determination of the price of oil going forward. This year has further illustrated the impact OPEC+ participants can have on the global oil and gas market, shown by the Saudi-Russian price rift. During his term, President Trump urged OPEC+ to increase or cut supply on a number of occasions. Most would agree that President Trump has been more engaged with OPEC+ than most of his predecessors. Trump’s international sanctions, which we will touch on below, have weakened the influence of OPEC’s Venezuela and Iran, which in turn concentrated power with Saudi Arabia and Russia. A Biden administration may not be as aggressive with OPEC+ compared to President Trump. Although Biden has not detailed his approach to the OPEC+ players, some assume he will attempt to rely on quiet diplomatic channels behind the scenes.International SanctionsIn November 2018, President Trump imposed economic sanctions on Iran and withdrew the United States from the Iran Nuclear Deal. President Trump’s approach to international sanctions on OPEC members Iran and Venezuela have decreased international oil production by approximately 3 million b/d, slightly more than 3% of world supply. If President Trump is re-elected, he is expected to continue the sanctions pressure on the two countries, restricting Iran and Venezuela’s oil exports. If Biden is elected, Iranian oil exports could rise 1.8 million b/d by the end of 2021. There is a possibility that Biden would amend the sanctions imposed on Iran, creating a partnered approach, assuming conditions are met, that would be similar to the deal struck under the Obama administration. Global oil supply has the ability to dramatically shift, depending on each candidate’s international sanctions approach.ConclusionWe have examined only a number of categories of each candidate’s proposed agendas and the impact each will have on the oil and gas industry. As with all industries, the oil and gas sector is affected by many macro and micro factors that transpire over a long period of time. The true impact of each candidate’s policies, along with the policies that are already enacted, may not be measurable for years to come. A summary of the key differences discussed above in each candidate’s proposed agendas are as follows:

What RIAs Need to Know About Current Estate Planning Opportunities

Estate and tax planning matters are an important component of the overall financial plan for many RIA clients. The current tax policy and market environment create unique estate planning opportunities that may not last if economic conditions normalize or if Biden wins in November. This webinar addresses the available opportunities that RIA principals and advisors should be aware of in the current environment. Original air date: October 28, 2020

2020 Alternative Asset Manager Update

Are Sustainable Investments the Future of Investment Management?

The market for sustainable investments has grown to over $12 trillion in the U.S. and the movement of investable assets into sustainable strategies is expected to accelerate. In this week’s post, we link to the newly published 2020 Alternative Asset Manager Update authored by Taryn Burgess, CFA, ABV. The update reviews the growth of sustainable investing over the last decade and considers the valuation implications for your RIA.2020 Alternative Asset Manager UpdateView Report

Analyzing Sources of Peer Information for Auto Dealers

Data Drill Down

In our quarterly newsletters, we use various data sources to keep tabs on the auto dealer industry. This includes items like SAAR to gauge the health and activity of the industry in terms of volumes. In this post, we discuss other metrics that help us analyze the dealerships we’re engaged to value. The goal of analyzing such metrics is two-fold: we seek to contextualize how the company’s performance compares to peers and whether a dealership is likely to get a higher multiple in the marketplace. We also strive to provide our clients with an in-depth analysis that can be beneficial to the management of their dealership. Understanding value drivers and performance relative to peers helps dealers understand and, hopefully, increase the value of their business. While sources like RMA (defined below) are frequently used in valuations across industries as a starting point, the auto dealer industry has the luxury of having other unique data sources that can provide further insight to our clients. Let’s peel back the onion and drill down into these various data sources.RMA Annual Statement StudiesBeginning on the outer layer of our proverbial onion, one of the base resources employed by appraisers for companies in a variety of industries is the Annual Statement Studies: Financial Ratio Benchmarks, as published by the Risk Management Association. We refer to this information simply as “RMA” for short.This annual study allows users to determine the composition of common sized balance sheets, income statements, and other key financial ratios. Though RMA data was initially published to aid banks in determining the suitability of loans, this information is still helpful in the valuation context because it allows us to gain insight into industry financial trends.RMA data is offered by North American Industry Classification System codes (“NAICS” codes). For auto dealers, there are Retail – New Car Dealers (#441110) and Retail – Used Car Dealers (#441120). As seen in the pictures below, the vast majority of peer information comes from new vehicle dealers with over $25 million in sales. Most auto dealers, whether they have one rooftop or several, tend to fall into the over $25 million category. In an industry where vehicles retail around $30 thousand, a dealer only needs to sell about 830 vehicles a year to get to $25 million in revenue, and this doesn’t even consider fleet, wholesale, and fixed operations.While we frequently show both new and used vehicle financial ratios from RMA, the data from new dealers is more likely to be appropriate for a typical franchised dealer, even those with material used vehicle operations.As alluded to previously, this data provides common size balance sheet and income statements. For example, RMA data shows inventory comprises about 60% of total assets, while short-term notes payable (the vast majority of which for auto dealers is floor-plant debt) comprise about 52.8%. Many dealers do not fully finance their used vehicles, which likely plays a role in inventory exceeding short-term notes payable in the RMA data. Inventory as a percentage of total assets and inventory turnover can also be used to determine the amount of inventory held by a dealer.These data points can then be applied to the subject company we are valuing to consider how floor plan debt usage may impact liquidity and expenses and whether they are carrying adequate inventory to support sales.RMA data also provides helpful insights into the following metrics:Working capital as a percentage of salesInventory turnoverAverage Days Outstanding (on receivables and payables)Gross and Pre-Tax profit marginsOfficer/director compensation as a % of sales While these metrics are helpful in analyzing dealers, it is critical to use caution when relying on this information. We believe the data works better as a starting place, as the average of 2,000 dealerships is not going to be directly comparable to the dealership in question. Therefore, we find it more helpful as a test of reasonableness than some figure to specifically tether analysis.NADA Dealership Financial ProfilesWhile RMA data is a useful starting point, the auto dealer industry has more directly comparable data available. Peeling back the next layer of the onion, The National Automobile Dealers Association (“NADA”) publishes Dealership Financial Profiles on a monthly basis.Like RMA, data from all types of dealerships is compiled in the “Average Dealership Profile.” For dealers with many rooftops, this may give a good overall perspective. However, when valuing a single point location, Dealership Financial Profiles help us to get even more specific.NADA offers data for domestic, import, luxury, and mass market dealerships. This is helpful because while operations can be substantially similar for different brands of dealerships, margins and profit drivers tend to be different for the various types of dealerships. This enhanced granularity allows for better comparisons than the information provided by RMA, and monthly information is also more helpful than annual studies. However, NADA information focuses primarily on the income statement, with minimal information on the balance sheet available (excluding the net debt-to-equity and current ratio). Sales, gross profit, operating profit, pre-tax profit figures are offered for various types of dealerships as seen below for domestic dealerships. Beyond just margins, NADA data drills down further into the following: Profitability by department (new, used, and fixed operations)New and used retail volumesF&I penetrationAdvertising, rent, floor-plan interest, and SG&A expenses Like the RMA data, strict comparisons should be made with caution. Still, these are very helpful data points that can lead to better discussions with dealer principals, both about the performance of the business and potential normalization adjustments for valuation purposes. For example, dealerships frequently rent their facilities from an entity that owns the property. This entity and the dealership operations frequently have overlapping ownership structures, and this provides another data point to help determine if the company is paying a fair market-based rent. Related parties may also perform certain advertising functions, which by nature have fewer data points to determine whether a company is overpaying or underpaying for these services. As we mentioned above, another advantage of NADA data is the frequency of publication. Monthly information may be subject to seasonal quirks if profitability is stronger during certain months but comparing to prior year periods largely neutralizes this impact. Using more current information is particularly helpful in the dynamic environment we’ve experienced in this pandemic. For example, in the above figure, revenues and gross profit were down for the average dealership through August 2020, but pre-tax profits actually rose as expenses declined more than gross profit. This analysis would not be possible until the following year of RMA studies. Ultimately, NADA data gets to closer comparisons than RMA, but we can still peel back another layer.20 Group DataIn our valuation engagements, we frequently ask for 20 Group data, which is compiled by OEMs and compares dealers to their peers.Unlike NADA data, the peers in a 20 Group statement will be only the same brand, and selected peers will likely be more similar to the subject company in terms of size or geography (or both). As such, this represents the closest comparison possible.Unfortunately, this data is not always available, and as noted in our other sources, we caution against heavy reliance on such information as necessary valuation adjustments are not frequently considered on dealer financial statements, and therefore, will not lead to fool-proof data points upon which to base valuation adjustments.Blue Sky Transactions DataAnother data source frequently considered in transactions of auto dealerships are Blue Sky multiples, as published by Haig Partners and Kerrigan Advisors.Blue Sky multiples offer different perspectives than the above information. These auto dealer focused investment banks publish indications of dealership intangible value they encounter in the transaction space. For valuation purposes, these multiples can be used in conjunction with peer performance to explain the Blue Sky value of a dealership. If a certain branded dealership typically gets a 5-6x Blue Sky multiple, and the dealership is performing better than their peers, all else equal, they may get a multiple at the upper end or even above this range.However, not everything is all equal. You’d pay more for a dealership that delivers consistently strong returns. But how much of the increased value is due to higher earnings and how much is to a higher multiple?If a company is underperforming its peers, but the buyer believes they can improve performance up to peers, a higher value paid on lower historical earnings implies a higher multiple, so even an underperforming dealer might get a higher multiple than a better performing peer.Multiples are based on some indication of value and some indication of earnings; they frequently describe value rather than prescribe value. Stated more simply, a valuation does not simply derive tangible book value and apply the mid-point of the Blue Sky multiple range to pre-tax earnings. A proper valuation will determine the value of the dealership and be able to communicate why the implied Blue Sky value is reasonable within the context of historical and expected earnings and compare this performance to that of its relevant peers.ConclusionIn total, these various sources offer plenty of perspective into the historical performance and expected value in the marketplace for an auto dealership. Each source offers a different type of insight, and each comes with its own strengths and drawbacks. We have summarized data available from RMA and NADA in the following table.For a better understanding of where your dealership stacks up relative to peers and potentially in the marketplace, contact a member of the Mercer Capital Auto Dealer Valuation team today.

Down and Out: Bankruptcy Valuations Portend Production Declines

Projections and reorganization valuations of some recent oil and gas debtors demonstrate that creditors are aiming to ride existing production out of bankruptcy as opposed to drilling their way out of it.Oil patch producers have been plunging towards bankruptcy for several months now as I have written before. This trend is on pace to continue with WTI still hovering around $40 per barrel. Hopes for even $50 per barrel prices could be cathartic for many, but alas prices have been flat for months now. There are dozens of areas and fields that have become economic at $50 compared to $40. Somewhat ironically, one of the pathways back to higher prices will be the decline of production in the U.S. (if not replaced elsewhere). That appears to be the case for most producers already in Chapter 11 bankruptcy.Whiting is a good example. According to its bankruptcy filings, projections show that Whiting is only expected to spend a paltry $6 million on capital expenditures in 2021 against $300 million in EBITDA. Cash flows are scheduled to be maximized towards claim recovery; particularly its reserve-based lending (RBL) claims of $581 million. As such, production is slated to decline steadily over the next five years as its creditors attempt to recover claims. Creditors’ priorities make sense from their standpoint. Even banks with financially stable clients are not advancing higher borrowing bases right now.Whiting’s midpoint reorganization value as estimated in its bankruptcy documents is also primarily reflective of its cash flows from existing wells and not from prospective future wells and acreage. As such, its valuation, while steady from an EBITDAX multiple perspective, is towards the bottom of Mercer Capital’s range of publicly traded implied production multiples.Whiting is not alone at these valuation metrics. Bruin, another bankrupt operator in the Williston basin, has a reorganization value of 5.4x projected EBITDAX and a production multiple of $18,558. Bruin also is expected to spend relatively little ($15 million) on exploration expenses, however, it also has 1/5th of Whiting’s production. While also at the low end of implied public multiples, Whiting and Bruin are at a higher premium than some in the market right now.Another bankrupt company, California Resources Corp. has a higher production multiple than either Whiting or Bruin. This appears to be driven by substantially higher realized oil prices in California, and also potentially by shallower decline curves that lead to longer lived wells in the San Joaquin and Los Angeles Basins. It’s also remarkable that California Resources plans to spend more than Whiting and Bruin combined in 2021.[caption id="attachment_34208" align="alignnone" width="638"]Source: Mercer Capital Analysis[/caption] How do these values stack up in the transaction marketplace? Not a simple answer. First, there aren’t many deals happening in this environment and the ones that are happening are not in the Williston or California. One recent deal is Devon Energy’s purchase of WPX Energy. All three reorganization values lag the implied transaction multiple for WPX Energy. A Permian-based operator with an oil tilted production mix, WPX, transacted for $27,198 per flowing barrel according to Shale Experts. However, it is not surprising that it went at a premium to these debtors; with plans to limit future drilling, the debtors’ reorganization values are thus more heavily weighted towards PDP production than any other reserve category. Additionally, the Permian has been a favored basin compared to the Williston and California in recent years. Amid this year’s turmoil, the Permian is still expected to lead U.S. oil growth for years to come. Depending on who one consults, the basin with the most amount of potential to return to profitability as oil crawls back towards $50 per barrel is the Permian. There are already a few top tier locations that are profitable at $35 per barrel, but those are limited locations and are mostly in the Delaware. Certain areas in the Permian contain several potentially economic locations between $40 and $50. In contrast, most of the Williston’s inventory becomes profitable at above $50 per barrel. Still, as it stands at around $40 per barrel, only a handful of areas (mostly in the Eagle Ford and Permian) are profitable to drill right now. According to the most recent Dallas Fed Energy Survey, oil prices are expected to rise less than 10% by next year. Accordingly, drilling activity has turned anemic. Rigs, which as recently as a year ago were plentiful across the fruited plains, are as sparse as some endangered species. That will not change until oil gets back over $50 and where differentials between benchmarks and actual realizations are smaller. In the meantime, production could continue to fall off. Since March, production in the U.S. fell as far as 20% in September. This is a precipitous decline in a short amount of time. The chart above reflects not only the lack of new drilling, but the steep decline that shale oil wells intrinsically have. This will be a critical consideration in bankruptcy hearings. How steep will decline curves be and how much will revenues (and thus debt recovery) be delayed or impaired by these declines? Additionally, if OPEC fills the supply gap once demand returns, which it is projected to do, U.S. producers could miss some of the comeback especially with current China tensions. That said, investment prospects remain cloudy as more look to get out than to get in. JPMorgan Chase just announced that it is shifting its financing portfolio away from fossil fuels. Although disputed by many experts, one of BP’s world oil scenarios contemplates peak oil as governments and markets shift away from fossil fuels more quickly than anticipated. ESG investing and stronger investor sentiments towards other fuel sources imply that its possible oil did in fact peak in 2019. If that is the case, then Whiting, Bruin and California Resource Corp’s creditors will be hoping that their debtor’s recovery will pick up alongside improving oil prices. If prices do not recover quickly then they will be joined by many more peers before 2020 ends, which will likely exacerbate more production decline in the U.S. Originally appeared on Forbes.com on October 13, 2020.

How Each Presidential Candidate’s Policies Would Impact the Auto Industry

Tale of the Tape

With the election just two weeks away, we think it’s timely to discuss the candidates’ platforms and determine the impact of their differing policies. Each candidate’s platform contains positions on many issues – some that would directly impact the automotive industry, and others that would indirectly impact the industry. A vote for one doesn’t necessarily signal a vote for the automotive industry or vice versa. While we don’t intend for this blog post to be political, we will examine each candidate’s position on four issues and discuss their impact on the automotive industry: trade policy, taxes, energy, and the environment.Trade PolicyUnder the current administration, President Trump has eliminated the Trans-Pacific Partnership and re-negotiated the North American Free Trade Agreement (NAFTA) by creating the United States-Canada-Mexico Agreement (USMCA). In addition to these agreements, Trump has created Section 301 Tariffs designed to impose taxes on vehicles that are assembled and imported from China. The latter aimed to promote more manufacturing in the United States and create new automotive plants in some key states, such as Michigan and Wisconsin. The moves have certainly forced several automakers such as Volvo, Ford, and Cadillac to shift some production for some of its models out of China to other countries in Europe to avoid the tariffs, but the direct impact these regulations have had on the creation of new manufacturing plants in the United States is unclear. Michigan, for example, has seen an increase in foreign investment in assembly plants, but not a large increase in new manufacturing plants over the last four years.Former Vice President Biden’s stated plans don’t differ too much with the USMCA. Since the cycle of a model of new vehicle manufacturing lasts upwards of seven to ten years, the potential threat of tariffs and taxes are somewhat offset by the sheer investment commitment. Biden’s messaging seems to aim at the possibility of more parts manufacturing and the creation of new auto parts plants in the United States. This initiative would assist in the promise to create new jobs domestically by a Biden administration.TaxesBiden’s tax policies appear to be aimed at raising corporate income taxes to approximately 28%. Additionally, Biden would propose a 10% “offspring penalty” surtax on profits made by American companies on goods produced abroad but sold in the United States. The latter policy is sought to discourage American companies from shifting assembly and manufacturing abroad to avoid corporate taxes in the United States.One of Trump’s early accomplishments in his first year in office was to lower the corporate income tax rate to 21%. Until the recent effects of the global pandemic, the lowered tax rates were a big contributor to the success and growth of the U.S. economy. Trump has boasted about further tax reductions in a second term, but specific information has not been provided. Under the Trump administration, the tariffs discussed previously have led to an overall increase in prices of imported automobiles since 2016.Energy and Electric Vehicles (EVs)The Trump administration has methodically rolled back emissions standards and mandates imposed under the prior Obama administration through the Corporate Average Fuel Economy (CAFE). Trump has also eliminated rules whereby California could set and impose tougher emissions standards than those instituted by the Environmental Protection Agency (EPA). The rollback of CAFE standards could reduce the demand for electric vehicles and sustainable batteries. Trump has also phased out, or allowed to expire, $7,500 EV tax credits for several manufacturers during his first term.Biden is committed to cleaner energy and has adopted a “Cleaner Cars for America” Proposal. Biden would potentially discard the rollback items from the Trump administration and provide further government assistance to manufacturers of EVs by promising the government will shift 3 million fleet vehicles from gas-powered to electric-powered. Additionally, Biden’s plan would develop 500,000 new electric charging stations designed to promote consumer confidence in EVs. It is also believed Biden supports additional tax mandates to support EVs, perhaps re-enacting the EV tax credits among others.EnvironmentUnder his plan for cleaner energy, Biden would continue to push for further cuts in air and water pollution in addition to the energy and emissions impact discussed earlier. Biden’s energy and environment policies could eventually lead to a similar “cash for clunkers” program designed to promote electric and hydrogen-powered vehicles. It is also rumored that Biden will seekeven higher fuel economy standards than those under President Obama. Specifically, Biden plans to tackle a worldwide ban on fossil fuel subsidies and a net-zero emissions policy no later than 2050.Trump’s policies regarding the environment and government regulations are not anticipated to change much from his previous term, as he most likely will continue to favor deregulation of environmental programs and his rollbacks of CAFE, along with lower fuel prices, could lead to increased demand for SUVs and less demand for clean vehicles and EVs.ConclusionWe’ve highlighted just a few categories of each candidate’s proposed plans and how they impact the automotive industry. As with all industries, the automotive industry is affected by numerous macro and micro factors that evolve over a longer period. The true impact of each candidate’s policies and the policies that have already been enacted may not be truly known for years to come. A summary of those key differences in each candidate’s proposed policies are as follows:Consult a professional at Mercer Capital to find out the valuation of your auto dealership or how it can be impacted in the future. Mercer Capital has extensive experience providing valuations of auto dealerships for a variety of purposes.

Low Rates and NIM Margins Spur Bank Interest in the Wealth Management Sector

Executives Seek Revenue Streams That Aren’t Tied to Interest Rate Movements

COVID-19 adversely affected sector M&A for a couple of months when most of the U.S. was under shelter at home/safer in place orders. However, deal activity is recovering quickly and now could be further accelerated as banks look to replace lost interest income with fee-based revenue. An increasing number of clients on the banking side of our practice are showing interest in the wealth management space, and it’s easy to understand why. Long-term rates hovering at historic lows have significantly impaired net interest margins, so banks are exploring other income sources to fill the void. Wealth management is a natural place to start since so many banks already offer financial advisory services of one form or another. There are many other reasons why banks have wealth managers on their radar:Exposure to fee income that is uncorrelated to interest ratesMinimal capital requirements to grow assets under managementHigher margins and ROEs relative to traditional banking activitiesGreater degree of operating leverage – gains in profitability with management feesLargely recurring revenue with monthly or quarterly billing cyclesSticky client baseAccess to HNW/UHNW client base and opportunity to increase wallet sharePotential for cross-selling opportunities with bank’s existing trust and wealth management clients These incentives have always been there, but COVID amplified the banking industry’s need to diversify their revenue base, and RIA acquisitions are almost always immediately accretive to earnings. The shape of the current yield curve suggests that long-term rates are likely to stay below historic norms for quite some time, dampening the outlook for bank interest income. Acquiring an RIA or bulking up an existing wealth management practice with experienced advisors is a relatively easy way to pick up non-interest income and improve profitability. Building-up non-interest income is also an effective hedge against a further downturn or future recessions that might require the Federal Reserve to lower rates even further. Still, there are several often overlooked deal considerations that banks and other interested parties should be apprised of prior to purchasing a wealth management firm. We’ve outlined our top four considerations when purchasing RIAs in today’s environment:With most of the domestic equity markets back to near-peak levels, the financial commitment required to purchase a wealth management firm has likely increased in recent months, lowering the prospective ROI of an acquisition. We often see some temptation to pay a higher earnings multiple based on rule-of-thumb activity metrics (% of AUM or revenue), but we would typically advise against paying above normal multiples of ongoing EBITDA for a closely held RIA, absent significant synergies or growth prospects for the target company.Since many wealth management firms are heavily dependent upon a few staff members for key client relationships, many deals are structured as earn-outs to ensure business continuity following the transaction. These deals tend to take place over two to three years with a third to half of the total consideration paid out in the form of an earn-out based on future growth and client retention. COVID-19’s impact on the markets and economy has elevated the demand for buyer protection, and many banks are now requiring larger earn-out components to protect themselves from future downturns or client attrition.It’s hard to know how the cultures of firms in any industry will mesh after a merger, and this side of due diligence has been most affected by COVID-19, as in-person meetings are still generally being avoided. The culture issue is especially true for bank acquisitions of wealth management firms. Compensation, work habits, client service expectations, and production goals can be drastically different at an RIA versus a bank, so it’s important to consider if these discrepancies could become problematic when the firms join forces. We’ve seen culture clashes blow up deals that looked great on paper.Degree of Operational Autonomy. Wealth managers (and their clients) value independence. Individual investors typically must consent to any significant change in ownership to retain their business following a transaction and may not be willing to do so if they feel that their advisor’s independence is compromised. Senior managers at the target firm will likely need to be assured that the new owner will exert minimal interference on operations and strategic initiatives if key personnel are to be retained. These considerations manifest the need for an outside advisor to ensure that proper diligence is performed and the transaction makes sense from an economic perspective. Bank boards need practical guidance on finding the right RIA at the right price and assessing cultural differences that could wreck the integration after the ink dries. As always, we’re here to help.

Last Quarter Took an L, but This Quarter We Bounce Back

SAAR Is Reaching a Post-Pandemic High, and Pent-Up Demand Is Leading to an Expected Bounce Back of M&A Activity

In September, lightweight vehicles marked a notable accomplishment during a tumultuous year, increasing to a seasonally adjusted 16.3 million. This is a 10% pickup from August, and the fifth consecutive monthly increase as the industry is recovering from lows at the beginning of the year. Though this is the highest SAAR seen post-COVID, it was still 4% below September 2019. Raw sales volume in September was actually up 6.1% from this time the prior year at 1.34 million, but this increase can be attributed to calendar year differences (and two additional selling days) with Labor Day weekend sales being including in September this year rather than August. Still, these are encouraging signs after a year of uncertainty for the industry. Strong demand for light trucks continued in September and supported volume growth, as well as ASPs. JD Power noted that a shift toward more expensive trucks/SUVs is a key driver of this price growth, with trucks and SUVs on pace to account for 76% of retail sales vs. 72% a year ago. The ASP is expected to rise 5.6% to $35,655. Despite overall price increases, the Fed has indicated interest rates will remain near zero for an indefinite period of time, which will aid in vehicle financing and help mitigate some of these transaction price hikes for consumers. Higher trade-in values are helping to offset some of the price increases as well, as used vehicle sales have been doing well with consumers seeking budget friendly options as economic struggles continue. Inventory constraints continue to plague the industry, although there has been some recovery. Inventory on dealers’ lots totaled 2.66 million units, an increase of 3.6% from August 2020 but down 26.7% compared to September 2019. Potential headwinds for the rest of the year include unemployment and the stalled government response to providing pandemic relief to consumers. Though job rates have been continuing to improve, the rate of recovery has slowed, and weekly jobless claims remain above pre-pandemic levels. Earlier this year, personal income levels were actually higher than pre-pandemic months due to increased unemployment benefits. Now that these benefits have elapsed, personal income levels are declining, but the unemployment rate remains elevated. As of September 2020, the unemployment rate was 7.4% compared to 3.5% the same time last year. More people out of work (without long-term job stability regardless of enhanced unemployment benefits) means less disposable income that can be directed toward large purchases such as vehicles. Slowed government response is also troubling for the industry as capital injection into the economy would help consumers increase spending levels. However, with Congress still at odds on a relief bill, and the current administration calling for halted negotiations due to differences in the appropriate stimulus amounts with House Democrats, the timing of further government assistance to reach consumers is uncertain. M&A ClimateAs we mentioned in our blue sky multiples post last week, M&A activity for dealerships in the first half of the year has been delayed or cancelled as uncertainty has widened the bid-ask spread. However, there is evidence of pent-up demand with Haig indicating that of the 42 dealerships that transacted in Q2, 33 were sold in June. As buyers and sellers start coming back to the market, there are expectations of the second half of the year to reach record levels as buyers continue to have strong convictions on the industry’s earnings growth and are impressed by the resiliency of the auto retail’s business model. And with interest rates poised to remain low indefinitely, buyers seek to capitalize on the low cost of capital. As Erin Kerrigan, managing director of Kerrigan Advisors noted,I see buyers really looking at this period as a moment in time to truly transform their business and make significant acquisitions to capitalize on the benefits of economies of scale.Public dealerships in particular are interested in the benefits of economies of scale as they try to further their prevalence in the market. Though there has been a bit of stagnation on the deal side during the beginning of the year, as we mentioned in our Q1 earnings call, executives believe consolidation in the industry will ultimately resume, and companies focused on maximizing liquidity may be best positioned to partake.Some of these public dealerships haven’t been holding off, however, with Asbury and more notably Lithia, resuming their acquisition efforts in Q2. As we discussed previously, Asbury acquired 12 franchise locations in Texas in July after the deal had initially been stalled at the beginning of the year. This acquisition has brought Asbury’s franchise mix to approximately 50/50 luxury and non-luxury.Lithia has been particularly acquisitive, as they have agreed to purchase various dealerships which are expected to generate an additional $2 billion in annual revenue. This is tacked onto their previous purchases this year that are expected to generate $1.7 billion in annual revenue (highlighted by the 10 Texas stores from John Eagle Dealerships that are anticipated to contribute $1.1 billion in revenue). In total, Lithia is expected to add $3.7 billion in additional revenue through store acquisition for 2020. This is part of Lithia CEO’s Bryan DeBoer goal set in July of the retailer reaching $50 billion in annual revenue by 2025 (almost four times their 2019 revenue). As he told Automotive News,The opportunity for consolidation within our industry remain plentiful, and our pipeline for acquisitions remains full.In total, Lithia has purchased 16 stores this year for a total now of 200 dealerships nationally. The Q3 earnings call that will be coming up should shed more light on the overall dealership sentiment toward acquisitions for the rest of the year. Be sure to stay tuned for our Q3 earnings call blog where we will break down the overall themes for the industry.M&A is going to be particularly important going forward as dealerships try to scale and consolidate fixed costs. Inventory constraints are leading to high gross margins per vehicle for the time being, but once inventory returns, margins will most likely decline once again. Volumes sold will return as an important consideration for dealerships. Furthermore, scale can be beneficial for dealerships in terms of expanding their technological capabilities and reach consumers digitally.Implications for Your DealershipWith SAAR and the buy/sell market bouncing back, the situation for many auto dealers seems to have improved significantly since the spring. Overall better sales and higher blue sky multiples are contributing to many dealerships increasing in value, and with the second half of 2020 predicted to have an active market of both buyers and sellers, now may be a good time if you are looking to sell or buy.If you are interested in how these current trends may be affecting the value of your dealership specifically, feel free to reach out to us. Mercer Capital has worked extensively with dealerships for the purposes of corporate planning, gift tax and estate planning, buy-sell agreements, and litigation support.We hope that everyone is continuing to stay safe and healthy during this time!

Oilfield Services in 2020

Fork in the Road: Survival or Bankruptcy?

To say that 2020 has been “rough” for U.S. oil and gas (O&G) industry participants would be the height of an understatement. The one-two punch of the Saudi-Russia dust-up over oil market share, and the COVID-19 pandemic, which together spiked oil supplies and made demand plunge, combined to set-up for a record bad year for the O&G industry. Oil prices, that ended 2019 near $60/barrel (WTI), tumbled below $22/barrel in late March, and hit a 2020 low of $17/barrel in April. A much welcome partial recovery during the month of May led to a somewhat stabilized price range of $36-$43/barrel through the third quarter. While $40/barrel oil prices provided at least some relief to O&G industry participants, prices at that level aren’t expected to lead to anything close to a recovery to pre-2020 activity levels. The industry continues to “flow red” with continued bankruptcies piling-up. Bankruptcy courts have been busy as a result of the O&G industry downturn. Already this year 36 bankruptcies were filed among the production segment operators alone. Industry insider conversations have included concerns that there could be 60-70 additional producer filings by the end of the year. If those predictions come true, 2020 would represent a record year for O&G-related filings in the annals of the bankruptcy courts. While that may seem like an unusually bad turn for a six-month period of depressed prices, it’s worth noting that the industry was significantly stressed beforehand. Natural Gas Intelligence’s Andrew Baker noted that the anticipated cutbacks in future capital expenditures among the producers for drilling, completions, and other activities in the field will most certainly spread the bankruptcy trend to the oilfield services (OFS) segment that never completely recovered from the 2014 industry downturn. Baker indicated that “many smaller or highly leveraged OFS companies may not be able to hold on” and will be forced to seek the protection of bankruptcy courts. As Baker referenced, size and financial leverage can generally contribute to an OFS participant business being forced into a bankruptcy filing. In this edition of Mercer Capital’s Energy Valuation Insights blog, we explore some of the many factors that play into making it more (or less) likely that an OFS participant will survive an industry downturn intact, or succumb to market pressures and enter into bankruptcy. OFS Bankruptcy DifferentiatorsThere are most certainly many factors that may contribute to, or deter, an OFS company’s need to file for bankruptcy protection during an industry downturn. Some are more general and more obvious, while others are more specific and not as readily discerned. Here we address some of the more general factors (margins, financial leverage, and breadth of product/service offerings), some industry specific factors (customer sectors and basins served), and the benefit of industry experience.General FactorsAs in any industry, the ability to survive a downturn in the OFS industry is all about maintaining cash flow, and therefore liquidity. No surprise here, a company generating higher margins in “normal” industry conditions is more readily able to navigate a downturn when the company’s margins are likely to get pinched. As such, bankruptcies during a downturn in the industry are materially more likely among highly competitive sectors of the OFS industry where margins tend to be lower, as opposed to less competitive sectors, where margins tend to be more robust. Beyond general competition levels, a particular OFS company’s margins may be influenced by a number of factors. These include proprietary products or processes, its having embraced efficiency inducing technology and automation, and other factors that contribute to lower cost of sales, or operating expenses. With higher margins, an OFS company is able to endure the margin reductions that come with industry downturns with a significantly lower probability of reaching a financial breaking point....the ability to survive a downturn in the OFS industry is all about maintaining cash flow, and therefore liquidity.Similarly, the degree to which an OFS company makes use of financial leverage to enhance returns can play into its ability to weather an industry storm. Take Company A and Company B that both generate the same operating cash flow margins – margins before consideration of financing costs in the form of interest expenses on outstanding debt. If Company A carries a lower level of debt financing (relative to Company B), its operating cash flow will be greater than Company B’s. The cash flow differential may not be a make-or-break matter during normal industry conditions when both companies are generating significant cash flows relative to their interest expense. However, during periods of reduced cash flow, the more leveraged company may reach a point where operating cash flows are inadequate to meet its interest payments. So, the financial leverage that enhances return during the times of industry strength can be the same financial leverage that leads to distressed liquidity during industry downcycles.An OFS company’s breadth of product or service offerings can also impact the ability to maintain operations during a downturn. Larger OFS participants, with multiple product or services offerings, have the benefit of being able to consider shifting its efforts among various offerings. In that way, the company can emphasize operations where it can continue providing more productive (profitable) lines and deemphasize less productive lines. It may even be in a position to sell-off assets related to less productive lines in order to maintain liquidity to continue operations of productive lines. WorldOil Magazine’s David Wethe cites examples of this type of shifting of products/services in Schlumberger’s sale of its land-rig unit in the Middle East and Precision Drilling’s sale of its Mexican operations as the companies struggled in recent years. Unlike these larger industry participants, smaller companies with very limited product or service offerings, don’t have nearly the same level of flexibility. Among these smaller OFS companies, diversity of offerings may simply not exist. That leaves the businesses without the ability to shift away from less profitable products or services, and therefore make them more prone to the necessity of a bankruptcy filing.Industry-Specific FactorsThe diversity and breadth of the OFS industry brings additional factors that may influence an industry participant being forced into a bankruptcy filing. Despite the misnomer, the OFS industry includes providers of products and services to both oil-focused and gas-focused E&P companies. The graphic below provides some insight as to just how wide an array of products and services are represented within the OFS industry.Sub-Sectors FocusDue to the significant differences between the operations of the OFS industry participants, an industry downturn doesn’t impact all OFS participants to the same degree. For instance, OFS businesses that disproportionately serve the natural gas side of the industry were not as significantly impacted by the precipitous drop in oil prices during the 2020 second quarter. In the same way, OFS participants may be impacted quite differently based on the E&P subsector that they serve. For example, during the 2020 oil price disruption, new drilling operations were much more adversely affected than were continuing production operations. Following a sharp decline in oil prices, exploration operations may be curtailed much more so than production operations. For example, when oil prices are in the $35 to $40 per barrel range, it can be economically beneficial to continue production from existing wells, but quite uneconomically viable to incur the cost of drilling new wells. Even much less economical to incur exploration related expenses. As such, OFS companies whose products or services support production activities – fracking, well maintenance services, and production chemical providers – face less dire circumstance at $35 to $40/barrel prices than OFS companies that support exploration activities – geological, seismic, drilling, and site preparation services.Basin FocusBeyond the differences between serving the oil versus gas subsectors, and the differences between serving exploration versus production subsectors, there are differences in the basins that a particular OFS business focuses on. These differences can generally be categorized into three areas – type of oil, midstream transportation availability, and production cost. Different basins may produce different types (grades) of crude oil (light versus heavy, sweet versus sour, etc.), which require varying levels of refining in order to generate end products. As such, the “price” of oil isn’t uniform across basins, and as a result, a drop in oil demand can impact different basins to varying degrees.[caption id="attachment_34074" align="alignnone" width="726"] http://www.eia.gov/maps/maps.htm[/caption] Similarly, the midstream transportation assets of a particular basin can influence the price of oil based on the location of the production facilities. Basins, where pipeline capacity is lacking, may have a higher cost of getting the oil to refining facilities and, therefore, require higher prices to justify continued production. In much the same way, different basins can have materially different production costs per barrel depending on the age of the fields and the specific geology of the field. As with basins that suffer from higher costs in getting produced oil to refineries, basins that have higher production costs (the total cost of bringing oil/gas to the surface) may not have the needed economics to justify continued production at oil prices that allow for continued production from basins with lower production costs. For example, Reuter’s Energy Correspondent, Liz Hampton, notes that oil firms operating outside the Permian basin (in Oklahoma, Colorado, Wyoming, Kansas, and parts of New Mexico) where production costs are higher may be particularly hit hard by oil prices in the $25 to $30/barrel range. On average, producers in those states need oil prices at $47 a barrel to make money. Liquidity Management and Cost StructureTo this point, we’ve addressed factors that primarily impact the demand for an OFS participant’s products and services. Now we move to factors beyond demand – liquidity and cost structure/control. In a pronounced industry downturn, where cash flows are known to be turning negative for an indeterminate amount of time, liquidity becomes a major focus point. If cash runs out, a previously slow decline in business can rapidly turn into a downward spiral. Managing the company’s liquidity can involve several related actions including reducing costs, drawing down existing lines of credit (before they become difficult to access), and engaging as soon as possible with debt providers. While it may seem that these actions would have the same benefit to all OFS participants, the results of such efforts can vary markedly.In a pronounced industry downturn, liquidity becomes a major focus point.OFS businesses that have closely managed their line of credit, such that they have abundant LOC capacity remaining when a downturn occurs, have flexibility that other OFS businesses lack. Likewise, OFS participants that maintain close debtor relationships are likely to get a better reception when negotiating with their debtors for adjustments to their debt structure, or for forbearance terms.In terms of cost reduction, a company’s particular cost structure plays a significant role in its ability to cut expenses. Businesses with higher fixed costs lack the level of flexibility in cost containment that lower fixed cost businesses have. For example, businesses in which human resources are a larger percentage of total expenses have greater flexibility when considering staff reductions, pay-cuts, furloughs, and reducing hours. Furthermore, the ability to take those type cost containment actions can be easier for OFS businesses where the time to identify and hire qualified employees is shorter, and the cost of training such employees is lower. These factors make it easier to take critical human resource related / cost containment actions, in that any resulting staff losses can easily be replaced, and at a lower replacement cost.Management ExperienceOur discussion of differences among OFS industry participants during a downturn, would be incomplete without addressing the benefit of a management team with deep industry experience. Industry downcycles in highly cyclical industries, can be even more challenging with a management team that has limited experience. Most industries experience some degree of cyclicality, but the O&G industry tends to bring a heightened level of ups and downs, and unexpected supply and demand shifts. Afterall, how many industries can even fathom the idea of the futures market, for their only product, pushing into the realm of negative pricing? How many industries can be so significantly impacted, in such a short period of time, by a market share spat between market participants on the other side of the globe – not to mention those market participants being countries (Saudi Arabia and Russia) rather than individual businesses. Not exactly an industry conducive to downturn survival if the management team has limited industry experience.In a recent management interview with one of our recurring OFS clients, the head of the company expressed how industry experience allows a seasoned management team to act quickly and decisively, and that such actions can make or break an OFS business in an industry wide downturn. He commented that less experienced management teams sometimes suffer from a “drug” known as “hopium” – a tendency to hope that the downturn will be short lived and therefore hesitate to take the necessary decisive action needed to stave off a cash crunch that can rapidly turn into a bankruptcy filing. He further noted that due to his teams’ deep industry experience across multiple O&G cycles, when the combined COVID-19 and Saudi-Russian dust-up hit, his team immediately, as he put it, flipped open to page 5 of their “Oh <bleep>” playbook and began a pre-planned series of actions to enhance liquidity and reduce costs, without allowing unwarranted “hope” to get in the way. As such, their business, while certainly feeling the impact of the downturn, is feeling it much less negatively than other OFS businesses.ConclusionWhile the O&G industry has many systematic forces that impact industry participants across the board, there are many unsystematic forces that lead to marked differences in the magnitude of the downturn’s impact on individual businesses. The OFS portion of the O&G industry is particularly diverse with subsector and basic focus potentially imposing greater, or lesser, downturn risk on a particular OFS market participant. Beyond those demand impacting factors, cost structure and level of industry cycle, experience among management teams have a significant impact on an OFS business’s ability to hold-on during an industry wide downturn and avoid the need for a bankruptcy filing.

Continuation of Market Rebound Drives Most Categories of Publicly Traded RIAs Higher in Q3

RIA Market Update

Share prices for publicly traded asset and wealth managers have trended upward during the second and third quarters after collapsing in mid-March with the broader market. Alt asset managers have fared well over the last year as volatility and depressed asset prices have created an opportunity to deploy dry power and raise new funds in certain asset classes. Traditional asset and wealth managers have generally moved in line with the broader equity market, while leveraged RIA aggregators have seen more volatility, both up and down, as the market bottomed in March before trending upward.[caption id="attachment_33973" align="aligncenter" width="950"]Source: Source: S&P Market Intelligence[/caption] Looking at the third quarter, traditional asset and wealth managers and aggregators trended upwards in July and August before pulling back as the market dipped in September. While the quarter was volatile, both of these categories ended the quarter up about 4%. The primary driver behind the increase was the increase in the market itself as most of these businesses are primarily invested in equities, and the S&P 500 gained about 8% over the quarter. [caption id="attachment_33974" align="alignnone" width="856"]Source: Source: S&P Market Intelligence[/caption] The upward trend in publicly traded asset and wealth manager share prices since March is promising for the industry, but it should be evaluated in the proper context. Pre-COVID, the industry was already facing numerous headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. While the 11-year bull market run largely masked these issues, asset outflows and revenue pressure can be exacerbated in times of market pullbacks and volatility. Smaller publicly traded asset/wealth managers have been most affected by these trends, which is reflected in their share price performance over the last year. As shown below, asset/wealth managers with more than $100 billion AUM have performed well over the last year, with the $100 - $500 billion AUM group up 28% and the $500 billion+ group up 4%. Smaller RIAs, those with under $100 billion AUM, have been down over the last year, with the smallest group (under $10 billion AUM) down 14%. [caption id="attachment_33975" align="alignnone" width="893"]Source: Source: S&P Market Intelligence[/caption] As valuation analysts, we’re often interested in how earnings multiples have evolved over time since these multiples reflect market sentiment for the asset class. LTM earnings multiples for publicly traded asset and wealth management firms declined significantly during the first quarter—reflecting the anticipation of lower earnings due to large decreases in AUM—but have since recovered in the second and third quarters as prospects for earnings growth have improved. [caption id="attachment_33976" align="alignnone" width="589"]Source: Source: S&P Market Intelligence[/caption] Implications for Your RIADuring such volatile market conditions, the value of your RIA is sensitive to the valuation date or date of measurement. In all likelihood, the value declined with the market in the first quarter before recovering most of that loss in the second and third. We’ve been doing a lot of valuation updates amidst this volatility, and there are several factors we observe in determining an appropriate amount of appreciation or impairment.One is the overall market for RIA stocks, which was down significantly in the first quarter but has since recovered to above where it was a year ago (see chart above). The P/E multiple is another reference point, which has followed a similar path. We apply this multiple to a subject RIA’s earnings, so we also have to assess how much that company’s annual AUM, revenue, and cash flow have increased or diminished since the last valuation while being careful not to count good or bad news twice.While the market for publicly traded companies is one data point that informs private RIA valuations, that’s not to say that privately held RIAs have followed the same trajectory as their smaller public counterparts. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds discussed above. Many smaller, privately-held RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.We also evaluate how our subject company is performing relative to the industry as a whole. Fixed income managers, for instance, held up reasonably well compared to their equity counterparts in the first quarter. We also look at how much of a subject company’s change in AUM is due to market conditions versus new business development net of lost accounts. Investment performance and the pipeline for new customers are also key differentiators that we keep a close eye on.Improving OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has generally improved with market conditions over the last several months. AUM has risen with the market over this time, and it’s likely that industry-wide revenue and earnings have as well. The third quarter was generally a good one for RIAs, but who knows where the last quarter of 2020 will take us in a wild year for RIA valuations and overall market conditions.

Take Advantage of Current Estate Planning Opportunities While You Can

It’s nearly impossible to discuss anything automobile-related without mentioning the name Henry Ford. Henry Ford established the Ford Motor Company in 1903 and also became one of the founding fathers of the automated assembly line mode for the production of his Model T vehicle. One of the famous quotes attributed to Mr. Ford is that “failure is only the opportunity to begin again.” This adage continues to inspire the auto industry today as it attempts to recover from turbulent economic conditions caused by the COVID-19 pandemic, much like its recovery from the Great Recession just a decade ago.Three converging factors have this fall shaping up to be the busiest estate planning season since 2012.While economic recovery is still uncertain as the pandemic continues on and new relief bills are on the ropes, there currently exist potentially attractive estate planning opportunities for auto dealer owners.Three converging factors have this fall shaping up to be the busiest estate planning season since 2012: 1) potentially depressed valuation of assets and businesses; 2) historically low interest rates; and, 3) uncertainty regarding the political administration going forward. Let's delve a little deeper into these three factors.Potentially Depressed ValuationsAt its core, the valuation of a business consists of three assumptions: cash flow, risk and growth. Cash flow can be defined as the expected earnings of a business into the future. With no certainty of the future, historical performance and recent performance can serve as a starting point for those future expectations. The second assumption is risk: what are the risks that the company faces to achieve those expected cash flows? Risks can be internal such as labor and management or risks can be external such as the economy or competition. The final assumption to valuation is growth: how are cash flows expected to grow in the future?All three of these valuation assumptions have been threatened by the pandemic. Recent cash flow has been threatened for most industries, not just the hospitality, retail, and restaurant industries. Certainly, for businesses, operating and economic risks have increased during the pandemic. As far as growth and recovery, we’ve all gotten an education into the alphabet soup of recovery: can the recovery for the general economy be described as v-shaped, u-shaped, w-shaped, k-shaped, or some other letter?Historically Low Interest RatesThose familiar with the concepts of finance and valuation also understand the relationship between interest rates and value. Generally, as interest rates (and risk) increase, the value of the asset decreases and vice versa. The pandemic and summer/fall of 2020 has created a unique opportunity regarding interest rates, as the Fed has brought rates to near zero in order to combat the pandemic.How are interest rates used in estate planning? Attorneys utilize many structures when seeking to transfer family wealth from one generation to the next: Grantor Retained Annuity Trusts (GRATs), Charitable Remainder Unified Trusts (CRUTs), installment sales, interfamily loans, and many other structures. Most of these structures utilize some form of a note/loan between family members. Under current tax law, a family member could not make an interest-free loan to a child or grandchild without that portion of the loan being considered as a taxable gift. To shield that portion of the loan from being a taxable gift, the loan must carry a stated interest rate. The IRS establishes guidelines for these interest rates in the form of Applicable Federal Rates (AFRs), which are determined monthly by the U.S. Treasury. The mid-term AFR rates have been historically low, and below 1% for most of 2020.The mid-term AFR rates have been historically low, and below 1% for most of 2020.How do low AFRs assist in estate planning? In addition to satisfying the IRS’ requirement so that the interest portion of the loan will not be treated as a gift, the lower level of AFRs should motivate estate planning this fall. Often, the structures that attorneys use in this form of planning (discussed above) depend on the cash flow from the asset being transferred (perhaps an operational business as an example) to fund the debt service in connection with the loan. In times of lower AFRs, the debt service is reduced, and it’s easier for the cash flow from the asset to cover the debt service. Additionally, the success of these transfer vehicles is usually dependent on the potential growth and appreciation in value of that asset after it is transferred to the next generation. With historically low AFRs and greater expected rates of return on the transferred assets, there are potential arbitrage opportunities on the spread of those returns.Uncertain Political ClimateThe fall of 2020 brings with it the national election season, and along with it, potential political change. Two important tax provisions that affect estate planning are at stake: the estate tax credit and the step-up basis for tax treatment. The current estate tax credit is $11.6 million per individual, meaning a married couple can shield and pass an estate worth $23.2 million ($11.6 million times two) to their heirs without incurring estate taxes. This provision is set to sunset in 2026 and will return to an amount of $5 million-plus inflation adjustments, expected to settle at a figure between $6 - $7 million per individual. At those levels, the unified estate tax credit limit for couples would lower by approximately $9.2 million, resulting in a greater pool of family estates that would be subject to estate taxes. If a new party wins the White House this fall, this provision could be debated and potentially changed sooner than 2026.Two important tax provisions that affect estate planning are at stake.A second tax provision that aids in estate planning could also be in jeopardy this fall. Among the pillars of Vice President Joe Biden’s proposed tax plan is the elimination of the step-up basis for taxation. Under current U.S. tax laws, the assets of an estate pass to their heirs at a tax value established at death (or alternate date of valuation). The value is transferred to their heirs at this established value at death or a stepped-up basis. Biden’s proposed tax plan would eliminate this step-up basis. Consider an estate portfolio with a value of $10 million and a tax basis of $2 million. Under the current unified estate tax credit, the portfolio example would not be subject to estate taxes and would transfer to the heirs at a stepped-up basis of $10 million. If the step-up basis was eliminated, the portfolio would transfer to the heirs at a basis of $2 million and would also be taxed on the imbedded capital gains of $8 million. There are also discussions that a change in power in the White House could also lead to increases in the capital gains tax rates, which are currently set at 15-20%. Increased capital gains tax rates and the elimination of the step-up basis could greatly diminish the value of a family’s portfolio at the death of the patriarch/matriarch.Unique Estate Planning Opportunities in Auto Dealer Industry TodayAs discussed above, this fall brings a unique opportunity for owners in the auto dealership industry to capitalize on low interest rates for planning tools and potentially lower valuations of the underlying assets being transferred. Last week’s blog covered the market’s update on Blue Sky multiples. Despite market optimism, valuation and blue sky multiples of auto dealerships are still very specific to the individual dealership and consider their unique conditions including financial performance, competition, and local economic conditions among other factors.In a previous Family Business Director blog post, colleague Travis Harms also discussed the impact of real estate on estate planning. It’s very common for the operations of the dealership to be contained in one entity and the real estate where the dealership resides to be contained in a separate asset holding company. Often when owners of auto dealerships desire to transfer their wealth/assets to the next generation, they may have children that are active in the business and they may have children that are not active in the business. We have consulted with owners on a strategy to gift interests in the operating business to the active children and interests in the real estate holding company to the non-active children. Owners/parents often view this strategy as equitable to their children and seek to reward/incentivize the active children with a direct interest in the operations of the dealership.ConclusionNow is a unique time, rife with estate planning opportunities with potentially lower valuation of assets, historically low interest rates, and changing political winds. Seek qualified professionals to assist you with your estate planning, from the attorneys determining and drafting the plan to the valuation professional providing the valuation. Not all valuations and valuation professionals are created equally. The role of all of the professionals in your estate planning process should be to protect the integrity of the proposed transaction. Often when these transactions are challenged, they are challenged based on the formation factors or the quality/conclusion of the valuation. Contact a professional at Mercer Capital to assist you and your attorney with your valuation needs involving your estate planning. Mercer Capital has extensive experience providing valuations for estate planning and valuations specific to the auto dealership industry.

Oil & Gas Industry Optimism Contained with Political Uncertainty Lying Ahead

Q3 2020 Macro Review

The third quarter of 2020 experienced a relatively stable price environment compared to the volatile prices seen in the first half of the year. The WTI range narrowed, hovering around $40 per barrel, and natural gas increased from $1.70 per MMbtu to $2.50 per MMbtu. According to the Dallas Federal Survey released on September 23, industry participants expect oil price to be nominally higher than last quarter’s expectations, but respondents continue to state that most new drilling remains uneconomic. The concurrent overlapping impact of (i) discord created by the OPEC/Russian rift and resulting supply surge; and (ii) the drop in demand due to COVID-19 related issues was historic and continued to play a role in the third quarter. As optimism surrounding a gradual demand recovery has increased, companies are preparing for an eventful end to 2020. As if COVID-19 and the Russian-Saudi price rift wasn’t eventful enough, an election in November will add to the mix for what seems to be an already pressing and critical time for the industry. The unfortunate, overlapping timing of these events has made the bankruptcy courts busy, with no indication of that trend coming to a halt. In this post, we will examine the macroeconomic factors that have affected the industry in the third quarter and peek behind the curtain on what the remainder of the year might hold.Global EconomicsOPEC+On June 6, OPEC+ members reached an agreement to continue cutting 9.7 million barrels a day, or about 10% of global output under normal circumstances, through July. The extended supply cuts helped oil prices continue their recovery from their drastic drop in April due to the demand issues caused by COVID-19. The original agreement that OPEC+ reached on April 12 stated that production was set to increase gradually after June, but members refined that plan and continued their supply cuts for another month.On July 15, OPEC + members agreed to loosen existing production caps by roughly 1.6 million barrels a day. The agreement was slated to begin in August as demand was showing signs of recovery amid the COVID-19 related lockdowns. The decision created a 10% increase in Brent prices to $43.30/bbl. OPEC expects the world’s demand for oil to increase by 7 million barrels a day next year, after a forecast 8.9 million barrel a day decline in 2020. A primary source of overall industry decline is the lack of jet fuel demand as travel has decreased significantly throughout the year. According to the Dallas Federal Energy Survey, 74% of industry executives believe that OPEC will play a bigger role in the determination of the price of oil going forward.Potential Market Consequences: Trump vs. Biden AdministrationThe upcoming election in November 2020 is on the industry’s mind as both administrations have expressed their energy initiatives that will be implemented during the next four years. The election comes at a pressing time in the industry, with the next four years of U.S. oil and gas policy at stake. The major topics at hand include domestic production, infrastructure plans, OPEC+ engagements, and international sanctions. The following chart shows the contrasting platforms of the two potential administrations:U.S. ProductionThe decline in production, 9.7 million b/d year-over-year in August, reflects voluntary production cuts by OPEC+ along with reductions in drilling activity and curtailments as of late. The EIA estimates that U.S. crude oil production increased to 10.8 million b/d in August as operators have brought wells back online in response to rising prices after curtailing production in the second quarter. Frac fleets have slowly grown since May, but still are down roughly 68% from the peak in 2020. After September, however, the EIA projects U.S. crude oil production to decline slightly as new drilling activity will not generate enough production to offset declines from existing wells. According to the Dallas Federal Energy Survey, 66% of industry executives believe that U.S. oil production has peaked. The upcoming election poses significant uncertainties as the two administrations’ contrasting agendas will play a major role in U.S. production moving forward.BankruptcyCompanies are on their heels heading into the end of 2020. Bankruptcy activity has heightened, and debt levels have increased as companies are hoping the worst is behind them. The question is whether the worst is yet to come. Balance sheets have become increasingly important and cash will remain king until the price environment becomes more economic. Deal activity has been quiet as of late, though ended with a bang given Devon’s announced merger with WPX. More deals could come as buyers and sellers turn to consolidation to reduce costs in these challenging times. That does, however, assume companies will not have to file for bankruptcy.Interest RatesThe U.S. Federal Reserve cut interest rates twice in the month of March. On March 3, the Fed made an emergency decision to cut interest rates by 0.5% in response to the foreseeable economic slowdown due to the spread of the coronavirus. This cut was anticipated and largely shrugged off by the markets as interest rates continued their precipitous decline. Benchmark rates were again cut on March 15 by a full percent to near zero. The Federal Reserve’s latest forecast suggests that rates will remain close to zero for the foreseeable future until inflation increases.ConclusionAs the industry attempts to recover from a dramatic timeline of events in the first half of 2020, many uncertainties remain ahead. Companies are trying to survive during the challenging environment while attempting to shore up the balance sheet and hang on tight with the election on the horizon. Potential policy changes might be the least of companies’ worries as other pressing issues are affecting them in the very short-term. All of the pieces are stacking up against the industry, and it will be interesting to analyze the next six months, which could very well look different.At Mercer Capital, we stay current with our analysis of the energy industry both on a region-by-region basis within the U.S. as well as around the globe. This is crucial in a global commodity environment where supply, demand, and geopolitical factors have varying impacts on prices. We have assisted clients with diverse valuation needs in the upstream oil and gas industry in North America and internationally. Contact a Mercer Capital professional to discuss your needs in confidence.

E&P Fourth Quarter 2020

Appalachian Basin

Appalachian Basin // The fourth quarter of 2020 experienced an increasing price environment compared to the volatile prices seen in the majority of 2020.

Transportation & Logistics Newsletter

Fourth Quarter 2020

Blue Sky Multiples Rebound from Q1 Declines but Full Recoveries Reserved for Top Brands

Blue Skies Ahead?

Last quarter, we sat down (virtually) with Kevin Nill of Haig Partners to discuss M&A trends in the Auto Dealer Industry. He noted amidst the uncertainty, buyers and sellers were either applying pre-COVID multiples to lower earnings or lower Blue Sky multiples to pre-COVID earnings. Sluggish deal volume continued into Q2 with transactions down 16% compared to 1H 2019, but the pace is picking up.In this post, we review Haig Partners' Q2 report on trends in auto retail and their impact on dealership values. We also look at how Blue Sky multiples have rebounded after declines in Q1. While most brands saw a partial recovery, a return to pre-COVID multiples was largely reserved for brands with the highest multiples in their category (luxury, mid-line import, and domestic).The Haig report succinctly described the landscape thusly:When customers couldn’t come into showrooms, dealers responded by selling vehicles online. When inventory levels for new vehicles fell, dealers focused on used car sales and were able to hold for more gross on both new and used vehicles. While waiting for the recovery, dealers reduced advertising, personnel and floorplan expenses significantly. The pandemic forced dealers to adopt new technologies and leaner business practices sooner than they otherwise might have. The result is that most dealers have become stronger during this time of crisis, not weaker. Investors have noticed. The publicly traded franchised groups have higher values today than before COVID, and we have seen the values of private retailers rebound as well. Dealership buyers are betting that the future of auto retail is bright, even when the lift from trillions of dollars of government stimulus spending wears off.Activity Ground to a Halt, but It’s Picking Back UpAccording to Haig, about 25-30 dealerships have been bought/sold each month on average. While the pandemic curbed activity significantly from March through May, there is evidence of pent up demand. Haig indicated that of the 42 dealerships that transacted in Q2, 33 were sold in June.While transaction activity has largely come from private acquisitions as seen above, our review of public franchised auto dealer earnings calls indicates public acquisitions are likely to pick up. Public companies, such as Lithia and Asbury (with its Park Place acquisition) have increased their appetite for acquisition. In order to compete in a digital world, public franchised dealers are looking to scale their operations. Online-centric competitors such as Carvana and Vroom have experienced rapid growth in recent years, though they are used vehicle dealers and thus uninhibited by franchise agreements. In order to add scale, public franchised dealers will need to leverage their relationships with OEMs and be more pragmatic in their growth. Still, scale is anticipated to benefit these players by spreading digital innovation costs over higher revenues.Advantageous Buying Opportunities Were Somewhat Short-LivedAs we mentioned above, deal activity from March through May was paused for numerous reasons. First, having to perform the due diligence process virtually reduces the likelihood of a transaction between two parties that don’t know each other well, even if both sides were eager to press forward. Widening gaps in valuations between buyers and sellers also made sellers less likely to relinquish their assets in a spiraling economic climate at the onset of the virus. After all, for many families, their auto dealership is the principal asset on the family balance sheet, and owners were wise to hold tight to their assets in a spiraling economic climate.According to Haig, COVID caused buyers to pull offers or demand price concessions amid concerns of earnings stability. However, buyers have come back to the table in recent months as profits have been much stronger than initially anticipated. Haig estimated Blue Sky values declined about 10% from 2019 levels in Q1; this figure ended up being only about a 5% dip in Q2. Kerrigan Advisors, another preeminent investment bank in the auto dealer space, sees Blue Sky values actually up 3.3% in Q2 2020 compared to Q4 2019. We’ll discuss the rebound in valuations in depth below.While SAAR has declined, gross profits (on a per vehicle basis) have improved.We see an interesting parallel in the minds of buyers, both of vehicles and dealerships. While SAAR has declined, gross profits (on a per vehicle basis) have improved. Through July, average new vehicle gross was up 7.8% per vehicle retailed compared to 2019, while used vehicles improved 5.1%. Consumers hoped an economic disruption would create a unique buying opportunity, but a lack of new vehicle inventory and interest rate tailwinds allowed dealers to raise prices. People with the financial wherewithal to purchase a new vehicle amid skyrocketing unemployment early on in the pandemic likely got a good deal, but NADA estimates incentive spending per vehicle declined 17% from April to August.Similarly, dealership buyers that were able to successfully negotiate price concessions on transactions already in progress likely got a good deal with the surprising earnings performance. Through July, average dealer sales were down 13.6% compared to 2019, but pre-tax earnings declined only 4.6%. As noted in The Blue Sky Report for Second Quarter 2020, published by Kerrigan Advisors, average dealership profits rebounded from lows to highs in the span of two months.Deals that were scuttled, delayed, or that didn’t even get off the ground, ultimately, may have benefited the seller that chose not to sell at the April lows. And as one of our colleagues has told me during the sell-side transaction process, every day you don’t sell your business, you are effectively buying it back at its current value in the marketplace. Dealers who chose to “re-buy” their dealership in April will be glad they did.Blue Sky MultiplesIn Q1, virtually every brand covered in the Haig Report saw a decline in their Blue Sky multiple. The lone exception was Mazda whose multiples actually improved over Q4 2019. This likely has less to do with pandemic mitigation as it does with other recent troubles. While Mazda’s franchise sales fell the least (7% decline) of all the major franchises compared to 1H 2019, this may say more about 2019 performance than it does about pandemic mitigation. Its range of Blue Sky multiples has improved in each of the last two quarters, but Mazda still remains slightly below its range of 3.0x – 3.75x from Q3 2019.In Q1, virtually every brand covered in the Haig Report saw a decline in their Blue Sky multiple.Every other brand declined about a half turn of pre-tax profits in Q1 (e.g. Mercedes-Benz fell from 6.50x – 8.0x in Q4 to 6.0x – 7.50x in Q1). Fortunately, as SAAR rebounded, heightened levels of uncertainty abated, and dealers and the country at large embraced and adapted to the new normal, valuations rebounded in Q2. However, only Porsche, Toyota, Ford, and Kia rebounded fully to their Q4 multiple range. Hyundai actually saw a modest uptick on the high end to pull even with Kia at 3.0x – 3.75x compared to 3.0x – 3.50x in Q4 2019.Notably, Porsche, Toyota, and Ford have recently been the leaders of their peer group. No luxury brands besides Porsche saw a full rebound to the top end of the pre-pandemic range. After years of tracking at the exact same range, Toyota stuck its nose in front of Honda, whose range only regained half of its pandemic losses. Similarly, Ford's Blue Sky multiples have moved in lockstep with Chevrolet since Q2 2018. Pre-pandemic declines to Ford's dealer valuations allowed Chevy and FCA to pull in front in Q4 2019. Now, all three of these domestic dealers sit at a 3.0x – 4.0x Blue Sky range with Buick-GMC just slightly behind.ConclusionFortunately, while there is still uncertainty about when the economy will return to “normal,” the auto dealer industry appears to have adapted to the circumstances at hand. Valuations have rebounded as earnings have recovered, and the industry has largely avoided the doomsday scenarios prognosticated in March. Still, not many people would have predicted working from home would remain so prevalent heading into October. As Q3 wraps up, we hope dealers continue to navigate these waters as they continue to re-buy their dealership.Blue Sky multiples provide a useful way to understand the intangible value of a dealership, particularly in a transaction context for someone familiar with the auto dealer space but perhaps not the specific dealership in question. Buyers don’t determine the price they are willing to pay based on Blue Sky multiples; they analyze the dealership and determine their expectation for future earnings capacity (perhaps within the context of a pre-existing dealership where synergies may be present) as well as the risk and growth potential of said earnings stream. For dealers not yet looking to sell, Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze these key drivers of value. We also help our dealer clients understand how their dealership may, or may not, fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to get the ball rolling.

How Growing RIAs Should Structure Their Income Statement (Part II)

Compensation Conundrums

Personnel costs are by far the largest expense item on an RIA’s P&L, but we’ve found significant variation in how RIA owners think about compensating their employees (and themselves). This is the second post of a two-part series on compensation best practices for growing investment managers. Last week, we introduced two common compensation conundrums for RIAsHow to structure employee compensation when you are not ready to bring on an equity partner.How to structure compensation and your P&L before you bring on an equity partner In our last example, we explained how owners of RIAs can structure employee compensation. This week will focus on how to structure partner compensation.Striking the Right BalanceSince RIA owners are often senior managers in their firm, their compensation and distributions are often intertwined and are subject to shareholder preferences regarding how they like to be paid. However, this can lead to problems as growing RIAs expand by bringing on new equity partners.Take the example below of an RIA with four partners with equal ownership considering a 25% equity grant to bring on a new partner who will help the company expand its reach. To minimize their tax burden, the owners historically have not paid themselves a salary and instead were compensated through distributions. However, if they bring on a new employee with a salary and 25% ownership, the new partner would receive higher compensation (including distributions) than the original partners who aren’t taking any salary or bonus. A similar complication arises for partners that pay out their entire EBOC (Earnings Before Owners’ Compensation) in bonuses to minimize reported profitability. We often see this in places with state dividend taxes but no state income tax. Equity incentives in these situations are rarely enticing to prospective hires since dividend prospects are minimal or non-existent as shown below. Before bringing on an equity partner, it is key to balance returns on labor (compensation) and returns on investment (distributions). To appropriately relate compensation expenses to reasonable returns on labor, owners should consider compensation levels commensurate with job responsibilities and revenue production. Compensation studies can help determine market levels of salaries and bonus expense, but the range of reported salaries in the RIA industry vary significantly. It is helpful to think about what it would cost to replace yourself if you decided to step away from the business; however, this may not be relevant for younger staff additions, whose market rates often depend on their relevant course experience and educational background. The return on investment is just the residual income after paying your staff (and yourself) an appropriate (market) level of compensation expense. RIA owners often think of their ROI as a ROS (Return on Sales) since the requisite capital to start these businesses is often quite minimal. In other words, they often think an appropriate return on investment is a reasonable pre-tax margin for an RIA of their size. If, for example, industry compensation costs are 70% of revenue and overhead expenses are 10%, then an appropriate pre-tax margin or ROS is 20% (100%-70%-10%). If your current margins are much higher or lower than industry norms, your compensation expenses are probably not in sync with the market. Does Money Talk Louder Than Words?Compensation discussions are never easy. If your company is growing and your employees are smart, they will ask for ownership in the business. Even if out-right ownership is not on the table, it is beneficial to align employee incentives with your own. But many owners of growing RIAs make the mistake of waiting too long to share equity ownership and before they realize it, the value of an equity stake in their firm is too expensive for the next generation of leadership to afford.

Trucking Industry Explosions and Implosions

The trucking industry has recently been shaken by a series of large accident-related litigation verdicts, also known as nuclear verdicts.The definition of what constitutes a nuclear verdict can vary; however, the most common definition is verdicts in excess of $10 million.No matter how they are defined, nuclear verdicts are causing upheaval in the trucking industry.Trucking companies have historically only had to insure drivers for $1 million each, amplifying the effect of significantly larger verdicts.

Bakken Production Has Rebounded, But Operating Challenges Remain Acute

The economics of oil and gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. In this post, we take a closer look at the Bakken.Production and Activity LevelsEstimated Bakken production declined approximately 16% year-over-year through September, in line with the Eagle Ford, though worse than production declines seen in the Permian (down approximately 5%) and Appalachia (essentially flat). However, the Bakken has rebounded strongly from production lows observed in May following April’s historic rout in crude oil prices. The Bakken was particularly impacted by production curtailments, driven in part by higher pricing differentials given the basin’s location, higher breakeven prices, and the fact that most operators in the basin have diverse operations, giving them optionality as to where to curtail production while being able to maintain cash flow necessary for near-term obligations (unlike pure-play counterparts). The rig count in the Bakken stood at 10 as of September 18, down over 80% from the prior year. Only the Eagle Ford has seen a more severe drop in rigs, with the rig count declining by more than 86% during the same period. While swift, the decline has stabilized. The Bakken’s rig count has ranged between 9 and 11 rigs during the third quarter. However, a meaningful increase in rigs is unlikely given reduced capex budgets. Commodity Prices Stabilize, Though Uncertain Demand Dynamics RemainThe third quarter of 2020 was relatively quiet for commodity prices, with near-term WTI futures prices oscillating around $40/bbl. Natural gas prices, which avoided crude oil’s steep declines in April, have generally been trending higher. Part of that relates to a reduction of associated gas production driven by lower oil production activity, as well as some regular seasonality as winter approaches. We note that CapitalIQ has revised the default futures contracts utilized for historical commodity pricing in order to make the output more reasonable. (Hence the lack of negative prices shown in the preceding chart.) As such, the information shown may not tie to previous analyses. However, there is still considerable uncertainty around future demand, both near-term and long-run. While resuming economic activity has spurred an increase in consumption, changing travel habits and concerns around a potential surge of COVID-19 cases during the upcoming traditional flu season have clouded experts’ ability to make projections. In the longer-run, BP’s 2020 Energy Outlook expects global liquid fuels consumption to peak by 2030 under a “business as usual” scenario. Under scenarios assuming more aggressive policy measures to reduce carbon emission, BP’s analysis suggests that liquid fuels consumption peaked in 2019 and will continue to trend downward. Financial PerformanceWith Whiting’s restructuring (discussed in a subsequent section), the Bakken-focused peer group with meaningful historical trading activity has become quite small. Continental Resources is down approximately 57% year-over-year, though that isn’t much worse than the overall exploration & production sector (as proxied by XOP, which is down 51% over the same period). Oasis Petroleum’s stock price has declined by approximately 88% over the past year and the company has warned of a potential bankruptcy filing. We note that neither company is pure-play Bakken, as Continental has a sizeable acreage position in Oklahoma’s SCOOP/STACK, and Oasis has operations in the Permian as well. Other publicly traded Bakken operators, including ExxonMobil, Marathon Oil, Hess, EOG, Ovintiv, ConocoPhillips, and QEP, also have diverse operations outside the basin. Northern Oil & Gas, which has traditionally focused on owning non-operating working interests in the Bakken, has expanded outside the basin with acquisitions in the Permian. Equinor, which entered the Bakken with its $4.7 billion acquisition of Brigham Exploration, announced that it is halting all U.S. shale drilling and well completion activity. The lack of a pure-play Bakken peer set makes it difficult to draw conclusions specific to the basin, but is also a telling fact about the difficult operating conditions in the area. Whiting Emerges, Oasis Potentially to Enter BankruptcyWhiting Petroleum, which announced its Chapter 11 reorganization process in April, emerged from bankruptcy in September. The reorganization process allowed Whiting to reduce its debt load by more than $3 billion, from over $3.4 billion to just $425 million. While shareholders were able to avoid being completely wiped out, the restructuring was extremely dilutive. Legacy shareholders now own approximately 3% of the equity of the new entity.Oasis Petroleum announced it skipped an interest payment due September 15. That puts the company in a 30-day grace period in which it can continue to negotiate with lenders regarding a restructuring. Oasis has been reviewing strategic alternatives with advisors, including “a recapitalization transaction with a third-party capital provider; restructuring of the Company’s existing debt either through an out-of-court process or under Chapter 11 of the Bankruptcy Code; or other strategic transaction.”Dakota Access Pipeline Under Siege AgainEnergy Transfer’s Dakota Access Pipeline (“DAPL”), which was the subject of protests in 2016 and 2017, is under renewed legal action. The pipeline, which was instrumental in helping minimize pricing differentials in the land-locked Bakken relative to other basins, has the capacity to transport 570 mbbl/d of crude oil from the Bakken to a hub in Illinois, with connections to pipelines serving refining markets in the Midwest and Gulf Coast.In July, a judge ruled that DAPL must be shut down and emptied by August 5, pending an environmental review by the Army Corps of Engineers. A U.S. appeals court reversed the shutdown order in August, though the requirement for the environmental review is still under appeal. Based on the current trial schedule, DAPL’s should be able to continue operating through at least late December before a federal court could mandate another shutdown.Despite the renewed legal scrutiny, Energy Transfer is pushing forward with an expansion plan which would roughly double DAPL’s capacity. The additional capacity is expected to come online in the third quarter of 2021.ConclusionThe Bakken was hit the hardest by curtailments driven by low commodity prices, but has also seen the sharpest rebound in production. Whiting’s successful restructuring should add stability to the basin, but Oasis may take its place shortly in the bankruptcy courts. While operating conditions are difficult across the U.S., the stress appears quite acute in the Bakken.We have assisted many clients with various valuation needs in the upstream oil and gas space in both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

How Growing RIAs Should Structure Their Income Statement (Part I)

Compensation Conundrums

Personnel costs are by far the largest expense item on an RIA’s P&L, but we’ve found significant variation in how RIA owners think about compensating their employees (and themselves). We’ll devote the next two posts to discussing best practices from an outsider’s perspective.The Scope of Compensation Costs for RIA FirmsAccording to Schwab’s 2020 Compensation Report, median compensation costs are 70% of revenue for firms with over $100 million in assets under management. We were a bit surprised by these findings since most publicly traded RIAs are in the 40% to 50% range, and our clients are typically in the 50% to 60% category, but these firms are usually larger than the median RIA in the Schwab study. There is also significant variation in these measures depending on the location, type of RIA, and how the owners choose to compensate themselves.The study reported that 76% of RIAs are planning to hire in the next twelve months, and 42% of firms recruited from other RIAs in the last year. The report also noted that 73% of these acquiring firms share equity with non-founders, suggesting that stock incentives are also part of the overall compensation package for the senior management group. [caption id="attachment_33740" align="alignnone" width="910"]Source: Schwab’s 2020 Compensation Report[/caption] The Compensation Conundrum for Newly Formed RIAsThis data illustrates the importance of a compelling compensation strategy for growing RIAs looking to recruit from other firms and retain talent. Newly formed RIAs don’t typically have the resources to offer higher base salaries and will often consider filling the void with stronger equity or equity-like incentives. While equity participation is especially lucrative for high growth firms with greater upside potential, partners of newly formed RIAs are generally hesitant to dilute their ownership.Equity offerings can be problematic for growing or newly formed RIAs whose principals do not take a salary or bonus from the business. While this structure makes sense in states with high income taxes, it overstates profitability and, if not remedied, would overstate income distributions to current (and prospective) owners.Over the next two posts we will delve into these two common compensation conundrums for RIAs:How to structure employee compensation when you are not ready to bring on an equity partner.How to structure compensation and your P&L before you bring on an equity partner. In this post, we address the first problem.Income (Not Equity) Partners Compensation is always a tricky issue, but the situation is especially complicated for RIAs as employees are typically able to estimate the profits of the company and compare their compensation to overall firm profits.Consider an RIA with two owners and two employees. The two employees know that the firm manages $250 million and estimate that the firm’s effective fees are 85 basis points, so they calculate that the firm likely generates $2,125,000 in annual revenue. By estimating overhead expenses and subtracting their own salaries, they surmise that the two owners/employees take home around $1.5 million, in aggregate. The two employees know they are paid well but also feel they should be rewarded for their part in the success of the company. The two owners, on the other hand, took a lot of risk starting their own business and feel they deserve to be compensated for their investment. They also want their employees to feel that they are being treated fairly. What do the owners do? When principals at RIAs are not ready to dilute their ownership in the business, they can structure compensation such that their employees are income-partners (but not actual equity partners). If you structure employee compensation to include a base salary and a bonus that is determined as a percent of company profits then your employees have the opportunity to participate directly in the upside of your business, without diluting your ownership positions. As shown in the adjusted model below, the owner’s take home pay did not change significantly; however, the employees are now directly compensated based on the profitability of the firm. Tying a new hires’ compensation to firm profitability is usually good practice but may be too costly if the shareholders aren’t paying themselves a salary and bonus. In the proposed model above, the partners increase their base salary to better align company profits with industry norms. We will dig deeper into this idea next week.

Used Cars are Stealing the Spotlight

Consumers Seek Budget Friendly Options as Economic Struggles Continue

Lightweight vehicle sales have continued to improve since April, albeit at a slower pace than in previous months. August’s SAAR came in at 15.2 million units, a 4% increase from July. This is notably a smaller increase than we have seen in previous months compared to the 11% increase in July and other double-digit increases across the previous months.August’s SAAR came in at 15.2 million units, a 4% increase from JulySAAR has yet to rebound to pre-COVID levels, down 11% from this time last year. However, it is worth noting that there were two fewer selling days last month than in August 2019, which also included the Labor Day sales weekend. September 2020 sales are likely to see a boost from the previous year with this calendar difference. However, even after making an adjustment to factor in the calendar discrepancy, retail sales volume in August was still off by 10% year over year. Overall for the year, total SAAR values are 80% of what they were in 2019.As NADA notes, there was higher vehicle turnover at dealer’s lots than this time last year with 45% of vehicles sold this August spending fewer than 20 days on the lot. This is up from 35% in August 2019. Vehicle incentives have continued to decline as well, down $49 from August 2019 and $848 from highs in April 2020.Overall Economic Struggles Continue to Plague the IndustryAlthough dealerships have shown an astute ability to pivot their business models to withstand this pandemic (check out our post on dealerships shifting to online sales for more on this), the overall stagnation in the economy from this dragging pandemic continues to be a hurdle for most industries. The government's stimulus package, which included the $1,200 payment to Americans and the extra $600-a-week payment to mitigate the effects of the pandemic, contributed to increased retail spending through June. However, with no second round of checks having been distributed and these packages expiring, spending has once again taken a hit.August retail sales were up 0.6%, below the 1% consensus estimate. July retail sales were also revised lower, to 0.9% from 1.2%. Sales at auto dealerships make up about 20% of total retail sales. Without Congress passing another stimulus bill, growth in sales could continue to decline. This could have stark implications for dealerships going forward, as lower spending affects big-ticket items such as automobiles more acutely than smaller necessities.Used Car Market Is Picking Up SpeedWith a shaky economy on many people’s minds, a winner in the auto dealer industry is emerging: the used car market. With new car advertisements flooding airwaves, used cars have often been overlooked in favor of “what’s new.” We are also at fault for this, with several of our recent blog posts being centered around electric vehicles and new vehicle inventory constraints. However, used cars are stealing the spotlight.The first signs of the used car boom came in May and June with the overall economic downturn, with J.D. Power calculating that auto dealers sold 2.1 million used vehicles in May and June, 9% more than they did in the same time in 2019. This trend continued into July with 2.2 million used vehicles stockpiled at U.S. dealerships that month, representing a 22% drop compared to July 2019.[caption id="attachment_33733" align="aligncenter" width="801"]Source: FRED[/caption] There are a few reasons for used cars having a moment in 2020, and most of these stem from the COVID-19 pandemic. Many people have lost job security but also need a car so they are buying used cars to save some extra cash. Consider that the average new car price has increased 2.9% since last year to $38,035 while used vehicle prices have increased 0.7% and are 44% less than new prices. However, used prices are anticipated to climb as demand increases. New vehicle inventory constraints are also continuing to plague new car dealers. Although manufacturing has ramped up, it is still failing to meet consumer demands, and many models have been slim or scarce. As Thomas King, president of the data and analytics division at J.D. Power noted: Given the ongoing disruption that COVID-19 has on the industry, the fact that retail sales of new vehicles are only 4% below the pre-virus forecast is evidence of strong consumer demand for vehicles. The modest decline also is a result of significant inventory constraints. These constraints are directly curtailing sales where vehicles are not simply available and are creating follow-on effects that are affecting overall volumes. Specifically, the constraints mean that manufacturers are reducing vehicle incentives while dealerships are reducing the discounts off MSRP that they have historically needed to offer.With new vehicle inventory being tight, consumers may be showing up to dealerships in search of a new car that’s unavailable, but salespeople can sometimes effectively pitch them on a different used vehicle instead.Another reason for the used car market’s success has to do with a topic we have also discussed previously in our blog: the decline in consumer sentiment for public transportation. With consumers trying to avoid being in close quarters are the pandemic drags on, Americans are buying used vehicles as backups to avoid trains, buses, and ride-sharing services.Finally, the used car industry has been at the forefront of using technology to reach their consumers remotely. As we discussed in our blog post on the Vroom IPO, Carvana and Vroom have been leading the way on bringing car buying into the 21st century and enabling consumers to purchase their product from anywhere. Although new car dealerships are picking up on the trend and adapting to circumstances, competing with many of these online used car dealers who have been developing their infrastructure for years is a tall order.The used car industry’s time in the spotlight is limitedWith all of this being said, the used car industry's time in the spotlight is limited: automakers will catch up on inventory shortages, dealerships will have the cars that consumers want, and sale incentives will return as well. But how long will it take? As the economy continues to struggle and the pandemic continues, there is not much of a clear answer and most are having to take the “wait and see” approach. However, some dealership owners are bullish on the used car prospects.EchoPark, Sonic Automotive Inc.’s standalone used vehicle store, recently turned a profit for the first quarter ever, mirroring the used car dealership success we have been discussing. Looking forward, they have high expectations for the brand. As CEO David Smith notes,As we expand our footprint into other areas across the country, we believe EchoPark will exceed the overall volumes and profitability of our franchised dealerships[…] We believe the combination of our customer-centric shopping experience, high-quality vehicle offerings, rock-bottom pricing and transparent trade-in appraisals is disrupting the pre-owned markets that we serve.If EchoPark has the success that Sonic Automotive is predicting, we could potentially see more public dealerships trying to capitalize on the used car boom moving forward as well.Looking ForwardLooking into September, there most likely will not be many significant changes regarding SAAR. As mentioned earlier in this post, year-over-year September may see a boost from the way the calendar year falls, but once adjusted for this, it is unlikely that we will see any significant trend changes to what we have been observing over the past months.A potential event that could spur car sales, however, is if Congress can come to an agreement on a stimulus package deal. While it is most likely not arriving in September, both parties are eager to pass a bill and get money into American's hands before Congress breaks prior to the election. In doing so, we may see the kind of growth rates in SAAR that we discussed in April or May as the economy gets a boost. Ultimately, however, it will be difficult for the auto dealer industry to reach pre-COVID sales until this recession ends, which will likely coincide with a vaccine. Positive vaccine results are a glimmer of hope for a return to normalcy in the future, but for now, a strong stimulus package that gives Americans more spending money is probably the best near-term scenario in driving auto sales growth.If you are interested in learning more about what this means for your dealership, feel free to reach out to us. We hope everyone is continuing to stay healthy and safe during this time!

M&A in the Bakken

Immense Drop in Deal Activity Due to COVID Concerns

Over the past several years, the Bakken has generally had much lighter acquisition and divestiture activity than other major basins in the United States. Given that deal activity across the energy sector has dropped an immense 42.7% over the past year, acquisition and divestiture activity has dropped even further in this basin over the past year.Observed deal activity has largely been the result of Northern Oil and Gas growing its production base in the area during the past several years.Recent Transactions in the BakkenDetails of recent transactions in the Bakken, including some comparative valuation metrics, are shown below.Northern Oil and Gas Continues Core Acreage BuildoutNorthern Oil has constituted approximately two-thirds of the observed deal activity (based on disclosed deal value) in the basin, including its bolt on acquisitions in June and August 2020 for several hundred acres. This activity furthers Northern Oil’s mission of building out its core position in non-operating interests through consistent, strategic acquisitions.Although production is down across the country, wells are slowly beginning to come back online, and Northern Oil believes increasing inventory while pricing is advantageous should drive returns in the future.According to Northern COO Adam Dirlam, “We continue to add to our core inventory. Record levels of wells-in-process should drive strong volumes, and improve upon our return on capital employed metrics in 2021 and beyond.”Since the start of 2018, the company has made six large publicly announced transactions totaling more than $820 million, including its large acquisition of private equity-backed Flywheel Energy LLC in April 2019.Below is a map of Northern Oil’s acreage to show its overall footprint in the basin.[caption id="attachment_33656" align="aligncenter" width="489"]Source: Northern Oil & Gas September 2020 Investor Presentation[/caption] ConclusionThe energy industry in Q1 and Q2 2020 has seen extreme volatility that has had investors and operators alike remaining cautious and waiting to see what happens next. As a result, acquisition and divestiture activity has been put on the back burner as companies struggle to plan ahead while remaining solvent.As we have moved from the second quarter to the third quarter, fundamentals in the Bakken have steadily improved as crude oil pipeline and storage limitations were alleviated. Stabilization of WTI pricing and well differentials in the region over the past couple of months have also aided as well. Companies like Northern Oil look towards the future as demand begins to creep upward from its mid-year lows, and the company has taken advantage of lower pricing to accrete acreage to its core position.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Does Personal Goodwill Apply to Auto Dealerships?

Observations from Recent Litigation Engagements

The concept of personal goodwill was a common topic in several recent auto dealer litigation cases. Not only is the presence (or not) of personal goodwill in a business, no matter the industry, hotly debated, but so is the quantification of that personal goodwill. However, I think the most important question to ask is “does it exist?” Often with ambiguous concepts like personal goodwill, the adage “you know it when you see it” is the most appropriate answer.What Is Personal Goodwill?Personal goodwill is value stemming from an individual’s personal service to a business and is an asset that tends to be owned by the individual, not the business itself. Personal goodwill is part of the larger bucket of an intangible asset known as goodwill. The other portion of goodwill, referred to as enterprise or business goodwill, relates to the intangible asset involved and owned by the business itself.[1]Commercial and family law litigation cases aren’t typically governed by case law resulting from Tax Court matters and can differ by jurisdiction, but Tax Court decisions offer more insight into defining the conditions and questions that should be asked in an evaluation of personal goodwill. One seminal Tax Court case on Personal Goodwill is Martin Ice Cream vs. Commissioner.[2] Among the Court’s discussions and questions to review were the following:Do personal relationships exist between customers/suppliers and the owner of a business?Do these relationships persist in the absence of formal contractual relationships?Does an owner’s personal reputation and/or perception in the industry provide intangible benefit to the business?Are practices of the owner innovative or distinguishable in his or her industry, such as the owner having added value to the particular industry? Another angle with which to evaluate the presence of personal goodwill, specifically to professional practices, is provided in Lopez v. Lopez.[3] Lopez suggests several factors that should be considered in the valuation of professional (personal) goodwill as:The age and health of the individual;The individual’s demonstrated earning power;The individual’s reputation in the community for judgment, skill, and knowledge;The individual’s comparative professional successThe nature and duration of the professional’s practice as a sole proprietor or as a contributing member of a partnership or professional corporation.Why Is Personal Goodwill Important?Many states identify and distinguish between personal goodwill and enterprise goodwill. Further, numerous states do NOT consider personal goodwill of a business to be a marital asset for family law cases. For example, a business could have a value of $1 million, but a certain portion of the value is attributable and allocated to personal goodwill. In this example, the value of the business would be reduced for personal goodwill for family law cases and the marital value of the business would be considered at something less than the $1 million value.How Applicable/Prevalent Is Personal Goodwill in the Auto Dealer Industry?Readers of this space know that in any writing pertaining to litigation matters, we always try to avoid the absolutes: always and never. The concept of personal goodwill is easier identified and more prevalent in service industries such as law practices, accounting firms, and smaller physician practices. Does that mean it doesn’t apply to more traditional retail and manufacturing industries? In each case, I think the fundamental question that should be first answered is “Is this an industry or company where personal goodwill could be present?”For the auto dealer industry, the principal product, outside of the service department, is a tangible product – new and used vehicles. In order for personal goodwill to be present in this industry, the owner/dealer principal would have to exhibit a unique set of skills that specifically translates to the heightened performance of their business.Name of Owner/Dealer in the Name of the BusinessWe are all familiar with regional dealerships possessing the name of the owner/dealer principal in the name of the business. However, just having the owner's name as part of the business name does not signify the presence of personal goodwill. An examination of the customer base would be needed to justify personal goodwill.It would be more difficult to argue that customers are purchasing vehicles from a particular dealership only for the name on the door, rather than the more obvious factors of brands offered, availability of inventory, convenience, etc. An extreme example might be having a recognized celebrity as the name/face of the dealership, but even then, it would be debated how that materially affects sales and success."... just having the owner's name as part of the business name does not signify the presence of personal goodwill."Auto dealers attempt to track performance and customer satisfaction through surveys, which could provide an avenue to determine this value (if for example factors that influenced the decision to buy listed Joe Dealer as being their primary motivation) though this is still unlikely and would be subject to debate.Another consideration of the impact of a dealer’s name on the success/value of the business would be how actively involved is the owner/dealer principal and how directly have they been involved with the customer in the selling process. Simply put, there should be higher bars to clear than just having the name in the dealership for personal goodwill to be present.In more obvious examples of personal goodwill in professional practices, the customer usually interacts directly with the owner/professional such as with the attorney or doctor in our previous examples. How often does the customer of an auto dealership come into contact or deal directly with the owner/dealer principal, or do they generally engage with the Salespeople, Service Manager, or General Manager?Presence of an Employment AgreementAnother factor that often helps identify the existence of personal goodwill is the presence of an employment agreement and/or non-compete agreement.The prevailing thought is that an owner of a business without these items would theoretically be able to exit the business and open a similar business and compete directly with the prior business. Neither of these items typically exist with an owner of an auto dealership. However, owners of auto dealerships must be approved as dealer principals by the manufacturer."Another factor that helps identify the existence of personal goodwill is an employment agreement and/or non-compete agreement."The transferability of a dealer principal relationship is not guaranteed, and certainly, an existing dealer principal would not be able to obtain an additional franchise to directly compete with an existing franchise location of the same manufacturer for obvious Area of Responsibility (AOR) constraints.So, does the fact that most dealer principals don’t have an employment or non-compete agreement signify that personal goodwill must be present? Not necessarily. Again it relates back to the central questions of whether an owner/dealer principal is directly involved in the business, has a unique set of skills that contributed to a heightened success of the business, and does that owner/dealer principal have a direct impact on attracting customers to their particular dealership that could not be replicated by another individual.ConclusionsPersonal goodwill in an auto dealership can become a contested item in a litigation case because it can reduce the value consideration. As much as the allocation, quantification, and methodology used to determine the amount of personal goodwill will come into question, several central questions should be examined and answered before simply jumping to the conclusion that personal goodwill exists.The difference in valuation conclusions between experts in litigation matters generally falls within the examination and support of the assumptions that lead to differences in conclusions. If present, personal goodwill for an auto dealership must exist beyond just having the owner’s name in the title of the business or the existence of an employment agreement.The existence and determination of personal goodwill can be a complicated topic. For more information or to discuss an issue in confidence, please don't hesitate to contact me.[1] In the Auto Dealer industry, goodwill and other intangible assets are referred to as Blue Sky value.[2]Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (1998).[3] In re Marriage of Lopez, 113 Cal. Rptr. 58 (38 Cal. App. 3d 1044 (1974).

Themes from Q2 2020 Earnings Calls

Part 2: E&P Operators

As discussed in our quarterly E&P newsletter, the oil & gas industry experienced a volatile path to price stability as COVID-19 and the Saudi-Russia price war took a toll on supply and demand. The road to recovery was apparent late in the quarter and was driven by supply cuts from OPEC+, curtailments by U.S. producers, and an increase in demand. In this post, we capture the key takeaways from E&P operator second quarter 2020 earnings calls.Theme 1: Cost Reductions Expected to PersistOne recurring theme among E&P operators in our prior E&P operator earnings calls quarterly overview included a continued focus on capital discipline. The six E&P operators we track typically characterize this concept as the reduction of operational costs and capital expenditures in the pursuit of increased operational and capital efficiencies. To that effect, all six operators pursued this goal in the second quarter, with most indicating the expectation that a substantial portion of these cost reductions will persist beyond the current environment of suppressed crude oil prices and uncertain projected economic activity.We expect capital efficiencies to increase across both the Bakken and the South in 2020. In the Bakken, we have achieved a 12% reduction to completed well costs. In the South, we've achieved a 10% reduction to our overall South completed well cost. 70% of these reductions are structural in the Bakken, and 80% of these reductions are structural in the South, driven by all aspects of our operations. – William Berry, CEO, Continental Resources, Inc.This flexibility, combined with mature production base and the structural well cost savings we have delivered, underpins our outlook for durable cash flow generation, as we were able to reduce our reinvestment rate, while maintaining production levels in a low-price environment. – Joseph Gatto, President & CEO, Callon Petroleum CompanyDiamondback has further adjusted downward our already low-cost structure and is prepared to operate successfully in a lower-for-longer oil price environment. A lot of the efficiency and cost gains made during this downturn will become permanent and will benefit Diamondback shareholders in a recovery. – Travis Stice, CEO, Diamondback Energy, Inc.When you look at these efficiency gains combined with service cost deflation and a consistent development strategy, we continue to drive down our well costs and drastically improve capital efficiency. As you can see […] we have reduced our well cost by approximately $1.8 million or 20% in the first two quarters of 2020. We believe that approximately 60% of these cost reductions are sustainable. – Joey Hall, Executive Vice President – Permian Operations, Pioneer Natural Resources CompanyTheme 2: Emphasis on Free Cash Flow to Reduce Debt and Reinforce DividendsIn our prior quarterly analysis, we noted that the operators seemed inclined to comment on their priorities moving forward. This was a recurring theme in the Q2 earnings calls. Short of referring to any such commentary as official guidance, most operators still discussed three to five year strategic goals, driven primarily by the growth of free cash flow projected to result from the cost reductions outlined previously. Among the priorities set forth by the operators, the two primary goals cited included debt reduction and providing for attractive dividends to shareholders.As I think about the first half of this year, we've made real progress on several priorities that will position us for the future: maximizing our cash flow by adjusting our spend rate, production and cost structure; increasing the strength of our balance sheet; continuing to return capital to shareholders through our dividend; and managing the oil price volatility with capital discipline, while also preserving our operational capacity. – Tim Leach, Chairman & CEO, Concho Resources Inc.With our reduction in forward capital spending, and expectation for true free cash flow generation at current commodity prices in the second half of 2020 and 2021, we will look to reduce both gross and net debt while continuing to return capital to our shareholders through our base dividend. – Travis Stice, CEO, Diamondback Energy, Inc.Initially we'd be looking to prioritize a bit of debt reduction as we then look to ease back into a base dividend structure. And then, in excess of that, there are a lot of other vehicles that we could consider the variable dividend is one, but certainly even share repurchases is another. I mean, nothing would be off the table. – Lee Tillman, President & CEO, Marathon Oil CompanyTheme 3: Expectation of Little to No Production Growth… MostlyRemarkably, the pursuit of production growth was not presented as an immediate priority by most operators at this time.We were saying essentially that – and early on – that we should not be, as an industry, overproducing into an oversupplied market. – William Berry, CEO, Continental Resources, Inc.Certainly, we're not seeing any signals that growth is needed from Diamondback or from our industry in general. So, growth in today's world is pretty much off the table. – Travis Stice, CEO, Diamondback Energy, Inc.Today, the world simply does not need more of our product. – Lee Tillman, President & CEO, Marathon Oil Company The exception was Pioneer Natural Resources, which was the only operator that specifically cited a positive production growth rate estimate:We say 5% plus on production growth, some years it maybe 6%, some years it maybe 7%, but we don’t want to just tie to one number based on rig activity, DUC activity, frac fleet activity. We can’t hit 5% every year, so we want the flexibility, some years it maybe 7%, 8%, some years it maybe 4%, some years it maybe 5%, and so we’re just saying 5% plus on production growth over the next several years. – Scott Sheffield, CEO, Pioneer Natural Resources CompanyOn the HorizonThe E&P operator earnings calls broadly paint the picture of a mature industry in uncertain times. The name of the game at this juncture is to shore up the balance sheet, increase efficiencies through capital discipline, and signal resilience by way of free cash flow growth and reinforced dividends to shareholders.However, as these companies stand relatively still as they fortify their positions for sustaining operations over the long-haul, changes and evolution are on the horizon. Most prominently, the U.S. presidential election looms around the corner. There is no indication of a consensus among the E&P operators regarding the likelihood of a regime change, or what changes would likely affect the industry if faced with a Democratic Biden administration.It should also be noted that the majority of the E&P operators have forthcoming formal ESG reports, with most slated to come out later this year. We expect these topics will be featured in our next quarterly review of the E&P operator earnings calls.

SEC Expands Accredited Investor Definition: What Does It Mean for RIAs?

Last Wednesday, the SEC announced an expansion to the definition of “accredited investor” to include individuals based on professional certifications and those with certain inside knowledge of private investments, among others. “Accredited investors” are deemed by the SEC to be sophisticated enough to bear the risks of often opaque private investments, which lack the disclosure requirements and some of the investor protections of their public counterparts. Under the accredited investor rule, private companies are limited to soliciting capital from accredited investors.Before the recent change, accredited investor status required net worth (excluding primary residence) over $1.0 million or an annual income of at least $200,000 ($300,000 for married couples) over at least the last two years and the current year.The old standard has been criticized over the years.While intended to protect smaller investors, the old standard has been criticized over the years as it effectively limits investment opportunities for unaccredited investors and potentially adversely impacts capital formation for small companies. Additionally, the wealth and income standards have been criticized as a poor proxy for financial sophistication and ability to bear risk.Another concern has been that the wealth and income standards have not changed since the rule was established in 1982. After 38 years of inflation, the real purchasing power of $1.0 million today has been significantly eroded. The wealth and income standards also do not consider geography or cost of living, which vary widely throughout the country.In the updated guidance, the SEC declined to revise the wealth and income thresholds for inflation or geography, saying that doing so would disrupt existing investments and add complexity and administrative costs. However, in an attempt to more effectively identify investors that have sufficient knowledge and expertise to participate in private investment opportunities, the SEC did add new ways to meet the accredited investor definition. The new guidance adds the following persons and entities to the accredited investor definition:Natural persons holding in good standing one or more professional certifications or designations or other credentials from an accredited educational institution that the SEC has designated as qualifying an individual for accredited investor status. Initially, the list of applicable professional certifications includes the FINRA Series 7 (General Securities Representative license), Series 82 (Private Securities Offerings Representative license), and Series 65 (Licensed Investment Adviser Representative). Additional professional certifications may be added from time to time by the SEC;Natural persons who are “knowledgeable employees,” as defined in Rule 3c-5(a)(4) under the Investment Company Act of 1940, of the private-fund issuer of the securities being offered or sold;LLCs with $5.0 million in assets and SEC- and state-registered investment advisers, exempt reporting advisers and rural business investment companies (RBICs); and,Family offices with assets in excess of $5.0 million and their clients. Additionally, “spousal equivalents” is added to the accredited investor definition, allowing spousal equivalents to pool their assets for purposes of meeting the net worth threshold. Will Wealth Managers Need to Vet Private Equity Investments?For most RIAs, the new guidance probably won’t change much. Under the new definition, RIAs themselves are now considered accredited investors, but RIA clients are not likely to be affected. Notably, although it was considered, the SEC did not expand the definition to include discretionary clients of fiduciary investment advisors.For most RIAs, the new guidance probably won’t change much.Since discretionary clients are not automatically accredited investors, the impact on RIA clients is limited to those individuals with the applicable professional certifications or who are “knowledgeable employees” of the issuer who were not already accredited investors under the old rule. The SEC estimates that just over 700,000 individuals hold the professional certifications listed above. Of these, many would have already qualified as accredited investors under the old wealth and income standard. For most RIAs who work predominately with high net worth (HNW) and ultra-HNW clients (who were already accredited investors), the incremental number of clients who now meet the accredited investor definition is likely to be quite small.For those that are newly-minted accredited investors, there is still the question of whether the types of private investments available to accredited investors would be an appropriate portfolio addition. Financial sophistication and the ability to understand the investment opportunity are just one part of the equation. Private investments often have long expected holding periods, low liquidity, and relatively high probability of permanent capital loss. While these features are often accompanied by higher expected returns, the high risk and low liquidity often make these investments inappropriate for investors who don’t have the capital base to endure substantial losses.Also, despite the SEC now allowing it, there is still the practical limitation of investment minimums and sourcing investment opportunities that will likely limit the ability of those newly endowed with accredited investor status to participate in private offerings. For now, the impact of the rule on capital formation is likely to be quite small, although the SEC has indicated the potential for continued expansion of the definition into the rank and file of retail investors.

Oil Frackers Are Breaking Records Again - In Bankruptcy Court

This year has beaten down America’s oil producers. It started bad, with the Russian-Saudi battle for market share, then cascaded into terrible as the COVID pandemic gutted petroleum demand and sent oil prices down to an unheard of -$38 (negative!) per barrel.Those with the weakest hands have taken shelter in bankruptcy court, where it has been a busy six months. With the announcement of offshore producer Arena Energy’s bankruptcy late last week the count of North American bankruptcy filings for producers stood at 36 (31 of those have been in the second and third quarter so far this year). In terms of aggregate debt, the industry is near $53 billion for 2020 so far. That puts the upstream segment on the precipice of having the most debt dollars exposed to bankruptcy protection in U.S. history and we still have four months to go.Some industry insiders are hearing that around 60-70 additional producers may file before year-end, meaning that a wave of companies are on this precipice. If that is the case, then Chapter 11 records will be left in the dust very shortly. That appears to be a monumental shift for six months of depressed prices, but it is important to remember that at around $50 per barrel (where oil had been most of the year prior) some upstream producers are barely breaking even. So when prices dropped even 15-20%, there wasn’t much margin left to work with.[caption id="attachment_33393" align="alignnone" width="640"]Source: Haynes & Boone Oil Patch Bankruptcy Tracker and Mercer Capital Research [/caption] As the industry heads down this road there will be some differences this time around compared to the surge in 2016, but with familiar signposts as well. What’s Different This Time?In 2016 a lot was different as far as the maturity and costs of drilling in the U.S. The Permian Basin was still getting its bearings on horizontal drilling in its bountiful stacked geologic formations in the Delaware and Midland sub-basins. Optimism and asset values were higher also as supply and demand balances were flipped in the U.S. at the time. While prices for 2016 averaged $43 per barrel, which is surprisingly close to today’s WTI prices of $42, asset values were far different and future drilling inventory (otherwise known as acreage) is currently valued significantly lower. The chart below gives us a glimpse of that.[caption id="attachment_33394" align="alignnone" width="640"]Source: Bloomberg[/caption] Rig counts and production declines are a hot topic right now as rigs and production are becoming scarcer items. This is different from last time because a higher percentage of U.S. production is tied to horizontal shale wells which decline much faster than conventional wells. According to the latest Dallas Fed Energy Survey, 82% of respondents shut-in or curtailed production in the second quarter 2020. Most of those producers expect minor or even significant costs to put those wells back online. This devalues reserves and limits recoveries for unsecured creditors. In contrast, few if any were shutting in wells in 2016. Another difference may be in how Chapter 11 reorganization plans consider future drilling plans and commitments. Let us not forget that an exploration and production company’s primary assets are essentially two things: (i) existing production and (ii) a drilling plan for future production. In the past, companies could effectively drill their way out of bankruptcy to generate cash flow, but as we’ve shown before, that may not be an option for some filers at $42 per barrel. Others that have hedged their production may have more latitude. That is a case by case situation. Drilling commitments and even force majeure are sometimes a significant negotiating point in bankruptcy cases. What’s Not Different This Time?For starters, this is some producers’ second or even third time that they have been in a restructuring situation in the past few years. This is sometimes known as the proverbial “Chapter 22” bankruptcy. Chaparral is one of those companies. In fact, Chaparral is an example of what else might not be different this time around –equitizing debt. Chaparral announced last week it will be equitizing all $300 million of its unsecured debt. Whiting’s bankruptcy will do this as well as their unsecured holders are estimated to recover around 39% of $2.6 billion in claims, but will end up owning 97% of the new company going forward, leaving 3% for the existing shareholders.Speaking of unsecured debt, the magnitude of unsecured debt will set records. However, the mix of secured vs. unsecured debt, overall, is similar to 2016. Asset values on the other hand are in different places, particularly PUD’s. This creates some uncertainty as to exactly where in the debt stack that creditors may recover their capital or otherwise must restructure their interest, often referred to by insiders as the “fulcrum security.” In a Chapter 11 bankruptcy scenario, there is typically a tier of creditors that is only partially “in the money.” For example, if a debtor’s secured debt will be paid in full, but unsecured debt will receive say 20 cents on the dollar, the unsecured debt is what is known as the fulcrum security. This could also change during the bankruptcy especially if commodity prices change during the process and before plans of reorganization are approved. As challenging as this year has been so far, it is far from over and there may be a glimmer of hope that prices could rise before the end of the year.There are some bullish signs for oil. Drawdowns on inventories exceeding projections and have been coming down since mid-July. They now stand at levels similar to where they were in early April and are much closer to equilibrium than thought even 45 days ago. Fuel demand (except for jet fuel) is likely to recover before the end of the year, thus bringing upward pressure on prices according to ExxonMobil’s (XOM) latest investor presentation.[caption id="attachment_33395" align="alignnone" width="940"]Source: ExxonMobil Investor Presentation and the International Energy Agency (IEA)[/caption] If this happens, it will improve creditor recoveries, and lubricate gears of the bankruptcy process. It would also bring relief to those who are not planning to file and are looking to weather this year’s storm. Nonetheless, it is unlikely that even a precipitous rise in prices could stop this year from breaking bankruptcy records. That is the unfortunate reality that makes 2020 a frustrating year for many. Originally appeared on Forbes.com on August 25, 2020.

Is the Hype Sustainable?

How EV Start-Ups Are Taking Advantage of SPACs to Enter the Public Market

As we mentioned in a previous blog post, the electric vehicle (EV) market has been all the rage lately, driven primarily by Tesla’s success in creating main stream electric vehicles. We’ve discussed the “Tesla Story” extensively in previous posts, and their stock has continued to rise. It was sitting around $2,200 last Friday (August 28), up from $216 last year, or an astounding 918%. Tesla split its stock 5-1 Monday and was hovering around $450 at the time of writing this post.As expected, other companies want to capitalize on the hype that Tesla has created in the industry, with EV start-ups trying to capture a slice of the pie. This summer has been a huge one for the industry, with electric vehicle startups Nikola, Fisker, Hyiilon, Lordstown, and Canoo all either going public or announcing plans to go public. Notably, however, they are not relying on the typical, lengthy IPO route to achieve this. Instead, they are using special purpose acquisition companies (or SPACs) to hit public markets quicker. In this post, we will walk through the companies going public, the deals, pros and cons of the SPAC, and what this could mean for your dealership.The EV Start-up ContendersNikola was the first of these EV start-ups to go public, announcing an IPO merger with VectoIQ Acquisition, a special purpose acquisition company, on March 3rd. After the merger was completed, the combined company was estimated to be worth $3.3 billion. Nikola was founded in 2015 and now is the global leader in zero-emission heavy duty trucks and hydrogen infrastructure. They hope to use the money raised from the public offering on the development of their electric semi trucks, of which they had around 14,000 preorders. This represents about $10 billion of potential revenue and three years of production. While the stock peaked 5 days after the offering at $79.73, the hype hasn’t lasted as its stock price has steadily declined back down to about $42 as of Monday. Despite the recent lackluster performance, future success is most likely hinging on if Nikola can deliver when they start rolling out vehicles.Hyiilon is seeking to follow in Nikola’s footsteps; on June 19th the company announced it would merge with Tortoise Acquisition, also a SPAC. At the time of the announcement, Nikola stock was up 80% from its IPO price, an encouraging sign for Hyiilon, who differentiates itself from Nikola and Tesla by offering a hybrid solution that works with existing diesel trucks. The company plans to introduce the first carbon-negative solution that will recycle natural gas. This, paired with a lighter design, could result in greater payloads that will lead to more profitable truck routes without having to invest in a totally new fleet. According to internal metrics, the company also outperforms Tesla and Nikola in range and payload capacity. The deal is expected to close in Q3 and once this happens, the ticker symbol will change from SHLL to HYLN, and Hyiilon will officially be a publicly traded company. Hyiilon has indicated that it will use the funds from the public offering for commercialization, production, and operations growth.While the Nikola and Hyiilon deals are in the heavy-duty truck space, Fisker, Lordstown Motors, and Canoo are EV start-ups in the standard light weight vehicle market. They announced their plans to go public through SPACs on July 13th, August 3rd, and August 18th, respectively. Fisker and Canoo both deal with traditional vehicles, though the designs are completely different. The founder of Fisker is best known for designing luxury vehicles for companies such as Ford, BMW, and Aston Martin. Looking to bring the same style to the electric vehicle market, Fisker and Spartan Energy Acquisition, a special purpose acquisition corporation backed by Apollo Global Management is expected to close in the fourth quarter, valuing the company at $2.9 billion. In a similar fashion, Canoo announced a merger with Hennessy Capital Acquisition Corp IV, another SPAC, valuing the company at $2.4 million. Canoo’s spin on the electric vehicle is a VW microbus-style van. Finally, Lordstown Motors entered the public space as well, trying to get more traction for their electric pickup truck, Endurance. Lordstown listed on its site some impressive features of the vehicle including 250-plus miles EV range, 7,500-pound towing capacity, and an 80 mph top speed. They are planning a merger with DiamondPeak that will give the company a pro forma equity value of $1.6 billion. Suffice it to say, there is a lot going on in the EV space right now.SPACsDespite some of these companies not even having a viable product yet, through the use of a SPAC rather than the traditional IPO route, these companies are all able to raise large funds from public market investors that are more averse to risk than private investors to back public development. Having mentioned the SPAC extensively above, it’s important to consider what it is specifically and why it could be considered so favorably by companies such as those in the EV industry. A special acquisition company (or SPAC) is a special type of company that goes public for the sole reason of buying another company regardless of how much it raises through an IPO. It’s for this reason that a SPAC is also known as a “blank-check” company. SPACs have become increasingly popular over the past few years, with 28 SPACs having IPO’d this year raising $8.9 billion. This is on track to reach $16.5 billion by the end of the year, a 21% increase from the prior year. What is prompting this SPAC boom? Some theorize that it has to do with the COVID-19 pandemic. IPO roadshows have become difficult to do in the current climate and don’t work as well remotely. Furthermore, there has been a shift toward one-on-one deals rather than one-to-many capital raises. However, while these circumstances can explain the increase in 2020, they fail to account for the increase over the past decade. Another favorable attribute includes risk mitigation for the selling company. The reasoning for this is because, with a SPAC, the company negotiates the price and then signs the deal. With a traditional IPO, it is the other way around, and there is no guarantee that it will be successful. Despite all of these factors, the most compelling argument for the SPAC boom doesn’t have to do anything with the cost (the SPAC is more expensive) or risk-mitigating factors, but instead primarily has to do with its timeline. With companies in “hyped-up” industries such as the EV market or the space tourism market (looking at you, Virgin Galactic), it makes sense for them to get to market as quickly as possible in order to extract gains in the market from this hype factor. Hence, the appeal of the SPAC. Despite all of the positives for companies, SPACs do have their drawbacks. One of these drawbacks is no reverse break fees, meaning that the potential to receive deal protection in the form of a reverse-breakup fee from the SPAC can be limited because of an inability to access the trust account cash other than post-business combination. Furthermore, since the SPAC structure is less risky for the company than an IPO, the SPAC should be compensated for this risk protection with an even bigger discount than regular IPO investors. Finally, there can be an uncertain amount of cash availability with SPACs due to a SPAC’s public stockholders having the option to elect to have their shares redeemed for cash in connection with the business combination. More investors redeeming their shares for cash means less cash for the company going public. How Long Can the Hype be Maintained?While in the 21st-century fads can catch on quickly and explode, they also have the potential to die out just as fast with “the next big thing” always around the corner. This seems to be the problem with companies that use SPACs to go public. Of the 222 SPAC IPOs since the start of 2015, 89 have completed mergers and taken a company public. Of these, the common shares have delivered an average loss of -18.8% and a median return of -36.1% since 2015. This is a stark contrast to traditional IPO returns which have averaged 37.2% since 2015. Behind these numbers is a common trend of an initial pop when the company is announced followed by a further jump if it is priced right when it begins trading. However, declines tend to follow these initial bursts. Only 26 SPACs in the group have had positive returns as of the end of July. It seems that while SPACs could be useful for helping a company ride the interest-wave in order to raise funding, they have to have a product that isn’t just hype-worthy but can sustain consumer interest over the years.Key TakeawaysThough these public offerings may not initially impact dealerships directly, the surge of electric vehicle start-ups capitalizing on SPACs could mean there may be more electric vehicle alternatives to Tesla in the near future. Traditional manufacturers could ultimately try to acquire these start-ups in order to bolster their own electric vehicle offerings. For example, General Motors has invested $75 million in the Lordstown deal. If large traditional manufacturers pivot to larger EV offerings through the investment in these companies, dealerships could ultimately benefit from the larger selection being offered to consumers. Furthermore, as the use of SPACs to reach the public market increases in prominence, it is not out of the question that we see dealerships using this vehicle in the near future as well. With the main public dealers all reaching the market around the same time and there not being any new entrants in a while, the industry is overdue for some new players. While ultimately these thoughts are speculative, observing what is going on in the space can help companies prepare for what might be ahead.

Is the Hype Sustainable?

How EV Start-Ups Are Taking Advantage of SPACs to Enter the Public Market

Themes from Q2 2020 Earnings Calls

Part 1: Mineral Aggregators

As discussed in our quarterly overview, the oil & gas industry experienced a volatile path to price stability as COVID-19 and the Saudi-Russia price war took a toll on supply and demand. The road to recovery was apparent late in the quarter and was driven by supply cuts from OPEC+, curtailments by U.S. producers, and an increase in demand. Mercer Capital has aimed to focus on the mineral aggregator space, most recently with the release of the second quarter mineral aggregator valuation multiples analysis. In this post, we capture the key takeaways from mineral aggregator second quarter 2020 earnings calls.Theme 1: M&A Activity Is Momentarily Taking a Back SeatAlthough mineral aggregators have the reputation to seek acquisitions through reinvesting strategies, they seem hesitant to pull the trigger as the current environment is providing many challenges.The world’s greatest deal would have to present itself, and that’s always possible. But the world’s greatest deal would have to present itself, given where we’re currently trading. – Daniel Herz, President & CEO, Falcon MineralsI think it’s fair to say that it’s always more difficult to get deals done when the bid ask spread is just so severe. I mean, the volatility in oil prices kills deals. I mean, it just makes it really hard to get things done. – Davis Ravnaas, President, CFO & VP of Business Development, Kimbell Royalty PartnersThe balance sheet is most important, holding us back from M&A. I mean, if we saw the best deal in the history of minerals, we’d have to think hard about it, but unfortunately those deals just aren’t out there. – Kaes Van’t Hof, President, Viper Energy PartnersTheme 2: Consolidation and Operators’ Stability Is Affecting AggregatorsAs the difficult environment plays out, a number of operators will be forced to liquidate or consolidate, leading to opportunities for aggregators to work with new, and often financially improved, partners. In Brigham Minerals’ second quarter earnings call, Ben Brigham expressed his excitement to have their assets migrate into the hands of Chevron, subsequent to the closing of Chevron’s acquisition of Noble Energy (expected in the fourth quarter of 2020). As times are tough, aggregators assess the stability of their operators, and may be fortunate, like Brigham, to land a major partner.We expect financially challenged operators to liquidate or consolidate with larger entities and those surviving operators will focus on drilling our highest remaining rate of return wells. So I think that’s going to continue to play out – where you have a weak operator with the weak balance sheet, they’re going to get taken out by a stronger operator with a better balance sheet, and that’s going to benefit our asset base. – Ben Brigham, Founder & Executive Chairman, Brigham MineralsDorchester Minerals states that during the challenging environment they are observing the "Financial stability of our operators and lessees and paying increased attention to operator credit risk and revenue recovery." – Dorchester Minerals Annual Meeting Presentation held May 18, 2020What we have found to be very successful in times like this is that you need to be more of a partner with your operators now than maybe you do in really good times where capital is more available. – Jeff Wood, President and CFO, Black Stone MineralsTheme 3: Natural Gas Optimism Is IncreasingIt is pretty ironic that the industry is shifting its focus to natural gas, as it was viewed as a secondary asset not too long ago. Although at a historically low price, it has shown consistency and resiliency during the first half of the year as opposed to greater volatility in oil prices. Aggregators have not ignored this trend and seem optimistic about the future for natural gas.We're seeing increased deal flow in gas. A lot of Marcellus stuff is coming to market. – Davis Ravnaas, President, CFO & VP of Business Development, Kimbell Royalty PartnersWhile it’s been challenging to find many silver linings lately, one of them is a more constructive outlook for natural gas prices with several of our major equity research firms calling for gas prices well above the strip for 2021. – Tom Carter, CEO & Chairman of the Board, Black Stone MineralsFurthermore, combining this competitive advantage with our robust hedge book and significant natural gas production, which has an increasingly positive macro outlook, provides even more enhanced cash flow stability into the coming quarters, as we emerge from this volatile period. And I think some of our gas positions have been remarkably resilient. – Davis Ravnaas, President, CFO & VP of Business Development, Kimbell Royalty PartnersTheme 4: Balance Sheet Priorities: Preparing for the Worst, Hoping for the BestIt is no surprise that aggregators are paying close attention to their balance sheet positions. Participants on the calls gauged their company’s balance sheet flexibility. The aggregators remained confident that their ability to pay down debt and appease investors continues to be a priority. This may come at a cost to some companies such as Black Stone Minerals, as they sold two asset packages in the Permian in June to strengthen their liquidity position.In early June, we announced the sale of two asset packages in the Permian. Both of those transactions closed in July and brought in net cash proceeds of $150 million. That cash, together with the retained free cash flow from our operations, enabled us to reduce total debt by over $230 million or 60% from the end of the first quarter of this year. – Tom Carter, CEO & Chairman of the Board, Black Stone MineralsWe purposely reduced our acquisition activity in the latter half of the first quarter and largely through the entirety of the second quarter in order to preserve liquidity and maintain optimal balance sheet flexibility and thus position ourselves to capitalize on more attractive opportunities we expected in the second half of the year, that's playing out well for us now. – Robert Roosa, Founder & CEO, Brigham MineralsWe will use the retained amount to strengthen the balance sheet by paying down debt of $2.5 million in the coming days. We continue to manage the Company in a conservative and prudent manner, especially given the risks and uncertainties in the energy sector and the broader economy so far this year. – Davis Ravnaas, President, CFO & VP of Business Development, Kimbell Royalty Partners

Q2 2020 Earnings Calls

Constrained Inventories and Improved SG&A Margins Expected to Normalize While the Future of Omnichannel Initiatives Stays Top of Mind

As expected, the COVID-19 pandemic has thrust many dealerships into relying on their digital and omnichannel offerings due to complications arising from stay-at-home orders. Further government restrictions have curbed new vehicle supply as manufacturers have struggled to ramp up supply. Many dealers noted inventory shortages. However, with sales volumes significantly below the 17 million seen over the last several years, both the numerator and denominator of the days of supply statistic are declining. Lower sales mean lower inventory isn’t a deal breaker; in the short term, limited supply has led to some gross margin improvement. However, total gross profit is still significantly down due to the lower sales (combination of lower inventory and lower demand). While sales have improved sequentially as restrictions have eased, parts and service (particularly collision) have trailed in their recovery as fewer miles driven has translated into reduced demand. Analysts inquired about the potential for stay-at-home orders to be ramped back up, particularly in large states such as Texas, California, and New York, though executives largely downplayed the likelihood and the impact it would have on their businesses.On Q1 calls, public auto dealer executives played down incremental costs related to digital initiatives and highlighted the reduction in SG&A related to online sales. Specifically, advertising and personnel costs are much lower for digital. In Q2, public auto dealers saw these initiatives come to fruition, and earnings largely beat estimates despite year-over-year revenue declines of 15-35%. Despite the successful cost cutting, executives were quick to point out not all of these cost savings were sustainable.Theme 1: Manufacturer plant closures have caused inventory shortages, but lower sales levels require less inventory. Some dealers noted higher gross margins due to their limited supply, while others highlighted issues sourcing their most popular models.Our second quarter new vehicle volumes declined 28%, and used vehicle volumes were down 14%, the latter of which was caused by inventory shortages. However, gross margin was extremely strong. New vehicle gross profit per unit was up 40% in the quarter. […] we are seeing a bit of an inventory strain in new and used and especially on the new side with some hot models that are typically our volume sellers. -Daryl Kennigham, President of U.S. and Brazilian Operations, Group 1 AutomotiveIt's going to be a tough road for July August September although we are seeing inventories improve. They're just not going to improve rapidly. I would look for October November time frame to get some normalized inventory levels. And the great news is this low supply equals high margin. -Jeff Dyke, President, Sonic AutomotiveWe are clearly constrained in inventory, and that means that for any given customer that comes to the site, the odds of them seeing the car they're looking for is lower, and therefore, your conversion rates will be lower. -Ernest Garcia, Founder, President, CEO & Chairman, CarvanaOur day supply was 52, down 34 days from the prior year. These levels are low, because of temporary OEM factory shutdowns. However, we expect the day supply to increase gradually through the summer selling season. -Dan Clara, SVP Operations, Asbury Automotive GroupTheme 2: Service & parts (primarily collision) fared better in April than vehicle sales. As the pandemic persisted, less mileage driven led to decreased demand due to less wear and tear.Collision is really what's taken the big hit for us […] when April really shut down for sales and service, collision was actually okay and then collusion took their hit in May forward. With less people driving on the road there's been less accidents. So collision has been a little bit further behind. -David Hult, CEO, Asbury Automotive GroupThere's just been people driving less mileage. And so our collision business, which isn't a massive part of our business overall. But it's probably the weakest when you look at it year-over-year. -Earl Hesterberg, President & CEO, Group 1 AutomotiveTheme 3: SG&A declined to lows as a percentage of growth for many of the public auto dealers. However, analysts and executives noted these results were unsustainable in the long-term.Store leaders continue to take prudent and decisive cost savings measures and personnel and advertising expenses, which comprise approximately 75% of our SG&A. These actions lead to significant sequential improvements throughout the quarter. Same store adjusted SG&A to gross profit was down to 64.8% in the quarter, an improvement of 480 basis points over the prior year. […] for the month of June, our company [SG&A] to gross profit improved to 57.4%, […] significant leverage in the cost structure is attainable as we maintain discipline and look to our e-commerce and digital home solutions to provide incremental sales with lower delivery costs. […] Our stores are well aware that their largest SG&A item is personnel. The next one is advertising. […] As we move forward, the target in SG&A gross percentage is 65% which we’ve talked about for years, I think it seems a lot more attainable in the near term. -Chris Holzshu, EVP & COO, Lithia MotorsWe were 64% which I would never [have] thought we'd be in the 60s with SG&A when looking at July 77% last year. […] We see less salespeople necessary to drive the business. The same thing on the fixed side. We're seeing better utilization of our people. […] I think advertising is moving from traditional to obviously online which obviously is less costly. -Roger Penske, Chairman & CEO, Penske Automotive GroupWe drove significant SG&A leverage through extensive cost reduction efforts, including leveraging our digital capabilities to reduce expenses across labor, advertising and discretionary spend. As Mike stated we will continue to maintain a discipline in our cost structure going forward, targeting to continue to operate SG&A as a percentage of gross profit below 69%. […] We were down about 40% in advertising year-over-year. Really driven by the environment and our digital capabilities and being far more efficient. -Joe Lower, CFO, AutoNationTheme 4: Digital innovation requirements loom large for smaller players who lack the scale to make the necessary investments. However, online used vehicle retailers do not have the same issues inherent to new vehicle retailing for traditional franchised players.Suddenly, buying cars online is becoming normalized. This is a big deal. We have restrictions on where we can market our new vehicle sales service to some degree in CPO where there are no restrictions or out and out pre-owned sales. -Ernest Garcia, Founder, President, CEO & Chairman, CarvanaI think there is a yearning in the pre-owned market for a brand that can be trusted. And scale also brings in the consumers' mind an idea of trust. And if you really have a good experience and you stand behind the product I think that's where the business is going to consolidate around and whether that's Carvana, CarMax, AutoNation, Vroom, I think the big players that are branded are clearly going to take share. It's a share consolidation in a very big ocean. That's how I see it developing. -Mike Jackson, Chairman & CEO, AutoNationIt's getting tougher and tougher for smaller independent dealers to be competitive in a world where the omnichannel and scale really matters so much. -John Rickel, SVP & CFO, Group 1 AutomotiveI know there's a lot of vibe in the market about growth and how big people can get over the years in consolidation in national branding. We have to remember that this is a franchise business. And that there's dealer agreement with every single one of these brands and then there's framework agreements on that. So until those documents materially change, I don't see the massive consolidation […] Once you start having multiple rooftops of any brand beyond your dealer agreement that exists, you have a framework agreement. And within those framework agreements there are limitations and how many you can acquire in an annual season […] And for a company A to buy company B of 40-plus stores overnight would take a significant amount of work with the manufacturers to make that happen and it would be a true test of some documentations that are out there. […] We all have restrictions on where we can market our new vehicle sales service to some degree in CPO where there are no restrictions or out and out pre-owned sales. -David Hult, CEO, Asbury Automotive GroupConclusionDespite public auto dealership's excitement surrounding the addition of online sales and lower SG&A expenses, key questions still remain. First, are the true costs being measured? “Omnichannel” requires both an online and in person presence. Quoting GPUs or SGA as % of gross may become muddled when trying to apportion which line item expenses are stuck in. What’s important to remember is these costs still exist, even if they seem small relative to the potential sales pickup. Digital may be more cost effective, but a full-on shift into digital for auto dealers likely sheds less cost than expected. Unless dealers plan to significantly shift their real estate strategy, it appears there are limits to how much cost can be taken out of overhead, even if advertising and personnel can be more efficient.How long dealerships can keep advertising and personnel costs low also remains to be seen. In a period of high unemployment, people may be happy to have their jobs. If we forecast out a few years, will people remain as jubilant to continue to do the work previously assigned to more people? Technology should help reduce personnel costs, but we’re simply pointing out there are limits. And on advertising, digital is the cheaper option – for now. Digital advertising is less established but gives more insight into the successful conversion of customers. For example, how are you supposed to know if someone decided to buy because they saw your billboard? In the long-term, this could lead to higher pricing power for digital advertising platforms.Finally, while large auto dealers have the scale to invest in digital platforms, smaller dealerships do not have such luxury. Their digital platforms may be limited to only when consumers looking to buy a specific make or model Google the closest location and head to the dealership or their website for an omnichannel experience. While these platforms may pale in comparison to larger players, it works for now. The question may become whether smaller players are forced to make commensurate digital investments. In the bear case, dealers would look to exit when deal multiples recover. For those with a more bullish view, we tend to agree with comments made by Asbury’s CEO (worth noting Asbury has the fewest dealerships of the publics). Dealerships may not want to overburden themselves with overinvesting in digital initiatives that aren’t being pushed by their OEMs. While dealers can be prisoners of the moment or attempt to “Keep up with the Joneses”, to use two puns in one sentence, we also caution it could be a risky play for dealers that step out of their lane and look to materially shift their operations online to compete with the well capitalized players in the nascent space.At Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight to the market that may exist for a private dealership. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Gin, Business Valuation, and Ryan Reynolds

Earn-Outs in RIA M&A

Typically, my love of business valuation and gin and tonics do not go hand-in-hand, and, unfortunately, Ryan Reynolds has never been thrown into this mix. But last week, three of my favorite things collided in Reynolds’ viral out of office reply.On Monday, Diageo, a European beverage company, announced it would be acquiring Aviation American Gin, owned by Ryan Reynolds (among others), for total consideration of $610 million, and, on Tuesday, Reynolds had a stark realization...Thanks for your email. I am currently out of the office but will still be very hard at work selling Aviation Gin. For quite a long time, it seems.In related news, I just learned what an ‘earn out’ is... And I'd like to take this opportunity to apologize to everyone I told to go f**k themselves in the last 24 hours. My lawyers just explained how long it takes to achieve an 'earn out'... so... turns out I'm not as George Clooney as I thought. The point is, to those listed below, I'm sorry... and I'll indeed be needing your help in the coming months and years. Thanks in advance!Mom, Blake, Peter, Diageo CEO, The Rock, George Clooney, Southern Glazer's, Betty White, TGI Friday's, Baxter, Calisthenics, AMC Theaters, Total Wine, The Number 8, Don Saladino, Darden, The Head of Alfredo Garcia, Soothing Lavender Eye Pillows.Ryan Reynolds Owner ? Aviation American GinApparently, the $610 million advertised transaction price is made up of an initial payment of $335 million and contingent payments of $275 million, based on the performance of Aviation American Gin over a 10-year period.Gin, Business Valuation, Ryan Reynolds, and your RIA Earn-outs are commonly used in RIA deals, and we expect contingent payments to make up an even larger percent of deal consideration for the next few months, quarters, or years depending on how long the current economic uncertainty lasts. And while we hope most of our clients would be thrilled by the prospect of $335 million in upfront cash payments, we don’t want you to end up feeling as Ryan Reynolds did last week. In this post, we explain what an earn-out is, why they are commonly used in RIA transactions, and how earn-outs may be used as a saving grace for deal activity in the current economic environment.What Is an Earn-Out? An earn-out is an agreement between a buyer and a seller to defer a portion of the purchase price. The amount of consideration ultimately paid is determined based on either some measure of post-closing financial performance such as AUM or EBITDA, or a specific milestone that occurs post-closing such as the renewal of a large contract.Contingent consideration allows for risk-sharing between the buyer and the seller. Deferral of the purchase price functions as a hedge for the buyer against poor future performance, while sometimes simultaneously providing the prospect of additional upside for the seller if they outperform buyer expectations. Importantly, contingent consideration influences post-transaction behavior. When it is necessary for the seller to continue operating the business following the sale (for RIAs, this is almost always the case), the presence of contingent consideration can incentivize the freshly-endowed sellers not to “call in rich” (like Reynolds thought George Clooney did in his sale of Casamigos tequila for $1 billion - actually 30% of the total consideration was subject to a 10 year earn-out like in Reynolds’ case), but continue to promote the success of the business.Why are Earn-Outs Commonly Used in RIA Transactions? Earn-outs are commonly used in RIA transactions, as the purchase price is not based on the value of hard assets acquired but expected future cash flows. Future cash flows of an RIA can vary dramatically as they depend on a large number of variables, including:The performance of financial markets;The skill of the investment management staff;The sustainability of the acquired firm’s fee schedule;The retention of key staff at the acquired firm;The motivation of key staff; andThe retention of client assets. As an example, we consider just one of these variables - market performance - and how an earn-out can be used as insurance to the buyer in case of a market downturn. While the market has almost recovered back to February highs, thanks mostly to the FANG stocks, some still think that this V-shaped recovery could turn into a W. Assume that RIA Capital buys ABC Investment Management, with $4.2 billion in assets, for a total price of $100 million. The transaction is structured such that two-thirds of the proceeds are paid up front and the remainder of the purchase price is paid over three years if ABC’s AUM grows by at least 5% per year. In Scenario A, ABC Investment Management’s AUM grows by 7.5% per year, and given the operating leverage inherent in most RIAs, EBITDA increases from $12.5 million to $15.8 million over the earn-out period. In this scenario, the entire earn-out is paid. The total consideration paid by the buyer is $100 million, which represents 6.8x average EBITDA in years 1-3.In Scenario B, ABC’s AUM falls by 15% in year one and slowly begins to recover, but, due to the operating leverage, EBITDA falls by almost 40% in the first year (a decline in revenue with little or no decline in expenses results in a larger drop in profitability). In Scenario B, the seller does not receive any contingent payments. The total consideration paid by the buyer is $67 million (the amount of the closing payment), which represents 6.6x average EBITDA in years 1-3.While the financial results in Scenario A and Scenario B differ quite drastically, the deal economics (from the buyer’s perspective) are similar. In both scenarios outlined above, the buyer paid roughly the same multiple of forward average EBITDA despite the difference in ABC’s EBITDA trajectory.Expect a Larger Portion of RIA Deal Proceeds to be Paid as Contingent ConsiderationRIA transaction activity has slowed during COVID-19. Most deals that were already in motion when COVID-19 hit, were finalized. However, new deal activity has been minimal. While a lot of due diligence can be performed virtually, buying an RIA in the middle of so much uncertainty is hard to swallow. However, the need for succession planning in the RIA space has not halted because of the pandemic. Rather, during COVID-19, many RIA principles have realized that succession planning is something that can no longer be delayed.So, how do you get buyers and sellers to execute a transaction during COVID-19 when the economic environment is so uncertain and when buyers likely have never set foot in the office they are buying or met management face-to-face? Part of the answer may be to bridge the gap between seller and buyer expectations by structuring the deal in a way that defers payment of a substantial portion of the purchase price in the form of contingent consideration.If you’re contemplating an offer for your firm that includes an earn-out, talk with an independent expert so you can better understand the value of the payments. And, Ryan Reynolds, if you are reading this, we would be happy to advise you on your next business deal.

Mineral Aggregator Valuation Multiples Analysis

Market Data as of August 14, 2020

As shown in the report, mineral aggregators’ stock prices have declined substantially over the past twelve months, but have rebounded from lows seen earlier in the year. The perfect storm of reduced asset values, record-low IRS rates, and the prospect of significant tax law changes early next year make this the ideal time to think about estate planning and tax-efficient ways to transfer assets to the next generation. With asset values trending upwards, vaccine candidates progressing rapidly, and political polling suggesting a high probability of a regime change in November, this perfect storm may not last long. Take advantage by taking action. In the current environment, there is little to gain by procrastinating, but potentially a lot to lose. We’re here to help with any valuation needs you have in this unique environment. Download our report below.Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership.Due to a variety of corporate structures (including master limited partnerships and Up-Cs) and complex capital structures (including preferred equity and non-traded common units), mineral aggregator enterprise values pulled from databases are often missing meaningful components of value, leading to skewed valuation multiples.Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis. Mineral Aggregator Valuation MultiplesDownload Analysis

Financial Advisors, Tell Your Clients to Gift Now!

Lower Asset Values Provide an Opportunity for Tax-Efficient Wealth Transfers Before November’s Election

Proposed Tax Changes Hasten Need for Estate Planning ServicesLast week we covered Joe Biden’s proposed estate tax changes and their impact on family wealth transfers if he gets elected in November. Biden’s current proposals include the elimination of basis step-up, significant reductions to the unified credit (the amount of wealth that passes tax-free from estate to beneficiary) and gift tax exemption, and increasing current capital gains tax rates to ordinary income levels for high earning households. The cumulative effect of these changes is a substantial increase in high net worth clients’ estate tax liabilities if Biden’s current proposals become law. Fortunately, there are several things you can advise your high net worth clients to do now to minimize their exposure to these potential tax law changes. Taking advantage of the current high-level of gift tax exemptions ($11.58 million per individual or $23.16 million per married couple) could save millions in taxes if Biden’s proposed lower exemption of $3.5 million per individual becomes law. Other options include the formation of trusts or asset holding entities to transfer wealth to the next generation in a tax-efficient manner (more on this later). Proper estate planning can mitigate the adverse effects of higher taxes on wealth transfers, but the window to do so may be closing if we have a regime change later this year. Further, the demand (and associated cost) for estate planning services may go up significantly in November, so you need to apprise your clients of these potential changes before it’s too late.Low Valuations Compound Tax Efficiencies for Current TransfersCOVID-19’s impact on the economy and financial markets may have depressed the value of your clients’ marketable securities and closely-held business interests. As my Mercer Capital colleague Travis Harmsrecently noted in his Family Business Director Blog, it does not matter if your client is looking to sell these assets in the near future, the IRS considers the relevant economic and market conditions at the date of transfer according to its Revenue Ruling 59-60:The fair market value of specific shares of stock will vary as general economic conditions change from ‘normal’ to ‘boom’ to ‘depression,’ that is, according to the degree of optimism or pessimism with which the investing public regards the future at the required date of appraisal. Uncertainty as to the stability or continuity of the future income from a property decreases its value by increasing the risk of loss of earnings and value in the future.One of the few positive side effects of the recent downturn is that it provides an opportunity for more tax-efficient transfers of family wealth for estate planning purposes. Travis illustrates the significance of the current opportunity with an example regarding the transfer of interests in a closely-held company.Consider a family business having a pre-pandemic value on an as-if-freely-traded basis of $25 million. Although the long-term prospects of the business remain unchanged, the dislocations caused by coronavirus have triggered a temporary reduction in fair market value of 25%. The founder has yet to do any estate planning and continues to own 100% of the shares. Exhibit 1 depicts the expected value trajectory for the family business both before and after the pandemic.Because of the resilience of the family business, the value trajectory resumes its pre-pandemic path after three years. The founder’s tax advisers suggest that – since the long-term prospects of the business are unimpaired – the current depressed fair market value provides an excellent opportunity to begin a program of regular gifts. The current lifetime gift tax exclusion is approximately $12 million, and the founder and his advisers devise a strategy of making an initial gift of $6 million, followed by annual gifts of $1 million in each of the following six years.We’ll examine two scenarios. In the first, the founder begins the gifting program immediately (the “Decisive” scenario). In the second, the founder defers the gifting program until the uncertainty associated with the pandemic has passed (the “Hesitant” scenario). In both cases, the shares gifted represent illiquid minority interests, so a 25% marketability discount is applied to derive fair market value.Since the annual gifts are for fixed dollar amounts, lower per-share values result in more shares being transferred, which reduces the ownership interest in the future taxable estate, all else equal. Exhibit 2 summarizes the shares that are transferred under the gifting program for the Decisive and Hesitant scenarios.Because the gifts under the Decisive scenario were made while share prices were depressed because of the coronavirus, a larger portion of the shares were transferred than in the Hesitant scenario. As a result, the founder retained just 33% of the total shares after using the $12 million lifetime exclusion, compared with 58% under the Hesitant scenario. As shown in Exhibit 3, the effect on the resulting taxable estate is compounded because, under the Hesitant scenario, the 58% retained interest represents a controlling position in the shares and the value is not reduced for the marketability discount. In fact, although not shown in Exhibit 3, a control premium to the as-if-freely traded could be applicable, which would exacerbate the disparity. In our example, failing to take advantage of the estate planning opportunity presented by the depressed asset prices added $7.2 million to the eventual estate tax bill. Procrastination can be costly. Historic Lows in Applicable IRS Interest Rates Provide Further Opportunity for Tax-efficient TransfersThe current AFR (the IRS-approved Applicable Federal Rate for interest on intra-family loans) is hovering at all-time lows – 0.25% to 1.15% per year, depending on loan duration. The new §7520 rate (named for that section of the Internal Revenue Code) applicable to Grantor Retained Annuity Trust (GRAT) transfers is also at a historic low of 0.80%. These low rates allow wealthy families to transfer assets and lock in their low values with minimal financing costs on intra-family loans and trust vehicles.Forbes provides an example of how GRATs and the new §7520 rate can be used to transfer assets to the next generation in a tax-efficient manner:Let’s suppose there is a family with assets worth $25 million; the value is down from $30 million before the crisis. They have real estate, investment assets, and a family business. The family wants to keep the business in the family. The older generation transfers $10 million worth of the business into a GRAT when the §7520 rate is 0.8% (May 2020), with the right to receive an annuity of $1 million a year for 10 years. At the end of 10 years, the remainder will be distributed to the grantor's children. Using the IRS Table B factor of 9.5737, the annuity stream is valued at $9,573,700, and the remainder interest is valued at its present value of $426,300. If the assets grow by 5% and have distributed income of 5%, the grantor will receive a stream of 10 payments of $1,000,000, and the beneficiaries will receive $10,200,416 at the end of the 10-year term (the future value of $10 million, minus ten annual payments of $1,000,000, and growing at 5% per year after income distributions of 5%). If the assets in the GRAT did not appreciate, the GRAT would invade principal, but would be paying the assets to the grantor. If the parents make a gift of $426,300 (the value of the remainder interest at this low rate), this would use up some of their estate exemptions, but the kids get more than $10.2 million. That is significant leverage on the use of the estate exemption that might be expiring in the near future.Putting it All Together…The perfect storm of record-low IRS rates, reduced asset values, and the prospect of significant tax law changes early next year make this the ideal time to advise clients to start thinking about estate planning and tax-efficient ways to transfer assets to the next generation. With asset values trending upwards, vaccine candidates progressing rapidly, and political polling suggesting a high probability of a regime change in November, this perfect storm may not last long. Take advantage by taking action. In the current environment, there is little to gain by procrastinating, but potentially a lot to lose. We’re here to help with any valuation needs your clients (or you) might have to get this done.

July 2020 SAAR

SAAR Increased to 14.5 Million in July, and Declines in Public Transportation and Ride-Sharing Usage Could be Creating Opportunities for Dealerships

SAAR has continued its upward trend coming in at 14.5 million, an encouraging 11% increase from June. However, sales continue to trail pre-COVID numbers with July 2020 14% below the same time last year.With demand picking up as customers can return to brick-and-mortar locations, dealerships aren’t feeling the need to offer as strong of incentives as they did at the start of the pandemic. According to JD Power, preliminary estimates put incentive spending for the month at $4,236 per unit, down from June 2020, but up by $166 compared to July 2019.As we mentioned in our previous SAAR post, inventory problems continue to be a difficult hurdle for dealerships to contend with as demand returns. JD Power reported that 41% of all vehicles sold in July spent fewer than 20 days on dealer’s lots, up from 35% a year ago.2020 is also proving to be an interesting year for new and used vehicles, as thin margins on cheap, new vehicles have manufacturers abandoning the investment. According to data from KBB, vehicles between $20K and $30K have declined from 44% of the market share in 2015 to 22% of the market share in 2020. Cars under $20,000 make up only 1.3% of new car sales so far this year. With the average price paid for a new vehicle around $39,000, this is way above many buyers’ budgets. As a result, entry-level buyers have been looking to the used car market instead. With the used car market getting bumps from new technologies, this has proven to be a viable and cost efficient option for new buyers.Pandemic Silver Linings for Auto DealershipsWhile the reopening of the country is bringing people back to dealerships, many places still aren’t being frequented like they had been in the past. Included in this list are bars, concert halls, and public transportation means. With fewer events going on, demand for ride shares has decreased significantly according to the Q2 earnings calls (stay tuned for next week’s blog post for a full rundown on those calls).The empty subways and buses should be on the radar of dealerships and could prove to be an ultimate silver lining among all of the negatives that the Covid-19 pandemic has created for auto sales. With social distancing difficult to achieve in a closed space environment like public transportation, there seems to have been a shift in consumer sentiment in favor of car ownership.The empty subways and buses should be on the radar of dealerships and could prove to be a ultimate silver lining to the struggles caused by the pandemic.A survey released in mid-July from CarGurus tracked customers’ views around buying a vehicle, and the results were striking! 39% of people planning to buy cars are looking to avoid ride-sharing, and 44% of them say they want to decrease or stop public transit use. Furthermore, as people start returning to the office, this number could increase, with 44% of people who take public transit to work citing that this is their top concern in returning to the office.As more data has been released noting the potential risks of using public transportation, the data surrounding people’s comfort level with public transport in the current climate is understandable. Even the government has become somewhat of a proponent of car ownership over public transportation during this time, as the CDC has encouraged companies to offer incentives for employees to use their own cars to ride to work, rather than public transportation or ride sharing.The Current State of Public Transportation and RidesharingWhen you look at the data behind public transportation usage since the pandemic began, it paints a clear picture of consumer preference during this time. Public transit ridership is measured by “unlinked passenger trips” with trips defined as whenever a person boards a transit vehicle, including transfers.Despite local governments pouring billions into public transit infrastructure, public transit ridership has been declining since at least 2014, with unlinked passenger trips falling 7.5%. The COVID-19 pandemic has escalated this decline significantly, with public transit unlinked trips dropping 85% from January to April at its lowest levels in more than a century. While this decline in usage could be attributed to overall declines in travel from stay at home orders, the graph below tells a different story. Vehicle miles did experience a decline as well, but it was strikingly smaller than that of public transit at 42%. Ridesharing services are facing a similar problem, as consumers are feeling uncomfortable sharing an enclosed space with a stranger. Uber has reported gross bookings on rides being down 75% in Q2. While Lyft declined to comment to the Washington Post on the impact of the pandemic on its business, the company has previously said its April ridership was down 75% in Q2. Recovery in this space as the country reopens has varied widely by city and state depending on which are reopening, recovering, or reimposing restrictions. For example, ridership recovery has been prominent in cities like New York that have recently been recovering after facing the brunt of Covid cases earlier this year. In San Francisco and Los Angeles, however, it has been depressed as California continues to struggle with its caseload. California’s gig worker legislation also poses an existential threat, particularly for Lyft where it derived 16% of its business. Manufacturers are encouraged by the changing sentiment surrounding car purchases, with Scott Keogh, Volkswagen’s U.S CEO noting that “We definitely do see a return to what I’ll call personal transportation and trust” and predicts a shift in consumer mindset to: “I know where this car has been; I know it’s mine.” What Increased Private Car Ownership Might Mean for the EnvironmentWith many cities having heavily invested in public transportation infrastructure, this Covid-induced fear of public transportation has many city officials nervous. New York City Mayor Bill de Blasio this past week issued statements against purchasing a car during the pandemic, as he told reporters “My advice to New Yorkers is do not buy a car. Cars are the past, the future is going to be mass transit – biking, walking – and there’s so many options right now and there’ll be more and more as we go forward.”The new guidelines by the CDC encouraging private car usage have raised concerns about what could be unbearable congestion and a surge of carbon emissions.While currently it may be safer to purchase a car to avoid unnecessary encounters with other individuals on public transit, ultimately this pandemic has an expiration date. More notable are worries that all of the efforts made to dissuade car usage for the sake of the environment could be unraveled through the emphasis on private car ownership.The new guidelines by the CDC encouraging private car usage have raised concerns about what could be unbearable congestion and a surge of carbon emissions if people turn to cars to avoid exposing themselves to the virus. University of British Columbia urban planning and public health professor Lawrence Frank notes that “promoting private vehicle use as a public health strategy is like prescribing sugar to reduce tooth decay.”However, both optimism from auto dealers on the prospect of new sales and concerns from public transportation advocates may be premature. With a vaccine predicted in 2021, consumer sentiments toward public transportation could easily revert back. Rebecca Lindland, an auto industry analyst, shares this viewpoint having seen previous trends come and go. For example, in 2008 when people started buying small fuel-efficient cars, she notes that “That only lasted two to three months, and then people went back to buying a vehicle that suited their wants and needs.” If people feel safer riding public transit with the development of COVID-19 vaccines and treatments, and parking and traffic once again become headaches, consumer preferences could shift off private car ownership.Looking ForwardWhile pandemic-related car sales stemming from public transportation avoidance may not be long-term, in the short run it could help boost dealership sales while they are trying to recover.However, many Americans are still hesitant to purchase a vehicle. This is despite a third of consumers saying they value having their own car more now than they did before Covid, and 93% were using cars more in the era of social distancing.The NADA expects new-vehicle retail sales to continue to recover for the rest of the year, while fleet sales will struggle.This hesitation stems not from opinions on transportation, but rather on the state of the economy. As unemployment remains high and there are uncertainties surrounding future government stimulus, consumers could be waiting for a more stable environment to make large purchases such as vehicles.Nonetheless, the National Auto Dealer Association expects new-vehicle retail sales to continue to recover for the rest of the year, while fleet sales will struggle. Inventory constraints may continue to plague the industry, but barring more production shutdowns, supply should ultimately be able to reach demand levels by end of the summer further supporting SAAR’s upward trajectory.

Q2 2020 Exploration & Production Newsletter Release

Region Focus: Permian Basin

Critical Issues in the Trucking Industry – 2020 Edition

Every year the American Transportation Research Institute (“ATRI”) publishes its report, Critical Issues in the Trucking Industry. A key piece of this annual report is a survey of key risk factors in the industry. While some of the risks of 2020 were not anticipated at the beginning of the year, some of the industry’s largest risk factors remain major concerns.

Estate Tax Planning May Be the Next Surprise for RIA Community

2020 Chicanery Never Ends

Road racecourses were originally built with at least one very long straightaway that allowed cars to reach maximum speed before braking for the turn. As cars became more powerful, the maximum speed attainable on the straights was dangerously fast. Racecourses added serpentine curves, known as chicanes, to the straights that require cars to slow down and maneuver before resuming a straightaway. 2020 has been a year of one chicane after another, and at this point, I don’t think anybody expects a direct path to 2021.RIAs Outran Two Challenges in 2020…After a decade of gaining speed, the outlook for the investment management industry suddenly turned fairly grim in March. With workforces on lockdown and equities falling, the pricing of publicly traded RIAs unsurprisingly trended downward. But running an investment advisory practice remotely turned out to be much less impossible than many imagined, and AUM rebounded rapidly with the markets. As such, Q2 did not turn out to be the industry bloodbath that many imagined, especially in the wealth management space.2020, however, is full of surprises, and the third quarter is bringing more. The persistence of the pandemic and the consequent economic strain on many has shifted political winds in favor of the minority party. If these trendlines don’t roll over between now and November 3, we’ll have a new executive and legislative regime and, with it, a redirection of tax policy. It’s not too early to start thinking about what impact certain legislative changes will have on the RIA industry, especially with regard to estate tax law.Estate Planning Rising in ProminenceInvestment advisors are not estate planners per se, but estate planning is a necessary part of financial planning for very wealthy clients. If political winds shift, more of your clients could be subject to estate taxes and, therefore, would benefit from estate planning. When my career started in the 1990s, the unified credit (the amount of wealth that passes tax-free from estate to beneficiary) was only $650 thousand, or $1.3 million for a married couple. The unified credit wasn’t indexed for inflation, and the threshold for owing taxes was so low that many families we now consider “mass-affluent” engaged in sophisticated estate tax planning techniques to minimize their liability.Then in 2000, George W. Bush was elected President, and estate taxes were more or less legislated away over the following decade. Over the past decade, the law has changed several times but mostly to the benefit of wealthier estates. That $650 thousand exemption from estate taxes is now $11,580,000. A married couple would need a net worth of almost $25 million before owing any estate tax, such that now only a sliver of RIA clients (not to mention RIA owners) need heavy duty tax planning.That may all be about to change. Joe Biden has more than gestured that he plans to increase estate taxes by lowering the unified credit, raising rates, and potentially eliminating the step-up in basis that has long been a feature of tax law in the United States.Biden’s Proposed Tax PoliciesBasis step-up is a subtle but important feature of tax law. Unusual among industrialized nations, in the United States the assets in an estate pass to heirs at a tax value established at death (or at an alternate valuation date). Even though no tax is collected on the first $11.6 million per person, the tax basis for the heir is “stepped-up” to the new value established at death. Other countries handle this issue differently, and Biden favors eliminating the step-up in tax basis. Further, he prefers taxing the embedded capital gain at death. Canada, for example, does this – treating a bequest as any other transfer and assessing capital gains taxes to the estate of the decedent.Capital gains tax rates are generally lower than ordinary income taxes, of course, but Biden has also suggested that he would raise capital gains taxes for high earning households to equal ordinary income tax rates, which he also plans to increase. Imagine a $10.0 million portfolio with a tax basis of $2.0 million. If your client passed today, it might go to heirs free of estate taxes and with a new tax basis of $10.0 million. If your client pays the maximum capital gains tax rate of 20%, the unified credit and basis step-up would save them $1.6 million (20% of the $8 million gain). The entire $10.0 million portfolio would pass to an heir tax free. If, instead, the unified credit is significantly reduced and capital gains rates rise to, say, 40%, the change will cost your client’s estate $3.2 million, and the bequest would be diminished to $6.8 million. If an estate tax is levied on top of that, the impact will be much greater.For those who want to minimize exposure to changes in tax law, estate planning can leverage the very low interest rate environment in conjunction with trusts and asset holding entities to transfer wealth efficiently and outside of the reach of the U.S. Treasury. The problem that may well present itself is the overwhelming demand for these services in late 2020 if the election is decisively in favor of the Democratic Party. If success in investing is “anticipating the anticipations of others,” this is a good time to think seriously about estate planning before tax planners become as scarce as toilet paper was in April.What is the Next Chicane?Where were you when you first realized that the Coronavirus pandemic was a big deal? I was in, of all places, New York with my family during the second week of March, and I’ll never forget how every day of the week it became more apparent that COVID-19 was going to change the trajectory of this year, if not beyond. First, the NBA suspended the season, then Tom Hanks – who was in Australia – tested positive, and then – also in Australia – the Formula 1 racing season was suspended about two hours before it was scheduled to start.F1 resumed on July 5 with the Austrian Grand Prix, and the motorsport, which is essentially a giant logistical exercise anyway, has successfully pivoted schedules, business practices, and financial models to adapt to operating in an environment with plenty of at-home viewers but nobody in the stands. Even for a business that thrives on making order out of chaos, Formula 1 is going better than expected, and the same could be said of the RIA industry. But now that you’ve successfully protected, and maybe even enhanced, your clients’ financial well-being and the earnings of your firm, the challenges that loom from political change are coming in fast. The chicanery of 2020 never ends.

Whitepaper Release: Understand the Value of Your Auto Dealership

If you’ve never had your auto dealership valued, chances are that one day you will. The circumstances giving rise to this valuation might be voluntary (such as a planned buyout of a retiring partner) or involuntary (such as a death, divorce, or partner dispute). When events like these occur, the topic of your auto dealership’s valuation can quickly shift from an afterthought to something of great consequence.The topic of valuation is of particular importance to owners of auto dealerships due to the complex and unique nature of the industry. In our experience working with auto dealers on valuation issues, the need for a valuation is typically driven by one of three reasons: estate planning, transactions, or litigation.The situation giving rise to the need for a valuation could be one of the most important events of your professional career. Familiarity with the various contexts in which your dealership might be valued and with the valuation process and methodology itself can be advantageous when the situation arises. To this end, we’ve prepared a whitepaper on the topic of valuing interests in auto dealerships.In the whitepaper, we describe the situations that may lead to a valuation of your auto dealership, provide an overview of what to expect during the valuation engagement, introduce some of the specific industry information and key valuation parameters that define the context in which an auto dealership is valued, discuss value drivers of an auto dealership, and describe the valuation methods and approaches typically used to value auto dealerships.If you own an interest in an auto dealership, we encourage you to take a look. While the value of your dealership may not be top of mind today, chances are one day it will be.Our hope is that this whitepaper will provide you with a leg up towards understanding the valuation process and results, and further that it will foster your thinking about the valuation of your auto dealership and the situations—good and bad—that may give rise to the need for a valuation.WHITEPAPERUnderstand the Value of Your Auto DealershipDownload Whitepaper

WHITEPAPER | Understand the Value of Your Auto Dealership

Understanding the value of an auto dealership requires an understanding of the industry’s unique terminology, factory financial statements, and hybrid valuation methodologies.The valuation of auto dealerships can be unique. Unlike most valuations used in the corporate or M&A world, cash flow metrics such as Earnings Before Interest, Taxes and Depreciation (“EBITDA”) are infrequently employed in auto dealership valuations. Further, the valuation of one auto dealership compared to another auto dealership can be completely different due to a variety of value drivers in the industry.In this whitepaper, we break down the value drivers of a dealership, discuss when you might need a formal valuation, introduce the valuation methodologies used by professional business appraisers, and go into some depth about topics such as dealer financial statements and normalizing adjustments to the balance sheet and income statement. We hope that the information in this whitepaper will make you a more informed user of business valuation services.

Bridging Valuation Gaps With Options

How Option Pricing Can Be Used to Understand the Future Potential of Assets Most Affected by Low Prices, PUDs and Unproven Reserves

Due to the precipitous drop in oil prices in 2020, oil E&P companies in the U.S. have struggled to pay their debts, and in many cases already have had to file for bankruptcy. In this post, we re-examine how option pricing, a sophisticated valuation technique, can be used to understand the future potential of the assets most affected by low prices, PUDs and unproven reserves. Whether companies are looking to sell these reserves to improve their cash balance, or are trying to generate reorganization cash flow projections during a Chapter 11 restructuring, understanding how to value PUDs and unproven reserves is crucial to survival in a down market. The Struggle: Valuation in Distressed MarketsThe petroleum industry was one of the first major industries to widely adopt the discounted cash flow (DCF) method to value assets and projects—particularly oil and gas reserves. These techniques are generally accepted and understood in oil and gas circles to provide reasonable and meaningful appraisals of hydrocarbon reserves. When market, operational, or geological uncertainties become challenging, such as in today’s low price environment, the DCF can break down in light of marketplace realities and “gaps” in perceived values can appear.The DCF can break down in light of marketplace realities and “gaps” in perceived values can appear.While DCF techniques are generally reliable for proven developed reserves (PDPs), they do not always capture the uncertainties and opportunities associated with the proven undeveloped reserves (PUDs) and particularly are not representative of the less certain upside of possible and probable (P2 & P3) categories. The DCF’s use of present value mathematics deters investment at low ends of pricing cycles. The reality of the marketplace, however, is often not so clear; sometimes it can be downright murky.In the past, sophisticated acquirers accounted for PUDs upside and uncertainty by reducing expected returns from an industry weighted average cost of capital (WACC) or applying a judgmental reserve adjustments factor (RAF) to downward adjust reserves for risk. These techniques effectively increased the otherwise negative DCF value for an asset or project’s upside associated with the PUDs and unproven reserves.At times, market conditions can require buyers and sellers to consider methods used to evaluate and price an asset differently than in the past. In our opinion, such a time currently exists in the pricing cycle of oil reserves, in particular to PUDs and unproven reserves. In light of oil’s low price environment, coupled with the future price deck, many, if not most, PUDs appear to have a negative DCF value.What does this mean for the E&P companies looking to reorganize under a Chapter 11 Bankruptcy? There are five key concepts for management teams and their advisors to be familiar with to understand how reserve valuation impacts Chapter 11 reorganization.Liquidation vs. Reorganization. The proposed reorganization plan must establish a “reorganization value” that provides superior outcomes for shareholders relative to a Chapter 7 liquidation proceeding.Liquidation Value. This premise of value assumes the sale of all of the company’s assets within a short period of time. Different types of assets might be assigned different levels of discounts (or haircuts) based upon their ease of disposal.Reorganization Value. As noted in ASC 852, Reorganizations, reorganization value “generally approximates the fair value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after the restructuring.” Reorganization values are typically based on DCF analyses.Cash-Flow Test. A cash-flow test examines the viability of a reorganization plan, and should be performed in order to determine the solvency of future operations. In practice, this test involves projecting future payments to creditors and other cash flow requirements including investments in working capital and capital expenditures.Fresh-Start Accounting. Upon emergence from bankruptcy, fresh-start accounting may be required to allocate a portion of the reorganization value to specific identifiable intangible assets. Fair value measurement of these assets typically requires use of the multi-period excess earnings method or other techniques often used in purchase price allocations following a business combination. If recent market transactions are utilized to establish a liquidation value, then it stands to reason that very little, if any, value will be given to the PUD reserves. For a company trying to avoid liquidation in a distressed market where sale prices do not indicate the true value, there may still be a way to demonstrate significant value if reserves are retained in reorganization. However, that reorganization value has typically been based on a DCF. It is possible that the DCF may capture significant value in PUD reserves because in reorganization debt levels are adjusted. When debt levels are adjusted the cash flow PUD reserves need to generate to be viable is much lower. This will provide two significant benefits: more time and possibly more cash. More time may allow global and regional oil and gas prices to increase while the additional cash flow from lower interest payments may allow investment in future PUD wells. Unfortunately, it is still the case that the present value calculation is strongly tied to current market conditions, and thus even for companies with reasonable leverage, many PUD and unproven reserves show negative cash flow. The presence of some sizable transactions made without significant PDPs shows that there are buyers who disagree with this assessment and see value in these reserves. The issue is demonstrating that value in either a sale or bankruptcy scenario. An option pricing model is one solution that could account for the value of the increased time provided by restructuring the debt.Option Pricing Providing A Potential SolutionOne of the primary challenges for industry participants when valuing and pricing oil and gas reserves is addressing PUDs and unproven reserves. As previously discussed, if one relied solely on the market approach many of these unproven reserves would be deemed worthless. Why then, and under what circumstances, might the unproven reserves have significant value?The answer lies within the optionality of a property’s future DCF values. In particular, if the acquirer has a long time to drill, one of potentially multiple forces come into play: either the PUDs potential for development can be altered by fluctuations in the price outlook for a resource, or, as seen with the rise of hydraulic fracturing, drilling technology can change driving significant increases in the DCF value of the unproven reserves.This optionality premium or valuation increment is typically most pronounced in unconventional resource or when the PUDs and unproven reserves are held by production. These types of reserves do not require investment within a fixed shorter and/or contractual timeframe.Current Pricing Environment:As oil prices have dropped and temporarily stabilized around $40 PUD values may drop precipitously. After the last recession, some PUDs faced a similar, yet more modest, decline in prices. In fact, nearly half the companies surveyed this spring by the Federal Reserve Bank of Dallas reported only being able to be solvent for 2-3 years at the most under these values. We have already seen some declare bankruptcy. Valuation would be made easier if we could determine when oil prices would rise again. Valuations vary as to producers’ sensitivity to this price. The Dallas Fed’s latest survey suggests that $40 is about the tipping point to restart shut-in wells, but not necessarily to drill new ones: Experienced dealmakers realize that the NYMEX future projections amount to informed speculation by analysts and economists many times vary widely from actual results. So what actions do acquirers take when values are out of the money in terms of drilling economic wells? Why do acquirers still pay for the non-producing and seemingly unprofitable acreage? In many cases, they are following a real option conceptual framework. Real Options: Valuation FrameworkPUDs are typically valued using the same DCF model as proven producing reserves after adding in an estimate for the capital costs (capital expenditures) to drill. Then the pricing level is adjusted for the incremental risk and the uncertainty of drilling “success,” i.e., commercial volumes, life and risk of excessive water volumes, etc. This incremental risk could be accounted for with either a higher discount rate in the DCF, a RAF, or a haircut. Historically, in a similar oil price environment, as we face today, a raw DCF would suggest little or no value for the PUDs or unproven reserves.An option pricing model can guide a prospective acquirer or valuation expert to the appropriate segment of market pricing for undeveloped acreage.In practice, undeveloped acreage ownership functions as an option for reserve owners; they can hold the asset and wait until the market improves to start production. Therefore an option pricing model can be a realistic way to guide a prospective acquirer or valuation expert to the appropriate segment of market pricing for undeveloped acreage. This is especially true at the bottom of the historic pricing range occurring for the natural gas commodity currently. This technique is not a new concept as several papers have been written on this premise. Articles on this subject were written as far back as 1988 or perhaps further, and some have been presented at international seminars.The PUD and unproved valuation model is typically seen as an adaptation of the Black Scholes option model. It is most accurate and useful when the owners of the PUDs have the opportunity, but not the requirement, to drill the PUD and unproven wells and the time periods are long, (i.e. five to 10 years). The value of the PUDs thus includes both a DCF value, if applicable, plus the optionality of the upside driven by potentially higher future commodity prices and other factors. The comparative inputs, viewed as a real option, are shown in the table below. When these inputs are used in an option pricing model the resulting value of the PUDs reflects the unpredictable nature of the oil and gas market. This application of option modeling becomes most relevant near the bottom of historic cycles for a commodity. In a high oil price environment, adding this consideration to a DCF will have little impact as development is scheduled for the near future and the chances for future fluctuations have little impact on the timing of cash flows. At low points, on the other hand, PUDs and unproved reserves may not generate positive returns and thus will not be exploited immediately. If the right to drill can be postponed for an extended period of time, (i.e. five to ten years), those reserves still have value based on the likelihood they will become positive investments when the market shifts at some point in the future. In the language of options, the time value of the currently out-of-the-money drilling opportunities can have significant worth. This worth is not strictly theoretical either, or only applicable to reorganization negotiations. Market transactions with little or no proven producing reserves have demonstrated significant value attributable to non-producing reserves, demonstrating the recognition by some buyers of this optionality upside. All that said, there are some challenges and dangers in applying the options model to reserves such as observable markets, risk quantification, assumption sensitivity, service and drilling availability, and time to expiration to name several. Utilization of the modified option theory is not in the conventional vocabulary of many oil patch dealmakers, but the concept is considered among E&P executives as well during transactions in non-distressed markets. If the right to drill can be postponed for an extended period of time, (i.e. five to ten years), the time value of the out-of-the-money drilling opportunities can have significant worth in the marketplace. Careful application is important, but given today’s conditions, the benefit can outweigh the challenges.

Outlook for Alternative Asset Managers During COVID-19

Despite the global pandemic, the long-term outlook for most alternative asset managers appears healthy due to strong investor interest and emerging opportunities caused by market dislocation. Demand for alt assets has benefited from increases in alt asset allocations among institutional investors, and this long-term trend appears poised to continue, pandemic or not. If anything, the current environment has highlighted the benefits of diversification that alt assets can provide. According to an April 2020 survey of institutional investors by Preqin, 63% of respondents indicated that COVID-19 would have no effect on their long-term alternative investment strategy, while 29% indicated that their long-term allocation to alternative investments would increase as a result of COVID-19.The current environment has highlighted the benefits of diversification that alt assets can provide.In the near-term, however, alt managers are likely to feel the effects of declining asset values. While public equity markets recovered significantly in the second quarter, the recovery was led by a handful of large-cap tech stocks while small-caps lagged behind significantly. For PE firms, this means that most portfolio company valuations are likely down (and performance fees are jeopardized), but it also represents an opportunity to deploy capital at attractive valuations.Furthermore, while long-term investing strategies may be unchanged, capital commitments for the remainder of 2020 are likely to decline. According to the Preqin survey, only 9% indicated that COVID-19 has increased their planned commitments to alternatives in 2020, while 58% indicated that their planned commitments have decreased (33% indicated no change).Of those commitments that are being made, they are likely to be concentrated in asset classes that are poised to benefit from the current environment. The brunt of the economic fallout from COVID-19 has been borne by a handful of industries, and given the severe short-term impact (and possible longer-term impact) that COVID has had on sectors like hospitality, energy, travel, retail, and restaurants, many investors are exercising caution and reducing exposure to these sectors, at least until there is more clarity about the timeline of the pandemic and the potential long-run consequences. According to the Preqin survey, 34% of investors plan to avoid retail-focused real estate in 2020, while 28% plan to avoid conventional energy-focused natural resources, and 26% plan to avoid retail-focused private equity.On the other hand, certain alt asset categories like distressed debt and tech-focused venture capital are poised to see increased investor interest. Distressed debt funds are raising record amounts of capital in anticipation of a rising number of investment opportunities. According to the Preqin survey, investors are planning to increase allocations to healthcare-focused private equity, distressed debt, logistics, software-focused venture capital, and defensive hedge funds.When it comes to maintaining existing assets, alt managers are often better positioned during a market downturn than traditional asset managers.When it comes to maintaining existing assets, alt managers are often better positioned during a market downturn than their traditional asset management counterparts. The investor base for alt managers tends to be largely institutional investors with long time horizons and perhaps less propensity to knee jerk reactions than retail investors. Also, since alt assets tend to be held in illiquid investment vehicles, investors are locked up for years at a time and can’t withdraw funds as easily as if the assets were in a mutual fund or an ETF.While sticky assets can provide cushion for alt managers in a downturn, the longer-term performance of these managers depends on their ability to raise new funds and put that money to work. Raising institutional capital is often a long and involved process in the best of circumstances. For many managers, the economic interruption of a global shutdown has presented challenges to a fundraising process that often involves extensive in-person due diligence (35% of respondents in the Preqin survey indicated that face-t0-face meetings are essential for decision making). And if new funds are raised, there is the question of whether or not managers can put that money to work. M&A transaction activity has declined significantly over the last several months, leaving deal teams at many PE firms on the sidelines. It is likely that there will be a huge backlog of transaction activity that will materialize at some point in the coming months/years, but the timeline is uncertain.Public alt managers were particularly affected during the selloff in March, reflecting the decline in portfolio asset values and expectations for realizing performance fees. Measured from February 19, 2020—the day the S&P 500 peaked—our index of alt managers declined nearly 45% by late March. Since then, an outsized recovery has left the index down just 8.0% from the market peak. Of the nine alt asset managers in the index, six were down over the period while three saw price increases, which reflects the varied outlook for the sector depending on asset class focus, among other things.The big winners in the sector were Apollo Global Management (APO) which was up 6.5% between the S&P 500 peak on February 19 and July 31 and KKR & Co. (KKR) which was up 4.8% over the same time period. APO saw credit AUM increase 43% over the second quarter, positioning the company to deploy capital as a robust pipeline of private credit opportunities emerges in the wake of COVID. Additionally, Apollo’s recent focus on responsible investing likely contributed to its superior performance as ESG funds outperformed traditional funds in the wake of COVID. KKR has also been successful at fundraising, adding $10 billion in capital commitments to its already substantial dry powder across its private equity and credit business during March and April. Those firms with large exposures to affected industries typically saw negative performance over the period. One of the worst-performing companies in the index was Cohen & Steers (CNS), which was down 22% between February 19 and July 31, reflecting its vulnerability due to its asset class focus (real estate) and predominately retail client base.The observations about the divergence of performance among the public alt managers are likely to apply to privately held alt managers as well. In the near term, those managers with large exposures to highly affected industries, or those that have seen large asset outflows, are likely to see their valuations decline. Those managers with less exposure to highly affected industries and those whose strategies and fundraising are poised to benefit from the current environment are likely to see valuations increase. Over the longer-term, we expect to see alt asset allocations accelerate in the aftermath of COVID-19 as investors seek diversification before the next downturn, which should be a boon for most alt asset managers—particularly those who deliver outsized performance in the current environment.

Electric-Vehicle Industry Is Heating Up

Policy and Oil Price Implications for EV Sales

I remember watching the movie Cars when it first came out in 2006. I was seven years old and can easily recall the infamous line Lightning McQueen would say before a race, “I am speed.” His determination on the racetrack was unrivaled as he went on to win many races and championships. However, Lightning’s winning tradition came to a halt in the third movie. He had lost his competitive edge as cars with new technology began to dominate the racetrack.Unlike Cars, however, the current focus for new auto technologies is less focused on speed, and more on sustainability, as there appears to be a shift in focus away from developing the century-old gasoline-powered vehicle to electric. The electric-vehicle (EV) industry has shown to be an attractive long-term alternative for manufacturers. In this post, we’ll survey the landscape including the beginnings of EVs, major players in the industry, and the future outlook.Origins of the Electric-Vehicle IndustryThe first electric-vehicle in the U.S. was introduced in 1890 with a top speed of 14 miles per hour. According to the American Census, by 1900, 28% of all cars produced in the U.S. were electric. However, Henry Ford’s mass production of gasoline-powered vehicles reduced the cost of this vehicle significantly. In 1912, a gas-powered car averaged $650 while an EV averaged $1,750, and as a result of this price disparity, EV’s lost a great degree of popularity.Fast forward nearly 100 years, and EV’s continue to trail their counterparts. For example, GM’s EV1 was produced in 1996 and contained 137 horsepower with a 0-60 mph acceleration time of about nine seconds. Moreover, charge time and range proved problematic with a 15-hour charge time and only a 90-mile maximum cruising range not drawing much consumer demand. As a result, this model was discontinued only after a couple of years of production. Charge time and range problems continued to plague the industry as manufacturers struggled to compete with traditional vehicles. However, in 2008, the EV industry revealed a glimpse of hope when Tesla Inc. released the all-electric Roadster. This vehicle had a range of almost 250 miles on a single battery with a 0-60 mph acceleration time of four seconds. These metrics were unrivaled in the EV industry, and Tesla ascended quickly as competitors could not compete with this level of technology in their batteries.Tesla’s Emergence as Market LeaderWhile Tesla dominates the industry, CEO Elon Musk revealed his intentions of offering a helping hand to its competitors. He recently tweeted the following: “Tesla is open to licensing software and supplying powertrains & batteries. We’re just trying to accelerate sustainable energy, not crush competitors!” Major automotive manufacturers have recognized Tesla’s dominance in the industry. Volkswagen (VW) CEO, Herbert Diess, reflects on Tesla’s technological achievements: “What worries me the most is the capabilities in the assistance systems. 500,000 Teslas function as a neural network that continuously collects data and provides the customer a new driving experience every 14 days with improved properties. No other automobile manufacturer can do that today.” Furthermore, Audi CEO, Markus Duesemann, recognizes the magnitude of Tesla’s accomplishments: “Currently, Tesla has larger batteries because their cars are built around the batteries. Tesla is two years ahead in terms of computing and software architecture, and in autonomous driving as well.” Tesla’s dominance in the EV industry is reciprocated by investor enthusiasm, though as we’ve noted, plenty of other factors are at play.Tesla continued to be the market leader in 2019 with its Model 3 alone accounting for 14% of total global EV sales.As Tesla continues to expand its EV line and invest in new technologies such as autonomous vehicles, other automotive manufacturers have set their sights on expansion of their electric vehicle fleet to try and keep up. GM Chief Executive, Mary Barra is optimistic regarding the trajectory of GM’s influence in the EV industry. She states, “We believe in an all-electric future, and we’re moving aggressively to have vehicles that people want.” GM revealed plans to expand its EV fleet through 2023 with 20 new vehicles including a $20 billion investment towards electric and autonomous technologies. Similarly, Ford plans to invest over $11.5 billion through 2022 and plans to use aspects of its E-Mustang in future EV’s.While other companies are investing in this space, Tesla continued to be the market leader in 2019 with its Model 3 alone accounting for 14% of total global EV sales. Other global models with a presence in U.S. markets that finished strong in sales for the year included the Nissan Leaf (#3), BMW 530e/LE (#6), Mitsubishi Outlander PHEV (#7), Hyundai Kona EV (#9), and the BMW i3 (#10). To put things in perspective, the combined sales of these other models still fell short of Tesla’s sales for its Model 3 alone.The Road to EV Success Paved by Government SubsidiesConsumers and manufacturers are increasingly showing interest in electric vehicles for their ability to reduce one’s carbon footprint. However, costs and infrastructure are proving to be difficult hurdles for them to catch up to petrol or diesel alternatives. The battery costs of an electric vehicle are showing to be the most acute, taking up 30% of the total costs of an EV. To help automakers past this hurdle, the government has provided subsidies to encourage electric vehicle sales. Each automaker is eligible for $7,500 in credits for each electric vehicle sold, up to $200,000 sales. Credit gets halved to $3,750 for six months after hitting that target, and then halved again to $1,875 for another six months. After that, the credit goes to zero. From 2014-2018, U.S. buyers claimed credits for 239,422 vehicles, worth $1.4 billion. So far, Tesla and GM have been the only manufacturers to hit the thresholds. Still, there have been proponents of the government extending incentives or increasing them to further support electric vehicle sales. With just over 2% of American vehicles sold last year being electric, losing federal tax credits could make the expansion of electric vehicles more troublesome.Costs and infrastructure are proving to be difficult hurdles to catch up to petrol or diesel alternatives.Beyond cost, electric vehicle manufacturers must improve poor supporting infrastructure. In March 2020, the U.S. had approximately 78,500 charging outlets and almost 25,000 stations for plug-in electric vehicles. While this number has been increasing over the years, it still pales in comparison to the approximately 115,000 gas stations in the U.S (which has sharply declined from much higher levels). Furthermore, a large portion of the total charging stations are in California.While daily commutes can be supported by overnight charging, consumers need to be confident that they can go on road trips and reliably find a charging station for EV’s to really take off. Electric vehicles have historically had an inferior range to their gas-powered counterparts. While the gap has narrowed over time, miles covered on one tank isn’t the only hurdle. Gassing up your car takes a fraction of the time required to fully recharge EVs, lengthening consumers’ ETA. California currently has 25% of charging stations and 35% of charging outlets. For EVs to become mainstream, access will have to be increased. So far, the government has been willing to subsidize purchases and incentivize production. There are also federal grants for cities and states looking to invest in the necessary charging infrastructure, but it will be interesting to see who foots most of the bill if EVs achieve the scale desired. More accessibility to charging stations should improve consumers’ interest in electric vehicles, though it won’t fully solve the problems of longer road trips.State and federal governments aren’t just using subsidies to power this shift, as there have been more regulations and requirements for more fuel-efficient vehicles. For example, the National Highway Traffic Safety Administration (NHTSA) and the Environmental Protection Agency (EPA) passed The Safer Affordable Fuel-Efficient Vehicles Rule (SAFE) which went into effect in March of this year. This rule tightens the fuel economy and carbon dioxide standards progressively by 1.5% each year from 2021 to 2026. Passenger cars and light trucks are subjected to this rule. This rule could undoubtedly act as a catalyst for manufacturers shifting additional focus towards EV production.Further, the Zero Emissions Vehicle (ZEV) program mandates a certain proportion of EV sales to non-electric sales in California and ten other states. Under this rule, plug-in hybrids, battery EV’s, and hydrogen fuel cell vehicles qualify as a ZEV. The 2020 ZEV production requirement is 9.5%, but it will rise to 22% by 2025.Tesla continues to capitalize on the benefits of producing strictly EV’s, as their 10-Q report indicated massive profits from the sales of regulatory credits totaling to $428 million in Q2 (about 7% of revenue). In order to dodge emission fines, other automotive manufacturers will purchase credits to make up for their own deficits in EV sales. For example, last year, Fiat Chrysler Automobiles (FCA) closed a deal with Tesla for about $1.3B in credits to stay in compliance with heightened European environmental regulations taking effect in 2021. Oil Price OutlookIn the past, high oil prices have increased the incentive to shift to electric. However, the pandemic’s disruption to global supply and demand of oil has significantly decreased the urgency in the near term. According to the U.S. Energy Information Administration (EIA), in March and April, consumption fell significantly for liquid fuels largely due to travel declines from stay-at-home orders. During this period, the consumption levels matched those of the early 1980s, hovering at an average of 14.7 mb/d (million barrels per day). As states reopened following the lockdown, liquid fuel consumption levels began to recover. However, amid coronavirus infections surging, another dip in liquid fuel consumption levels may be on the horizon. While low oil prices are the current reality, the ultimate resurgence of travel post-COVID-19 is expected to bring back higher oil prices. Volkswagen’s chief strategist, Michael Jost, does not view this year’s slump in oil prices as a barricade to the company’s transition for expanding its EV fleet. Jost does not see oil getting any cheaper in the long run, as he states, “We have a clear commitment to become C02 neutral by 2050, and there is no alternative to our electric-car strategy to achieve this.” While oil prices are expected to rebound, the International Energy Agency (IEA) projects a decline in North American oil demand through 2040, which is contingent upon the implementation of policy initiatives to curb greenhouse gas emissions. While the Stated Policies Scenario suggests only a fall in demand of 4 mb/d, the IEA projects a decline of 11 mb/d under the Sustainable Development Scenario, which the IEA views as a feasible solution for mitigating the potential impacts of air pollution and climate change. EVs through the Eyes of the ConsumerClearly, governments have both rewarded early adopters and outlined penalties for manufacturers that don’t increase compliance in the future. However, EVs still make up a relatively small size of the overall car market. Despite the aforementioned subsidies, the price mark-up of these vehicles to its gasoline counterparts continues to be a concern. For example, in June 2019, the average retail selling price of new cars was about $36,600 compared to $55,600 for EV’s. This is one of the big reasons why consumers are hesitant to purchase an EV. Subaru of America CEO, Tom Doll reflects on the public’s unwillingness to accept EV’s, as “people don’t seem to accept the (EV) price up. They sit at their kitchen table and consider their budget. They’re doing the price up for an EV and most say, ‘It’s just not worth it at this point, with gas prices being so low.” Still, Subaru is expected to roll out their first EV model in 2021.If upfront costs are comparable, lower expenses over the life of the car may make EVs more worthwhile despite road trip drawbacks.Rising fuel prices may renew interest in EVs, but upfront costs will likely be more important. Lithium-ion battery prices have decreased significantly since 2010, and it is believed that low battery prices will outweigh the benefits of low oil prices, thus propelling EV sales. Tesla’s move to develop a new cobalt-free battery could be a game-changer in decreasing over EV prices. The 30% reduction in wholesale battery prices expected in 2023/4 could mean a drop of 10% in car prices. As noted above, EV’s on average were about $19k pricier but had opposite trajectories. Where ASP’s increased about 2% annually, EV’s declined 13.5%. If upfront costs are comparable, lower expenses over the life of the car may make EVs more worthwhile despite road trip drawbacks.Concluding ThoughtsIt is safe to say that Lightning McQueen would be no match against Ford Motor Company’s new Mustang Mach-E 1400. It is expected to debut on the NASCAR track soon. As described by Mark Rushbrook, motorsports director of Ford Performance, the all-electric Mustang is “an all-around athlete” with an impressive 1400 horsepower.Technological innovation plays a vital role in the future of EV’s, as we have seen Tesla emerge as the industry leader through its technological advancements in software and battery capabilities. The future of the EV industry seems bright in the long-run as falling battery prices paired with heightened emission standards serve as pillars for sustaining the expansion of this sub-industry, even if consumers are less motivated to make the switch. However, manufacturers with significantly more scale than Tesla shouldn’t be too far behind and may ultimately eclipse them. The main concern for auto dealers lies in whether their manufacturer can develop models that are desirable to consumers and meet emissions regulations. Whether or not there is a meaningful shift towards EVs over the coming years, dealers will likely continue to adapt to consumer preferences as they always have.Our thanks to our summer analyst, Will Pesto, who drafted this post in collaboration with our Auto Dealer Group.

Stress Testing and Capital Planning for Banks and Credit Unions During the COVID-19 Pandemic

A stress test is defined as a risk management tool that consists of estimating the bank’s financial position over a time horizon – approximately two years – under different scenarios (typically a baseline, adverse, and severe scenario).The concept of stress testing for banks and credit unions is akin to the human experience of going in for a check up and running on a treadmill so your cardiologist can measure how your heart performs under stress. Similar to stress tests performed by doctors, stress tests for financial institutions can ultimately improve the health of the bank or credit union (“CU”). The benefits of stress testing for financial institutions include: Enhancing strategic/capital planningImproving risk managementEnhancing the value and earning power of the bank or credit unionAs many public companies in other industries have pulled earnings guidance due to the uncertainty surrounding the economic outlook amid the coronavirus pandemic, community banks and CUs do not have that luxury.Key stakeholders, boards, and regulators will desire a better understanding of the ability of the bank or CU to withstand the severe economic shock of the pandemic. Fortunately, stress testing has been a part of the banking lexicon since the last global financial crisis began in 2008. We can leverage many lessons learned from the last decade or so of this annual exercise.Conducting a Stress Test It can be easy to get overwhelmed when faced with scenario and capital planning amidst the backdrop of a global pandemic with a virus whose path and duration is ultimately uncertain.However, it is important to stay grounded in established stress testing steps and techniques. Below we discuss the four primary steps that we take to help clients conduct a stress test in light of the current economic environment.Step 1: Determine the Economic Scenarios to ConsiderIt is important to determine the appropriate stress event to consider.Unfortunately, the Federal Reserve’s original 2020 scenarios published in 1Q2020 seem less relevant today since they forecast peak unemployment at 10%, versus the recent peak national unemployment rate of 14.7% (April 2020).However, the Federal Reserve supplemented the original scenario with a sensitivity analysis for the 2020 stress testing round related to coronavirus scenarios in late 2Q20, which provides helpful insights. The Federal Reserve’s sensitivity analysis had three alternative downside scenarios: A rapid V-shaped recovery that regains much of the output and employment lost by year-end 2020A slower, more U-shaped recovery in which only a small share of lost output and employment is regained in 2020A W-shaped double dip recession with a short-lived recovery followed by a severe drop in late 2020 due to a second wave of COVIDSome of the key macroeconomic variables in these scenarios are found in Table 1.In our view, these scenarios provide community banks and credit unions with economic scenarios from which to begin a sound stress testing and capital planning framework.Step 2: Segment the Loan Portfolio and Estimate Loan Portfolio Stress LossesWhile determining potential loan losses due to the uncertainty from a pandemic can be particularly daunting, we can take clues from the Federal Reserve’s release of results in late 2Q20 from some of the largest banks.While the specific loss rates for specific banks weren’t disclosed, the Fed’s U, V, and W sensitivity analysis noted that aggregate loss rates were higher than both the Global Financial Crisis (“GFC”) and the Supervisory Capital Assessment Program (“SCAP”) assumptions from the prior downturn. We note that many community banks and CUs may feel that their portfolios in aggregate will weather the COVID storm better than their larger counterparts (data provided in Table 2).We have previously notedthat community bank loan portfolios are more diverse now than during the prior downturn and cumulative charge-offs were lower for community banks as a whole than the larger banks during the GFC.For example, cumulative charge-offs for community banks over a longer distressed time period during the GFC (four years, or sixteen quarters, from June 2008 - June 2012) were 5.1%, implying an annual charge-off rate during a stressed period of 1.28% (which is ~42% of what larger banks experienced during the GFC).However, we also note that this community bank loss history is likely understated by the survivorship bias arising from community banks that failed during the GFC.Each community bank or CU’s loan portfolio is unique, and it will be important for community banks and CUs to document the composition of their portfolio and segment the portfolio appropriately. Segmentation of the loan portfolio will be particularly important.The Fed noted that certain sectors will behave differently during the COVID downturn. The leisure, hospitality, tourism, retail, and food sectors are likely to have higher credit risk during the pandemic. Proper loan segmentation should include segmentation for higher risk industry sectors during the current pandemic as well as COVID-modified/restructured loans.Once the portfolio is segmented, loss history over an extended period and a full business cycle (likely 10-12 years of history) will be important to assess. While the current pandemic is a different event, this historical loss experience can be leveraged to provide insights into future prospects and underwriting strength during a downturn and relative to peer loss experience. In certain situations, it may also be relevant to consider the correlation between those historical losses and certain economic factors such as the unemployment rate in the institution’s market areas. For example, a regression analysis can determine which variables were most significant statistically in driving historical losses during prior downturns and help determine which variables may be most relevant in the current pandemic. For those variables deemed statistically significant, the regression analysis can also provide a forecasting tool to estimate and/or test the reasonableness of future loss rates based on assumed changes in those variables that may be above and beyond historical experience. Lastly, higher risk loan portfolio segments (such as those in more economically exposed sectors) and larger loans that were modified during the pandemic may need to be supplemented by some “bottom-up” analysis of certain loans to determine how these credits may fare in the different economic scenarios previously described.To the extent losses can be modeled for each individual loan, these losses can be used to estimate losses for those particular loans and also leveraged to support assumptions for other loan portfolio segments.Step 3: Estimate the Impact of Stress on EarningsStep 3 expands the focus beyond just the loan portfolio and potential credit losses from the pandemic modeled in Step 2 and focuses on the institution’s “core” earning power and sensitivity of that over the economic scenarios modeled in Step 1. When assessing “core” earning power, it is important to consider the potential impact of the economic scenarios on the interest rate outlook and net interest margins (“NIM”). While the outlook is uncertain, Federal Reserve rate cuts have already started to crimp margins. Beyond the headwinds brought about by the pandemic, it is also important to consider any potential tailwinds in certain countercyclical areas like mortgage banking, PPP loan income, and/or efficiency brought about by greater adoption of digital technology and cost savings from branch closures.Ultimately, the earnings model over the stressed period relies on key assumptions that need to be researched, explained, and supported related to NIM, earning assets, non-interest income, expenses/efficiency, and provision expense in light of the credit losses modeled in Step 2.Step 4: Estimate the Impact of Stress on CapitalStep 4 combines all the work done in Steps 1, 2, and 3 and ultimately models capital levels and ratios over the entirety of the forecast periods (which is normally nine quarters) in the different economic scenarios. Capital at the end of the forecast period is ultimately a function of capital and reserve levels immediately prior to the stressed period plus earnings or losses generated over the stressed period (inclusive of credit losses and provisions estimated).When assessing capital ratios during the pandemic period, it is important to also consider the impact of any strategic decisions that may help to alleviate stress on capital during this period, such as raising sub-debt, eliminating distributions or share repurchases, and slowing balance sheet growth.For perspective, the results released from the Federal Reserve suggested that under the V, U, and W shaped alternative downside scenarios, the aggregate CET1 capital ratios were 9.5%, 8.1%, and 7.7%, respectively.What Should Your Bank or Credit Union Do with the Results?What your bank or credit union should do with the results depends on the institution’s specific situation.For example, assume that your stress test reveals a lower exposure to certain economically exposed sectors during the pandemic and some countercyclical strengths such as mortgage banking/asset management/ PPP revenues.This helps your bank or CU maintain relatively strong and healthy performance over the stressed period in terms of capital, asset quality, and earnings performance. This performance could allow for and support a strategic/capital plan involving the continuation of dividends and/or share repurchases, accessing capital and/or sub-debt for growth opportunities, and proactively looking at ways to grow market share both organically and through potential acquisitions during and after the pandemic-induced downturn.For those banks and CUs that include M&A in the strategic/capital plan over the next two years, improved stress testing capabilities at your institution should assist with stress testing the target’s loan portfolio during the due diligence process. Alternatively, consider a bank that is in a relatively weaker position.In this case, the results may provide key insight that leads to quantifying the potential capital shortfall, if any, relative to either regulatory minimums or internal targets.After estimating the shortfall, management can develop an action plan, which could entail seeking additional common equity,accessing sub-debt, selling branches or higher-risk loan portfolios to shrink the balance sheet, or considering potential merger partners.Integrating the stress test results with identifiable action plans to remediate any capital shortfall can demonstrate that the bank’s existing capital, including any capital enhancement actions taken, is adequate in stressed economic scenarios. How Mercer Capital Can Help A well-reasoned and documented stress test can provide regulators, directors, and management the comfort of knowing that capital levels are adequate, at a minimum, to withstand the pandemic and maintain the dividend.A stress test can also support other strategies to enhance shareholder value, such as a share buyback plan, higher dividends, a strategic acquisition, or other actions to take advantage of the disruption caused by the pandemic.The results of the stress test should also enhance your bank or credit union’s decision-making process and be incorporated into strategic planning and the management of credit risk, interest rate risk, and capital.Having successfully completed thousands of engagements for financial institutions over the last 35 years, Mercer Capital has the experience to solve complex financial issues impacting community banks and credit unions during the ups and downs of economic cycles. Mercer Capital can help scale and improve your institution’s stress testing in a variety of ways. We can provide advice and support for assumptions within your bank or credit union’s pre-existing stress test. We can also develop a unique, custom stress test that incorporates your institution’s desired level of complexity and adequately captures the unique risks you face. Regardless of the approach, the desired outcome is a stress test and capital plan that can be used by managers, directors, and regulators to monitor capital adequacy, manage risk, enhance the bank’s performance, and improve strategic decisions. For more information on Mercer Capital’s Stress Testing and Capital Planning solutions, contact Jay Wilson at wilsonj@mercercapital.com. Originally appeared in Mercer Capital's Bank Watch, July 2020.

Independent RIAs Drive M&A During Downturn

RIA M&A Amid COVID-19 (Part II)

The outlook for RIA M&A at the end of the first quarter was murky. While we did not expect deals already in motion to be canceled, we did expect deal activity to temporarily slow. We theorized that this slowdown could actually benefit the industry if RIA principals used the downtime to think about succession planning. DeVoe & Company summarized similar expectations for RIA M&A in a "Four-Phase Outlook for M&A Post COVID-19" published in its Q1 RIA Deal Book: Live transactions get completed.A lull in activity as owners respond to the COVID-19 pandemic rather than seek out new dealsA surge in activity caused by delayed deals coming to the marketReturn to normalcy where the trends of increased M&A continue with an aging ownership base and a need for succession planning So, were these expectations on track?Review of M&A in Q2 2020As anticipated, previously announced deals in the final stages of negotiations did close but new deal activity slowed some in the second quarter. According to Fidelity’s Wealth Management M&A Report, M&A activity in January and February kept pace with 2019 levels but fell off in March, April, and May. There were 24 transactions involving RIAs with over $100 million but less than $20 billion in AUM announced in Q2 2020 (and many of these deals were announced in June 2020). Still, this represents a decline in M&A activity compared with last year, as shown in the chart below.[caption id="attachment_32836" align="aligncenter" width="675"]Source: Fidelity Wealth Management M&A Transaction Report; Complied by Mercer Capital[/caption] Interestingly, in the second quarter of 2020, independent RIAs, rather than consolidators, drove much of the deal activity. Over the last few years, we have written about RIA consolidators time after time: Acquisition activity in the sector has been led primarily by RIA consolidators, with Focus Financial Partners, Mercer Advisors (no relation), and United Capital Financial Advisers each acquiring multiple RIAs during 2017 (January 2018)Several trends which have driven the uptick in sector M&A in recent years continued into 2018, including increasing activity by RIA aggregators (January 2019)RIA consolidators now account for about half of wealth management acquisition activity—and that percentage has been increasing (January 2020) In the second quarter, two independent RIAs—The Mather Group (TMG) and Creative Planning—accounted for approximately 21% of the total transactions announced, while consolidators accounted for only 17% of the deals. The Mather Group (an independent wealth management firm with seven offices around the U.S.) announced its sixth acquisition in the last 18 months on June 16, 2020, only one week after announcing a previous acquisition. The acquisition of Knoxville-based Resource Advisory Services, with $116 million in AUM, will bring TMG’s AUM to over $3.9 billion. TMG’s acquisition of Resource Advisory Services is indicative of a few M&A trends. First, in a relationship-driven business such as wealth management, the fastest way to expand a firm’s footprint is often through acquisitions. TMG has been working to expand its footprint into the Southeast and this acquisition is a sensible addition to their recent acquisition of Atlanta-based Barnett Financial. Additionally, this acquisition highlights a struggle many RIA owners face: a need for scale but a hesitation to partner with PE-backed firms who have a reputation for pushing growth at all costs. Many RIA principals need a succession plan, and private equity capital isn’t always the right answer. Resource Advisory Services’ founder David Lewis said, “I’m thrilled to partner with a next-generation founder who isn’t private-equity backed, and feel very confident TMG’s long-term vision will support my advisors into the future.” Creative Planning, based in Overland Park, Kansas, is one of the nation’s largest independent RIAs, announced three deals in the second quarter. Its most recent acquisition of Starfire Investment Advisers ($560 million AUM) was Creative Planning’s eighth deal in 2020 and its twelfth deal since it started on its acquisition spree last year. Creative Planning organically grew its AUM to $48 billion and since February 2019, has added another $5 billion in AUM through acquisitions. We expect to see more acquisitions from Creative Planning as it strives to reach $100 billion in AUM and become more of a household name. While Creative Planning is a driver in the trend of consolidation, it differentiates itself from traditional RIA consolidators by acquiring 100% of target companies and integrating them into the Creative Planning brand and investment philosophy. Additionally, while it is PE-backed, NY based General Atlantic holds a non-controlling minority share. Creative Planning’s M&A activity and investment from General Atlantic makes us ask: When does an RIA shift from being an independent wealth manager to an acquirer of independent wealth managers? Mercer Advisors (no relation) seemed to make this transition when it first started buying RIAs in 2016. Since then, it has acquired around 30 advisory firms and has financed its acquisition activity by selling a sizeable stake in the company to PE firm Oak Hill Capital Partners while maintaining an investment from Genstar Capital. The line between independent wealth manager and consolidator can be murky, but the trend this quarter was clear. Established consolidators, who primarily rely on debt financing or capital from PE firms, slowed acquisition activity in the second quarter. Dynasty Financial announced two deals in Q2, Focus Financial and Mercer Advisors each announced one deal, and Wealth Enhancement Group and HighTower Advisors did not report any deal activity in the second quarter – while strategic acquisitions by independent RIAs continued. RIA consolidators who use leverage to buy RIAs were much more vulnerable to the decline in the market at the end of March. Most RIA consolidators have never been through a market downturn and their balance sheets may have not been as well-capitalized as needed to handle what many expected to be a few bad quarters and potentially years. With leverage on the balance sheet, interest coverage ratios became a concern for consolidators and the downturn in March likely served as a warning for aggregators to reevaluate their balance sheets. Most independent RIAs, on the other hand, have lived through market downturns previously and had capital built up to slug through a few bad quarters. Some even had the capital to acquire firms when competition from other buyers temporarily eased.Outlook for RIA M&AWhile RIA M&A did slow some in Q2, we don’t expect that this slowdown will continue as M&A activity picked up in June. We have been contacted by several RIA principals who are using this time to reconsider their buy-sell agreements and their plans for their firms. These conversations often prompt strategic discussions which can pique some firms’ interest in making acquisitions, can guide others down a path of internal succession planning as they prepare for retirement, and can serve as a wakeup call to others who are tired of dealing with the volatility inherent in many RIA practices. We also hope that the recent downturn and lack of activity from RIA consolidators will lead buyers to proceed with more caution when partnering with leveraged consolidators. Amid a market downturn, when RIA principals should be focused on servicing client assets, the charge to save margin to meet interest coverage ratios will trickle down to the principal of those RIAs.

Fiat Chrysler & Peugeot (PSA) Merge into “Stellantis”

Analyzing the Timeline and Twists and Turns of a Transatlantic Merger During a Pandemic

Last week, we analyzed Asbury Automotive Group’s acquisition of Park Place, a deal scuttled by COVID-19 that came back to life under revised terms. This week, we are moving upstream to look at the merger between Fiat Chrysler (FCA) and Group PSA (manufacturer of Peugeot and Citroen) and observe the new name of the entity, the merits and hurdles of the ongoing deal, and some potential impacts on auto dealers.What’s in a Name?A fresh start with a new name feels reasonable.On July 15th, the name Stellantis was announced, which drew jokes from various people within the industry. The press release indicated the name comes from the Latin verb “stello," meaning to "brighten with stars.” The name will be used exclusively at the Group level, as a corporate brand, with the names and the logos of its constituent brands remaining unchanged. While the change drew some attention, we think it’s largely much ado about nothing. Sure, the press release was filled with a litany of corporate platitudes about how the name “draws inspiration from this new and ambitious alignment of storied automotive brands and strong company cultures …” but overall we think it might be more of a practical choice considering FCA-PSA doesn’t really roll off the tongue. Also considering its 18 brands on a combined basis, the sheer size of the transaction, and many previous corporate name changes, a fresh start with a new name feels reasonable.While Stellantis won’t appear on any of the cars, it’s not the only industry participant to not have one of its brands in the corporate name. GM and Daimler are the other exceptions in the industry whose names go back a lot longer. Every manufacturer besides Tesla makes cars under a brand other than the corporate name (Toyota makes Lexus, Volkswagen makes Audis, etc.).The company includes manufacturers in Detroit, Paris, Turin, Charlton, Russelsheim, and more. A full list of these brands are included in the graphic below.[caption id="attachment_32791" align="aligncenter" width="642"]*Parts manufacturer[/caption] Merits of the DealHaving exhausted the new name, let’s look at the deal. The deal was announced in October 2019, and in December, Group PSA and FCA released a joint press release highlighting:Benefits of scale in developing more sustainable, tech-savvy (including autonomous) modelsCombined company to be 4th largest global OEM by volume (8.7 million units in 2018) and 3rd largest by revenue (170 billion euros in 2018)Diversification across markets in Europe, North America, and Latin AmericaAnnual run-rate synergies of 3.7 billion euros with no plant closures50/50 merger expected to lead to investment-grade credit rating with high level of liquidity The company indicated 40% of its synergies would come from its combined technology, product, and platform. Stellantis expects another 40% of its synergies to come from sourcing its suppliers at a discounted price due to its bargaining power, or as the company called it, “enhanc[ing] its purchasing performance.” Savings on marketing, IT, G&A, and logistics round out the last 20% of anticipated savings. Mergers frequently try to cut duplicative costs and add to pricing power, both from suppliers and customers. However, since the combining legacy companies largely operate on different continents, minimal enhancements to market share are unlikely to drive higher selling prices to dealers and consumers. This could help enhance blue sky values for FCA dealers, which have lagged other brands. Enhancements to technology and tweaks to its platform could also help improve the brands’ SSI ratings, which were generally below their respective averages in 2019.Pandemic Impact on the Deal Regulatory HurdlesThe initial press release indicated the deal was expected to take 12-15 months subject to “customary closing conditions, […] and satisfaction of anti-trust and other regulatory requirements.” While the COVID-19 pandemic was certainly not anticipated, the reasons for the deal are “stronger than ever,” according to FCA Chairman John Elkann. Last month, PSA CEO Carlos Tavares also expressed confidence that the $50 billion merger will proceed as planned, noting “the merger with FCA is the best among the solutions to cope with the crisis and its uncertainties.”The deal structure of the Stellantis merger shields it from some inherent issues in acquisitions.While many auto dealers are seeing transactions being placed on pause, the deal structure of the Stellantis merger shields it from some inherent issues in acquisitions. During the pandemic, acquirors are looking to either use a reduced Blue Sky multiple on 2019 earnings or an old multiple on reduced 2020 earnings. This has widened the bid-ask spread, as dealers don’t want to sell at depressed values. With this stock swap merger of equals (“MoE”), each side has to provide equal value to the deal, and pandemic related concerns may cancel each other out. According to Elkann, “both parties in FCA-PSA deal are committed to get parity in the merger deal.” PSA shares are set to be exchanged at a rate of 1.742 shares of the new combined company for each share contributed by FCA. However, it is possible the pandemic has disproportionate impacts on the two companies, requiring a change in the exchange ratio based on adjustments to their relative contributions.There are other issues at play besides the exchange ratio before this deal can be finalized. Both sides have already announced they no longer intend to pay their planned ordinary dividends of 2.2 billion euros for 2019 results which was included in the initial deal. While this is sensible to preserve liquidity in this environment, ordinary dividends aren’t expected to be a sticking point. It’s FCA’s 5.5 billion euros special dividend that may cause problems. According to Tavares, the “time has not come to discuss this issue,” though it is widely speculated that it could be revised downwards in light of the downturn in the global auto industry. This may be a point of contention for FCA shareholders. Peugeot shareholders were also supposed to get PSA’s 46% interest in Faurecia SE in order to help achieve a merger of equals status. This interest was worth approximately 3 billion euros at announcement when the French auto parts company’s shares traded at 50 euros. Shares have declined to about 37 euros (as of July 27th), meaning PSA’s interest is closer to about 2.2 billion euros due to the pandemic.Regulatory HurdlesHaggling between the two companies over the appropriate compensation of this interest and the special dividend isn’t the only hang-up. FCA’s Italian unit had been in talks with Rome over a 6.3 billion euro state-backed loan from Intesa Sanpaolo (Italy’s largest retail bank) to combat the coronavirus crisis. Optically, a special dividend approaching this amount did not sit well, but the loan was ultimately approved. This was the largest crisis loan to a European carmaker. The state support should “preserve and strengthen the Italian automotive supply chain,” according to Economy Minster Roberto Gaultieri. FCA’s COO for Europe said “100% of the money this facility provides will be directed to our Italian business,” though neither side indicated whether any conditions surrounding the special dividend had been imposed.Europe is expected to be the main regulatory roadblock (or maybe more of a speed bump).While the deal has received the green light in the U.S., China, Japan, and Russia, Europe is expected to be the main regulatory roadblock, though executives have categorized it as more of a speed bump. In addition to earlier concerns in Italy about the special dividend, EU antitrust regulators began its investigation into the deal in June, citing potential to harm competition in small vans in 14 EU countries and Britain. So far, Stellantis has not offered any concessions. According to the European Commission, commercial vans are an “increasingly important market in a digital economy where private consumers rely more than ever on delivery services.” Through a joint venture, FCA and PSA already hold 34% of the van market in Europe. On July 22nd, the European Commission announced its probe had been suspended as the parties failed to provide requested information. The EU was originally supposed to offer its decision in mid-November, which has now been delayed.Will the Deal Happen?Though both sides are confident that the merger will go through as planned, there are clearly some details that will need to be tweaked throughout this process. Merger arbitrage traders usually provide a pretty good real-time view as to the likelihood of a transaction. For example, if a company is to be purchased at $50/share in cash, but shares are trading at $35, that means the market doesn’t think the deal will go through on those terms. However, the market’s view on the success of the FCA-PSA merger is nuanced. Arbitrage traders typically need to be able to short one side of the deal to execute their trade, but France has temporarily banned short-selling. Also, as an MoE, swapping stock certificates means both sides retain equity in the combined company, so share prices give different insight than an acquisition anyway. This means the share prices likely have more to do with the operating environment of the pandemic than the likelihood of the merger, though it may offer hints to what adjustments to the exchange ratio, special dividend, or Faurecia stock may be looming. Because the synergies are centered around cost-cutting measures, and regulatory hurdles don’t appear to be a deal backer, Stellantis will likely come into being if the two sides can hammer out the details.

WHITEPAPER | Valuation of Independent Trust Companies

In this whitepaper we review the history of trust companies and how consolidation in the banking industry, changing consumer preferences, and favorable trust law changes have led to the proliferation of independent trust companies. We analyze the average trust company’s income statement and industry-wide trends, such as trust companies’ relative immunity to fee pressure. We consider valuation “rules-of-thumb,” and why they often fail to address the issues specific to a given firm. Finally, we consider the various valuation methodologies, including the use of discounted cash flow models and guideline public company analysis, and how the use of multiple valuation approaches can serve to generate tests of reasonableness against which the different indications can be evaluated.

Valuation Considerations in Bankruptcy Proceedings

An Overview for Oil & Gas Companies

The outbreak of the COVID-19 pandemic in the United States has caused a severe public health crisis and an unprecedented level of economic disruption. While some economic activity is beginning to come back, predictions for longer-term negative economic impacts have also become more prevalent. The initial thoughts of a quick V-shaped economic recovery have been replaced with a more nuanced consideration of how this situation will impact businesses within different industries and geographic areas over the next several years. In some of the most hard-hit industries, we are already seeing what is expected to be a prolonged surge in corporate restructurings and bankruptcy filings.While some oil & gas industry bankruptcies have already occurred, expectations for many more to come are widely held.In the first half of 2020, the U.S. oil and gas industry suffered what was arguably its worst six-month period ever. The combined impact of the Saudi/Russian price war and the drop in energy demand due to the onslaught of the COVID-19 pandemic was unprecedented. Brent crude prices that had begun the year near $67 per barrel had dropped to $50 per barrel by early March before plummeting to $19 per barrel by the end of the quarter when the Saudi/Russia spat was in full force, but while the impact of the pandemic was still materializing. Since the start of the pandemic, liquid fuel consumption has dropped by 15% with production levels falling 10%. Drilling activity has been even harder hit with rig counts (active rotary rigs) now at a mere 30% of early first quarter levels. Despite oil prices having partially recovered, oilfield activity remains anemic with the OFS industry having shed nearly 90,000 jobs through May. While in a few areas oil and gas can be produced profitably at mid-year 2020 prices (WTI at 38.31 and Henry Hub at $1.63), most areas cannot. Thus, while some oil & gas industry bankruptcies have already occurred, expectations for many more to come are widely held.For oil & gas companies, the decision to file for bankruptcy does not necessarily signal the demise of the business. If executed properly, Chapter 11 reorganization affords a financially distressed or insolvent company an opportunity to restructure its liabilities and emerge from the proceedings as a viable going concern. Along with a bankruptcy filing (more typically before and/or in preparation for the filing), the company usually undertakes a strategic review of its operations, including opportunities to shed assets or even lines of business. During the reorganization proceeding, stakeholders, including creditors and equity holders, negotiate and litigate to establish economic interests in the emerging entity. The Chapter 11 reorganization process concludes when the bankruptcy court confirms a reorganization plan that both specifies a reorganization value and reflects the agreed upon strategic direction and capital structure of the emerging entity.In addition to fulfilling technical requirements of the bankruptcy code and providing adequate disclosure, two characteristics of a reorganization plan are germane from a valuation perspective:11. The plan should demonstrate that the economic outcomes for any consenting stakeholders are superior under Chapter 11 proceeding compared to a Chapter 7 proceeding, which provides for more direct relief through a liquidation of the business. This is generally referred to as the “best interests test.”2. The plan should demonstrate that, upon confirmation by the bankruptcy court, it will not likely result in liquidation or further reorganization of the business. This is generally referred to as the “cash flow test.”Finally, upon emerging from bankruptcy, companies are required to apply “fresh start” accounting, under which all assets of the company, including identifiable intangible assets, are recorded on the balance sheet at fair value.Best Interests TestWithin this context of a best interests test, valuation specialists can provide useful financial advice to:Establish the value of the business under a Chapter 7 liquidation premise.Measure the reorganization value of a business, which, absent liquidation, represents the economic “pie” from which stakeholder claims can be satisfied. A plan confirmed by a bankruptcy court should establish a reorganization value that exceeds the value of the company under a liquidation premise.A Floor Value: Liquidation ValueIf a company can no longer pay its debts and does not restructure, it will undergo Chapter 7 liquidation. The law generally mandates that Chapter 11 restructuring only be approved if it provides a company’s creditors with their highest level of expected repayment. The Chapter 11 restructuring plan must be in the best interest of the creditors (relative to Chapter 7 liquidation) in order for it to be approved. Given this understanding of the law, the first valuation step in successful Chapter 11 restructuring is assessing the alternative, liquidation value. This value will be a threshold that any reorganization plan must outperform in order to be accepted by the court.The value in liquidating a business is unfortunately not as simple as finding the fair market value, or even a book value for all the assets. The liquidation premise generally contemplates a sale of the company’s assets within a short period. Any valuation must account for the fact that inadequate time to place the assets in the open market means that the price obtained is usually lower than the fair market value. Everyone has seen the “inventory liquidation sale” sign or the “going out of business” sign in the shop window. Experience tells us that the underlying “marketing period” assumptions made in a liquidation analysis can have a material impact on the valuation conclusion.Liquidation value can occur under three sub-sets: assemblage of assets, orderly liquidation, and forced liquidation.From a technical perspective, liquidation value can occur under three sub-sets: assemblage of assets, orderly liquidation, and forced liquidation. As implied, these are asset-based approaches to valuation that differ in their assumptions surrounding the marketing period and manner in which the assets are disposed. There are no strict guidelines in the bankruptcy process related to these three sub-sets; bankruptcy courts generally determine the applicable premise of value on a case by case basis. The determination (and support) of the appropriate premise can be an important component of the best interests test.In general, the discount from fair market value implied by the price obtainable under a liquidation premise is related to the liquidity of an asset. Accordingly, valuation analysts often segregate the assets of the petitioner company into several categories based upon the ease of disposal. Liquidation value is estimated for each category by referencing available discount benchmarks. For example, no haircut would typically be applied to cash and equivalents, while less liquid assets (such as accounts receivable or inventory) would likely incur potentially significant discounts. For some assets categories, the appropriate level of discount can be estimated by analyzing the prices commanded in the sale of comparable assets under a similarly distressed sale scenario. Within the oil & gas industry, the operating assets come in many varieties, from oil & gas reserves, industry-specific well-site equipment and midstream assets, and less industry-specific equipment utilized by oilfield service providers.Reorganization ValueOnce an accurate liquidation value is established, the next step is determining whether the company can be reorganized in a way that provides more value to a company’s stakeholders than discounted asset sales.ASC 852 defines reorganization value as:2The value attributable to the reconstituted entity, as well as the expected net realizable value of those assets that will be disposed of before reconstitution occurs. This value is viewed as the value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after restructuring.Typically, the “value attributable to the reconstituted entity” (i.e., the new enterprise value for the restructured business) is the largest element of the total reorganization value. Unlike a liquidation, this enterprise value falls under what valuation professionals call a “going concern” value premise. This means that the business is valued based on the return that would be generated by the future operations of the emerging, restructured entity and not what one would be paid for selling individual assets. The intangible elements of going concern value result from factors such as having a trained workforce, a loyal customer base, an operational plant, and the necessary licenses, systems, and procedures in place. To measure enterprise value in this way, reorganization plans primarily use a type of income approach, the discounted cash flow (DCF) method. The DCF method estimates the net present value of future cash flows that the emerging entity is expected to generate. Implementing the discounted cash flow methodology requires three basic elements:1. Forecast of Expected Future Cash Flows. Guidance from management can be critical in developing a supportable cash flow forecast. Generally, valuation specialists develop cash flow forecasts for discrete periods that may range from three to ten years, or in the case of upstream companies, the economic life of the company’s reserves. Conceptually, one would forecast discrete cash flows for as many periods as necessary until a stabilized cash flow stream can be anticipated. Due to the opportunity to make broad strategic changes as part of the reorganization process, cash flows from the emerging entity must be projected for the period when the company expects to execute its restructuring and transition plans. Major drivers of the cash flow forecast include projected revenue, gross margins, operating costs and capital expenditure requirements. The historical experience of the petitioner company, as well as information from publicly traded companies operating in similar lines of business, can provide reference points to evaluate each element of the cash flow forecast.2. Terminal Value. The terminal value captures the value of all cash flows after the discrete forecast period. Terminal value is determined by using assumptions about long-term cash flow growth rate and the discount rate to capitalize cash flow at the end of the forecast period. This means that the model takes the cash flow value for the last discrete year, and then grows it at a constant rate for perpetuity. In some cases, the terminal value may be estimated by applying current or projected market multiples to the projected results in the last discrete year. An average EV/EBITDA of comparable companies, for instance, might be used to find a likely market value of the business at that date. For upstream oil & gas companies, a terminal value is typically not utilized given the finite nature of the underlying resource. Instead, the discrete cash flows are projected for the entire economic life of the reserves.3. Discount Rate. The discount rate is used to estimate the present value of the forecasted cash flows. Valuation analysts develop a suitable discount rate using assumptions about the costs of equity and debt capital, and the capital structure of the emerging entity. Costs of equity capital are usually estimated by utilizing a build-up method that uses the long-term risk-free rate, equity risk premia, and other industry or company-specific factors as inputs. The cost of debt capital and the likely capital structure may be based on benchmark rates on similar issues and the structures of comparable companies. Overall, the discount rate should reasonably reflect the operational and market risks associated with the expected cash flows of the emerging entity.The sum of the present values of all the forecasted cash flows, including discrete period cash flows and the terminal value (if appropriate), provides an indication of the business enterprise value of the emerging entity for a specific set of forecast assumptions. The reorganization value is the sum of that expected business enterprise value of the emerging entity and proceeds from any sale or other disposal of assets during the reorganization. Since the DCF-determined part of this value relies on so many forecast assumptions, different stakeholders may independently develop distinct estimates of the reorganization value to facilitate negotiations or litigation. The eventual confirmed reorganization plan, however, reflects the terms agreed upon by the consenting stakeholders and specifies either a range of reorganization values or a single point estimate.In conjunction with the reorganization plan, the courts also approve the amounts of allowed claims or interests for the stakeholders in the restructuring entity. From the perspective of the stakeholders, the reorganization value represents all of the resources available to meet the post-petition liabilities (liabilities from continued operations during restructuring) and allowed claims and interests called for in the confirmed reorganization plan. If this agreed upon reorganization value exceeds the value to the stakeholders of the liquidation, then there is only one more valuation hurdle to be cleared: a cash flow test. This is an examination of whether the restructuring creates a company that will be viable for the long term—that is not likely to be back in bankruptcy court in a few years.Cash Flow TestFor a company that passes the best interest test, this second requirement represents the last valuation hurdle to successfully emerging from Chapter 11 restructuring. Within the context of a cash flow test, valuation specialists can demonstrate the viability of the emerging entity’s proposed capital structure, including debt amounts and terms given the stream of cash flows that can be reasonably expected from the business. The cash flow test essentially represents a test of the company’s current and projected future financial solvency.The cash flow test essentially represents a test of the company’s current and projected future financial solvency.Even if a company shows that the restructuring plan will benefit stakeholders relative to liquidation, the court will still reject the plan if it is likely to lead to liquidation or further restructuring in the foreseeable future. To satisfy the court, a cash flow test is used to analyze whether the restructured company would generate enough cash to consistently pay its debts. This cash flow test can be broken into three parts.The first step in conducting the cash flow test is to identify the cash flows that the restructured company will generate. These cash flows are available to service all the obligations of the emerging entity. A stream of cash flows is developed using the DCF method in order to determine the reorganization value. Thus, in practice, establishing the appropriate stream of cash flows for the cash flow test is often a straightforward matter of using these projected cash flows in the new model.Once the fundamental cash flow projections are incorporated, analysts then model the negotiated or litigated terms attributable to the creditors of the emerging entity. This involves projecting interest and principal payments to the creditors, including any amounts due to providers of short term, working capital facilities. These are the payments for each period that the cash flow generated up to that point must be able to cover in order for the company to avoid another bankruptcy.The cash flows of the company will not be used only to pay debts, and so the third and final step in the cash flow test is documenting the impact of the net cash flows on the entire balance sheet of the emerging entity. This entails modeling changes in the company’s asset base as portions of the expected cash flows are invested in working capital and capital equipment, and modeling changes in the debt obligations of and equity interests in the company as the remaining cash flows are disbursed to the capital providers.A reorganization plan is generally considered viable if such a detailed cash flow model indicates solvent operations for the foreseeable future. The answer, however, is typically not so simple as assessing a single cash flow forecast. It is a rare occurrence when management’s base case forecast does not pass the cash flow test. The underpinnings of the entire reorganization plan are based on this forecast, so it is almost certain that the cash flow projections have been produced with an eye toward meeting this requirement. Viability is proven not only by passing the cash flow test on a base case scenario, but also maintaining financial viability under some set of reasonable projections in which the company (or industry, or general economy) underperforms the base level of expectations. This “stress-testing” of the company’s financial projection is a critical component of a meaningful cash flow test.“Fresh Start” AccountingCompanies emerging from Chapter 11 bankruptcy are required to re-state their balance sheets to conform to the reorganization value and plan.On the left side of the balance sheet, emerging companies need to allocate the reorganization value to the various tangible and identifiable intangible assets the post-bankruptcy company owns. To the extent the reorganization value exceeds the sum of the fair value of individual identifiable assets, the balance is recorded as goodwill.On the right side of the balance sheet, the claims of creditors are re-stated to conform to the terms of the reorganization plan. Implementing “fresh start” accounting requires valuation expertise to develop reasonably accurate fair value measurements. ConclusionAlthough the Chapter 11 process can seem burdensome, a rigorous assessment of cash flows, and a company’s capital structure can help the company as it develops a plan for years of future success. We hope that this explanation of the key valuation-related steps of a Chapter 11 restructuring helps managers realize this potential.However, we also understand that executives of oil & gas companies going through a Chapter 11 restructuring process need to juggle an extraordinary set of additional responsibilities—evaluating alternate strategies, implementing new and difficult business plans, and negotiating with various stakeholders. Given executives’ multitude of other responsibilities, they often decide that it is best to seek help from outside, third party specialists. Valuation specialists can relieve some of the burden from executives by developing the valuation and financial analysis necessary to satisfy the requirements for a reorganization plan to be confirmed by a bankruptcy court. Specialists can also provide useful advice and perspective during the negotiation of the reorganization plan to help the company emerge with the best chance of success.With years of experience in both oil & gas and in advising companies through the bankruptcy process, Mercer Capital’s professionals are well-positioned to help in both of these roles. For a confidential conversation about your company’s current financial position and how we might assist in your bankruptcy-related analyses, please contact a Mercer Capital professional.1 Accounting Standards Codification Topic 852, Reorganizations (“ASC 852”). ASC 852-05-8.2 ASC 852-10-20.

Asbury-Park Place Acquisition as Seen Through a Monday Night Football Commercial

You Make the Call!

One of my favorite memories as a kid was watching Monday Night Football. Three things, in particular, stood out: the iconic introduction theme music, the “Game of the Week” feeling, and the IBM: You Make the Call commercial segment. Invariably at some point during the hotly contested game, the IBM commercial would be inserted. The announcer would narrate a controversial play and the highlight would run to a critical juncture, only to be paused and allow for the viewer to play armchair referee and guess the outcome or “make the call.” These commercials basically pre-dated instant replay review and the official’s ability to “go under the hood” to review the play and determine the proper outcome.With the revival and announcement of Asbury Automotive Group’s acquisition of the Park Place dealerships in Texas earlier this month, I was once again reminded of the IBM commercial.In this week's post, we review a timeline of the transaction, along with an analysis of Asbury’s stock price against the rest of its public competitors and also examine the operational strategy of Asbury over the years to explain aspects of the Park Place acquisition.As with any merger or acquisition, the true success or failure of the deal may not be known for years. Investors and industry professionals can try and play armchair quarterback and try to predict the outcome. This blog post aims to provide ample information so that you can “make the call” on the transaction.Transaction TimelineThe original transaction was announced in December 2019 and would include 19 franchise locations, one open point, two collision centers, and an auction business all located in the Dallas and Austin markets. Franchises included: Mercedes-Benz, Lexus, Jaguar, Land Rover, Porsche, Volvo, Sprinter, and five ultra-luxury (Bentley, Rolls-Royce, McLaren, Maserati, and Karma). At the date of the announced transaction, Asbury’s common stock traded at $122.67/share. On March 18, 2020, Asbury secured additional borrowings on its existing lines of credit and used vehicle floor plans. Recall that the first two weeks of March saw COVID-19 cases and the impact of shelter-in-place orders and other economic interruptions in the United States. At this point in the timeline, it still appeared that the transaction would continue, although Asbury’s stock price had already declined by a whopping 64% to $44.62/share. Just one short week later, Asbury terminated the Park Place transaction on March 25, 2020, citing the uncertain market conditions related to the COVID-19 pandemic. Interestingly, Asbury’s stock had rebounded slightly from the week before to trade at $58.67/share. Earlier this month, news broke that the Asbury-Park Place transaction was moving forward again on July 6. The auto industry had experienced some modest gains in the monthly SAARs for May and June, and this news was a shot in the arm for the auto M&A market. As more information has been released, the revised transaction with Park Place is scaled slightly lower from the original proposed transaction in December 2019. Terms of the revised transaction include the acquisition of 12 franchises, no open point, two collision centers, and the auction business. Pricing terms include total consideration paid of $735 million, excluding vehicles, reflecting $685 million of Blue Sky value on $95 million of EBITDA with $20 million in run-rate synergies. As I reviewed Asbury’s Q1 earnings call from earlier in the Spring, there were hints that this transaction might have still been in the works. At the time of the re-announcement, Asbury’s share price had increased to $78.41/share. In the two weeks following the announcement, Asbury’s share price increased by 25%. It appears that investors are excited by the revived transaction in the short run. We analyzed the historical trading prices of the other auto public competitors to determine how Asbury’s trends compared to the overall public auto market. While other public competitors (Lithia Motors and Sonic Automotive) have experienced larger rebounds than Asbury, the boost provided by Asbury’s transaction announcement has exceeded the gains by any other public competitor in that short time. It remains to be seen if investors will continue to show this level of enthusiasm in the months to come. Asbury’s Operational Strategy In its presentation to investors and explanation for the transaction, Asbury executives cited the following objectives: 1) conscious effort to acquire more luxury franchises, and 2) move out of less desirable markets and move into more favorable markets. Asbury management further postulated that luxury dealerships are more resilient than other franchises during market downturns, provide more stable margins, have less competition due to fewer dealers across the country, and maintain a higher portion of their gross profits from parts and service than other franchises such as import, domestic or mid-market.Let’s examine these objectives and play armchair quarterback with Asbury’s executive management. Since a large focus of the proposed transaction centers around luxury dealerships and their performance during economic downturns, we analyzed Asbury’s franchise platform from 2008 to present day. As much has been written in this space and in numerous industry pieces, perhaps the closest comparison to the present unstable economic conditions is the Great Recession in 2008 and 2009.Since 2008, Asbury has operated approximately 93 to 115 franchise locations in any given year. While the overall number of franchise locations hasn’t shifted too dramatically, the shift in dealership types can definitely be viewed following the additions from the Park Place transaction. As early as 2008, Asbury operated with only one-third of its franchises as luxury brands. Post-Park Place, Asbury’s brand mix will now be almost 50/50 luxury vs non-luxury. In addition to the brand shift, Asbury has also vacated several markets and entered into more favorable new markets. Specifically, Asbury has vacated Arkansas, California, and New Jersey. In recent months, Asbury has also divested of its Mississippi locations and one of its Atlanta Nissan locations, but has made an acquisition in the Denver, Colorado market. With the additional platform provided by the Park Place locations, Asbury’s focus will be on Florida and Texas as the two main sources of total revenue. Resiliency of Luxury BrandsIn order to test Asbury’s theories regarding the resiliency of luxury franchises against others during a downturn, we examined various financial indicators from public manufacturers’ from 2005 through 2012. For purposes of our analysis, we categorized the following as luxury brands: Audi AG, Bayerische Motoren Werke, Tata Motors Limited, Daimler AG, and Porsche Automobil Holding SE. We also compiled a sample group for other dealership classifications including import, mass market, and domestic. The results will be slightly skewed as several public companies overlap into multiple categories. Nevertheless, we indexed and measured the performance of the luxury brands to the other dealership groups by median revenue, gross profit, earnings before tax (“EBT”) and earnings before interest, taxes, depreciation and amortization (“EBITDA”).Our study provided the following analysis of each financial metric indexed against a baseline median from 2005 data: [caption id="attachment_32683" align="alignnone" width="782"]Source: Capital IQ[/caption] For these indicators, luxury brands fared better than most other dealership groups but seemed to lag slightly behind import dealerships. Asbury executives will be banking on similar success and performance of their luxury brands as the auto industry continues to try and recover from the turbulent economic conditions caused by the pandemic.ConclusionsSo how will Asbury perform and will the revived acquisition of the Park Place dealerships prove to be successful? Only time will tell in the coming months and years.But for now, investors and industry professionals can hit the pause button and evaluate it just as viewers did with IBM's iconic commercials from Monday Night Football in the 1980s and “YOU MAKE THE CALL!”

RIAs Rally After Worst Quarter in Eleven Years

The Industry Is Now in a Bull Market Following March’s Sell-Off

It probably doesn’t feel like it, but most RIA stocks are up over the last year. Over this time, we’ve had two bull markets and one bear market in one of the most volatile twelve-month periods that I can remember. This volatility has been especially beneficial to alternative asset managers since hedge funds are usually well-positioned to take advantage of variability in security prices. The aggregators are the only segment of RIAs that are down over the last year since their models rely on debt financing, which exacerbated their losses during March’s sell-off.Last quarter showed the positive side to leverage as aggregators bested all other classes of RIAs during generally favorable market conditions in April and May. Other investment managers also fared well since collective AUM and ongoing revenue recovered with the market over the quarter. The primary driver behind the increase was the increase in the market itself, as most of these businesses are primarily invested in equities, and the S&P gained about 20% over the quarter.The recent uptick is promising, but it should be evaluated in the proper context. Pre-COVID, the industry was already facing numerous headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. The 11-year bull market run masked these issues (at least ostensibly) as AUM balances largely rose with equities over this time. Finally faced with a market headwind, the bull market for the RIA industry came to a grinding halt in March before rallying again in April and May.As valuation analysts, we’re typically more concerned with how earnings multiples have changed over this time since we often apply these cap factors to our subject company’s profitability metrics (after any necessary adjustments) to derive an indicated value. These multiples show a similar rise in Q2 after a sharp decline in the first quarter. There are a number of explanations for this variation. Earnings multiples are primarily a function of risk and growth, and risk has waned since March’s run-up and growth prospects have recovered. Specifically, future earnings are likely to increase with the recent rally, so the multiple has picked up as well since March’s bottom. Conversely, the decline in Q1 reflected the market’s anticipation of lower earnings with falling AUM and management fees. The multiple usually follows ongoing revenue, which is simply a funtion of current AUM and effective fee percentages, as discussed in a recent post. Implications for Your RIADuring such volatile market conditions, the value of your RIA largely depends on the valuation date or date of measurement. In all likelihood, the value declined with the market in the first quarter before recovering most of that loss in the second. We’ve been doing a lot of valuation updates amidst this volatility, and there are several factors we observe in determining an appropriate amount of appreciation or impairment.One is the overall market for RIA stocks, which was down 20% in the first quarter (see chart above) before gaining just as much in the second to end up back in the same spot as year-end. The P/E multiple is another reference point, which has followed a similar path. We apply this multiple to a subject RIA’s earnings, so we also have to assess how much that company’s annual AUM, revenue, and cash flow have increased or diminished since the last appraisal, while being careful not to count good or bad news twice.We also evaluate how our subject company is performing relative to the industry as a whole. Fixed income managers, for instance, held up reasonably well compared to their equity counterparts in the first quarter. We also look at how much of a subject company’s change in AUM is due to market conditions versus new business development net of lost accounts. Investment performance and the pipeline for new customers are also key differentiators that we keep a close eye on.Improving OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality is that RIAs are all impacted by the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has generally improved with market conditions over the last couple of months. AUM has risen with the market over this time, and it’s likely that industry-wide revenue and earnings have as well though year-end is still a high water mark for many RIAs. July has been kind so far, but who knows where the back half of 2020 will take us in a wild year for RIA valuations and overall market conditions.

June 2020 SAAR

A Lackluster Month, But a Move in the Right Direction

After SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) rebounded in May, June’s results seem to pale in comparison. However, with SAAR coming in at just over 13 million, this is still an increase from May’s SAAR of 12.3 million, albeit a small one. Sales have continued to remain below the previous year's numbers, with June 2020 declining 20% from the same period 2019.After SAAR rebounded in May, June’s results seem to pale in comparison.Despite the country continuing to reopen, supply constraints, especially of popular pickup trucks, have been cutting into potential gains for the industry. Rollbacks on the financing offers that dealerships had depended on at the beginning of the pandemic have also cut into vehicle sale gains. Haig Stoddard, senior analyst for Wards Intelligence, noted that both extensive job and wage losses related to the pandemic also precipitated flat SAAR, and that “with June 30 inventory expected to remain relatively close to May’s, total sales are not expected to get much stronger in July from June.”With no sign that sales will be returning to pre-COVID levels anytime soon, many dealerships are streamlining operating expenses to boost their bottom line. This has been especially true for advertising expenses, with dealerships reevaluating not only how much and where they spend, but whether the effort is converting to sales. Many dealership managers have cut everything from paid-search campaigns, to third party lead generators, to direct mail since March. While TV and print advertising have taken a hit, social media advertising has continued to do well.Social media ads have multiple advantages over more traditional advertising mediums. First, it allows for more targeted content as ads can be administered to demographics more likely to be interested in the product. Social media advertising is also cheaper and more transparent; it’s easier to track if someone clicks on an ad and ends up being a customer whereas it is less clear whether someone shows up to a Honda dealership because they saw an ad on TV. Although dealerships have long relied on both TV and print to advertise, the impact on advertising may be another way the COVID pandemic is pushing the industry into the 21st century.Advertising is not the only area that dealerships are cutting costs as employment issues continue to plague the industry. Though the Paycheck Protection Program loans from the government have softened some of the blow, uncertain future revenues have kept dealerships hesitant to bring back employees. Specifically, franchised dealers have terminated or furloughed an estimated 300,000 employees, which is more than a quarter of the industry’s workforce. This downsizing effect occurred at the onset of the pandemic and has grave implications for workers. Although sales came back in May and June, cash flow going forward is still uncertain, and the pandemic may trigger permanent changes to staffing models. Some of the biggest dealership groups across the country have already announced that thousands of their job cuts are permanent due to factors such as low vehicle sales and success of digital channels.Pandemic Production ConcernsWhile cutting costs can help boost bottom-line numbers in the short-term, dealerships are relying on manufacturing ramp-ups to provide the vehicles needed to drive sales. Even though the recent reopening of manufacturing plants reflects a glimpse of normalcy, the resurgence of pandemic cases in the United States could lead to a second shutdown. So far, production appears to be ramping up with minimal disruptions. As the New York Times notes, reopening factories will involve developing new procedures to screen workers for COVID-19 symptoms and reducing interactions between employees. Some of these new procedures include allowing time for cleaning workplaces, staggering arrival times, adding transparent barriers to assembly lines, and installing no-touch faucets and doors. Having adjusted their procedures, both Ford and G.M. are nearly back to normal with shift schedules, as ninety percent of GM’s hourly workers are back to work. With cases rising throughout the country, manufacturers are inevitably going to run into problems as the pandemic continues.However, with cases rising throughout the country, manufacturers are inevitably going to run into problems as the pandemic continues. At Ford’s truck plant in Louisville, Kentucky, around 1,300 of the plant’s roughly 8,600 workers miss work on an average day, said Todd Dunn, president of the UAW’s local at the plant. Most of these absences have been attributed to virus-related issues such as being unable to get childcare or living with people at higher risk. The company has been pulling workers from the third shift to cover the first two, as well as hiring hundreds of temporary workers to fill the gaps. Similarly, the GM engine factory is facing issues with its workforce, with about 8% of the employees out sick in mid-June.Worker discontent could also contribute to delayed production as some workers feel that not enough precautions are being taken. At Fiat Chrysler’s Jefferson North plant in Detroit, employees refused to work because they believed one of their co-workers had the virus. Last month, workers at Ford factories in Michigan and Missouri questioned the automaker’s safety protocols after multiple workers tested positive for the virus. The UAW local in GM’s SUV plant in Arlington, Texas also pushed for the automaker to make temporary closures, citing the spiking COVID-19 cases in the area.Manufacturers have been hesitant to shut down again, and Fiat issued warnings after the production stoppage. Mike Resha, Fiat Chrysler’s head of North American manufacturing, wrote in a letter on June 28 that “Unauthorized work stoppages in our facilities create both disruption, and, potentially, safety concerns, and therefore cannot be tolerated [and] will result in zero pay.” Both Ford and GM have cited the safety measures they have put into place to protect workers, and no closures are expected.If manufacturers are able to give their employees peace of mind through enhanced safety efforts, production ramp-ups should help alleviate the pent-up demand that auto dealers are experiencing as a byproduct of this pandemic. However, if these efforts are not a priority, production capabilities could suffer once again.USMCA and the Auto IndustryAs of July 1, 2020, auto manufacturers now have to contend with new regulations with the United States Mexico Canada Agreement ("USMCA") coming into effect. The USMCA was initially signed on November 30, 2018, and will serve as an updated version of the 25-year-old, trillion-dollar North American Free Trade Agreement (commonly known as “NAFTA”). Included in the updated agreement are new policies on labor and environmental standards, intellectual property protection, and digital trade provisions. It also will directly impact the automotive industry.According to IndustryWeek, while NAFTA originally required automakers to use 62.5% of North American-made parts in their cars to be imported duty-free (aka no tariffs), the new agreement gradually raises the bar to 75% by 2023. This imposed adjustment will incentivize automakers to increase the amount of North American parts they use in their cars and light trucks. Furthermore, 40 to 45% of automobile parts must be made by workers who earn at least $16 an hour by 2023.The new agreement could significantly impact the automotive supply chain by increasing production costs.The new agreement could significantly impact the automotive supply chain by increasing production costs. However, the USMCA removes the threat of a tariff fight within North America, so the tradeoff may be worthwhile. However, last-minute changes in the agreement have created confusion in the industry. Specifically, Kristen Dziczek, vice president of the Labor & Economics Group at the Center for Automotive Research in Ann Arbor, noted concerns as to how “[...] the labor value rule is going to be implemented, we found out this week.”Automakers who are currently dealing with the fallout from the pandemic and efforts to keep workers safe also have to worry about being in compliance with new regulations. To assist manufacturers during this volatile time, the federal government is providing some leeway with education and outreach efforts being a priority. If auto manufacturers incur higher costs, they will attempt to pass these onto auto dealers, who will in turn seek to pass them on to consumers in order to maintain their earnings (and valuations).Looking ForwardAll things considered, going forward, both the continued reopening of the economy and manufacturing plants working at full capacity are going to be critical to raise dealership’s flattened sales numbers. However, predicting the trajectory of the U.S. economy, let alone the trajectory of the auto sector, is extremely difficult considering the volatility exhibited during the pandemic.While May showed signs that the country may be returning to normal, the surge of cases in the U.S. in June is causing state governments to reconsider reopening plans. Another complete shutdown would be devastating for many dealerships. For auto dealerships to return to normal, it will take precautions on all ends of the supply chain, with manufacturing plants taking extra measures to keep their workers healthy, and dealerships taking extra precautions to ensure customer safety.

June 2020 SAAR

A Lackluster Month, But a Move in the Right Direction

FULL Disclosure: The SBA Outs the Investment Management Industry’s Participation in the PPP

Not much these days gets me to crawl out of my bunker and risk becoming a victim of the Coronavirus pandemic, but this weekend I had the opportunity to drive a new McLaren flat-out on a closed road course here in Memphis. The question wasn’t “is it worth the risk?” Rather, “where’s my helmet?!”570 horsepower does wonders with barely 3,200 pounds to propel, and even though I “only” got the car up to 145 in the straights, it was the behavior of the car in the curves that really impressed me. McLarens are built on a chassis that is essentially a “tub” of carbon fiber, not the usual cage of metal tubes. Because of this, the ride is exceptionally smooth, even under race conditions. Most supercars beat you to death at speed; no matter how many G's you pull, the McLaren feels deceptively like you’re driving carpool.Contrast this with a few observations I have about the investment management industry’s experience, so far, with the Paycheck Protection Program, which hasn’t gone smoothly at all.Under pressure from many questioning the efficacy and/or execution of the Paycheck Protection Program, or PPP, the Small Business Administration released the program participants’ data. Although the information given is described as “redacted,” it includes plenty, including approximate loan amount, name and address of the borrowing company, industry classification, number of jobs retained by the program, and sponsoring lender.Few industries have generated as much controversy from participating in the PPP as has investment management, probably because asset valuations (and therefore revenue) have held up and in many cases grown because of Treasury’s support of financial market liquidity. That said, we only know market behavior since inception of the PPP in hindsight, and we’re still many trading days away from the end of this pandemic and the recession it has precipitated.In any event, we spent some quality time with the SBA’s release of PPP borrower data to see what impact the program has had on the investment management industry. After scrubbing out some misclassified businesses, we found more than 2,400 program participants (RIAs, trust companies, financial planning firms, etc.) that borrowed at least $150,000 (a separate release covered smaller loans). Even though the borrower pool is relatively small (there are at least 10,000 RIAs that aren’t participating), the demographics of the pool are telling.Loan SizeThe typical loan size that investment firms applied for through PPP is modest. The SBA’s data release classified loan sizes in five categories. Within those categories, about two-thirds (~1,600 or so) of the investment firm participants borrowed between $150,000 and $350,000. About one-quarter of the participants received loans between $350,000 and $1.0 million. 134 firms received loans between $1.0 million and $2.0 million. The remaining 50 firms applied for loans larger than $2.0 million, and we only found four who received loans in the largest category, between $5.0 million and $10.0 million. This suggests that, for all the controversy of large businesses milking the PPP for unnecessary capital, few, in fact, got substantial funds from the program.LocationThe largest pool of investment management firms borrowing through the PPP was not New York, but California, with over 350 borrowers. New York was second, and if you add in New Jersey and Connecticut then that contiguous region had a few more borrowers than California. On a stand alone basis, Texas actually had the third-largest number of borrowers, with nearly 200. Unsurprisingly, Florida, Pennsylvania, Illinois, and Massachusetts all had between 100 and 150 program participants from the investment management industry, with states like Minnesota, Georgia, Michigan, and Washington producing more than 50 each. The data suggests that the industry is not as concentrated in New York and California as many might think, although sixteen states produced fewer than ten borrowers each.Type of CorporationApproximately two-thirds of the borrowers listed themselves as either a Limited Liability Company, a Partnership, or a Subchapter S corporation. This confirms our experience with the popularity of tax pass-through organizational structures in professional services firms.Race/Ethnicity of OwnershipAs the investment management industry has started the process of discussing the lack of minority inclusion in the space, the PPP data offers confirmation. We found only 27 firms (around 1%) that listed themselves as being Native American, Asian, Black, or Hispanic owned. Some minority-owned firms may have chosen not to answer (loan qualifications are not demographic-contingent).GenderSimilarly suggesting the narrowness of opportunity in the investment management industry, only 49 firms listed themselves as being female-owned. Again, some women-owned firms likely chose not to describe themselves that way (we have a woman-owned client who participated in the program but didn’t specify their firm as such), but the order of magnitude is what it is.Veteran-OwnedWe counted fifteen firms as being veteran-owned and were surprised this number wasn’t larger (we also have a Veteran-owned firm as a client).Jobs RetainedThe data release also includes a disclosure for the number of positions used in calculating the PPP loan application, giving a good approximation of the number of full-time equivalent employees of the applicant. The total group listed over 52,000 employees. Consistent with the small size of the average loan amount, fully one-quarter of the program participants listed fewer than 10 employees. The next quartile had 10 to 15 employees. Almost another 25% of applicants had 16 to 30 employees. Only 70 participants showed 100 employees or more.So, if you’re an RIA owner and you’ve now been listed as a participant in the Paycheck Protection Program, was it worth it? The disclosure of program participants puts investment managers in an awkward position if they are simultaneously telling clients that they are safe and well-managed while also accepting government aid. That said, turning down low-cost working capital doesn’t seem prudent to me under any circumstances. Firms can always pay the money back if they don’t need it, and if markets tank next week and RIA revenues plummet, the extra capital will do what it was intended to do: keep the workforce in place until conditions improve.As I told my wife, what could possibly go wrong?

Current Environment Challenges America’s Most Prolific Basin

Permian Basin Update

The economics of oil and gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. In this post, we take a closer look at the Permian Basin.Production and Activity LevelsPermian production grew approximately 3% year-over-year through June, in line with Appalachia and avoiding the declines observed in the Bakken and Eagle Ford (down 28% and 10%, respectively). The Permian is still one of the focus areas of supermajors Exxon and Chevron, and also relatively well-capitalized independents such as Concho, Diamondback, Parsley, and Pioneer. As such, it has been more resilient than other oil-focused basins and experts expect to see production growth. Rig count in the Permian at June 26th stood at 131, down 70% from the prior year. While significant, this decline is less severe than reductions seen in the Bakken and Eagle Ford of 82% and 85%, respectively. Appalachia rig counts declined by a more modest 52%, though the gas-focused basin had fewer rigs to drop and faced a more benign commodity price environment. With companies beginning to bring production back online, this may be the nadir, though significantly lower E&P capex budgets will likely keep a lid on rig counts in the near term. The Permian is also seeing gains in new-well production per rig. While this metric doesn’t cover the full life cycle of a well, it is a signal of the increasing efficiency of operators in the area. New-well production per rig in the Permian increased 2% on a year-over-year basis through June, compared to changes of -42%, 12%, and 6% in the Bakken, Eagle Ford, and Appalachia, respectively. (Note that the decline in Bakken production is an artifact of the significant production curtailments in the basin. The EIA forecasts a normalization in July.) Commodity Prices Rebound After Unprecedented DeclineWTI front-month futures prices increased over 90% during the second quarter of 2020, though it was a bumpy road getting there. Prices at the beginning of the quarter were ~$20/bbl, still depressed in the wake of the Saudi/Russian price war, and demand destruction caused by COVID-19. In early April, prices generally increased, approaching nearly $30/bbl by the middle of the month. However, on April 20, WTI futures prices collapsed, falling below $0 to settle at negative $37/bbl. While there are numerous technical reasons for the collapse, there was significant concern regarding crude storage capacity as production had not declined in tandem with demand. However, crude futures prices generally increased thereafter, driven by supply cuts from OPEC+, curtailments by US producers, and a recovery in demand. WTI front-month futures prices ended the quarter at $39.34/bbl. Financial PerformanceAll Permian E&P operators analyzed have had year-over-year stock price declines. Pioneer and Parsley were the best performers in the Permian group, only down 37% and 44%, respectively. Concho also outperformed the broader E&P index (XOP), down 50% compared to the XOP’s 52% decline. Centennial was the worst performer in the group, down 88% year-over-year, though it has rebounded significantly since its lows in early April. While the Permian has been less affected by the most recent batch of E&P bankruptcies, it has not been immune. At the end of June, two Permian operators filed for bankruptcy. Sable Permian filed for bankruptcy on June 25 with approximately $1.3 billion of interest-bearing debt. The company previously underwent debt restructurings in 2017 and 2019. On June 29, Lilis Energy filed for Chapter 11. The company entered proceedings with a Restructuring Support Agreement with certain investors. Under the terms of the agreement, common equity holders will not receive any consideration in the restructured entity. Though commodity prices have recovered from recent lows, they remain below levels at which certain operators can cover operating expenses on existing wells (and well below prices required to drill new wells), according to a Dallas Fed survey. As such, more Permian bankruptcies are likely coming. Texas Railroad Commission Decides Against ProrationOn April 14, the Texas Railroad Commission (which, despite its name, regulates oil & gas activities in the state of Texas) held a meeting to discuss prorating production in the state in light of significant demand destruction and concerns regarding oversupply. Proponents of proportion, led by Scott Sheffield of Pioneer and Matt Gallagher of Parsley, argued that proration was needed to save American jobs and ensure that the energy industry is able to respond once demand returns. Opponents argue that government mandates were unnecessary and that operators should adjust production in response to market prices. Some, specifically midstream operators, were concerned that such a mandate would allow E&P companies to eschew contractual commitments.On May 5, two of the three Texas Railroad commissioners voted against proration.ConclusionWhile commodity prices have recovered from recent lows, they remain below levels at which certain E&P companies can operate sustainably. Two Permian operators have filed for bankruptcy, and more are likely coming. However, the Permian’s economics remain superior relative to most basins, so it will likely fare better than other areas in this difficult environment.We have assisted many clients with various valuation needs in the upstream oil and gas space in both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

E&P Third Quarter 2020

Bakken

Bakken // The third quarter of 2020 experienced a relatively stable price environment compared to the volatile prices seen in the first half of the year.

Transportation & Logistics Newsletter

Third Quarter 2020

Whitepaper Release: Valuing Independent Trust Companies

If you’ve never had your trust company valued, chances are that one day you will. The circumstances giving rise to this valuation might be voluntary (such as a planned buyout of a retiring partner) or involuntary (such as a death, divorce, or partner dispute). When events like these occur, the topic of your firm’s valuation can quickly shift from an afterthought to something of great consequence.The topic of valuation is of particular importance to owners of independent trust companies given the typical independent trust company’s ownership structure, where a majority interest is held by the firm’s founders or senior partners, with younger, more junior partners holding smaller stakes. Such an ownership dynamic—with its (relatively) frequent arms-length transactions and potential for ownership disputes—heightens the need to understand the value of your ownership interest. In our experience working with independent trust companies on valuation issues, the need for a valuation is typically driven by one of three reasons: shareholder agreements, transactions, or litigation.The situation giving rise to the need for a valuation could be one of the most important events of your professional career. Familiarity with the various contexts in which your firm might be valued and with the valuation process and methodology itself can be advantageous when the situation arises. To this end, we’ve prepared a whitepaper on the topic of valuing interests in independent trust companies.In the whitepaper, we describe the situations that may lead to a valuation of your firm, provide an overview of what to expect during the valuation engagement, introduce some of the key valuation parameters that define the context in which a firm is valued, and describe the valuation methods and approaches typically used to value independent trust companies. If you own an interest in an independent trust company, we encourage you to take a look. While the value of your firm may not be top of mind today, chances are one day it will be. Our hope is that this whitepaper will provide you with a leg up towards understanding the valuation process and results, and further that it will foster your thinking about the valuation of your firm and the situations—good and bad—that may give rise to the need for a valuation. WHITEPAPERValuation of Independent Trust CompaniesDownload Whitepaper

Vroom, Zoom, and Stock Market Boom

As we teased last month, Vroom filed an S-1 with the SEC in May enabling its initial public offering (IPO) on June 9th. The online automotive retailer priced the 21,250,000 shares at $22/share. By the end of the trading day, Vroom’s stock had increased 118% to $47.90. For perspective, the NASDAQ as a whole rose only 0.3% that day.The company positions itself as “an innovative, end-to-end platform designed to offer a better way to buy and a better way to sell used vehicles.” A press release also touted its “contact-free” nature, apparently seeking to distinguish Vroom from traditional, franchised, brick-and-mortar dealers as COVID-proof.In this post, we consider Vroom’s business model compared to other online dealers, the company’s investment thesis that may have driven their spike, and see what the filing could tell us about the broader industry and the IPO market more generally.Drafting Behind CarvanaLeading up to an IPO, companies must put their best foot forward and offer plenty of promise. While being a futuristic company that uses buzz words like “data science” and “machine learning” sounds nice, will the benefit of an ecommerce boom ultimately be conferred on Vroom? We’ve previously noted this with Tesla. Despite being the buzz-worthy poster child, Tesla isn’t the only company with online retailing or electric vehicles. Carvana, Vroom’s most direct comparable in terms of online car retailing, IPO’d in 2017 and has about triple the revenue and gross profit margin. Carvana’s public life began with a rather inauspicious start; it opened trading at a 10% discount to its $15 IPO price and finished the day at $11.1 for a 26% decline. However, just over three years later, the stock is now trading 683% above its IPO price (as of June 26th). Carvana rode triple-digit quarterly revenue growth for 23 consecutive quarters, a feat unlikely to be duplicated by Vroom. However, Vroom is hoping their business model differences will be persuasive to investors.Vroom CFO Dave Jones acknowledges the similarities between the companies from the consumer perspective, but he emphasized their asset-light approach as something that materially distinguishes the two from an investment perspective. This approach has been taken in other industries, and such companies benefit from staying out of the fray when difficult operating environments depress margins. It remains to be seen whether Vroom will be able to navigate this effectively.Investment Thesis from the S-1Vroom used its S-1 to make the case for the growth of ecommerce in the auto space, particularly for used vehicles.While their asset-light approach helps distinguish them from Carvana, Vroom used its S-1 to make the case for the growth of ecommerce in the auto space, particularly for used vehicles. Vroom highlights industry fragmentation (42,000 dealers), millions of peer-to-peer transactions, and dissatisfaction with the status quo as reasons its ecommerce platform can continue to grow. The Company calculates the Used Auto market as the largest consumer product category with $841 billion sales on approximately 40 million units in 2019. This surpasses both Grocery and New Auto sales, which are $683 billion and $636 billion, respectively. Vroom pitches the current used vehicle business model is broken, with “limited selection, lack of transparency, high pressure sales tactics, and inconvenient hours.”Vroom also highlights the gross profit advantages inherent in used vehicles. From 2007 to 2009, the S-1 notes gross margins for new vehicles fell from 6.9% to 6.7%. Not only were gross margins higher for used vehicles, but they actually increased during these troubling times from 8.9% to 9.4%. While careful to explicitly make this forecast, Vroom heavily implies its ability to capitalize on COVID, a story that investors seem to be buying, at least for now.Financial Realities of VroomUnder “Use of Proceeds,” Vroom intends to use the $468 million in fresh capital (excluding certain underwriting costs) for general corporate purposes, including advertising and marketing, technology development, working capital, operating expenses, and capital expenditures. This should help fuel future growth as the company burns cash. Like many companies going public in recent years, Vroom is not turning a profit as it intends to “invest in growth to scale our company responsibility and drive towards profitability.” Advertising expense in 2019 was $72.5 million, which is 6.1% of revenue and more alarmingly, 125% of gross. With advertising consuming only about 40% of its SG&A expense in 2019, Vroom is spending about 3 times gross on SG&A. The company will be hoping that scale will eventually allow them to throttle back advertising spend without giving price concessions on its gross.A red flag for Vroom and its ability to draw future investors is its gross margin. In 2019, gross margin declined to 4.85%, down from 7.11% in 2018. While the company would likely point to its superior ecommerce margins of 6.1%-6.4% over the past two calendar years, it is notable Vroom’s gross margins are well below average margins (11.3%-11.4%) for used vehicle for these years. The asset light approach, one they have used to differentiate, may become a cause for concern as well due to the cost of outsourcing much of its critical operations.Future for Vroom, and Other Auto RetailersWill Vroom be able to carve out a place in the market? There are plenty of examples of duopolies such as Pepsi and Coke, Lyft and Uber, and Republican and Democrat. Uber and Lyft are hot auto-adjacent tech companies, but their service has been commoditized as many of its gig drivers opt to drive for both companies to increase their opportunities for trips and tips. The gig economy has spawned other fast-growing tech companies with many competitors in the food delivery space (DoorDash, Grubhub, Uber Eats, Postmates, etc.). Again, these companies have been forced to compete heavily on price despite not offering all of the same restaurants (not a complete commodity if you want a specific pizza only carried by DoorDash). Consolidation talks have already taken place in this industry, and it begs the question of how online auto-retailing will shake out. There are plenty of examples of tech subsectors having one giant player that is the go-to option for consumers (Amazon for online retail, Google for search engines, etc). Vroom, and the industry more generally, will be hoping that there are many seats at the table. For now, no single party owns more than 2% of the market.How will younger consumers who grew up with iPhones and tablets in their hands prefer to shop?The S-1 highlighted ecommerce penetration in the industry sitting at just under 1%, compared to about 16% for total retail (thanks, Amazon). Vroom’s long-term value proposition likely hinges on your view of the future of car buying and the Internet’s role in the market. Consumers were forced online during recent stay-at-home orders, but will these necessary precautions breed long-term shifts? How will younger consumers who grew up with iPhones and tablets in their hands prefer to shop?The ability to seamlessly browse across brands seems appealing, but traditional franchised dealership executives have voiced concerns over how much of the transaction can really take place fully online. Analysts have also frequently questioned the incremental costs associated with delivering cars and whether or not they are covered by the cost savings on retail. With its asset-lite approach, Vroom will provide a good case study.State of the IPO MarketAfter high-profile IPO flops in 2019, including Uber, Lyft, and WeWork (who couldn’t even make it to IPO), the tides appear to have turned in 2020 as exemplified by Vroom and to a lesser extent, Warner Music. Companies such as DoorDash, Lemonade, Airbnb, and others are looking at potential virtual IPOs, which may shed more light on whether Vroom was the anomaly or the precedent.Stock Market VolatilityCOVID-19 has led to significant market volatility with certain industries hammered (cruise lines, restaurants, and airlines to name a few) and others soaring (consumer durables such as cleaning supplies and virtual communication like Slack and Zoom). Speaking of the latter, a case of mistaken identity sent Zoom Technologies (ticker: ZOOM), a thinly traded Chinese wireless communications company, stock up 47,000%. Investors meant to be investing in the popular Zoom Video Communications (ZM), which has overtaken other platforms such as Skype as the dominant player during stay-at-home orders. Trading was halted to fix this issue, but this has not been the only curious case in the market over the past few months.COVID-19 has led to significant market volatility with certain industries hammered and others soaring.As a further example of the fluid, volatile nature of the current stock market, consider Hertz, the established rental car company. On the same day Vroom was publicly listed, Hertz saw its share price jump to $5.53. Yes, the same Hertz that filed for bankruptcy protection on May 22nd. The pandemic-induced demand shock on car rentals and air travel, that begets more rental cars, compounded years of problems including competition from ride-hailing services. The share price increase represented a nearly 900% rise from a May 27th low and an even more astonishing 80% higher than the day before it filed for bankruptcy protection. The sharp increase prompted Hertz to consider tapping the equity markets for one last bite at the apple. Despite the stock being theoretically worthless, the company was seeking to take advantage of the market’s exuberance after gaining bankruptcy court approval on June 12th. However, Hertz ultimately scuttled these plans as the SEC balked at the company’s filing which included a statement that the company’s shares could “ultimately be worthless.”There are theories abound as to what caused Hertz’ unfathomable increase. Central bank liquidity has no doubt fueled the risk-off mindset as the S&P index has increased nearly 35% since a March 23rd low (as of June 26th). The broader market reversal began when the Fed announced it would be buying individual corporate bonds, a promise they only started to make good on nearly 3 months later. Specific to Hertz, they appear to have benefitted, at least in part, from retail investors bidding up the price. As of June 15, data from Robintrack indicated more than 170 thousand Robinhood users held shares in the company. It was the #1 traded stock on the popular retail investor app that doesn’t charge commissions on trades. Some have taken it a step further to connect it to the dearth of gambling options with professional sports on hold. A more nuanced view might be that strategic investors are seeking to exploit the structure of the company’s debt. In the past, equity holders threatened to hold up the process, pressuring credit holders to pass on some of the value during bankruptcy proceedings. Hertz’ debt is largely held in asset-back-securities which fragments the voice of creditors and may ultimately weaken their bargaining power. While Hertz and Vroom are on the opposite ends of their time as a public company, each exhibit reasons to be wary of what the market might or might be telling private business owners.ConclusionSo, what does the stock price of Vroom mean for the value of my private dealership? Virtually nothing. While dealerships, like all businesses, require careful analysis in order to determine a reasonable indication of value, the value of your dealership probably did not double in a day. However, the public market does offer the opportunity to gain valuable insights from companies that operate all over the country. Vroom’s S-1 and successful IPO should signal what many dealership owners already know: digital platforms will become increasingly important, inherent margin advantages in used vehicle retailers are attractive, and growth captures the eye of investors.Contact a Mercer Capital professional to discuss the effect the dynamic auto dealership industry is having on your business today.

M&A in the Permian Basin

The Road Ahead: Deal Count and Deal Motives Changing in Challenging Times

Transaction activity in the Permian Basin, and frankly elsewhere as well, is in a unique, and potentially critical situation as companies are facing unpredictable consequences and uncertain futures.A table detailing E&P transaction activity in the Permian over the last twelve months is shown below. Relative to 2018-2019, deal count decreased by ten and median deal size declined by roughly $60 million year-over-year. Although this table looks busy with a number of deals, the transactions that occurred before March are most likely not indicative of the road ahead. Industry participants are much more concerned with deals that have been announced following the dramatic fall in oil price due to COVID-19 and the Russian-Saudi price war, which in this case was determined to be after March 1, 2020. Looking at the table, only four deals have been announced post-March. Although the sample is small, they could be the best indication of what is to come, assuming prices remain depressed.Black Stone Minerals Letting Go of Core Permian AcreageIn early June, Black Stone Minerals announced that they were selling a total of $155 million of royalty interest assets in two separate transactions to strengthen their balance sheet and liquidity position. This appeared to be core acreage in the Permian as the price per flowing barrel was a premium compared to average private transactions of $40,000 per flowing barrel in March and April. The deal with Pegasus Resources included a 57% undivided interest across parts of the company’s Delaware Basin position and a 32% undivided interest across parts of the company’s Midland Basin position. Black Stone noted that proceeds from the sale will be used to reduce the balance outstanding on the company’s revolving credit facility. Black Stone expects its total debt levels to be under $200 million after closing the two transactions.HighPeak Energy & Pure Acquisition Combine Forces After Early ComplicationsPure Acquisition, a blank-check company, announced in early May that it was acquiring Howard county focused HighPeak Energy in a deal worth $845 million. The original deal, which was terminated due to the crash in oil prices and market uncertainty, included a three-way merger agreement with private-equity-backed Grenadier Energy Partners. The new business combination between HighPeak Energy and Pure Acquisition will hold a pure-play 51,000-net-acre position in the northern Midland Basin. Jack Hightower, HighPeak Energy’s Chairman and CEO, commented, “With the decline of energy prices over the last few months, several energy companies are struggling. However, due to our low drilling and completion costs and our low operating costs, our breakeven prices are much lower than our competitors which enables us to operate profitably at lower price levels.” Time will tell whether the merger will be able to capitalize. The transaction is expected to close in the third quarter of 2020, with the combined company trading on the NASDAQ.Ring Energy Taking a Conservative Approach Moving ForwardIn mid-April, Ring Energy agreed to sell its Delaware Basin asset located in Culberson and Reeves Counties, Texas for $31.5 million to an undisclosed buyer. The asset included a 20,000 net-acre position with current production of 908 boepd (63% oil) at the time of the deal. Kelly Hoffman, CEO of Ring Energy stated, “The proceeds from this transaction will be used to reduce the current balance on the company’s senior credit facility. The current environment mandates a cautious, conservative approach going forward, and strengthening our balance sheet is a step in the right direction.” Ring Energy continues to hold positions in the Permian and Ventral Basin Platform and the Northwest Shelf. The company recently completed a redetermination of its senior credit facility and expects the transaction to close before the end of July.ConclusionM&A transaction activity in the Permian was skewed, in terms of deal count, as most activity during the last twelve months occurred in the second half of 2019. Deal motives moving forward will be interesting to monitor as companies may be forced to let go of premium acreage, notably in the Permian Basin, to improve their liquidity positions. It does not appear to be a seller’s market, as sellers realize the intrinsic value associated with acreage. If companies have the luxury and are not forced to sell, they seem to be holding on tight searching for the light at the end of the tunnel.

What Market Volatility Means for your RIA

Is Volatility the New Normal?

By the middle of March, most RIA owners were hunkering down for what looked to be the next recession. By the end of March, the S&P 500 had fallen approximately 24% from its all-time high of 3,386 on February 19, 2020 to 2,585 on March 31, 2020. By the middle of June, however, the stock market and most RIAs’ assets under management have recovered to where they were about a year ago. While we gave up the gains of the final year of an 11-year market run up, the market and income statements of most RIAs look much the same as they did 18 months ago. Despite this, most RIA principals feel they are in a very different position than they were a year ago.Due to the COVID-19 global pandemic, the future of the economy has become more uncertain. The VIX, which calculates the expected volatility of the U.S. Stock market, hit a new all-time high on March 16th of 82.69, which was higher than the peak during the financial crisis in 2008. The recent VIX measure is especially noteworthy given the comparatively sleepy decade which preceded it.If one thing has become more clear, it’s that market volatility is here to stay – at least for a while. In this post, we explore what this volatility means for you and for your RIA.AUM, aka Revenue Base, is More VolatileFor RIAs that charge fees on a quarterly basis, the fees charged on March 31, 2020 will be significantly lower than the fees charged as of June 30 (barring any significant decline in the market over the next 7 days – which is not out of the question). Many RIAs have quickly adjusted to this new normal. Rather than charging fees quarterly, which makes them more susceptible to the large swings in the market, they have switched to charging fees on a monthly basis.Active Managers May be Able to Exploit Mispricing in the MarketDuring times of increased volatility, active managers are generally able to take advantage of the swings in stock valuations away from fair value, allowing them to realize increased returns for their clients. This may be more difficult in the current market as the volatility today is not just driven by increased “fear” in the market, but a lack of liquidity in our financial system.Over the last few months, bid-ask spreads have widened, and trading volumes have generally declined. A lack of liquidity in market structure is associated with increased risk. In a less liquid market, it is more likely that you could get stuck in a losing position. Additionally, in less liquid markets, prices tend to overreact, making market moves less informative. While there are more winning opportunities presented to active managers, there are also more losing ones.Sector-Specific Managers are Missing OutMost of the recovery in the market since the March decline is attributable to the resilience of tech stocks. Investors are willing to bet that tech companies, such as Microsoft and Apple, will emerge from the COVID-19 pandemic stronger than before. Just five stocks - Microsoft, Apple, Amazon, Google parent Alphabet, and Facebook - account for more than 20% of the market cap of the entire S&P 500 index, according to BofA Global Research. This means that asset managers without exposure to the tech industry are likely lagging the broader market, as measured by the S&P 500.Internal Transactions Have Been CanceledMost sellers of RIAs are currently unwilling to sell at the pricing implied by valuations as of March 31, 2020, which likely did not forecast the quick recovery in equity markets in April. Additionally, the next generation of leadership is likely not currently in the financial position to take on additional risk. Rather, many households are decreasing risk as they prepare for the possibility of another global recession.External Transactions are on PauseUnlike the slowdown in M&A in many other industries, the stall in deal activity in the RIA space is not due to a lack of financing. Rather many deals have been put on hold as the due diligence process is impeded by travel restrictions meant to limit the spread of COVID-19. While most business and due diligence can be conducted over Zoom calls, it’s hard to actually sign an eight-figure check without having ever stepped foot in the main office of the company you are buying. And most sellers don’t want to hand their businesses over to someone they haven’t actually met.Planning is More Important Than EverDuring this time when the outlook for global markets, the economy, and one’s own health and financial well-being is uncertain, many RIA principals are working to nail down the unknowns associated with business ownership. RIA principals are devoting more time to working on their buy-sell agreements in an effort to protect the working relationships with their partners and ensure they and their families are protected financially in the event of a divorce, partner dispute, disablement, or death.The current environment is ripe with uncertainty. This presents both challenges and opportunities for principals of investment management firms. As we all know, this will eventually pass, so most of our clients are focused on positioning rather than acting.

Impairment Testing of Oil & Gas Reserves

2020 Global Events Causing Significant Reserve Write-Downs

Oil & gas producers have been forced to take steps to improve their liquidity and make production cuts as prices have fallen to the lowest in decades, primarily due to a price war between Saudi Arabia and Russia as well as a demand slump amid the coronavirus pandemic. Weakness in the equity markets at the end of Q1 and through Q2 in 2020, due to the virus outbreak and substantial decline in commodity prices, have forced public oil & gas companies to take large impairment charges in recent quarterly reports (See table below for a non-exhaustive list of companies that have taken Q1 impairment charges). Even before prices started to collapse, energy companies were cutting outlooks and planning major asset write-downs. Last fall, Schlumberger planned to take a $12.7 billion charge as shale drilling slowed, and Chevron Corp. announced a $10 billion charge related to offshore assets in the Gulf of Mexico and its Appalachia shale assets. This post is aimed at discerning whether an oil & gas company may need to make interim impairment assessments in light of recent major global events and discuss the impairment testing process. The Basics of Impairment TestingIn an earlier post from Mercer Capital titled Goodwill Impairment Testing in Uncertain Times, we cover the basics of impairments, namely when it is appropriate to assess and how to perform tests of impairment with the most notable item for testing relating to goodwill on a company’s balance sheet.In short, under ASC Topic 360 impairment tests for long-lived assets should follow a two-or three-step process:Assess Impairment IndicatorsTest for RecoverabilityMeasure the Impairment In addition to the listed indicators in the accounting guidance, an entity may identify other indicators or “triggering events” that are particular to its business or industry. Once an indicator is identified, a company then tests for recoverability. For oil & gas companies, conditions such as extreme volatility of supply, demand, and sustained periods of low commodity prices brought on by international commodity price wars, adverse global politicking, and the novel coronavirus pandemic can constitute as triggering events to necessitate interim impairment testing.Oil & Gas Reserves – Accounting MethodologyAs opposed to the vast majority of companies outside of the energy sector, oil & gas companies have reserves that are considered long-lived assets for accounting purposes. These reserves are subject to the same impairment testing rules outlined above such that they are required to be tested on a periodic basis or when triggering events occur.Before performing any impairment testing, however, the accounting methods used to account for these oil & gas reserves need to be considered. Under ASC Topic 932, companies can use one of two methods to account for their oil and gas operations: the successful efforts method or the full cost method.Under the successful efforts method, the cost of drilling an oil well cannot be capitalized unless the well is successful. Costs for unsuccessful wells (dry holes) must be charged as an expense against revenue in the matching period.Under the full cost method, companies may capitalize all operating expenses relating to searching for and producing new oil reserves. Costs are then totaled and grouped into cost pools.Impairment Considerations Related to Oil & Gas Reserves In Statement of Financial Accounting Standards No. 19, the FASB requires that oil & gas companies use the successful efforts method. However, the SEC allows companies to use the full cost method. Guidance for impairment testing of reserves under both methods differ but are available to valuation and other practitioners conducting the tests.Successful Efforts MethodOil & gas companies that use the successful efforts method apply the guidance in ASC 932-360-35 and ASC 360-10-35 to account for the impairment of their reserve assets.Timing of Impairment Testing and Impairment IndicatorsUnder the successful efforts method, an oil & gas company generally performs a traditional two-step impairment analysis in accordance with ASC 360 when assessing reserves for indications of impairment. As mentioned above, impairment assessment for reserves may be determined on an annual basis or in the case of a triggering event. To begin, we bifurcate the total reserve assets into two major groups: proved properties and unproved properties.Proved properties in an asset group should be tested for recoverability whenever triggering events or changes in circumstances indicate that the asset group’s carrying amount may not be recoverable. Generally, companies that apply the successful efforts method will perform an annual impairment assessment upon receiving their annual reserve report by preparing a cash flow analysis. Companies can consider proved (P1), probable (P2), and possible (P3) reserves and other resources since these are all included in the value of the assets. Typically, the impairment evaluation of proved properties are performed on a field-by-field basis. Property groupings may differ due to specific circumstances like shared platform infrastructure or other logical reasons.Oil & gas companies should also assess unproved properties periodically to determine whether they have been impaired. The assessment of these properties is based mostly on qualitative factors and are generally assessed on a property-by-property basis.Measurement of Impairment LossA company that applies the successful efforts method then evaluates each asset group for impairment using the two-step approach under ASC Topic 360. In step one, the company will perform a cash flow recoverability test by comparing the summation of an asset group’s undiscounted cash flows with the asset group’s carrying value. If the undiscounted cash flows are less than the asset group's carrying value, the assets are likely impaired. The company would then proceed to step two of the impairment test to compare the asset group’s determined fair value with its carrying amount. An impairment loss would be recorded and measured as the amount by which the asset group’s carrying amount exceeds this determined fair value.Recognition of Impairment LossAn impairment loss for a proved property asset group will reduce only the carrying amounts of the group’s long-lived assets. The loss should be allocated to the long-lived assets of the group on a pro rata basis by using the relative carrying amounts of those assets. However, the loss allocated to an individual long-lived asset of the group should not reduce the asset’s carrying amount to less than its fair value if that fair value is determinable without undue cost and effort.For unproved properties, if the results of the assessment indicate impairment, a loss should be recognized by providing a valuation allowance. Under the successful efforts method and consistent with U.S. GAAP, companies are prohibited from reversing write-downs.In most cases, write-downs occur when oil & gas reserves cannot be extracted economically, such as on properties where drilling has not started or where properties were expected to be developed based on higher oil prices than are currently estimated. As evidenced in recent market events, if oil prices drop too low, the cost to develop the properties may outweigh the net revenues associated with production.Full Cost MethodAlthough less common in U.S financial reporting, companies that use the full-cost method of accounting should apply the guidance in Regulation S-X, Rule 4-10; SAB Topic 12.D; and FRC Section 406.01.c.Timing of Impairment Testing and Impairment IndicatorsUnder the full-cost method, a full-cost ceiling test must be performed on proved properties each reporting period. This “ceiling” is a formulaic limitation on the net book value of capitalized costs prescribed by SEC guidance listed above. This ceiling formula is equal to: + The present value of estimated future net revenues, minus any estimated future expenditures to develop and produce proved reserves, using a discount rate of 10% + The cost of any properties not being amortized + The lower of cost or the estimated fair value of unproved properties that are included in the amortized costs - Any income tax effects associated with differences between the book and tax basis of the excluded properties and the unproven properties being amortized Similar to the successful efforts method, unproved properties must be assessed periodically for inclusion in the full-cost pool, subject to amortization.Measurement and Recognition of Impairment LossIf a full cost pool ceiling is exceeded, the excess amount must be recorded as an expense. If the cost center ceiling later increases, like the successful efforts method, write-downs may not be reversed and the amount written off may not be reinstated.Determination of Fair Value of Oil & Gas ReservesIn the event that a step two analysis needs to be performed, the determination of fair value of the reserve assets can be performed under three approaches:Income approach — Under this approach, valuation techniques are used to convert future cash flows to a single present amount using a discount rate. The measurement is based on the value indicated by current market expectations about those future amounts.Market approach — This approach requires entities to consider prices and other relevant information in market prices and transactions that involve identical or comparable assets or companies. Valuation techniques commonly used under the market approach include the guideline public company and guideline transaction methods.Asset approach —Also known as the cost approach, the value of a business, business ownership interest, or tangible or intangible asset is estimated by determining the sum of total costs required to replace the investment or asset with similar utility. When determining the fair value of oil & gas reserves, companies use various methods and approaches. The vast majority utilize a discounted cash flow (DCF) model to estimate the fair value of reserves. Depending on circumstances other approaches or a mix of approaches may be appropriate for determining fair value of a company’s reserves.Concluding ThoughtsThe oil & gas market and the energy sector as a whole have taken a beating and experienced unprecedented events due to the global impacts from the pandemic and international price wars. While the scale of the full economic effects from these events has yet to be seen, companies are having to question and consider the need for interim impairment testing on reserves.At Mercer Capital, we have experience in implementing both the qualitative and quantitative aspects of interim oil & gas reserve impairment testing. To discuss the implications and timing of triggering events, please contact a professional in Mercer Capital’s Energy Group.

Valuation and M&A Trends in the Auto Dealer Industry

Shifting Out of Neutral

For this week’s blog post, we sat down with Kevin Nill of Haig Partners to discuss trends in the auto dealer industry and the recent release of their First Quarter 2020 Haig Report. Haig Partners is a leading investment banking firm that focuses on buy/sell transactions in the auto dealer industry, along with other transportation segments. As readers in this space are familiar, Haig Partners also publishes Blue Sky multiples for each of the auto manufacturers based on their observations and data from participating in transactions in this industry.It’s still early on, but how does the economic disruption due to COVID-19 compare to the Great Recession in 2008/2009 on the auto dealer industry?KN: 2008 provided a great recipe for how to manage dealerships in a time of financial stress. But COVID-19 hit so quickly and with unprecedented shutdowns and associated reductions in sales volume and service revenue. The financial disruption was far more harsh in 2020 but there were some tailwinds that dealers didn’t have during the Great Recession. For example, almost 100% of lenders offered interest, principal and curtailment deferments immediately. PPP funds were available to most dealers and provided some necessary working capital. Interest rates were lowered to almost 0% immediately. And most OEMs got aggressive quickly with 0% deals for 72 and 84 months. SW: As Kevin alludes to, the biggest difference between 2008 and 2020 in navigating these troubling times is the assistance from OEMs. Industry bailouts were widely debated, and these manufacturers have been conscientious about being part of the solution this time around.What impact has the COVID-19 pandemic had on a) Blue Sky multiples, b) deal flow, and c) overall dealership value?KN: The pandemic has clearly impacted dealership operating performance and instilled some uncertainty around future earnings for the remainder of 2020 and even into 2021. In general, valuations have tended to recede approximately 10% but there are some dealerships that continue to attract pre-COVID 19 value due to franchise attractiveness and/or geographic demand. Buyers appear to be taking 2 different approaches – 1) they are utilizing 2019 and pre-COVID 19 2020 YTD results (i.e. historic performance) and then applying a slightly lower historic multiple to arrive at a moderately discounted value; or 2) they are utilizing unadjusted pre-COVID 19 multiples but against a forecasted 2020 and 21 earnings base that reflects a slightly lower expectation for income. Either way, it typically works out to about a 10% lower valuation. But again, some stores remain as or more valuable than before the pandemic. New transaction deal flow has been impacted in the short term simply because potential sellers have been fully engaged and focused internally on operating their dealerships during an unprecedented period of stress. They’ve been working on getting their PPP money, furloughing and rehiring associates, building a process to sell and deliver vehicles remotely, managing inventory, etc. We expect when the proverbial dust settles, there will be some motivated sellers who have experienced the Great Recession of 2008 and now the pandemic and will raise their hands and say enough’s enough. Additionally, the pandemic has further set in motion the need to have scale to compete in the new digital age of automotive retailing and some owners are recognizing it’s time to get big or get out. SW: Our valuation approach considers a broader analysis of historical earnings to estimate ongoing earnings. We are cautious not to overvalue a dealership in its best year or undervalue a dealership in its worst year if neither are sustainable. Typically, forecasted earnings approaches were only utilized on start-up locations or early-stage dealerships where historical financials could not be produced. The economic impacts of the pandemic to the current year’s earnings will present a challenge to all valuation professionals. As to the impact of the pandemic on dealership valuations, we think it is relative to each individual dealership and their unique set of factors.Has any segment/classification of franchise (luxury, domestic, import, high-line) type been hit harder with regards to the impact of their implied Blue Sky multiples than others?KN: Higher value dealerships – luxury, very large dealerships or very high performing dealerships might experience moderately lower interest in the near term. This is strictly a function of capital availability as we wonder how many lenders are prepared to extend large amounts of credit on an expensive dealership. These types of stores generally have less risk and yield attractive valuations and will still be in demand but it may take several months of normalcy before buyers and lenders are ready to step up for an expensive BMW or Mercedes-Benz dealership as an example.Have you seen different effects on value in different areas of the country? If so, what are those differences?KN: The quantity and severity of COVID-19 cases and the related state shutdowns is partially correlated to valuations and demand for dealerships. Businesses in the northeast and California, where the pandemic hit hard and governors reacted with severe operating restrictions, have suffered far more than dealerships in the southeast and TX. The latter areas were able to operate, albeit with some restrictions, and sell and service vehicles more effectively. As a result, we’ve spoken with a number of dealers who’ve enjoyed record performance in May as states reopened and consumers took advantage of good weather, stimulus checks, and big OEM incentives. SW: In our discussions with clients, the severity of the impact on operations/earnings is also widespread. In addition to the pockets of the country mentioned by Kevin, we have noted dealers in Arkansas and Utah seem to have suffered less than other areas.Are there buying opportunities for larger auto groups, public companies, and those poised to be in the auto dealer market for the long-term?KN: Auto retail remains a highly attractive investment despite the inherent cyclicality of the industry. Dealerships can be very profitable and generate significant cash, further supplemented by the offshore and captive insurance companies many owners operate. Public companies, outside investment groups including PEFOs (private equity and family office investors), and well-capitalized private dealers have access to low-cost capital and are able to enjoy significant operational synergies. As the industry continues to consolidate and as the need for technical proficiency to master and innovate within the digital retailing sphere accelerates, buyers are going to continue to find opportunities to invest with strong returns.What is the profile of buyers and sellers that you’re seeing on current M&A deals?KN: For sure, a majority of buyers, particularly for the more attractive and valuable dealership assets are the consolidators, both private and public. They are pursuing opportunities to broaden their geographic footprint and franchise representation. Growth becomes a way to leverage both their cost structure over more stores but also to take market share through their improved processes, customer acquisition and retention strategies, and digital strength. Of course, smaller stores remain attractive to local buyers who want to expand their portfolio in their “backyard” or extend into nearby markets. Lastly, outside investor capital or PEFOs are again evaluating opportunities in this sector as they believe stores have some newfound upside with the recent reductions in performance. SW: Family office investors tend to have longer-term investment horizons than public/private consolidators. Additionally, family office investors present additional challenges as they often require more education, due diligence, and they also must bring a dealer principal/operator to the transaction or retain an existing person from the acquired company to assume this role. Once such a person is in the fold, bolt-on acquisitions become smoother and a platform can be created.What are your predictions for the auto M&A market for the remainder of 2020 and 2021?KN: We think 2Q 20 will again be slow as deals that were “inked” before or right at the beginning of the pandemic have been slow-walked to allow time for stability to return to operations. However, judging by the strong progress within our pipeline and conversations with other dealers and professional service providers, the back half of 2020 and 2021 should see some pretty strong transaction volume. Further, we anticipate some dealers will re-evaluate their future once they’ve had the chance to catch their breath from the shutdown and restart of business. This could include a full exit or a partial disposition of certain stores either to raise capital or eliminate some problem stores.What impact has the pandemic had on digital retailing vs. facilities/image requirements?KN: The concept of executing the purchase of a vehicle remotely had begun to gain some smaller degrees of traction before the start of the pandemic. However, a fully digital solution has received far more interest since consumers were forced or chose to transact as much of the vehicle purchase over their phone, tablet, or computer during the shutdown. Even home delivery has ramped up for both sales and service. Various surveys seem to indicate a digital end to end solution is becoming more desirable but a vast majority of consumers still want to come to the dealership for a test drive and thus complete the sale on site. We see those dealerships and groups who have the capital and sufficient intellectual horsepower to invest in digital solutions to be the winners over time. This is one more reason consolidation will continue. We are also hearing that OEMs are recognizing this trend and may soften their stance around upgrades of facilities, larger buildings, more acreage, etc. It’s a tough balance for dealers to have the best online solution and also invest millions of dollars to have the most extravagant and new building when fewer customers want to come to the store for both sales and service. SW: We tend to agree that these improvements appear to be declining as a value driver. We expect there to be more pressing needs for capital than facility upgrades, both from acquirors and dealer principals. These funds will go to consolidation efforts and shoring up finances coming out of the pandemic.What impact will the bankrupt rental car companies have on mitigating the sluggish used vehicle supply market?KN: It appears the bankruptcies of a couple of the large rental companies will restructure debt and equity, not necessarily eliminate operations. It allows the weaker operators time to weather the storm until rental activity ramps up. However, if the recovery goes slowly and business and vacation travel doesn’t pick up, you could see some permanent reductions in rental volume. That could impact nearly new used vehicles from supply in the coming years which are good sources of inventory for dealers and generally produce strong gross margins. What effect will the slowing down of new vehicle production supply from factory shutdowns have on auto dealer valuations and M&A activity? We believe tight inventories will be a short-term disruption that gets resolved over the next few months as production returns to normal. If you couple a big ramp up in production with lower new volume sales, dealer lots should get back to a steady state inventory level well before most current and any new transactions close. SW: Near-term supply will continue to remain a question as manufacturers cope with COVID outbreaks and the need to shut plants down for a day to sanitize. The stop-start nature may play a significant role in how quickly supply can ramp up.Do you anticipate that we will see a V, U, W-shaped recovery, or something else?KN: We are by no means economists and read the same data you and your clients see around the recovery expectations. It seems the consensus lies in the U or W recovery as it’s highly unlikely we immediately return to the low levels of unemployment pre COVID-19. Regrettably, too many businesses won’t reopen and certain industries that are large employers will be slow to recover. Think hospitality, transportation, entertainment, energy, etc. The near term improvement will occur far more quickly than the Great Recession comeback but it’s probably wishful thinking to believe we bounce back to past levels in just a couple of months. The good news is we have low rates, stimulus, OEM incentives and a strong banking sector to accelerate growth this time around. We thank Kevin Nill and Haig Partners for their interesting perspectives on the auto dealer industry. Industry participants are cautiously optimistic that retail sales, earnings performance and deal flow are trending in the right direction, but not without additional challenges. To discuss how recent industry trends may affect your dealership’s valuation, feel free to reach out to one of the professionals at Mercer Capital.

Does Your Bank Need an Interim Impairment Test Due to the Economic Impact of COVID-19?

Analysts and pundits are debating whether the economic recovery will be shaped like a U, V, W, swoosh, or check mark and how long it may take to fully recover. To find clues, many are following the lead of the healthcare professionals and looking to Asia for economic and market data since these economies experienced the earliest hits and recoveries from the COVID-19 pandemic.Taking a similar approach led me to take a closer look at the Japanese megabanks for clues about how U.S. banks may navigate the COVID-19 crisis. In Japan, the banking industry is grappling with similar issues as U.S. banks, including the need to further cut costs; expanding branch closures; enhancing digital efforts; bracing for a tough year as bankruptcies rise; and looking for acquisitions in faster growing markets.Another similarity is impairment charges. Two of the three Japanese megabanks recently reported impairment charges. Mitsubishi UFJ Financial Group (MUFG) reported a ¥343 billion impairment charge related to two Indonesian and Thai lenders that MUFG owned controlling interests in and whose share price had dropped ~50% since acquisition. Mizuho Financial Group incurred a ¥39 billion impairment charge.In the years since the Global Financial Crisis, there have not been many goodwill impairment charges recognized by U.S. banks. A handful of banks including PacWest (NASDAQ-PACW) and Great Western Bancorp (NYSE-GWB) announced impairment charges with the release of 1Q20 results. Both announced dividend reductions, too.Absent a rebound in bank stocks, more goodwill impairment charges likely will be recognized this year. Bank stocks remain depressed relative to year-end pricing levels despite some improvements in May and early June. For perspective, the S&P 500 Index was down ~5% from year-end 2019 through May 31, 2020 compared to a decline of ~32% for the SNL Small Cap Bank Index and ~34% for the SNL Bank Index.This sharper decline for banks reflects concerns around net interest margin compression, future credit losses, and loan growth potential. The declines in the public markets mirrored similar declines in M&A activity and several bank transactions that had previously been announced were terminated before closing with COVID-19 impacts often cited as a key factor.Price discovery from the public markets tends to be a leading indicator that impairment charges and/or more robust impairment testing is warranted. The declines in the markets led to multiple compression for most public banks and the majority have been priced at discounts to book value since late March. At May 31, 2020, ~77% of publicly traded community banks (i.e., having assets below $5B) were trading at a discount to their book value with a median of ~83%. Within the cohort of banks trading below book value at May 31, 2020, ~74% were trading below tangible book value.Do I Need an Impairment Test?Goodwill impairment testing is typically performed annually. But the unprecedented events precipitated by the COVID-19 pandemic now raise questions whether an interim goodwill impairment test is warranted.The accounting guidance in ASC 350 prescribes that interim goodwill impairment tests may be necessary in the case of certain “triggering” events. For public companies, perhaps the most easily observable triggering event is a decline in stock price, but other factors may constitute a triggering event. Further, these factors apply to both public and private companies, even those private companies that have previously elected to amortize goodwill under ASU 2017-04.For interim goodwill impairment tests, ASC 350 notes that management should assess relevant events and circumstances that might make it more likely than not that an impairment condition exists. The guidance provides several examples, several of which are relevant for the bank industry including the following:Industry and market considerations such as a deterioration in the environment in which an entity operates or an increased competitive environmentDeclines in market-dependent multiples or metrics (consider in both absolute terms and relative to peers)Overall financial performance such as negative or declining cash flows or a decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periodsChanges in the carrying amount of assets at the reporting unit including the expectation of selling or disposing certain assetsIf applicable, a sustained decrease in share price (considered both in absolute terms and relative to peers) The guidance notes that an entity should also consider positive and mitigating events and circumstances that may affect its conclusion. If a recent impairment test has been performed, the headroom between the recent fair value measurement and carrying amount could also be a factor to consider.How Does an Impairment Test Work?Once an entity determines that an interim impairment test is appropriate, a quantitative “Step 1” impairment test is required. Under Step 1, the entity must measure the fair value of the relevant reporting units (or the entire company if the business is defined as a single reporting unit). The fair value of a reporting unit refers to “the price that would be received to sell the unit as a whole in an orderly transaction between market participants at the measurement date.”For companies that have already adopted ASU 2017-04, the legacy “Step 2” analysis has been eliminated, and the impairment charge is calculated as simply the difference between fair value and carrying amount.ASC 820 provides a framework for measuring fair value which recognizes the three traditional valuation approaches: the income approach, the market approach, and the cost approach. As with most valuation assignments, judgment is required to determine which approach or approaches are most appropriate given the facts and circumstances. In our experience, the income and market approaches are most used in goodwill impairment testing. However, the market approach is somewhat limited in the current environment given the lack of transaction activity in the banking sector post-COVID-19.In the current environment, we offer the following thoughts on some areas that are likely to draw additional scrutiny from auditors and regulators.Are the financial projections used in a discounted cash flow analysis reflective of recent market conditions? What are the model’s sensitivities to changes in key inputs?Given developments in the market, do measures of risk (discount rates) need to be updated?If market multiples from comparable companies are used to support the valuation, are those multiples still applicable and meaningful in the current environment?If precedent M&A transactions are used to support the valuation, are those multiples still relevant in the current environment?If the subject company is public, how does its current market capitalization compare to the indicated fair value of the entity (or sum of the reporting units)? What is the implied control premium and is it reasonable in light of current market conditions? At a minimum, we anticipate that additional analyses and support will be necessary to address these questions. The documentation from an impairment test at December 31, 2019 might provide a starting point, but the reality is that the economic and market landscape has changed significantly in the first half of 2020.Concluding ThoughtsWhile not all industries have been impacted in the same way from the COVID-19 pandemic and economic shutdown, the banking industry will not escape unscathed given the depressed valuations observed in the public markets. For public and private banks, it can be difficult to ignore the sustained and significant drop in publicly traded bank stock prices and the implications that this might have on fair value and the potential for goodwill impairment.At Mercer Capital, we have experience in implementing both the qualitative and quantitative aspects of interim goodwill impairment testing. To discuss the implications and timing of triggering events, please contact a professional in Mercer Capital’s Financial Institutions Group.Originally published in Bank Watch, June 2020.Request for ProposalMercer Capital is pleased to prepare a proposal for impairment testing services for your bank or bank holding company. Follow the link below to complete a submission.Bank Impairment Testing Proposal Request »

Mercer Capital's Mineral Aggregator Valuation Multiples Analysis

Market Data as of June 2, 2020

Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership.Due to a variety of corporate structures (including master limited partnerships and Up-Cs) and complex capital structures (including preferred equity and non-traded common units), mineral aggregator enterprise values pulled from databases are often missing meaningful components of value, leading to skewed valuation multiples.Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis. Download our report below.Mineral Aggregator Valuation MultiplesDownload Analysis

Hedging And Bank Retreats Complicate Royalty Aggregators’ Valuation

As the clouds begin to clear from the oil patch storm that began three months ago, management, analysts and investors are wondering what is going to happen next. Has the proverbial storm system passed? Is it time to venture out and rebuild, or are we still in the eye of the hurricane, with the back wall on its way? Both are possibilities.As for management teams of royalty aggregators and MLPs, they have mostly given up on gambling on a specific outcome for now. The ones who have initiated new policies are battening down the hatches for another wave to come through. Of the six publicly traded upstream royalty aggregators (VNOM, MNRL, FLMN, KRP, BSM and DMLP) most either suspended guidance or locked down their hedging positions over the last few months so they don’t have to extend their risk profiles. “We really only have today what we have in front of us, which is a strip, and we had to make the tough decision based on the first quarter being one of the biggest cash inflows that we’re going to have over the next five quarters or six quarters, based on where the strip is today,” explained Travis Stice of Viper Energy Partners, LP. This rationale makes sense considering the motives of various stakeholders, particularly bankers.Just about every public aggregator has had their borrowing bases shrunk by their bankers, typically in the range of 20%-25%. This is not a big problem per se for most as they did not have much debt leverage anyway, but it is indicative of the recoil mentality going on. Another indicator of this mentality is the cut in distributions. Kimbell and Viper dropped payout ratios substantially for the short-term. Thus, changing yields significantly. The charts below show this before/after effect of reduced payouts as of last week. [caption id="attachment_32106" align="aligncenter" width="800"]Source: Company Filings, Capital IQ and Mercer Capital Analysis[/caption] Dorchester is the outlier here, but it is paying out 140% of its earnings right now which is unsustainable. It will have to pull back its payout ratio sometime, perhaps sooner rather than later. In fact, one of the most dramatic examples of this pullback was Blackstone Mineral’s recent announcement that they were selling $155 million of choice Permian royalty interests for an average of $86,111 per flowing barrel. This does not appear to be non-core acreage they sold either. In fact, it is a significant premium compared to what they are trading at as of early June and is on par with Viper whose assets are almost entirely Permian based. It’s also a big premium to average private transaction ranges of $40,000 per flowing barrel that was cited in my last column. [caption id="attachment_32109" align="aligncenter" width="374"]Source: Company Filings, Capital IQ and Mercer Capital Analysis[/caption] Considering values have fallen significantly, it might be fertile ground for more acquisitions, but management teams generally don’t seem to think so (Kimbell’s Springbok acquisition did happen in late April as an exception). Sellers’ mindsets are stickier and although prices are low, bid ask spreads remain wide. “From our perspective though, the seller’s expectations remain robust, and rightfully so. This is an asset class that’s highly valuable, where if it’s in the best areas, there will be activity over time. There will be production over them and likely growth over time. And so sellers’ expectations will remain, I think, relatively high and they’ll be patient,” said Daniel Herz of Falcon Minerals. This mentality was consistent across analyst calls. Where does that leave aggregators from a valuation perspective? That is more complicated. The change in prices and the mixed bag of hedgers vs. non-hedgers makes it more challenging. A more specifically constructed discounted cash flow analysis will become as relevant as ever as opposed to benchmarking metrics against guidelines or an index. Why? Hedging is just that – hedging. It boxes in commodity price ranges and limits downside, which banks want. It also limits upside, which shareholders do not want. Several aggregators are hedged in varying degrees through 2020 and into 2021 as well. This makes comparison trickier. Prices have already risen to nearly $40 per barrel in West Texas which is faster than many expected. It may bob up and down this year, but what if the supply shock sends prices on a march upward? It could leave hedged aggregators behind and either undervalued or overvalued. It also de-links several of these entities as a more direct proxy to commodity prices and makes it a more fluid exercise in which to attempt to intrinsically value this aggregator group or any royalty company or asset. Commodity mix matters too. Oil has been on the downside of a roller coaster, while gas has been stuck at the bottom for a while now, but has been more stable, local and predictable. As such, gas is becoming more popular than it was even six months ago. Chatter on analyst calls affirm this. [caption id="attachment_32110" align="aligncenter" width="388"]Source: Company Filings, Capital IQ and Mercer Capital Analysis[/caption] Lastly, shut ins and production drops are potentially looming as well. Most management teams believed it would impact them, but not significantly. In fact, it was portrayed as a good thing because it could preserve value for down the road as opposed to realizing little value today. Better to put food in the refrigerator for later than letting it rot on the table now, was the idea. (Not a bad idea by the way). However, if shut ins become more permanent, there will be no food for later. The proverbial fridge will go unplugged. Valuations appear to have reset a bit, and from an EBITDA perspective, earnings are going to slide, but the market appears to think this will be temporary. How temporary will be the question. The recent OPEC+ meeting was an indicator that prices could rebound sooner rather than later, but that remains to be seen. [caption id="attachment_32109" align="aligncenter" width="331"]Source: Company Filings, Capital IQ and Mercer Capital Analysis[/caption] Whatever may happen going forward, it has been a turbulent ride the past few months. It is also a signal that things are strange when public aggregators stop aggregating and even go so far as to sell premium assets. It likely will not happen for very long, but it has turned some things upside down. That is both a risk and an opportunity. Originally appeared on Forbes.com on June 9, 2020.

How Proper Normalization Adjustments Contribute to a Better Finished Product

Trusting the Process

"Head chef" in my family is a title and role that I not only enjoy but take very seriously. Like most folks, the last few months have created many more opportunities to refine my home cooking skills and sample different recipes and cuisines. My kitchen cooking repertoire has always exceeded my grilling capabilities. With the extra time at home, I decided to tackle the holy grail of grilling challenges: smoking a beef brisket. For those that have never tried, the brisket is one of the most intimidating cuts of meat to tackle. In addition to a million different temperature/time/technique recommendations, the brisket starts as a very tough piece of meat. It’s not uncommon to labor for 10+ hours smoking a brisket and still have it turn out like a leather shoe.After spending some time researching, I honed in on my process. This included preparing the brisket by trimming excess fat and cooking the meat at a higher temperature for a period of 4 hours or until the meat reached a certain internal temperature. The next step involved lowering the cooking temperature for another set of hours until the internal temperature of the meat reached an ideal 203 degrees. Not 200, not 205……203! The final step involved foiling or tenting the brisket in a dark, damp, confined space for a period of several hours, allowing it to rest and come to its final temperature. How’d it turn out? I’ll revisit that topic at the end of the post.Much like smoking a brisket, the valuation of an auto dealership is a process, and the client or intended audience for the valuation must trust the process (apologies to any Philadelphia 76ers fans that lived through the rebuilding years under Sam Hinkie).In previous posts, we discussed the valuation methodologies and the value drivers of an auto dealership valuation. The next step in the process is to normalize the financial statements.Normalization adjustments take private company financials and adjust the balance sheet and income statement in order to view the company from the lens of a “public equivalent.” Adjustments are often interrelated; a change to the balance sheet frequently will affect the income statement as we’ll discuss. Some typical areas of potential normalization adjustments in the automobile dealership industry include, but are not limited, to the following.Balance SheetInventoriesMost automobile dealerships report the value of their new and used vehicle inventories on a Last-In, First-Out (“LIFO”) basis. LIFO accounting allows the dealership to reduce the value of their inventories and pay fewer taxes. General valuation theory calls for inventories to be restated at First-In, First-Out (“FIFO”) basis. The FIFO adjustment affects both the balance sheet and the income statement. On the asset side of the balance sheet, we add the LIFO reserve amount to the reported LIFO inventory, raising the value of the inventory. Liabilities also increase due to the additional taxes that would be paid on a FIFO-equivalent inventory, calculated as the LIFO Reserve multiplied by the corporate tax rate. We will discuss the income statement impact later. Fixed AssetsFrequently, dealers own everything in two separate, but related entities. One entity owns the operations of the dealership and other owns the underlying real estate. In those cases, most dealerships still report some cost value of land or leasehold improvements on their factory dealer financial statements. The business valuation expert must determine who owns the real estate, and if not owned by the dealership, the value of the land and leasehold improvements needs to be adjusted/removed. This adjustment reflects the true value of the tangible assets of the dealership. Failure to properly assess and make this adjustment will skew the implied Blue Sky multiple on the concluded value for the dealership. Working CapitalMost factory dealer financial statements list the dealership’s actual working capital, along with the requirements from the factory on the face of the dealer financial statement, as seen in the graphic to the right. It’s important for the business valuation expert to assess whether the dealership has adequate working capital, or perhaps an excess or deficiency. Comparisons to required working capital are not always rigid. An understanding of the auto dealer’s historical operating philosophy can help determine whether there is an excess or deficiency as different sales strategies can require different levels of working capital, regardless of the factory requirements. Goodwill/Intangible/Non-Operating AssetsOften auto dealers might have intangible and non-operating assets such as goodwill from a prior acquisition, cash surrender value of life insurance, personal seat licenses ("PSLs"), excess/non-operating land, airplanes, etc. These assets do not contribute to the cash flow from operations and/or are not included in the tangible assets of the business. Blue Sky multiples inherently capture the intangible value of a dealership’s expected future earnings. The appraiser must remove goodwill and intangibles on the balance sheet to establish the tangible asset base of the dealership before any application of a Blue Sky multiple. Owner Accounts Receivable Occasionally, auto dealers loan money into the dealership with no intention of ever repaying those funds, and dealers sometimes misplace or disguise items on the dealer financial statement to overstate working capital. Valuation analysts have to ask about these items specifically during their management interviews with the dealer principal or controller to know if adjustments to the dealer financial statement are warranted. Income StatementInventoriesAs discussed earlier, the use of LIFO inventory systems creates normalization adjustments on both the balance sheet and the income statement. On the income statement, the inventory adjustment affects the cost of goods sold (“COGS”), and ultimately, the gross profit margin. The shortcut method to the adjustment analyzes the change in the LIFO reserve year-over-year. If the LIFO reserve increases, the resulting normalization adjustment decreases COGS and increases profits. Conversely, if the LIFO reserve decreases, the resulting normalization adjustment increases COGS and decreases profits. Officers’/Dealer CompensationLike all valuations, the compensation of the officers’/dealer principal must be considered for potential adjustment. Typically, a business valuation expert will review actual compensation paid and determine a replacement or market equivalent compensation level; experienced business valuators in the auto dealer industry have techniques and benchmarks to determine a reasonable replacement cost. In addition, some auto dealers have non-active employees or family members on the payroll. The salaries of non-active employees also must be normalized by adding back those expenses as they would not be included for a public equivalent.RentAs noted previously, the underlying real estate utilized by the auto dealer is frequently owned in a separate, related entity. As such, the dealership pays rent to the related party entity. The business valuation expert needs to determine if the rental rate paid is equivalent to a market rental rate. Often, this rental rate creates additional profitability at either the dealership entity or the real estate entity. Experienced business valuators in the auto dealer industry have several techniques and benchmarks to determine a fair market rental rate for the facilities.Other Income Items Most factory dealer financial statements have a line item on the income statement for other income items/additions. This category can be sizeable for a dealership depending on its sales volume and level of profitability. It’s important for a business valuator to determine the items that comprise this category and how likely they are to continue at historical levels. Some common items that appear in this category include factory dealer incentives on sales volume levels for vehicles, factory dealer incentives for service performance, document/preparation fees on the sale of new and used vehicles, and additional costs for financing and other services sold as a part of the vehicle transaction ("PACKs").Discretionary/Non-Recurring/Personal Expenses Like all valuations of privately-held companies, auto dealership valuations should normalize all expenses that are discretionary, non-recurring, or personal in nature. Often, these expenses can be determined during the management interview phase of the business valuation.Expected Industry Profitability vs. Actual Profitability The valuations of auto dealerships are also unique in that underperforming stores can often be more “valuable” than stores performing at or above the market from a multiple perspective. One reason for this phenomenon is that hypothetical buyers recognize the improvements they can make to profitability for underperforming stores. Experienced business valuators in the auto dealer industry know to consult expected industry profitability levels depending on the manufacturer, geographic region, and competition. Expected profitability levels can be an added benchmark to the totality of the other normalization adjustments determined in the valuation process.ConclusionsJust like the cooking technique with the brisket, the process of normalization adjustments and the overall valuation is a roadmap for advancing from the start of the engagement to a finished conclusion. Skipping any steps along the way in the process will lead to a flawed/incomplete valuation conclusion, or a leather shoe of a brisket. I’m happy to report that trusting the process with smoking the brisket resulted in a happy family and a tasty/tender dinner!We have highlighted many of the typical normalization adjustments that must be considered in the valuation of an auto dealership. With the many nuances that must be considered, hiring a business valuation expert that specializes in this industry rather than a generalist business appraiser can make all the difference in providing a reasonable valuation conclusion.

The Evolution of Rule-Based Valuation Metrics and Why They Still Don’t Work

One of our first blog posts addressed the fallacies of rule-based valuation measures in RIA transactions. Our position hasn’t changed, but these so-called rules of thumb have certainly evolved over time.In a recent podcast with Michael Kitces, industry transaction specialist Elizabeth Nesvold of Raymond James explains the history and rationale behind these changes. For this week’s post, we’ll discuss this evolution and why such measures are usually more misleading than meaningful.Ten to twenty years ago, it was just assumed that all RIAs were worth 1-2% of AUM. At that time, many RIAs were able to charge 1% of AUM for their services, so a valuation of 1-2% of AUM equated to a 1-2x multiple of revenue, which was also thought to be a reasonable estimate of value. Over the last decade, AUM-based valuations have broken down with fee compression and the proliferation of non-asset-based sources of revenue. The example below illustrates how AUM multiples break down for firms with different fee structures and revenue sources. Firm A charges higher fees and has other sources of income. Its revenue yield (total revenue as a percentage of AUM) is therefore much higher at 1.1% (versus 0.3% for firm B), so a 2% of AUM valuation translates into a 1.8x revenue multiple, which is within a range often observed for investment management firms. Firm B, on the other hand, charges lower fees and has no alternate source of revenue, so a 2% of AUM valuation would be nearly 7x revenue, well above a reasonable valuation estimate for most RIAs. Mathematically, the AUM multiple is the product of the revenue multiple and the revenue yield (e.g. 2% = 1.1% of 1.8x for Firm A), so this measure varies directly with realized fees. As fee schedules changed, many RIA owners began valuing their businesses with revenue multiples. This approach isn’t much better as it ignores how efficiently the business is managing its costs. Firms with similar levels of revenue can have drastically different EBITDA margins, so blindly applying the same revenue multiple to all of them can lead to nonsensical valuations. Applying a 2x revenue multiple to a low margin RIA like Firm D would likely overvalue the subject company since it would imply an unrealistically high multiple of earnings or cash flow. Just like AUM multiples vary with realized fees, revenue multiples are directly proportional to profit margins since these cap factors are the product of EBITDA multiples and profit margins (2x revenue multiple= 40% EBITDA margin times a 5x EBITDA multiple for firm C). Because of these shortcomings, many industry analysts now use earnings multiples to value RIAs. We consider cash flow metrics superior to AUM and revenue measures since earnings multiples take into account realized fees and profit margins. Earnings multiples are directly related to growth prospects and inversely related to risk, so valuing all RIAs with the same profitability multiple can be problematic as well. Investment management firms can have radically different risk profiles due to varying customer concentrations, manager dependencies, and regulatory pressures. Growth prospects also vary with scalability, capacity limitations, and new business development. Applying a one-size-fits-all earnings multiple to businesses with varying risk profiles and growth prospects will lead to inaccurate valuations. The appropriate multiple also changes over time. This is true for all industries but is especially true for RIAs, whose business is tied to market conditions, which have been highly volatile in recent years. The EBITDA multiple for publicly traded RIAs with under $100 billion in AUM has been cut in half in the last two years, so if your firm was worth 8x in 2018, all else equal, that’s probably no longer the case, as depicted in the graph below. Even though the multiple has changed, the methodologies for valuing investment management firms remain the same.Most RIA appraisals include a discounted cash flow (DCF) analysis and a market methodology involving publicly traded investment managers or industry transactions if there are sufficiently similar companies with reported financial metrics. Rules of thumb are overly simplistic and often lead to nonsensical appraisals.The reality is that there is no magic formula for valuing RIAs, so try not to fall into that trap. Any reasonable appraisal of your business will include a careful study of trends in asset flows, realized fees, profit margins, client retention, investment performance, stock transactions, shareholder agreements, and budgeted financial performance, among other things. It’s a lot to keep up with, but we’re happy to walk you through it.

Themes from Q1 2020 Earnings Calls

Part 2: Mineral Aggregators

As discussed in our quarterly overview, the oil & gas industry took arguably its worst beating in history due to Saudi Arabia-Russia price war and demand destruction caused by COVID-19. Rather than restating the events and underlying economics behind the drastic downturn in the market, it would be more beneficial to read Part One of this series and cut to the chase with Part Two of the Q1 2020 earnings calls, which focuses on mineral aggregators.Theme 1: Dividend Policies Varying Moving ForwardParticipants and investors seemed to question aggregators’ current and future distribution plans, as this asset class is primarily a yield investment vehicle.“The $0.025 dividend payment reflects a payout ratio of 23% of pro forma free cash flow. It really is simply about getting back to a more stable economic and energy environment. I would expect that we’ll see our payout ratio return to its traditional level of 90% plus.” – Daniel Herz, President & CEO, Falcon Minerals“We committed to a 100% payout ratio through the first quarter, and we want investors to know that our word is important, and we remain committed to following through and doing what we said we were going to do.” – Robert Roosa, CEO & Director, Brigham Minerals“That resulted in us cutting the distribution to 25% of available cash. And I think it’s going to be a very fluid process. I can only really use the baseline of 25% for now.” – Travis Stice, CEO, Viper Energy PartnersTheme 2: Hedging: Defensive Strategies Leading to Limited Upside ExposureAlthough mineral aggregators enjoy certain advantages relative to operators, their performance remains tied to commodity prices. As a result of the uncertain and volatile pricing environment, there have been difficult decisions made in regard to hedging. Some aggregators are hedged through 2021, limiting the potential upside of these investments if prices continue to increase.“We currently have a substantial portion of our oil and natural gas production hedged in the form of swaps going out two years with prices for oil averaging in the low $40s and natural gas averaging around $2.49 per MMBTU.” – Robert Ravnaas, CEO & Chairman, Kimbell Royalty Partners“Because of this market uncertainty and our concern that it may persist for some time, we have put in place substantial hedges for 2021 for both oil and has to further our already robust 2020 hedge positions.” – Jeff Wood, President & CFO, Black Stone MineralsTheme 3: Aggregator Advantages Muted for the MomentUnlike traditional royalty trusts, mineral aggregators reap the benefit of reinvesting capital to acquire new acreage. This advantage, however, has been paused as the M&A market is in a standstill due to the wide bid-ask spread between buyers and sellers. It will be interesting to monitor the performance of the aggregators closely if they are unable to benefit from their acquisition strategies.“Right now, our acquisition machine is silent for the foreseeable future. Now, mineral owners tend to be stickier with respect to perception of value, and there’s often less leverage in the mineral space. So, I think it’s going to be pretty quiet here for the next couple quarters.” – Travis Stice, CEO, Viper Energy Partners“The A&D market, as you might imagine, is pretty slow currently, but we expect it to pick up in the next, let’s call it, 2 to 6 months. From an M&A perspective, we plan to continue to fund our micro acquisition strategy at current depressed commodity prices and continue to be well positioned as a consolidator in the highly fragmented minerals industry.” – Robert Ravnaas, CEO & Chairman, Kimbell Royalty Partners“There will be production over time and likely growth over time. And so sellers’ expectations will remain, I think, relatively high and they’ll be patient. – Daniel Herz, President & CEO, Falcon Minerals

Pandemic Practice Management Opportunities

RIAs are Taking Advantage of this Time to Revisit Shareholder Agreements

Sports cars are not known for durability. Colin Chapman, who developed the Lotus, reportedly once said that if a sports car wasn’t falling apart as it crossed the finish-line, it was over-built. Jaguar owners once remarked that their cars were so unreliable that they could derisively boast “drove it cross-country and it only caught fire twice!” But the neediest of the marques must be Ferrari, many models of which include regularly scheduled procedures that require the complete removal of the engine. The “engine-out” is needed for otherwise normal things like replacing belts, and adds more to the cost of routine maintenance than my first three cars cost, combined. If you study the market for used sports cars, you rarely see a high-mileage Ferrari – it’s no wonder.We’re now a full three months into the unusual operating circumstances brought about by the Coronavirus pandemic. The RIA industry is weathering this all very well, in no small part because financial markets rebounded quickly enough to stem what could have been a disastrous downturn in management fees, and because technology has enabled most RIAs to serve their clients very well, and in many cases with greater efficiency, from remote locations. Many are talking about how the pandemic has been an accelerant of change, not necessarily a cause. Practice management issues that would otherwise be easy to delay addressing are now seen as warranting more immediate attention. To this end, we’ve had a number of clients reach out to us in the process of revisiting their shareholder agreements.We’ve been an advocate of strong buy-sell agreements for investment management firms for a long time. Orderly ownership transition not only assures that the buyers and sellers of interests in an RIA are treated fairly, but it also helps to ensure the sustainability of the business. Re-writing a shareholder agreement can feel like an engine-out service, but nothing is as costly – both in terms of time wasted and money spent – as a shareholder dispute. To that end, we have a whitepaper on buy-sell agreements. Although this was targeted specifically at wealth management firms, the same issues and themes apply to asset managers, trust companies, and other investment management businesses.Pull your shareholder agreement out and compare it to our whitepaper. You’ll probably find that the “downtime” afforded by working remotely and traveling less is a perfect time to clean up some practice management issues, including your buy-sell.Here's the code with a black border added to the image: htmlWHITEPAPERBuy-Sell Agreements for Wealth Management FirmsDownload Whitepaper

May 2020 SAAR

May Vehicle Sales Supported Optimistic Predictions, But a Slow Manufacturing Rebound is Threatening to Hinder This Growth

May ReopeningsMay brought some hope of a return to normalcy with most states easing lockdown restrictions and stay-at-home orders. With this easing of orders, businesses were optimistic that their economic struggles may be alleviated as their customers could finally return. However, the effects of shutting down an entire global economy do not go away as soon as lockdowns end with major supply chain disruptions contributing to bottlenecking and inconsistent inventories. This issue will be prevalent across many industries and auto dealers won't be exempt. The industry will be impacted by manufacturing slowdown problems.May SAAR UpdateAfter a devastating April SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks), predictions for a rebound in May proved to be correct. Vehicle sales in the month jumped with SAAR increasing 38.6% to 12.2 million. Though this was a 29.7% decline from May 2019, the uptick from April and March numbers point to a recovery. Dealers are hopeful that April was the lowest the SAAR would reach, and with this new data, feel greater confidence in their predictions.May vehicle sales jumped with SAAR increasing 38.6% to 12.2 million.As we mentioned in our April SAAR post, many of these sales reflected dealers embracing online technologies and incentive programs to get cars out the door. Recently released data for May from Edmunds.com showed that the annual percentage rate (APR) on new financed vehicles averaged 4% last month. This was a drop compared to the April average of 4.3%. More strikingly, however, was the difference from the year-ago average of 6.1%. May’s 4% rate is the lowest average interest rate since August 2013.While auto dealers were able to use different methods to increase sales, factories that supply auto parts and cars did not have such flexibility. The reopening of plants for General Motors, Ford Motor, in mid-May came after an almost 2-month production hiatus. Furthermore, though plants have begun reopening, they are not running at full capacity. Jamie Butters, Chief Content Officer of Automotive News, noted that disruptions in both Mexico and the U.S. manufacturing industries from the virus and social distancing measures threatens to cut the flow of vehicles and vehicle parts. According to a report from industry research firm LMC Automotive, fewer than 9 million vehicles are expected to be produced in 2020, the lowest since 2011 when an earthquake in Japan disrupted the global supply chain. If volumes are going to snap back like some have forecast, this will either require a pivot to used vehicles, or an increase in the expectations for vehicle production.Dealership Inventory HeadwindsEven if auto dealers wanted to reopen their dealerships at 100% capacity, they need the pipeline of inventory to do so. Dealers who liquidated inventory (sometimes at fire sale prices) may have trouble sourcing popular models if production can’t ramp back up quickly enough. As the Lansing State Journal notes, “Every vehicle that is sold is a catch-22 for the industry. Every sale depleted inventory but with manufacturing all but frozen those inventories could not be replenished.”According to data from the BEA, April saw an inventory-to-sales ratio of 3.6, its highest level since February 2009. This likely says more about severely depressed sales than any excess in inventory. Prior to the pandemic, this ratio was actually below 2.0 for four consecutive months, a figure that has only occurred twelve times since 2000. Although BEA data for May inventory has not been released yet, according to Motor Intelligence, new-vehicle U.S. inventory fell 32% in May, to about 2.6 million, the lowest in recent years. Among the vehicles in the shortest supply are large pickup trucks. In a research note Monday, Barclays warned of a “critical risk of supply shortages” of large pickups, estimating dealers had only 44 days of inventory before running out of models such as the Ford F-150 and GM’s Chevrolet Silverado. The truck stock is half of what it was earlier in the year.Barclays isn’t the only bank focused on inventory. John Murphy of Bank of America asked all of the public auto dealers about the potential for short inventory in the summer months, and many acknowledged the potential for shortages. Below are some select quotes regarding the topic from the earnings call:“At the end of March, our total new vehicle inventory was $861 million, and our day supply was 105, up 18 days from the prior year. In April, we were able to drop our new car inventory approximately $120 million from March 2020. While these levels may seem high, because the OEM factories have been shut down, we believe we could run into a low day supply for the summer selling season. […] in some of our luxury and some of our domestic specifically, we could run into a lower day supply of some of the models.” –Dan Clara, SVP Operations Asbury Automotive Group“But I think we're going to have a big issue on incoming inventory from all the manufacturers. You've seen the German manufacturers starting and then stopping from the standpoint of a new production. I know from Daimler's perspective in Mexico. They pushed off heavy duty trucks like two months. It's not the fact that they don't want to open or not meeting the protocols in the plant is the fact that the supplier base -- in the old days, maybe back in '08 and '09 at least OEMs are more vertical from the standpoint of the supplier their parts for their vehicles. That's not the case today. So, they have to rely on many, many suppliers and I think that's going to be key.” – Roger PenskeRental Company DeclineRental car bankruptcies could result in a high number of used cars diluting an already crowded used car market.A decline in the rental car industry may compound the problem. In late May, Hertz and the parent company of Advantage Rent A Car filed Chapter 11 bankruptcy due to debt and global travel being wiped out from the COVID-19 pandemic. New vehicle sales to rental car companies accounted for about 10% or 1.7 million vehicles last year. That demand came to a screeching halt due to the COVID-19 pandemic, and some analysts expect no more than 250,000 such sales in 2020. While the disruption in the rental car industry most directly impacts automakers, used car dealerships could find themselves in trouble as well. With downsizing expected among restructuring efforts, the rental car bankruptcies could result in a high number of used cars diluting an already crowded used car market and impacting overall used car prices. Although this may mean a good deal on a vehicle purchase for consumers, trade-in values would decrease and lower values could damage auto brands and impact newer model pricing.Despite the prospects of inventory shortages and used vehicle surpluses later in the summer, as long as there is not another major disruption to the supply chain and travel, these issues may not be long lasting. As Chris Holzshu of Lithia Motors noted in their earnings call, “Once the ramp up starts, it takes about 30 days for a vehicle to get completed on the production line and make it to one of our stores.” Though a month of disruption is not ideal, it can be managed. Dealers will hope to get through short supply by nudging customers towards less in-demand models. As travel picks up in the future, rental car companies can expect to see increased activity and thus, less saturation of the used car market.ConclusionWhile the rest of the country began to try to start fresh after months indoors, I decided that I needed a change in my own household as well in the form of an Australian Shepherd puppy. As you can see, Bobby loves Mercer Capital and the auto dealer industry team just as much as I do. We follow SAAR and other key industry trends to gain insight into the private dealership market. To discuss how recent industry trends may affect your dealership’s valuation, feel free to reach out to us.

Themes from Q1 2020 Earnings Calls

Part 1: E&P Companies

In the first quarter of 2020, oil benchmarks ended arguably their worst quarter in history with a thud. The concurrent overlapping impact of (i) discord created by the OPEC / Russian rift and resulting supply surge; and (ii) the drop in demand due to COVID-19 related issues was historic. Brent crude prices began the quarter around $67 per barrel and dropped to $50 per barrel by early March before plummeting to $19 per barrel by the end of the month. WTI pricing behaved similarly although it continued to trail Brent pricing by a narrowing margin (about $5 per barrel) at the end of the quarter. For context, WTI recovered to a range of roughly $25 per barrel to $30 per barrel relative to when the earnings calls occurred in late April and early/mid-May. As of yesterday, WTI closed at $37.29 per barrel. Natural gas has trended downward but has been more stable in the U.S. as its pricing is generally more tied to region-specific factors.This week, we examine some of the most discussed items and trends from E&P companies’ Q1 earnings calls. We will turn our attention to those in the mineral aggregator space in a subsequent post.E&P CompaniesOperators experienced mixed earnings in the first quarter. Although operators started the year with a positive outlook, the events that occurred in March quickly forced them to reconsider their forecasts. Investors and participants were far less concerned with earnings figures for the quarter than future implications of current events.Theme 1: Setting Priorities During Uncertain TimesOperators seemed inclined to comment on their priorities moving forward. Making cuts to capital expenditures was predicted and unanimous among the group; however, the operators discussed other measures that they are implementing to combat the current depressed environment.“Paying our interest expense, retaining our people and paying our dividend remain our priorities through these uncertain times.” – Travis Stice, CEO, Diamondback Energy“First, optimizing our cash flow by adjusting our spend rate, production and cost structure. Second, maintaining a strong balance sheet. Third, continuing to return capital to shareholders through our dividend. And finally, maintaining flexibility to cut further while also preserving our operational capacity.” – Timothy Leach, Chairman & CEO, Concho Resources“Our capital allocation priorities are balance sheet, dividend and capital spending.” – Scott Sheffield, Chairman & CEO, Pioneer Natural ResourcesTheme 2: Maintaining Bank Relationships in Times of NeedBanks will continue to play a substantial role as many of the operators relied on tapping into their credit lines and/or other debt instruments to satisfy liquidity needs.“Our banks are very strong. Our credit facility is strong. We don’t have covenants really in there, debt-to-capital covenants, only one we have, and we’re well south below that and we’re not in any realm of even approaching that. Our debt would have to go up by $8 billion to hit that covenant level. So, I told you we’ve got a lot of cushion.” – John Hart, CFO & Treasurer, Continental Resources“As of today, the undrawn capacity on our credit facilities total $6.75 billion. We believe a strong balance sheet is essential to succeeding in this industry and we are committed to maintain our investment grade credit rating.” – Don Templin, CFO, Marathon Petroleum CorporationTheme 3: Prepared for the Worst While Hoping for the BestMany operators focused on their individual advantages to convey their resilience during the difficult pricing environment.“Diamondback is prepared to operate in a lower oil price environment and our cost structure will prove to be a differentiator through this downturn. Low interest expense, low leverage, industry leading low cash G&A, a full hedge book, strong midstream contracts and benefit of Viper and Rattler will allow them to operate effectively through these uncertain times.” – Travis Stice, CEO, Diamondback Energy“Just as Pioneer entered this downturn as one of the best positioned companies, we will emerge just as strong. The key points here, obviously, is maintaining our top-tier balance sheet through capital discipline, combined with significant cost reductions in 2020.” – Scott Sheffield, Chairman & CEO, Pioneer Natural Resources“We still have levers we can pull if conditions deteriorate further, and we will maintain flexibility to make additional cuts to our spending.” – Timothy Leach, Chairman & CEO, Concho ResourcesTheme 4: Providing Flexibility with LiquidityE&P companies are attempting to maximize liquidity to allow financial flexibility.“Just to be on the safe side, we did increase our liquidity position in early April by adding a 364-day credit facility, a little over $900 million that get our liquidity up to $2.4 billion.” – Scott Sheffield, Chairman & CEO, Pioneer Natural Resources“We’ve taken steps to maintain our financial flexibility. We’ve secured $3.5 billion of additional liquidity, including a new $1 billion 364-day revolver, and issued $2.5 billion of senior notes.” – Mike Hennigan, CEO, Marathon Petroleum Corporation“With our reduction in spending, current hedge protection and suspensions of our buyback program, we expect to maximize liquidity and retain cash to pay down debt.” – Travis Stice, CEO, Diamondback Energy There is no question that E&P companies were forced to react quickly during the first quarter of 2020. Macroeconomic events mixed with a global pandemic slashed demand and caused prices to plummet. The operators tried to convey their confidence and resilience with their strategies moving forward. Time will tell whether they come out of this situation as stronger companies.

Top Three Valuation Considerations for Credit Unions When Contemplating a Bank Acquisition

After five or six years of strong bank M&A activity, 2020 slowed drastically following the onset of COVID-19.Eventually, we expect M&A activity will rebound once buyers have more confidence in the economy and the COVID-19 medical outlook. In that case, there will be greater certainty around seller’s earnings outlook and credit quality, particularly for those loan segments more exposed in the post-COVID-19 economic environment. The factors that drive consolidation such as buyers’ needs to obtain scale, improve profitability, and support growth will remain as will seller desires to exit due to shareholder needs for liquidity and management succession among others. Credit Unions as Bank AcquirersOne emerging trend prior to the bank M&A slowdown in March 2020 was credit unions (“CUs”) acquiring small community banks.Since January 1, 2015, there have been 36 acquisitions of banks by CUs of which 15 were announced in 2019. In addition to the factors favoring consolidation noted above, credit unions can benefit from diversifying their loan portfolio away from a heavy reliance on consumers and into new geographic markets.In addition to diversification benefits, bank acquisitions can also enhance the growth profile of the acquiring CU. From the first quarter of 2015 through the second quarter of 2019, CU bank buyers grew their membership by ~23% compared to ~15% for other CUs according to S&P Global Market Intelligence.A positive for community bank sellers is that CUs pay cash and often acquire small community banks located in small communities or even rural areas, that do not interest most large community and regional bank acquirers.Valuation Issues to Consider When a Credit Union Acquires a Commercial BankThere are, of course, unique valuation issues to consider when a credit union buys (or is bidding for) a commercial bank.Transaction Form and Consideration. Transactions are often structured as an asset purchase whereby the CU pays cash consideration to acquire the assets and assume the liabilities of the underlying bank.Taxes (CU Perspective). CUs do not pay corporate income taxes, and this precludes them from acquiring certain tax-related assets and liabilities on the bank’s balance sheet, such as a deferred tax asset.Taxes (Bank Perspective). If a holding company owns a bank that is sold to a CU, then any gain will likely be subject to taxation prior to the holding company satisfying any liabilities and paying a liquidating distribution to shareholders.Expense Synergies. CUs often extract less cost savings than a bank buyer because bank acquisitions are often viewed as part of their membership growth strategy whereby the transaction expands their geographic/membership footprint and there will be no or fewer branch closures.Capital Considerations. CUs must maintain a net worth ratio of at least 7.0% to be deemed “well capitalized” by regulators. The net worth ratio is akin to a bank’s leverage ratio and the pro-forma impact from the acquisition on the net worth ratio should be estimated as the increase in assets from the acquisition can reduce the post-close net worth ratio of the CU. Some CUs may be able to issue sub debt and count it as capital but CUs often rely primarily upon retained earnings to increase capital.Other. CU acquisitions can often take longer to close than traditional bank acquisitions and, thus, an interim forecast of earnings/distributions may need to be considered for both the bank and CU to better estimate the pro forma balance sheet at closing.Valuation Considerations for Credit Unions When Contemplating Acquiring a BankBased upon our experience of working as the financial advisor to credit unions that are contemplating an acquisition of a bank, we see three broad factors CUs should consider.Developing a Reasonable Valuation Range for the Bank TargetDeveloping a reasonable valuation for a bank target is important in any economic environment but particularly so in the post-COVID-19 environment.Generally, the guideline M&A comparable transactions and discounted cash flow (“DCF”) valuation methods are relied upon.In the pre-COVID-19 environment, transaction data was more readily available so that one could tailor one or more M&A comp groups that closely reflected the target’s geographic location, asset size, financial performance, and the like.Until sufficient M&A activity resumes, timely and relevant market data is limited.Even when M&A activity resumes, inferences from historical data for CU deals should be made with caution because it is a small sample set of ~35 pre-COVID-19 deals where only 75% of announced deals since 2015 included pricing data with a wide P/TBV range of ~0.5x to ~1.7x (with a median of ~1.3x).While deal values are often reported and compared based upon multiples of tangible book value, CU acquirers are like most bank acquirers in which value is a function of projected cash flow estimates that they believe the bank target can produce in the future once merged with their CU. A key question to consider is: What factors drive the cash flow forecast and ultimately value?No two valuations or cash flow estimates are alike and determining the value for a bank or its branches requires evaluating both qualitative and quantitative factors bearing on the target bank’s current performance, outlook, growth potential, and risk attributes. The primary factors driving value in our experience include considering both qualitative and quantitative factors. In a post-COVID-19 valuation, a CU may have a high degree of confidence in expense savings, but less so in other aspects of the forecast—especially related to growth potential, credit losses, and the net interest margin (“NIM”). Developing Accurate Fair Value Estimates of the Loan Portfolio and Core Deposit Intangible It is important for CUs to develop reasonable and accurate fair value estimates as these estimates will impact the pro forma net worth of the CU at closing as well as their future earnings and net worth.In the initial accounting for a bank acquisition by a CU, acquired assets and liabilities are marked to their fair values, with the most significant marks typically for the loan portfolio followed by depositor customer relationship (core deposit) intangible assets. Loan Valuation.The loan valuation process can be complex before factoring in the COVID-19 effect on interest rates and credit loss assumptions.Our loan valuation process begins with due diligence discussions with management of the target to understand their underwriting strategy as well as specific areas of concern in the portfolio.We also typically factor in the CU acquirer’s loan review personnel to obtain their perspective.The actual valuation often relies upon a) monthly cash flow forecasts considering both the contractual loan terms, as well as the outlook for future interest rates; b) prepayment speeds; c) credit loss estimates based upon qualitative and quantitative assumptions; and d) appropriate discount rates.Problem credits above a certain threshold are typically evaluated on an individual basis.Core Deposit Intangible Valuation.Core deposit intangible asset values are driven by both market factors (interest rates) and bank-specific factors such as customer retention, deposit base characteristics, and a bank’s expense and fee structure.We also assess market data regarding the costs of alternative funding sources, the forward rate curves, and the sensitivity of the acquired deposit base to changes in market interest rates.Simultaneously, we analyze the cost of the acquired deposits relative to the market environment, looking at current interest rates paid on the deposits as well as other expenses required to service the accounts and fee income that may be generated by the accounts.We analyze historical retention characteristics of the acquired deposits and the outlook for future account retention to develop a detailed forecast of the future cost of the acquired deposits relative to an alternative cost of funds.Evaluating Key Deal Metrics to Model Strength or Weakness of TransactionOnce a valuation range is determined and the pro forma balance sheet is prepared, the CU can then begin to model certain deal metrics to assess the strength and weaknesses of the transaction.Many of the traditional metrics that banks utilize when assessing bank targets are also commonplace for CUs to evaluate and consider, including net worth (or book value) dilution and the earnback period, earnings accretion/dilution, and an IRR analysis. These and other measures usually are meaningfully impacted by the opportunity cost of cash allocated to the purchase and retention estimates for accounts and lines of business that may have an uncertain future as part of a CU.One deal metric that often gets a lot of focus from CUs is the estimated internal rate of return (“IRR”) for the transaction based upon the following key items: the cash price for the acquisitions, the opportunity cost of the cash, and the forecast cash flows/valuation for the target inclusive of any expense savings and growth/attrition over time in lines of business.This IRR estimate can then be compared to the CU’s historical and/or projected return on equity or net worth to assess whether the transaction offers the potential to enhance pro forma cash flow and provide a reasonable return to the CU and its members.In our experience, an IRR estimate 200-500 basis points (2-5%) above the CUs historical return on equity (net worth) implies an attractive acquisition candidate. ConclusionMercer Capital has significant experience providing valuation, due diligence, and advisory services to credit unions and community banks across each phase of a potential transaction.Our services for CUs include providing initial valuation ranges to CUs for bank targets, performing due diligence on targets during the negotiation phase, providing fairness opinions and presentations related to the acquisition to the CU’s management and/or Board, and providing valuations for fair value estimates of loans and core deposit prior to or at closing. We also provide valuation and advisory services to community banks considering strategic options and can assist with developing a process to maximize valuation upon exit by including a credit union in the transaction process.Feel free to reach out to us to discuss your community bank or credit union’s unique situation in confidence. Originally published in Bank Watch, May 2020.

Driving Value: Key Components of an Auto Dealership Valuation

As a lifelong, avid sports fan, the lack of live sports over the past few months has created a huge void. In their absence, I have enjoyed watching the replays of several classic, iconic games from my childhood and teenage years: the 1986 World Series Game 6 aka the “Bill Buckner game,” the 1992 Elite 8 matchup between Kentucky and Duke aka the “Laettner Shot,” and the 1992 NLCS Game 7 between my beloved Atlanta Braves and the Pittsburgh Pirates aka the “Sid Bream Slide game” among others. The replays have been fascinating for the memories and emotions that they evoke, but it’s also interesting to see the finer details that had been lost or blurred from my memory over time. And yes, Buckner still missed the ball, Laettner still hit that miraculous shot (unfortunately), and Sid Bream was still safe! But what made these games iconic and have the classic value over time that they still do today?The appreciation and ultimate value of an auto dealership is impacted by several key value drivers.All of them had certain ingredients that were “controllable.” An Elite 8 or playoff game will always have greater stakes than a regular season game, and playoffs tend to have greater talent at a higher level of competition. It also just means more when it’s your team. And rivalries will always up the ante. These situations increase the likelihood of a game becoming a classic, but I also realized the games I rewatched had other uncontrollable components that contributed to their value – pressure moments, unlikely heroes like role players stepping up, and the never-ending spirit to keep competing until the final out or buzzer.Just like these classic sporting events, the appreciation and ultimate value of an auto dealership is impacted by several key value drivers. Some of these value drivers are controllable or able to be affected by the owner, and some are outside of their control.Auto dealers, like most business owners, are likely always curious about what their dealership might be worth. While there are many times they may want to know, there are various life events that make them need to know the value such as a transaction (including buy-sell), litigation, divorce, wealth-transfer, etc. While valuations tend to be performed infrequently around these events, dealers can evaluate their business and improve its value by understanding and focusing on the value drivers of their auto dealership and addressing them on a consistent basis. So, what are some of the value drivers of an auto dealership?FranchiseAn auto dealership’s franchise affiliation has a major impact on value. Each franchise has a different reputation, selling strategy, target consumer demographic, etc. Public value perception of franchises tends to be unique and are most easily illustrated through Blue Sky multiples. As the Haig Report and Kerrigan’s Blue Sky Report indicate, Blue Sky multiples vary over time even if they are frequently stagnant from period to period. Often auto dealerships and franchises are grouped into broader categories, such as: luxury franchises, mid-line franchises, domestic franchises, import franchises and/or ultra high-line franchises. Dealers may not have significant influence over the value perception of their franchise, making this value driver appear “uncontrollable.” However, dealers do have the opportunity to make bolt-on acquisitions and expand their operations to more rooftops. This will likely improve foot traffic to the various franchises in general and ultimately may improve the value of the business, particularly if they are able to appropriately decide which franchise to add.Real Estate/Quality of FacilitiesTypically, most dealership operations are held in one entity, and the underlying real estate is held by a separate, often related entity. Several issues with real estate can affect an auto dealership valuation. First, an analysis of the rental rate and terms should be performed to establish a fair market value rental rate. Since the real estate is often owned by a related entity, the rent may be set higher or lower than market for tax or other motivations that would not reflect fair market value. Second, the quality and condition of the facilities are crucial to evaluate. Most manufacturers require facility and signage upgrades on a regular basis, often offering incentives to help mitigate these costs. It’s important to assess whether the auto dealership has regularly complied with these enhancements and is current with the condition of their facilities. Owners seeking to drive value can do their part in making sure their facilities are up to date and appealing to customers.Due to the coronavirus pandemic, facility upgrades may become less of a value driver. Stay-at-home orders have forced consumers to buy automobiles through more automated means. While dealers have long touted their omnichannel offerings, the pandemic has put them to the test. The shift to digital platforms is expected to decrease foot traffic to the actual dealership. With the focus moved away from the dealer’s real estate and physical showroom, the importance of the latest and greatest signage is likely to be diminished. It’s possible that the quality of a dealer’s facilities may become less of a value driver if consumers are less dependent on those facilities.Employees/ManagementThe quality and depth of management can have a positive impact on an auto dealership valuation. Auto dealerships with greater management depth and less dependence on a few key individuals will generally be viewed as less risky by an outside buyer. Also, an auto dealership’s CSI (Customer Service Index) and SSI (Service Satisfaction Index) rating can influence incentives from the franchise and the overall perception of the consumer. A strong CSI and SSI are reflections of a strong service department and a commitment to quality customer service. While franchise customer service figures are not controllable, owners can make sure their employees provide consistent, exemplary customer service which will boost reputation and drive value.Recent Economic PerformanceLike most industries, the auto industry is dependent on the national economy. The auto industry measures and tracks sales of lightweight automobiles and trucks in a Seasonally Adjusted Annual Rate (SAAR), which is an indicator of historical economic performance in the auto industry. In addition to monitoring and understanding the current month’s SAAR, the longer-term history of the SAAR and its trends also provide insight into the auto industry and an auto dealership valuation. Below is a long-term graph of the SAAR over the past 20 calendar years:While dealerships tend to ebb and flow with the general economy, the industry can also be cyclical based upon the average age of cars owned. Consider a period with significant volumes over a number of years. Because cars are typically owned for several years, these customers are not repeat customers except to the extent they visit the parts and service departments. All else equal, periods with high volume sales tend to be followed by lower volume periods. As you might expect, dealers have minimal influence over these cycles. Like the bottom of the 9th in Game 7 of the World Series, it’s just going to mean more.Buyer DemandBuyer demand in the transaction market can illustrate the value climate for auto dealer valuations. Typically, buyer demand is measured by the deal activity in the M&A market. The Haig Report indicated that 2019 was another strong year for the buy-sell market after a sluggish beginning. They estimated 78 stores were acquired by public and private buyers in Q42019 alone. Similarly, Kerrigan’s figures also illustrate a strong buy-sell market for 2019 after a slow start. Kerrigan notes 2019 was the strongest year for transactions since 2014. Increased buyer demand leads to higher multiples and ultimately valuations for dealers. While this is not something that dealers can directly influence themselves, adhering to the other aspects noted in this piece can increase the likelihood dealers receive a favorable multiple.Buyer demand and M&A activity will be severely affected in 2020 as the buy-sell market has largely been placed on pause due to the economic conditions and stay-at-home mandates related to COVID-19. Again, this is largely out of the dealer’s control, though they can take steps to make their dealership more attractive.Location/MarketThe value of an auto dealership can be more complex than urban vs. rural or major metropolitan city vs. minor metropolitan city. Each store location is assigned a certain area or group of zip codes referred to as an area of responsibility (AoR). Particularly, how does a location’s demographic characteristics line up with a certain franchise? For example, a high-line auto dealership would perform better and seemingly be more valuable in a major metropolitan area with a high median income level, such as Beverly Hills, California, or South Beach in Miami than in a mid-western city. Conversely, a mid-line Store would probably fare better in areas with more moderate median income levels.We’ve discussed how the national economy can affect an auto dealership’s value, but in some instances, performance can also be greatly influenced by its local economy. Certain local markets are dominated by a particular trade or industry. Examples can be auto dealership locations near oil & gas refining areas, mining areas, or military bases. For example, there may be an influx in car sales as members of a particular base are deployed or return home. In such instances, a dealership is probably more dependent on local economic conditions than national economic conditions. This is where it is key for owners to recognize the environment in which they operate and tailor their operations to maximize these opportunities. Like Steve Kerr said when Michael Jordan was double-teamed in Game 6 of the NBA Finals, “I’ll be ready.”Single-Point vs. Over-Franchised MarketThe amount of competition in an auto dealership’s AoR, as well as the nearest location of a similar franchised auto dealership, can also have an impact. It’s important to make the distinction that we are talking about a single-point market and not a single-point dealership. A single-point market refers to a market where there is only one auto dealership of a particular franchise. An over-franchised market would be a larger market that may contain several auto dealerships of a particular franchise within a certain radius. Often, an auto dealership in a single-point market would be viewed as more valuable than one in an over-franchised market that would be competing with its own franchise for the same consumers. Additionally, the auto dealerships of the same franchise in the same market could be drastically different in size. One may be part of a larger auto group of dealerships, while the other may be a single-point dealership location, meaning that owner only owns that one location. A dealer with one of many Ford dealerships in a city, for example, is likely to be worth less because customers going to buy a new Ford have many convenient options. Additionally, a dealer with a single-point franchise is likely to lose out on customers that aren’t sure what make or model they want. If they only offer vehicles from one franchise at their location, they may draw less foot traffic due to less variety. We’ve already discussed how certain brands tend to receive higher Blue Sky Multiples and how that should factor into acquiring a new franchise. Owners looking to enhance the value of their dealership operations should also consider the saturation of franchises in their market. While a Lexus dealership may have a higher Blue Sky multiple than a Kia, if there are no other Kia dealerships in the market, they may be able to earn more in profits. Improving earnings are an easier way for owners to improve the valuation of a dealership as multiples tend to represent other uncontrollable market influences.Conclusions and ObservationsAs we’ve discussed, the value of an auto dealership is influenced by a variety of factors. Some of the factors are controllable, and some are external. Just like a classic sporting event, auto dealers have to focus on what they can control, hoping to create value and maintain or grow it over time.To find out the value of your auto dealership today, contact one of the automotive industry professionals at Mercer Capital. Whether or not you may have an upcoming life event that may necessitate a valuation, we can help you understand your progress and further understand our process. That way, when it comes time, you’ll be ready.

So You Got a PPP Loan, Now What?

At the time the Coronavirus Aid, Relief, and Economic Security (CARES) Act was passed in late March, the S&P 500 index was off roughly 30% from its all-time high, and many RIAs had seen similar declines in AUM and run-rate revenue. Since then, markets have recovered significantly, although due largely to Fed action rather than fundamentals. There is still a great deal of uncertainty and a real possibility that there will be a significant revenue hit for RIAs. With high fixed costs, that has the potential to cause a great deal of financial strain for many RIAs.In order to mitigate the potential impact of the COVID-19 crisis, many RIAs applied for and received loans under the Paycheck Protection Program (PPP) established by the CARES Act. These loans are intended to help small businesses keep employees on payroll during the COVID-19 crisis and may be forgiven if staffing levels are maintained and certain other requirements are met.The disclosure requirements related to the PPP loans are an important consideration for RIAs—which typically pride themselves on transparency. The SEC has released guidance stating, “If the circumstances leading you to seek a PPP loan or other type of financial assistance constitute material facts relating to your advisory relationship with clients, it is the staff’s view that your firm should provide disclosure of, for example, the nature, amounts and effects of such assistance.” The SEC considers using the PPP loan to pay staff providing advisory services to clients, a “ material fact” that requires disclosure. Many firms that received PPP loans have already filed revised Form ADVs with PPP loan disclosures.Many RIA owners are wondering what signaling effect the loans will have on clients.Now that the loans have been received and disclosure is strongly advised (if not mandated), many RIA owners are wondering what signaling effect the loans will have on clients. Will clients view PPP loans as a sign their advisor is experiencing financial strain or on the verge of financial insolvency? Or will clients view it as a precautionary measure rather than a last-ditch effort to stay afloat financially?We think that when properly explained to clients, there’s little reason for clients to be alarmed by their advisory firm receiving a PPP loan. A candid disclosure and discussion with clients about the receipt of the PPP loan, its intended use, and its potential impact on the firm is likely enough to put clients at ease.As a preliminary matter, it is worth putting the size of these loans in context. The amounts we’ve seen disclosed range from a few hundred thousand to around a million dollars for firms with assets under management in the $1 to $3 billion range. For firms of this size, this amounts to a month or so of revenue. That’s not nothing, but it’s not life changing either. A PPP loan is not likely to make a significant impact on a firm’s solvency.For most RIAs, the PPP loans are a safety net, not a matter of survival. Adding capital to the balance sheet makes a lot of sense in times of economic uncertainty for any business. The balance sheet of an RIA is usually somewhat of an afterthought—money comes in and is quickly used to pay compensation and other expenses. If there’s anything left, it’s distributed on a regular basis. All that’s typically retained on the balance sheet is a few months of operating expenses.Given the current economic uncertainty, it makes sense that RIA owners are paying more attention to their balance sheets. Adding additional capital to ensure the RIA is able to continue to operate at the same level regardless of what happens in the financial markets is a prudent business decision. It allows the RIA to protect its staffing level, provide security for its employees, and continue providing the same level of service. That assurance directly benefits clients.Many RIAs applied for PPP loans out of an abundance of caution and not desperation.Many RIA clients are business owners themselves, and many have likely received PPP loans for their own businesses. We think clients will recognize that in most cases RIAs have applied for PPP loans out of an abundance of caution and not desperation.It's also important to note that the economic situation seemed much more dire just a few months ago when RIAs and other businesses began applying for PPP loans. At that time, the length of the shutdown was still indefinite and the path by which we would return to normalcy was much less clear. Now that the uncertainty has abated somewhat, many RIAs have found that they didn’t need the funds from the PPP loan during the peak of the shutdown and don’t think they will in the future. Some RIAs are considering returning the money because they haven’t needed it.All of that is to say that we don’t view an RIA receiving a PPP loan as a sign for alarm, and we don’t think clients will either as long as the rationale is explained clearly. The number of RIAs that have received PPP loans is (at least anecdotally) quite large. At least seven firms on the Dynasty Financial Partners platform have received the loans, as have many of our clients. While RIA’s profitability may suffer, we ultimately expect that most of the firms receiving PPP loans will weather the COVID-19 crisis with only minimal operational impact, and the PPP loans provide an additional level of assurance that this will be the case.

Issue No. 6 | Data as of Mid-Year 2020

Feather Articles: Take Advantage of Current Estate Planning Opportunities While You Can and Q3 2020 Earnings Calls

Royalties And Minerals: A New Market Is Emerging

The marketplace has delivered some jarring blows over the past few months to players in the mineral and royalty space. Although this asset class enjoys certain benefits relative to oil and gas producers, its value is still connected to commodity prices. The recent swing downward has staggered market participants and quickly changed several assumptions regarding a sense of normalcy. In analyzing the sector, we pulsed EnergyNet, one of the largest private mineral transaction platforms in the market. Chris Atherton, EnergyNet’s CEO, is about as close to the royalty and mineral market as anyone. How close? Consider the following:EnergyNet has closed over 400 royalty, overriding royalty, and/or mineral transactions this year through April 2020.The platform frequently handles transactions with participants ranging from individuals all the way to integrated majors such as Chevron CVX and Shell.Geographically, they handle transactions across the contiguous United States.They regularly broker transactions across the dollar size spectrum in this market, ranging all the way from five figures to eight figures. Therefore, it is reasonable to suggest EnergyNet represents an excellent glimpse into the royalty and mineral market at large (no – I did not get paid to say that). In the course of my correspondence with Chris Atherton, several interesting market movements began to emerge. After the March 7th launching point with the OPEC+ impasse, EnergyNet’s platform has taken several twists and turns. Both demand and supply shocks have squeezed the market and values have plummeted. The timeline below chronicles this: [caption id="attachment_31848" align="alignnone" width="709"]Source: EnergyNet[/caption] ObservationsThe fact that valuations have decreased is not news at this point, but what is interesting is that this environment has changed a lot of things along the way:Buyer Pool – Currently EnergyNet has 33,000 buyers vs. 7,000 sellers on its platform. Buyer registrations have skyrocketed in the past few months. New investors are seeking what they perceive as a potential good deal. At the same time, many of the larger participants on their platform (majors and independent producers) have paused much of their selling activity. Possibilities for this hiatus can vary. Changing economics are certainly a factor, but sellers also may be concerned about entering restructuring negotiations and do not want to be divesting assets in the time leading up to what may eventually be a bankruptcy filing.Liquidity and Valuations – Although typically not falling as far as upstream producers, valuations for minerals and royalties have plummeted. Deals, even in quality basins, are trading for half of what they were a few months ago. Liquidity has been a part of this. As buyers and sellers wallow in uncertainty, more and more deals are either terminating or not happening at all. [caption id="attachment_31849" align="alignnone" width="640"]Source: EnergyNet [/caption] Basin Preferences – During this time, a previously unexpected occurrence has happened: gas assets are considered a more “tradeable” investment. Said Atherton: “With gas in the proverbial doghouse, buyers are becoming more attracted to its relative stability. Sellers have noticed this too and are more reticent to trade. The transaction volume is still thin, but interestingly, the rationale has shifted.” This has led to an uptick in Appalachian and East Texas interest. Colorado has lost favor, as much due to its changing regulatory climate as commodity prices. The Bakken has had decreasing interest as well with its higher breakeven prices and transportation issues. [caption id="attachment_31850" align="alignnone" width="640"]Source: EnergyNet [/caption] Takeaways“We are going to have a different market coming out of this.” says Atherton. What exactly that market will look like is another question. Speaking of questions, what will drilling activity look like going forward? How might the relationship between the mineral owner and operator change? It is possible that litigations between royalty owners and operators will pick up?Arguably, the most pertinent question above all is this: How will horizontal wells respond to being shut-in? This is an experiment that has never been tried before. Nobody knows how the wells may or may not respond when the spigots get re-opened at some future point. This uncertainty is part of why values are so depressed right now. The answer, whenever it comes, could be the lynchpin to what royalty and mineral valuations will look like in the future.Originally appeared on Forbes.com.

Q1 2020 Earnings Calls

COVID-19 Causes Declines in Q1, but Executives Maintain Optimism Going Forward

Auto dealers stock prices declined in the first quarter of 2020 following the broader market trend. Though many dealers saw year-over-year gains in sales and earnings in the first two months of the year, earnings calls focused on the coronavirus pandemic. Volumes have fallen across the country, though executives pointed to recent positive trends. Downturns have muddied the M&A market, and some companies don’t plan to rehire everyone that has been let go. Many praised the support of OEMs including significant incentives such as 0% financing. With dealership doors shuttered, many executives touted their online presence, though there was not a consensus on digital’s long-term place in the market.CarMax (stock price -4% year-to-date May 26th) and Carvana (+48%) have performed better than traditional franchised dealers (-23% on average), pointing to the strength of this business model during this time. Vroom, Inc., another online used car seller, even filed for an IPO despite the significant macroeconomic headwinds and recent poor performance of auto-adjacent tech-company offerings. If the offering occurs as scheduled and performs well, this bodes well for AutoNation, who owns about 7% of the company after a $50 million investment in late 2018. In mid-April, AutoNation granted its CEO, Cheryl Miller, a leave of absence for health reasons. They also returned their PPP loan well before the Safe Harbor Deadline (most recently postponed to May 18th) due to shifting guidance about eligibility. It should also be pointed out that their eligibility as one of the largest auto dealers in the country drew ire from the public.AutoNation wasn’t the only public auto dealer facing its own issues amid the market turbulence. Asbury scuttled their $1 billion Park Place transaction, which included $10 million in damages, not counting other expenses incurred related to due diligence and financing. This would have been one of the largest transactions in the auto dealer space in years. Penske waited until after their earnings call to announce they were cutting their dividend, “consistent with the other measures the company has implemented the impact of COVID-19.” The S&P 500 has rallied significantly from March lows due to significant liquidity injections and optimism of a quick “V-shaped” recovery, but there may be more room for it to fall if more companies like Penske and Group 1 have to cut dividends.Theme 1: April was the worst month for national sales volumes in decades. However, recovery has been evident on a weekly basis even throughout April as companies ramp up their digital capabilities.In the U.S., our workshops have generally remained open, unlike many of our showrooms, but the flow of service customers has been down 40% to 50% since mid-March, simply because most of our customers have been living under shelter-in-place orders. The closure of most of our U.S. showrooms since mid-March has reduced new and used vehicle sales by a similar percentage. […] As April progressed, we began to see some rebound in our week-over-week sales base in the U.S. market. For the final week, retail unit sales were down approximately 25%, and service revenues were pacing about 30% lower than prior-year levels. -Earl Hesterberg, President and CEO, Group 1 AutomotiveDuring this period, our overall vehicle sales volumes fell roughly 40% compared to the prior year. […] In the past week though, the year-over-year vehicle sales declines have improved to roughly 30%, with used vehicle sales being slightly more resilient than new vehicle sales. Parts and service gross has also improved over the past week as states begin to relax their stay-at-home orders and customers begin to return for delayed repair and maintenance work. -David Bruton Smith, CEO and Director, Sonic AutomotiveTheme 2: Coronavirus has accelerated the push to digital, resulting in heavy investment which means online shopping will continue beyond the pandemic. However, some executives believe consumer preferences and their (lack of) understanding of financing options will continue to be roadblocks to fully online.I think that [digital] trend was already underway where the value of a brand and experience and a warranty/guarantee has all been expressed as a consumer of things that are valued and there’s been a movement towards companies like AutoNation with One Price, CarMax, Vroom, Carvana. […] I think for digital, this whole disruptive period with corona is an inflection point from which there’s no turning back. […] You need first-class digital capability; you need a safe environment for your customers and a safe environment for your associates. That is the Holy Grail going forward. We see no difference in profitability between the digital channel and the traditional challenge whatsoever. -Michael Jackson, Chairman and CEO, AutoNation[W]e believe that about half of the consumers today would really prefer to be able to buy cars in the comfort of their own home. We are seeing though that there is still many of the consumers and we’ve narrowed it down that we think that about 20% of the consumers have the ability to [complete the car buying process] by doing it digitally and doing it all from home without human interaction. The other 80%, we really believe even though they want to that’s the biggest impediment not the desire, but consumers just don't have the ability. -Bryan DeBoer, President and CEO, Lithia MotorsA lot of customers that come in whether they don't know what they're looking to acquire, they don’t know the kind of vehicle that they want for their family or they have some financial issues. As we’ve said before, you know, our average consumer has $5,100 of negative equity that they’re working to, you know, leverage our finance specialists to help them find the right solutions for them. -Chris Holzshu, EVP and COO, Lithia MotorsTheme 3: Auto dealers cut headcounts to manage SG&A expenses, but not all these jobs will return when markets stabilize due in part to digital. Some are optimistic they will bring everyone back, and most directly relate rehiring to the rate at which business returns.I don't know that [headcount related cost saves are] near-term, I think what we have to do is understand what will be the footprint of our business. How much will be digital? How much will be done from home? How many people we have actually working in the operations? […] As we see the number of people we have furloughed and as a business going [forward will] be decided by how business comes back. -Roger Penske, Chairman and CEO, Penske Automotive GroupWe didn’t furlough any technicians. Because of our cash position and how we manage our expenses [the quarter could have been better] had we just cut the normal expense as you would in a typical recession. We believe that this was going to be temporary. And eventually, the business was going to come back. […] we have strong metrics that will dictate to us when we bring people back. And when we see those metrics starting to be achieved, we’ll certainly bring people back at that time. The folks that we’ve furloughed, we communicate with them consistently, and we were hopeful one day to bring them all back. -David Hult, President and CEO Asbury Automotive GroupWe’ve bought back 1,000 associates thus far, meaning that our staffing reduction is around the same as the business reduction. There is no predetermined cadence or plan as to when we bring back additional employees. […] [I]f I look back to 2008 and 2009, I would observe re-staffing trailed the improvement in business. […] And what other efficiencies and effectiveness around digital is figured out or we come to grips with, whether that leads fact that we hire everyone when we ultimately have a full recovery in our back, well, I can’t answer that today, other than I can say, rehiring will trail the growth of the business. -Michael Jackson, Chairman and CEO, AutoNationTheme 4: M&A has been delayed or canceled due to the coronavirus as buyers aren’t willing to pay what sellers want with earnings deteriorating. Executives believe consolidation will ultimately resume and companies focused on maximizing liquidity may be best positioned for such acquisitions.As we saw business decline, we acted decisively to fortify our business to prepare for the inevitable slowdown. Unfortunately, this included canceling the Park Place acquisition […] we thought the Park Place deal was going to be a transformational deal for us, and it was a heck of an acquisition, but things happen. On the other side of that coin, we’re sitting on a lot of cash and probably the lowest net leverage ratio we’ve had. […] I think we need to see the dust settle a little bit. There is some activity out there. […] I don’t want to comment on [reengaging] the Park Place transaction. But we feel like from a cash position and where we’re sitting operationally, we have the ability to be very flexible and being acquisitive when the right opportunities come. -David Hult, President and CEO Asbury Automotive GroupI think it's going to be brand-by-brand where you have your strengths and also we have scale where you can consolidate some of the fixed costs, but I think it's too soon to look at that. […] We would focus [capital allocation] today, probably investing in the used car business from the superstore perspective and also look at expanding our footprint get on commercial trucks side. -Roger Penske, Chairman and CEO, Penske Automotive GroupWe need to verify earnings quality that they’re within that 90% to 95% earnings level of what they were pre-COVID-19. So, those earnings quality verifications will determine the second half closing date or possibly even beyond that in the event that earnings quality hasn’t improved. There are chances that if earning quality doesn't improve then we would actually renegotiate the transaction in terms of the goodwill amount as well. -Bryan DeBoer, President and CEO, Lithia MotorsOur liquidity position, for us, is about as strong as it's ever been. So as we come out of this, we do believe there's going to be some M&A opportunities for us -Jeff Dyke, President, Sonic AutomotiveSummaryEarnings calls this quarter were uniquely positioned. Despite much of the financial impact occurring in Q2, the demand shock caused by the coronavirus was so severe that many dealers saw a decline in Q1 figures. While things are expected to get worse in Q2, there is optimism as numbers continue to improve on a weekly basis. Still, it should be noted that volumes are becoming less negative, not reversing to positive in most instances. Hopefully trends will continue their positive trajectory by next quarter’s calls. Tough times are ahead for public and private dealers, but current investments in digital strategies may lead to some long-term benefits as a silver lining to this difficult situation.At Mercer Capital, we follow the auto industry closely in order to understand not only recent trends, but how investors ascribe value to the public dealerships. These give insight to the market that may exist for a private dealership. To understand how the above themes may or may not impact your business, reach out to one of us, and we’d be happy to chat via telephone, email, Zoom, or whatever your preferred communication in this dynamic digital age.

The Family Office

Managing Family Wealth Since 27 BC

After appearing on our Family Business Director Blog earlier this month, we decided to share this post as it provides useful guidance on assessing whether a family office is right for your family. Private investment office… Family business advisor... Single-family office… The name differs and the definition varies greatly depending on whom you ask. But the concept remains the same. Wealthy families often seek assistance to manage their accumulated wealth, organize family affairs, and preserve capital for future generations.The concept of a family office dates back as far as 27 BC.The concept of a family office dates back as far as 27 BC when Emperor Augustus Caesar, who at the time controlled approximately 25% of global GDP, employed a group of appointees to manage his estate, businesses, military, and even lifestyle. The concept continued to evolve in the sixth century when it was common for the king’s steward to manage the royal family’s wealth. However, the modern family office, as we know it today, took shape in 1882 when the Rockefeller family (with approximately $1.4 billion, equating to around $255 billion today) founded their family office to organize the family’s business operations and manage their investment needs.A family office is different than a traditional wealth management firm. A family office typically provides a full suite of services including accounting, budgeting, family education, investment management, insurance, charitable giving, and sometimes even concierge services including travel arrangements, personal security, and miscellaneous other household services. However, it is hard to define the “typical” family office as most develop out of a family’s specific needs. Additionally, many wealthy families likely employ professionals who carry out such duties, without necessarily defining or even realizing their function is similar to a single-family office.Single-Family Office vs. Multi-Family OfficeA single-family office is tailored to meet your family’s specific needs. However, to warrant the cost of a single-family office, a family’s assets likely must exceed $100 million, and to afford a full investment practice, assets likely must exceed $250 million. As such, the multi-family office took shape to provide similar services to ultra-wealthy families (typically those with assets in excess of $25 million), while allowing for cost-sharing between multiple families. A multi-family office can be commercially owned by a group of outside investors or privately owned by a founding family with significant wealth. For example, the Rockefeller family office, which has served the Rockefeller family for almost 140 years, recently expanded its services to over 250 clients.There are key legal and regulatory differences between a single-family office and a multi-family office. Because single-family offices serve only one family, they are not registered with the SEC (the Investment Advisor Act of 1940 made single-family offices exempt from SEC registration). Multi-family offices, on the other hand, are typically structured as registered investment advisors (RIAs), which are registered with the SEC, or trust companies, which are typically regulated at the state level.Additionally, a single-family office’s main goal is to preserve and generate wealth for the family. Whereas a multi-family office also seeks to generate a profit for itself. This results in a somewhat lower return on assets for families belonging to a multi-family office as the profits are split between the families and the ownership base. We have compiled what the average income statement for a single-family office and multi-family office looks like to highlight this difference. [caption id="attachment_31050" align="alignnone" width="784"]Charts Compiled by Mercer CapitalData per The Global Family Office Report 2019AUM = Global Average AUM for SFOs and MFOs Portfolio Return = Average Family Office Portfolio Return from Q1/Q2 2018 through Q1/Q2 2019 in N America Expenses = Average Global Expenses for SFOs and MFOs[/caption] As shown above, the total return on assets managed by a single-family office (5.2%) is slightly higher than the return on assets managed by the multi-family office (4.9%). The return generated by the multi-family office, however, is sensitive to our assumption of fees charged for family office services. We have estimated multi-family office fees to be 1.0% of AUM. Family offices have varying fee structures but typically include a combination of fixed fees, hourly fees, and asset-based fees. While these asset-based fees typically range between 50bps to 100bps, for comparability, we have assumed a fee at the higher end of this range to provide an estimate for comprehensive services such as would be provided by a single-family office.Investment Performance At first glance, the average return for the portfolio (5.9% for the twelve months ended Q1/Q2 2019) appears rather low, given that wealthier individuals typically have a greater ability to take risk, leading to generally higher returns. However, keep in mind that family offices don’t just manage an individual’s investable assets, as does a typical wealth manager from whom you would likely expect a 7%-ish return. A family office generally manages a family’s entire portfolio, including cash.The “average” portfolio for a family office is shown below. [caption id="attachment_31052" align="alignnone" width="851"]Source: The Global Family Office Report 2019[/caption] Recently, family offices have started investing in more diverse and riskier products, such as private companies and distressed debt, that have typically been reserved for institutional investors. Family offices have reduced their allocation to hedge-funds over time, unable to justify such high fees for often mediocre performance and have reallocated these funds to direct investments in debt and equity. Over the last few years, family offices have become somewhat of a disruptive force in the private equity and venture capital space as they are able to offer competitive pricing and terms since their holding periods are longer than the typical private equity fund and they have more flexible investment criteria than a private equity firm who may be working to manage the expectations of hundreds of investors, instead of one family.Growing Presence of Family OfficesEducating your family about how your wealth and/or family business is managed is essential for the preservation of your family legacy.In the 1980s family offices started to multiply as the number of families who were able to afford such services increased the concept. In 2018, EY estimated that there were approximately 10,000 single family offices worldwide, a ten-fold increase over less than a decade. Looking forward, the number of single and multi-family offices is expected to continue increasing as the number of wealthy families grows and investor preferences continue to shift towards having more control over one’s own wealth. While family offices are more streamlined than traditional investment firms there are some obvious drawbacks of mixing business and family. This is why family education and communication is so important. Educating your family about how your wealth and/or family business is managed is essential for the preservation of your family legacy.As the family office continues to evolve and wealthy families have more options when it comes to managing their wealth, it will be increasingly important for families to ask who can help them best align the family’s interests, making it easier to operate your business, cooperate with other family members, and allow yourself more time to do what is important to you.

Why Are Small Cap RIAs Down 40% Over the Last Year?

Most Investment Managers Remain in Bear Market Territory Even as the Broader Market Recovers

Believe it or not, the S&P 500 is exactly where it was a year ago. It’s been a wild ride, but most diversified investors probably haven’t done as bad as they think during this time. Unfortunately, that’s not the case for the RIA industry, which is still reeling from the Coronavirus pandemic and numerous other industry-specific headwinds. Such a divergence is unusual for an industry tied to market conditions, so this week we analyze the driving forces behind this disparity.From a quantitative perspective, most of this deterioration is attributable to rising cap rates. Earnings multiples (the inverse of cap rates) tend to follow trends in AUM, which are leading indicators for future revenue and profitability. The market fall-out in the first quarter precipitated a sharp decline in AUM and lowered expectations for future management fees and cash flow. Trailing twelve month multiples shrank to all-time lows in anticipation of much weaker earnings reports over the next few quarters. Smaller RIAs have generally fared worse as lower margins and AUM provide less of a cushion against adverse market events.The earnings decline is a bit more intuitive. The bear market triggered declines in AUM and management fees, which combined with a bit of operating leverage has created margin pressure for most of these businesses. The cumulative effect of a 10%-15% earnings decline and a 30%-35% multiple contraction is a sharp contraction in equity prices.The recent pullback is certainly a catalyst but not the only culprit here. Pre-COVID, the industry was already facing numerous headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. The 11-year bull market run masked these issues (at least ostensibly) as AUM balances largely rose with equities over this time. Finally faced with a market headwind, the bull market for the RIA industry came to a grinding halt last quarter.A notable exception in the RIA space is the alt asset sector. Many of these businesses have actually thrived in the current environment as their AUM is typically not directly tied to equity market conditions. As a result, they generally did not fare as well over the last decade relative to more traditional asset managers, but recent events have made most of their asset classes more attractive than public equities.OutlookIt’s difficult to assess how long these divergent trends in pricing will hold up. We’d expect some mean reversion over time, though alt managers should continue to outperform other classes of RIAs in a bear market with elevated levels of volatility. If, on the other hand, we get more months like April, we should see a bounce in traditional asset manager multiples. Unfortunately, May hasn’t been so kind.The trends in earnings multiples are a bit more revealing. Falling cap rates suggests a more promising outlook for alt manager cash flows, though it varies by asset class. A hedge fund that thrives on volatility, for example, should fare much better than, say, an MLP or commodity investor. The sharp decline in small cap RIA multiples so far this year tells us that the market is anticipating drastically lower levels of profitability for many of these businesses. The recent bear market compounded the prevailing headwinds pertaining to asset outflows and fee pressure, and several publicly traded RIAs have lost over half their value over the last year.Implications for Your RIAYear-to-date, the value of your RIA is most likely down; the question is how much. Some of our clients are asking us to update our year-end appraisals to reflect the current market conditions. There are several factors we look at in determining an appropriate level of impairment.One is the overall market for RIA stocks, which is down 20% in the first quarter. The P/E multiple is another reference point, which has endured a similar decline. We apply this multiple to a subject RIA’s earnings, so we also have to assess how much that company’s annual AUM, revenue, and cash flow have diminished over the quarter while being careful not to count bad news twice.We also evaluate how our subject company is performing relative to the industry as a whole. Fixed income managers, for instance, have held up reasonably well compared to their equity counterparts. We also look at how much a subject company’s change in AUM is due to market conditions versus new business development net of lost accounts. Investment performance and the pipeline for new customers are also key differentiators that we keep a close eye on. On balance, it’s a lot to keep up with, and we’re happy to walk you through it if you’re considering a valuation.

April 2020 SAAR

April Showers Bring May Flowers? High Optimism Following a Historically Low April SAAR

April SAAR UpdateLast month, we mentioned the troubles that the auto industry is experiencing were most likely going to get worse before they got better considering the increases in COVID-19 cases and stay-at-home orders. April was always going to be the low point with the first part of March largely unimpacted, and cities and states now beginning to ease restrictions in May. SAAR (a measure of Light-Weight Vehicle Sales: Autos and Light Trucks) declined to 8.8 million units in April, its lowest level since the data started being recorded in 1976. This was a 47.6% drop compared to April 2019, and seasonally adjusted sales volumes were 24.5% below March, which was already 32.2% below February.SAAR declined to 8.8 million units in April, its lowest level since the data started being recorded in 1976.It is important to note that while overall volumes fell precipitously, the impact was felt differently throughout the country due to differences in state and local laws and responses to the pandemic. NADA noted that states with fewer restrictions on selling vehicles outperformed markets where restrictions were more stringent. Dealerships in the Northeast and West most likely felt stronger effects than those in the South or Plains. With no statewide stay-at-home orders in place in April for Arkansas, Iowa, Nebraska, North Dakota, South Dakota, Utah, or Wyoming, dealerships in these states may have not felt the same pain as their counterparts in breakout areas such as New York and New Jersey.Another factor contributing to dealership performance in April was the allowance of online car sales. Pennsylvania went from mid-March to April 20th without vehicle sales as a law had to be passed to allow for remote notarization to facilitate online sales with contactless delivery. Kentucky and Hawaii were also among the last states to ease online restrictions. Online sales during this pandemic have been important in keeping numbers up, though the transition was not seamless which likely had a negative effect on April volumes towards the beginning of the month.Financing Deals Supporting April SalesDespite the grim numbers, dealerships and experts remain optimistic about the industry during this time. One important reason for this is that although volumes declined throughout the country, dealerships managed to surpass expectations based on the impact on the Chinese auto market. During February, at the peak of coronavirus in China, Chinese automakers experienced almost an 80% drop. With less than a 50% decline, dealers in America are faring better than expected. How did the U.S. manage to avoid China's fate? A lot of it comes down to financing and incentives.While April sales decreased, zero-percent financing deals hit a record last month. More than one in every four new vehicles sold in April featured 0% financing, up from about 5% of new cars in March. Furthermore, lenders are offering loans for both new and used vehicles that allow borrowers to delay making payments for up to 4 months. With the Fed’s cuts putting downward pressure on interest rates, 0% financing is not as costly for dealerships as it might have been under normal conditions. A caveat to this is that some dealers are avoiding long-term 0% financing as it can be harmful to resale values and thus, risky for car buyers. Bob Carter, Executive Vice President for Sales at Toyota Motor’s North American unit said, “We’re not into zero-for-84 months. It’s not only not healthy for the industry, but also for the consumer.” Prevalence of 0% financing has certainly increased, though likely only for certain qualified buyers with good credit.Cost Effectiveness of 0% Interest Rate DealsWith so many dealers delaying payments or offering 0% financing, we were curious to see the impact these would have on profits. To do this, we used a present value calculation with certain assumptions to see the effects of 0% financing. Basic assumptions include:60-month loanNational average interest rate of 5.27%Average vehicle price for April 2020 from Kelley Blue Book of $38,060Depreciation cost of $100/day We assumed a depreciation cost associated with the vehicle sitting on the lot. Although determining a depreciation cost per day isn’t an exact science, we based this on the Sonic Automotive Earning Call, where Jeff Dyke, President of Sonic Automotive, equated sitting on inventory like a “banana rotting every day, $50, $100, $175 a day, whatever the number is, it’s rotting every day. If you’re sitting on it, you’re just creating a big bubble, and you’re going to have to pay for it at some point.” For illustrative purposes, we settled on a $100 a day depreciation cost. The following charts show a summary of the results from three present value calculations. As seen above, delaying payments by two months only reduces the present value of the loan from $38,174 to $37,848, or about $325. This represents less than 1% of the value of the car, and these terms would likely appeal to furloughed consumers who expect to be rehired between the purchase and the beginning of payments. If instead, the dealer offers 0% financing for the life of the loan, the present value of payments received drops to $33,494. That is a $4,680 difference between 0% financing and a 5.27% interest rate. While offering a 0% loan would not come from a bank, captive lending arms may find the F&I loss is worth the vehicle sale. These calculations illustrate that dealerships would be indifferent between selling a car today with 0% financing or waiting about 47 days to sell a car financed at 5.27%. Implicit in our depreciation assumption is that price concessions would likely have to be made to move the inventory. Additionally, every day a car sits on the lot costs dealerships on floorplan interest costs. It may be more comfortable for some to wait things out instead of accepting an upfront loss on F&I, but these calculations demonstrate that there are also costs to waiting, even if they are not as upfront. May SAAR ExpectationsThe outlook for the industry and the economy as a whole is steadily improving.Looking forward, expectations are high for a rebound in May. Sonic Automotive has said that the second quarter will be “the worst in our history” but believes declines due to the coronavirus pandemic bottomed out in early April, and the summer will bring a return to pre-virus levels. Lithia Motors CEO Bryan DeBoer has a similar stance, saying in their Q1 earnings call that, “I would say in vehicle sales, there's no chance that it will trough again unless there's a relapse or something in COVID-19 and the states get more strict because we’re already seeing relaxation of stay-at-home orders and early indications are we’re plus 10[%] week over week in new [vehicle sales]; we’re plus 30[%] week over week in used [vehicle sales].” Both Sonic and Lithia are planning on monthly announcements as to what they project their volumes to be. Market data supports this optimism, as TrueCar CEO Mike Darrow said that the raw data he has been following had been growing more positive in the last several days of April. Furthermore, JD Power released data and analysis suggest a rebound in the used car market mid-April.As stay-at-home restrictions and the outbreak of the virus begin subsiding, it is logical to assume that there will be an uptick in vehicles sold to both meet consumer current demand, as well as handling the pent up demand that the pandemic has caused. It is important to remember the uncertainties still concerning how successful the economy will be in reopening, but fortunately, the outlook for the industry and the economy as a whole is steadily improving.As I still sit at my desk working from home and reflecting on how I spent much more time watching shows than I did cleaning out my apartment like I had planned on during this pandemic, I am heartened to remember that although the uncertainty surrounding this time period can generate a lot of anxiety, there will be a day where we can leave our homes, hug our friends and family, and go back to living our normal lives. I hope that everyone out there is staying healthy and continues to check-in on their loved ones.

April 2020 SAAR

April Showers Bring May Flowers? High Optimism Following a Historically Low April SAAR

Are Public RIA Dividend Yields a Mirage?

Investors Quarantine Their Positions Despite the Search for Income, Strong Fundamentals

Twenty-five years before the marketing group at General Motors rebadged a humble Yukon to create the first Cadillac SUV, the Escalade, a body shop in California called Traditional Coach Works was modifying Coupe de Villes into a car/truck configuration they dubbed the Mirage. Whether or not anybody really needed a Cadillac to haul a 4x8 sheet of plywood was beside the point; the car was aptly named for the double-take any casual observer might have upon seeing one. The Mirage was sold through Cadillac dealers at nearly twice the cost of a standard Coupe de Ville, and in spite of that premium, buyers saw enough function in the form to order over 200 of them. A few are still around.Since the Coronavirus pandemic settled into the American consciousness in mid-March, industry pundits such as myself have been actively musing about the impact of the crisis on the RIA community. Two months later, we’ve learned:Most investment management firms can work very effectively on a virtual basis (at least for months at a time), and,The Fed is not afraid of moral hazard, and is, in fact, more than willing to socialize the cost of market disruptions (remember the other Golden Rule: whoever has the gold makes the rules). This should be calming, even inspiring, to shareholders of investment management firms. RIA operations are mostly unaffected by this pandemic, and RIA financial performance has been supported by massive central bank intervention. None of this explains the pricing of publicly traded RIAs, however; especially when you look at the impact that slumping valuations have had on RIA dividend yields.Are we really in a yield-starved environment? One would think so, with longer dated Treasuries priced more on the basis of a return OF capital than return ON capital. The broader market has shrugged off the likelihood of steep declines in earnings, leaving the dividend yield on the S&P 500 mostly unchanged from what it was before the advent of COVID-19. RIA pricing, ironically, has not enjoyed the same support.The valuation dysphoria facing the investment management industry does not make sense. RIAs are viewed by many as an ideal growth and income asset: with durable customer relationships producing revenue streams that drift upward with financial markets, and cost structures that can be leveraged to improve distributable cash flow per dollar of revenue. Despite this very supportable investment thesis and the absence of many alternatives, the market seems to have lost interest in the RIA sector. Why?A review of comments from first quarter earnings calls does not suggest that most industry participants are getting ready to cut dividends:Silvercrest Asset Management Group(6.0% yield): “Silvercrest currently pays a generous quarterly dividend of $0.16 or an annual dividend of $0.64 per Class A share of common stock. The firm anticipates that it can support the current dividend for a sustained period of time, even while continuing to invest in the business.” – Rick Hough, Chairman and CEOWaddell & Reed (7.1% yield): “…we feel pretty comfortable with respect to the level of the dividend at this point. There's quite a difference between the cash flows that we generate versus reported net income. And at this point, we feel very comfortable with the current level of dividend, [and] the sustainability of that.” – Philip Sanders, CEOBlackrock (2.9% yield): “As we’ve previously announced in late January, we increased our quarterly cash dividend by 10% to $3.63 per share and have no plans to reduce our dividend during the remainder of the year.” – Gary Shedlin, Chief Financial OfficerFranklin Resources (5.5% yield): “…just to complete the capital management with dividends. We [intend to] keep where they are, as you know we're pretty - a sacrament to us. We want to continue to pay out [the] dividend.” – Matthew Nicholls, Chief Financial Officer The one exception to this otherwise reassuring chorus is Invesco, which has suffered greatly from asset outflows, and recently cut its dividend in half:Invesco(7.9% forward yield): “Our decision to reduce our common dividend by 50% was done certainly with an understanding that the environment could weaken from here. It wasn’t necessarily our working assumption, but certainly we’re not thinking that we’re seeing a snap back going forward. But we don’t intend, and we certainly don’t intend to make another difficult decision like this again, and we do feel confident that this was the right action at the sufficient level to give us the flexibility that we desire to manage the balance sheet, even if the environment were to deteriorate from here, and we’ve stress tested this all which ways.” – Loren Starr, Chief Financial Officer Whether Invesco is the bellwether or uniquely challenged remains to be seen. On the whole, it’s difficult to rationalize a business leveraged off of market performance that has become priced so differently than the market. Either the RIA industry is being unfairly punished (and therefore represents a nice yield play at these prices) or broader equity markets are due for a comeuppance, or some combination of the two. Dividend stocks haven’t gotten much love in the growth obsessed market of the past couple of decades. But with bonds priced to yield very little, talk of negative rates, and little in the way of meaningful income from shares in other industries, the coupon-with-upside opportunity represented by public RIAs won’t go unnoticed forever. The yields available from much of the public RIA community may seem like a mirage, but they may, instead, prove to be an income oasis in the investment desert of ZIRP.

2020 Commodity Prices Upend 2019 E&P Bankruptcies

The recent historic decline in oil prices has strained the balance sheets of E&P companies. Whiting Petroleum Corporation, the first publicly traded U.S. E&P company to declare bankruptcy in 2020, announced its Chapter 11 reorganization process on April 1. More are expected to follow.Despite a much more benign commodity price environment of ~$50-$60/bbl in 2019, a number of E&P companies declared bankruptcy last year and have seen their reorganization processes derailed in 2020 as a result of low oil prices.Sanchez Energy DIP Financing ImpairedSanchez Energy filed for bankruptcy in August 2019, citing a misalignment between the company’s capital structure and the “continued low commodity price environment.” At the time of filing, Sanchez had approximately $2.3 billion of debt outstanding, according to Haynes Boone.As part of the bankruptcy process, Sanchez secured $200 million of debtor-in-possession (DIP) financing. DIP financing is generally senior to the company’s other indebtedness, and thus usually recovered in full. However, in light of commodity price declines caused by COVID-19’s energy demand destruction, Sanchez is only worth an estimated $85 million according to the court-approved reorganization plan. This implies a substantial impairment of the DIP financing (to say nothing of the other $2.3 billion of debt).Despite the approved reorganization plan, the ultimate ownership of the company is still in question.Alta Mesa Sale Terms RevisedAlta Mesa announced its bankruptcy in September, a month after Sanchez, citing a need to “reorganize its capital structure.” According to Haynes Boone, Alta Mesa’s debt totaled $871 million.Alta Mesa received a $310 million stalking horse bid on December 31 from a joint venture between Mach Resources (an E&P company) and Bayou City Energy (a private equity firm). The joint venture won the subsequent auction in January 2020, bidding $320 million, but was unable to secure the necessary financing amid the initial stages of the Saudi/Russian price war in March. The sale ultimately went through, but at a $100 million discount.EP Energy Restructuring Plan ScrappedEP Energy, an Eagle Ford and Permian-focused producer, filed for bankruptcy in October. The company was spun out from El Paso Corp. during 2012 in a leveraged buyout (LBO) led by Apollo and subsequently taken public in 2014. The LBO left EP Energy with a massive debt balance, which stood at $7.3 billion per Haynes Boone.EP Energy’s restructuring plan was approved on March 6, the same day Saudi Arabia and Russia failed to come to terms on an OPEC+ supply cut. It soon fell apart, as Apollo and other financial backers pulled out.The company has submitted a motion requesting an extension, which would give EP Energy until October 31, 2020 to file a revised restructuring plan.Approach Resources Buyer Backs OutApproach Resources was the last U.S. public E&P to file for bankruptcy in 2019, seeking to explore strategic alternatives including “the restructuring of its balance sheet or the sale of its business” as stated in its November press release. The company received a stalking horse bid of $192.5 million from Alpine Energy Capital in February. The court approved the sale in early March. Later in the month, Alpine announced that it was terminating the agreement. The approach subsequently sought to force Alpine to complete the purchase.The matter has not yet been resolved.ConclusionRecent commodity price volatility has driven certain E&P producers to file for bankruptcy and has prevented several more from emerging. While prices have bounced back from recent lows, they remain below breakeven costs for many producers. As such, we expect to see continued bankruptcy filings and protracted restructuring processes.If you want to learn more about the valuation side of the bankruptcy process, and how we at Mercer can use our years of experience in bankruptcy and the oil & gas industry to help you emerge from Chapter 11 well-prepared for future success, contact one of our valuation analysts for a confidential discussion.

Complex Valuation Issues in Auto Dealer Litigation

Solving the Puzzle

Litigation engagements are generally very complex, consisting of many moving parts. The analogy that comes to mind is the nostalgic game of Tetris. While invented in 1984 by a Russian named Alexey Pajitnov, most of us remember the iconic version popularized through the Nintendo Gameboy in the 1990s. The game featured seven game pieces cascading down at increasing speed forcing the game player to manipulate them by rotating and placing them, trying to create a flat surface. As anyone that has played can attest, the game creates more anxiety and stress as the pieces cascade faster and begin to pile up.Like the game, many clients involved in auto dealer valuation disputes also experience anxiety and stress as problems begin to pile up. When assisting these clients in our family law and commercial litigation practices, we strive to help alleviate the pain points, or “clear the blocks.”We hope you never find yourself a party to a legal dispute; however, we offer the following words of wisdom based upon our experience working in these valuation-related disputes.The following topics, posed as questions, have been points of contention or common issues that have arisen in recent litigation engagements. We present them here so that if you are ever party to a dispute, you will be a more informed user of valuation and expert witness services.We begin with seven questions to represent each of the original Tetris pieces, and we’ve added two questions to consider additional issues raised during the COVID-19 crisis.Should Your Expert Witness Be a Valuation or an Industry Expert?Oftentimes, the financial and business valuation portion of a litigation is referred to as a “battle of the experts” because you have at least two valuation experts – one for the plaintiff and one for the defendant. In the auto dealer world, you are hopefully combining valuation expertise with a highly-specialized industry. It is critical to engage an expert who is both a valuation expert and an industry expert – one who holds valuation credentials and has deep valuation knowledge and also understands and employs accepted industry-specific valuation techniques. Look with caution upon valuation experts with minimal industry experience who utilize general valuation methodologies often reserved for other industries (for example, Discounted Cash Flow (DCF)1 or multiples of Earnings Before Interest, Taxes and Depreciation (EBITDA)) with no discussion of Blue Sky multiples. Does the Appraisal Discuss Local Economic Conditions and Competition Adequately?The auto industry, like most industries, is dependent on the climate of the national economy. Additionally, auto dealers can be dependent or affected by conditions that are unique to their local economy. The type of franchise relative to the local demographics can also have a direct impact on the success/profitability of a particular auto dealer. For example, a luxury or high-line franchise in a smaller or rural market would not be expected to fare as well as one in a market that has a larger and wealthier demographic. In certain markets, an understanding of the local economy/industry is more important than an understanding of the overall auto dealer industry and national economy. Common examples are local markets that are home to a military base, oil & gas markets in Western Texas or natural gas in Pennsylvania, or fishing industries in coastal areas. There’s also a balance between understanding and acknowledging the impact of that local economy without overstating it. Often some of the risks of the local economy are already reflected in the historical operating results of the dealership. If There Are Governing Corporate Documents, What Do They Say About Value, and Should They Be Relied Upon? Many of the corporate entities involved in litigation have sophisticated governance documents that include operating agreements, buy-sell agreements, and the like. These documents often contain provisions to value the stock or entity through the use of a formula or process. Whether or not these agreements are to be relied upon in whole or in part in a litigated matter is not always clear. In litigation, the focus will be placed on whether the value concluded from a governance document represents fair market value, fair value, or some other standard of value. However, the formulas contained in these agreements are not always specific to the industry and may not include accepted valuation methodology for auto dealers. Two common questions that arise concerning these agreements are 1) has an indication of value ever been concluded using the governance document in the dealership’s history (in other words, has the dealership been valued using the methodology set out in the document)?; and 2) have there been any transactions, buy-ins or redemptions utilizing the values concluded in a governance document? These are important questions to consider when determining the appropriate weight to place on a value indication from a governance document. If they’ve never been used, and don’t conform to accepted valuation methodologies for auto dealers, then how reliable can these be? Additionally, some litigation matters (such as divorce) state that the non-business party to the litigation is not bound by the value indicated by the governance document since they were not a signed party to that particular agreement. It is always important to discuss this issue with your attorney. Have There Been Prior Internal Transactions of Company Stock and at What Price?Similar to governance documents, another possible data point(s) in valuing an automotive dealership are internal transactions. A good appraiser will always ask if there have been prior transactions of company stock and, if so, how many have occurred, when did they occur, and at what terms did they occur? There is no magic number, but as with most statistics, more transactions closer to the date of valuation can often be considered as better indicators of value than fewer transactions further from the date of valuation. An important consideration is the motivation of the buyer and seller in these internal transactions. Motivations may not always be known, but it’s important for the financial expert to try to obtain that information. If there have been multiple internal transactions, appraisers have to determine the appropriateness of which transactions to possibly include and which to possibly exclude in their determination of value. Without an understanding of the motivation of the parties and specific facts of the transactions, it becomes trickier to include some, but exclude others. The more logical conclusion would be to include all of the transactions or exclude all of the transactions with a stated explanation. What Do the Owner’s Personal Financial Statements Say and Are They Important?Most owners of an auto dealership have to submit personal financial statements as part of the guarantee on the floor plan and other financing. The personal financial statement includes a listing of all of the dealer’s assets and liabilities, typically including some value assigned to the value of the dealership. In litigated matters, the stated value by the dealer principal on their personal financial statement provides another data point to valuation. One view of a personal financial statement is that no formal valuation process was used; so at best, it’s a thumb in the air, blind estimate of value of the business. The opposing view would say the individual submitting the personal financial statement is attesting to the accuracy and reliability of the financial figures contained in a document under penalty of perjury. Further, some would say that the business owner is the most informed person regarding the business, its future growth opportunities, competition, and the impact of economic and industry factors on the business. While they are not business appraisers, they are instrumental to a valuation expert’s understanding of risk and growth in their business. It’s never a good situation to be surprised by the existence of these documents. A good business appraiser will always ask for them. The value indicated in a personal financial statement should be viewed in the light of value indications under other methodologies and sources of information. At a minimum, personal financial statements may require the expert to ask more questions or use other factors, such as national and local economy to explain the difference and changes in values over time. If an expert opines the value is X, but the personal financial statements says 3X or 1/3X, an expert must be prepared to explain the difference. Does the Appraiser Understand the Industry and How to Use Comparable Industry Profitability Data? The auto dealer industry is highly specialized and unique and should not be compared to general retail or manufacturing industries. As such, any sole comparison to general industry profitability data should be avoided. If your appraiser solely uses the Annual Statement Studies provided by the Risk Management Association (RMA) as a source of comparison for the balance sheet and income statement of your dealership to the industry, this could be problematic. RMA’s studies are organized by the North American Industry Classification System (NAICS). Typical new and used retail auto dealers would fall under NAICS #441110 or #441120. This general data may do the trick in certain industries, but most dealers sell both new and used vehicles. Further, RMA does not distinguish between different franchises. The National Automobile Dealers Association (NADA) publishes monthly Dealership Financial Profiles broken down by Average Dealerships, which would be comparable to RMA data. However, NADA drills down further, segmenting the industry into the four following categories: Domestic Dealerships, Import Dealerships, Luxury Dealerships, and Mass Market Dealerships. While no single comparison is perfect, an appraiser should know to consult more specific industry profitability data when available. Do You Understand Actual Profitability vs. Expected Profitability and Why It’s Important?Either through an income or Blue Sky approach, auto dealers are typically valued based upon expected profitability rather than actual profitability of the business. The difference between actual and expected profitability generally consists of normalization adjustments. Normalization adjustments are made for any unusual or non-recurring items that do not reflect normal business operations. During the due diligence interview with management, an appraiser should ask does the dealership have non-recurring or personal expenses of the owner being paid by the business? Comparing the dealership to industry profitability data as discussed earlier can help the appraiser understand the degree to which the dealership may be underperforming. If a dealership has historically reported 2% earnings before taxes (EBT) and the NADA data suggests 5%, the financial expert must analyze why there is a difference between these two data points and determine if there are normalizing adjustments to be applied. Let’s use some numbers to illustrate this point. For a dealership with revenue of $25 million, historical profitability at 2% would suggest EBT of $500,000. At 5%, expected EBT would be $1,250,000, or an increase of $750,000. In this case, the financial expert should analyze the financial statements and the dealership to determine if normalization adjustments are appropriate which, when made, will reflect a more realistic figure of the expected profitability of the dealership without non-recurring or personal owner expenses. This is important because, hypothetically, a new owner could optimize the business and eliminate some of these expenses; therefore, even dealerships with a history of negative or lower earnings can receive higher Blue Sky multiples because a buyer believes they can improve the performance of the dealership. However, as noted earlier, the dealership may be affected by the local economy and other issues that cannot be fixed so the lower historical EBT may be justified. For more information on normalizing adjustments, see our article Automobile Dealership Valuation 101. What Is the Date of Valuation and Why Does It Matter? Depending on the state, family law matters might require the date of valuation to be the date of filing, the date of separation, the date of the trial (current), or some other date. Commercial litigation can require the date of valuation to be the date of a certain event, the date of trial (current), or some other date. Why does the date matter? In addition to the standard of value (generally fair market value or fair value), a business valuation contemplates a premise of value – often a going-concern business. The business appraiser must use the relevant known and knowable facts at the date of valuation to incorporate into a valuation conclusion. These facts reflected in historical financial performance, anticipated future operations, and industry/economic conditions can differ depending on the proper date of valuation.As we are all experiencing during COVID-19, the conditions of March/April 2020 are vastly different than year-end 2019. It would be incorrect, however, to consider the impact of COVID-19 for a valuation date prior to Spring 2020.How Have Auto Dealer Valuations Been Affected by COVID-19? Valuations of auto dealers involve many factors. We also try to avoid absolutes in valuation such as "always" and "never." The true answer to the question of how auto dealer valuations have been affected by COVID-19 is “It Depends.”As a general benchmark, the overall performance of the stock market from the beginning of 2020 until now can serve as a barometer. Depending on the day, the stock market has declined anywhere between 20-30% during that time from previous highs. Specific indicators of each auto dealer, such as actual performance and the economic/industry conditions relative to their geographic footprint, also govern the impact of any potential change in valuation.The litigation environment is already rife with doom and gloom expectations and we’ve previously written about the phenomenon referred to as divorce recession in family law engagements. While some auto dealers may go out of business as a result of COVID-19, the valuation of most may be deflated from prior indications of value, but generally, the conclusion is not zero. As always, it depends on the specific facts and circumstances of each particular auto dealer under examination.Putting It All TogetherAs with all litigation engagements, the valuation of automobile dealerships can also be complex. A deep knowledge of the industry along with valuation expertise is the optimal combination for general valuation needs and certainly for valuation-related disputes. Understanding how these components fit together is important to a successful resolution, just like the assembly and combination of pieces in a game of Tetris. If you have a valuation issue, feel free to contact us to discuss it in confidence.1 DCF methodology might have to be considered in the early stages of a Company’s lifecycle where the presence of historical financials either does not exist or are limited.Images by DevinCook via Wikimedia Commons

Outlook for Asset Management Firms Amid COVID-19

Falling Asset Prices Threaten Profitability as Spotlight Turns to Relative Performance

The recent sell-off in equities have put pressure on the financial performance of most asset managers, given that revenues and cash flows are highly correlated with the market. At the same time, it is also a critical time for these businesses to deliver on their value proposition of alpha net of fees. Active managers have generally underperformed their benchmarks over the past 10 years, which has driven outflows into low-fee passive products. The extreme financial market volatility and dispersion over the last two months has created major price dislocation and the potential to generate outperformance. The current environment may well be the time for active managers to prove themselves by protecting clients’ assets relative to index performance and justifying their fees.Underperformance Has Driven OutflowsFor active managers, the eleven-year bull run that preceded the current downturn was accompanied by relative underperformance, falling fees, and asset outflows. Over the last decade, indexing to the market largely beat out stock picking and asset allocation based on security-specific research or macroeconomic factors. The strong performance of large cap indices like the S&P 500 between the 2008-2009 recession and February of this year has been largely driven by a handful of sizeable tech companies, and active managers struggled to deliver alpha in that environment. Not only did the indices beat the active managers, but the fees on the passive products tracking these indices have also fallen to virtually zero. Not surprisingly, investors have chased after the strong relative performance and low fees of passive index tracking products. In August last year, passively managed assets exceeded active for the first time.Many asset managers have explained underperformance over the last decade in the context of a runaway bull market while suggesting that the merits of active management would be proven in the next downturn. So, now that a bear market and significant volatility are here, will active managers outperform? Intuitively, it makes some sense, as market shocks and liquidity needs in a downturn can cause disconnects between asset prices and fundamentals that active managers seek to exploit. There is some evidence to suggest that active/passive relative performance is cyclical. As the chart below shows, the 10-year bull market through 2019 was accompanied by passively managed funds outperforming. With the bull market over, the era of passive outperformance may be as well.However, initial data from Morningstar indicates that only about 42% of active funds beat their indices between February 20, 2020 and March 16, 2020, compared to 44% during the preceding rally (December 24, 2018 – February 19, 2020). While active funds collectively have not fared well, some asset classes have fared better than others. Some alternatives, commodities, and sector equity funds have outperformed by wide margins during the bear market. Funds with long-short exposure or large cash holdings relative to the benchmark have also had high success rates.Outflows from Active Funds AccelerateOutflows from active funds have accelerated as the global pandemic has caused investors to rapidly shift into cash. As shown in the table below, March saw record outflows from long-term funds and record inflows into money market funds. The outflows in long-term funds were concentrated in actively managed funds. Passively managed U.S. equity funds saw $41 billion in net inflows in March, while all categories of actively managed funds saw outflows in March.Stock Price Performance for Publicly Traded Asset Managers The combination of accelerating outflows and falling asset prices represents a major headwind for active asset managers, and the price movement in publicly traded asset managers has reflected this. As shown in the table below, the stock prices for most of these companies are down 20-30% so far this year. Only Legg Mason and BlackRock are above where they were at year-end, and the performance of Legg Mason is not related to its fundamentals, but rather a fortuitously timed transaction. Franklin Resources agreed to buy Legg Mason for $50.00 cash per share on February 18, 2020, one day before the S&P reached its peak. Since then, Legg’s shares have been anchored close to $50.00, while Franklin Resources’ price has fallen significantly as it is stuck on the other side of a trade that now looks very good for Legg Mason shareholders. BlackRock, on the other hand, has performed well due to its positioning as the largest player in passive products. About 75% of BlackRock’s $7.4 trillion in assets under management are passively managed, and its growth has been driven not just by market movement but by strong inflows into its iShares ETF franchise and other passive products. The strong relative performance of BlackRock’s shares in this environment suggests that the market views BlackRock and its massive passive franchise as better positioned to perform than its smaller, more actively managed counterparts. Outlook for Future Financial Performance Moody’s recently downgraded its outlook on global asset managers to “negative” from “stable,” citing economic headwinds and market declines resulting from the coronavirus pandemic. With asset prices down across virtually across the board, asset management revenues and profitability will take a significant hit in the second quarter and perhaps beyond depending on the market trajectory. The financial performance of asset management firms over the next several years will largely be tied to the shape of the market recovery. As of early May, the run-rate financial performance for asset managers has improved significantly as asset prices have recovered from March lows.The longer-term outlook for active managers depends more on the ability of these managers to deliver alpha net of fees in the current environment and stem the asset outflows that have drained AUM over the last decade. While the initial data indicates that active management relative performance has not improved during the bear market, there is opportunity over the next several months as markets calm and prices reconnect with fundamentals. The coming months will be a critical time for asset managers to prove themselves.

Revolution or Evolution: COVID-19 Pushing Auto Dealers into the 21st Century

While making a trip to the grocery this past week, I came across a billboard that caught my eye, but not for the right reasons. An advertisement had been recently removed, exposing a much older advertisement beneath. It was a 3-videos-for-$5 ad from Blockbuster. It provoked an instant sense of nostalgia as I remembered going with my family to pick out movies on Friday nights. Unfortunately, this old ad now serves as a cautionary tale of what can happen to businesses that aren’t able to keep up with ever-evolving consumer demands. Blockbuster had the chance to keep up by buying Netflix for $50 million in September of 2000, but the CEO thought it was a joke. Now with a market cap of $130 billion (as of May 1st), due to the influx of streaming demand, Netflix’s worth now surpasses Disney’s. The same cannot be said for Blockbuster, which shut down for good in 2014. Every industry faces the Blockbuster/Netflix dilemma at some point as they try to innovate to keep up with the changing times and stay relevant. The next big thing is always easier to see with the benefit of hindsight. The most recent of these changes has been in the retail space with the “retail apocalypse,” as brick-and-mortar stores are closing their doors as consumers opt for the ease of online purchases. Although initially evading the switch, the current COVID-19 pandemic has auto dealers scrambling to find ways to maintain sales as stay-at-home orders are keeping customers from the dealership. To move vehicles off the lot, dealerships have been pushed into a new era of online car sales. While many auto dealers have only somewhat dipped their toe into the digital space, they have now been pushed off the deep end. As Plato once said: "Necessity is the mother of invention." Early Modelers of Online Car SalesBefore the coronavirus outbreak, the two major players in online car sales were Carvana and Tesla. Though both engage with their customers primarily through electronic platforms, their business models differ. Founded in 2013, Carvana now boasts an inventory of over 29,950 used vehicles that can either be delivered to customers or picked up in one of their vending machines. Customers can even get approved for financing online. The company is now live in 146 markets and has doubled revenue in each quarter since its founding. Their ability to provide a larger selection of vehicles than traditional used car dealerships has helped it expand to the third-largest used-car retailer in the country. They also only sell used cars, which differentiates them from traditional dealers and may ultimately be more profitable. Gross profits for used vehicles are higher than for new vehicles. While Carvana operates as a virtual dealership for used cars, Tesla was founded in 2003 and operates as a manufacturer that eliminates the need for dealerships all together with its direct to consumer online sales strategy. Tesla has also experienced considerable revenue growth, and like Carvana, sports a lofty valuation compared to the traditional auto dealers.Tesla’s share price is up 88% and Carvana’s is up 15% since the end of 2019.While not frequently employed in the valuation of auto dealerships, Tesla’s revenue multiple is 6.2x, compared to 0.5x or below for the five most traditional players. Carvana’s revenue multiple of 1.7x is also significantly higher despite negative earnings even before interest, taxes, depreciation, and amortization (EBITDA). While both of these companies likely command higher multiples due to their growth characteristics, their business models also appear to be weathering the coronavirus as Tesla’s share price is up 88% and Carvana’s is up 15% since the end of 2019, while traditional auto dealers are down at least 25%.How Auto Dealers Are RespondingWhile these two companies used to be the outsiders, the pandemic has forced many auto dealers to follow in their footsteps. Fiat Chrysler launched a new online sales program this month that allows customers to go through the car buying process online. The purchased vehicle can be delivered to their home without a visit to the dealership, similar to the model Carvana and Tesla follow. Mark LaNeve, Ford Motor Co.’s U.S. Chief of Sales told Reuters that “around 93% of Ford’s 3,100 U.S. dealers are doing some or all aspects of sales online, from virtual tours to financing and home delivery, as the pandemic has shuttered showrooms in a growing number of states.” General Motors has increased efforts toward their online sales program, “Shop, Click, Drive,” that launched in 2013 but had not gained much traction. Other automakers such as Porsche have announced additional incentives for dealers to conduct digital sales as well.Looking Long-TermWith all the different measures being taken to bring car sales online, it is clear that dealerships are willing and able to provide this experience to their customers. However, there are significant costs in these changes, such as technology investment and retraining costs. Furthermore, while dealerships may be able to cut costs in the long-term by not having to utilize personnel to sell vehicles, this would have an adverse impact on employment. An example of this is Amazon’s effect on retailers with total retail employees declining by nearly 200,000 since 2017. The main concern and million-dollar question keeping auto dealers from fully investing in online business is this: Will consumers buy into an online model for the long-haul?Although a heavy investment into online technology may prove beneficial during this pandemic, if things return to “normal” and consumers revert to old buying preferences, dealerships might end up with large sunk costs.For many dealers, the switch to online vehicle shopping has been a long time coming.There are differing opinions regarding whether COVID-19 will lead to a long-term switch in consumer vehicle purchase preferences. For many dealers, the switch to online vehicle shopping has been a long time coming. With consumers being more tech-savvy than ever, e-commerce retail sales as a percent of total sales has grown steadily over the years, reaching 11.4% in Q4 2019. Rhett Ricart, CEO of Ricart Automotive in Columbus, Ohio, and chairman of the National Auto Dealer Association, believes that the coronavirus pandemic “is going to fundamentally change how people view buying a car.” Additionally, he predicts that “By the end of the year, you’re going to see 80%-90% of U.S. new car dealers with full e-commerce capability in their shop” to handle everything online except for the test drive and maybe the final signature. Online sales at his dealership have doubled since the pandemic started to ramp up. Certain data points support this assumption.Before the pandemic struck, 61% of car buyers say that the car buying experience was not better, and sometimes worse, than the last time they purchased a vehicle. A key area of frustration for buyers is how long it takes to purchase a vehicle from the paperwork to negotiation. The cross-selling many dealerships employ to increase profits can also grate on some consumers who don’t want to be upsold. With digital retailing allowing dealerships to reduce the time it takes to buy a car, this could end up alleviating a consumer pain point.While some dealers are more bullish on their predictions for the online vehicle sales market, others remain skeptical. David Smith, CEO of Sonic Automotive, has noted that although consumers can conduct a majority of the sales process online, he has doubts over whether this sales model will be long lasting. “It is such a large purchase for most people,” he said. “It’s not like going to the grocery store. It’s a big deal. It’s a big purchase. People like to see it and browse.” He might be onto something, with 79% of buyers waiting but still willing to buy, there are a whole lot of potential car buyers holding out even though many dealers have gone online. And with the average monthly car payment for a new car being around $550, it’s reasonable that a customer wants to see the car in person before they make such a big commitment. Furthermore, considering that Carvana has yet to turn a profit, and Tesla has only achieved a narrow profitability in the past year, there are still many uncertainties on the success of online vehicle sales.ConclusionUltimately, the jury is still out on whether we are witnessing a revolution in the auto industry such as we saw with Blockbuster and online streaming, or simply an evolution into more tech-savvy dealerships. While we doubt the pandemic will be enough to radically push the entire process online for all consumers, we do believe certain benefits of digital are here to stay.Most auto dealers are trying to find ways to offer customers vehicles in any way they can. The adoption of e-commerce tools for dealerships, even in the short-run, can help to show consumers that dealerships are willing to go the extra mile in order for them to be comfortable making a purchase during this difficult time.After beginning with a Plato quote, I thought it would be fitting to end with one as well: "There are two things a person should never be angry at, what they can help, and what they cannot." In the midst of this unprecedented global pandemic, I find it to be a timely reminder.

Ernest Hemingway, Albert Camus, and Credit Risk Management

In the March 2020 Bank Watch, we provided our first impressions of the “reshaping landscape” created by the COVID-19 pandemic and its unfolding economic consequences.This month, we expand upon the potential asset quality implications of the current environment. One word that aptly describes the credit risk environment is inchoate, which is defined as “imperfectly formed or formulated” or “undeveloped.”We can satiate our analytical curiosity daily by observing trends in positive COVID-19 cases, but credit quality concerns created by the pandemic and its economic shocks lurk, barely perceptible in March 31, 2020 asset quality metrics such as delinquencies or criticized loans.However, the pandemic’s effect on bank stock prices has been quite perceptible, with publicly-traded bank stocks underperforming broad-market benchmarks due to concerns arising from both asset quality issues and an indefinite low interest rate environment.Bridging this gap between market perceptions and current asset quality metrics is the focus of this article.At the outset, we should recognize the limitations on our oracular abilities.Forward-looking credit quality estimates now involve too many variables than can comfortably fit within an Excel spreadsheet—case rates, future waves of positive diagnoses, treatment and vaccine development, and governmental responses.The duration of the downturn, however, likely will have the most significant implications for banks’ credit quality.We neither wish to overstate our forecasting capacity nor exaggerate the ultimate loss exposure.We recognize that transactions are occurring in the debt capital markets involving issuers highly exposed to the pandemic’s effects on travel and consumption—airlines, cruise operators, hotel companies, and automobile manufacturers.Investors in these offerings exhibit an ability to peer beyond the next one or two quarters or perhaps have faith that the Fed may purchase the issue too.To assess the nascent credit risk, our loan portfolio analyses augment traditional asset quality metrics with the following:Experience gleaned from the 2008 and 2009 Great Financial CrisisCollateral and industry concentrations in banks’ loan portfolios“The World Breaks Everyone and Afterward Many Are Strong in the Broken Places”A Farewell to Arms (1929) by Ernest Hemingway, which provides the preceding quotation, speaks to a longing for normality as the protagonist escapes the front lines of World War I.While perhaps a metaphor for our time, the quotation—with apologies to Hemingway—also fits the 2008 to 2009 financial crisis (“the world breaks everyone”) and uncertainties regarding banks’ preparedness for the current crisis (will the industry prove “strong in the [formerly] broken places”?).To simulate credit losses in an environment marked by a rapid increase in unemployment and an abrupt drop in GDP, analysts are using the Great Financial Crisis as a reference point.Is this reasonable?Guardedly, yes; in part because no preferable alternatives exist.But how may the current crisis develop differently, though, in terms of future loan losses?Table 1 presents aggregate loan balances for community banks at June 30, 2002 and June 30, 2007, the finalperiod prior to the Great Financial Crisis’ onset.One evident trend during this five year period is the grossly unbalanced growth in construction and development lending, which led to outsized losses in subsequent years.Have similar imbalances emerged more recently?We can observe in Table 2 that loans have not increased as quickly over the past five years as over the period leading up to the Global Financial Crisis (67% for the most recent five year period, versus 90% for the historical period).Further, the growth rates between the various loan categories remained relatively consistent, unlike in the 2002 to 2007 period.The needle looking to pop the proverbial bubble has no obvious target.Using the same data set, we also calculated in Table 3 the cumulative loss rates realized between June 30, 2008 and June 30, 2012 relative to loans existing at June 30, 2008.This analysis indicates that banks realized cumulative charge-offs of 5.1% of June 30, 2008 loans, although this calculation may be understated by the survivorship bias created by failed banks.The misplaced optimism regarding construction loans resulted in losses that significantly exceeded other real estate loan categories.Consumer loan losses are exaggerated by certain niche consumer lenders targeting a lower credit score clientele.Are these historical loss rates applicable to the current environment?Table 4 compares charge-off rates for banks in Uniform Bank Performance Report peer group 4 (banks with assets between $1 and $3 billion).Loss rates entering the Great Financial Crisis and the COVID-19 pandemic are remarkably similar.We would not expect the disparity in loss rates between construction and development lending versus other real estate loan categories to arise again (or at least to the same degree).Community banks generally eschew consumer lending; thus, consumer loan losses likely will not comprise a substantial share of charge-offs for most community banks.For consumer lending, the credit union industry likely will experience greater fall-out if unemployment rates reach the teens. Regarding community banks, we have greater concern regarding the following:Commercial and industrial lending. Whether due to business opportunities or regulatory pressure to lessen commercial real estate concentrations, we have observed shifts in portfolios in favor of C&I lending and are uncertain regarding the maintenance of underwriting standards.Some evidence also exists that C&I loan losses were increasing prior to the crisis, although the impact appeared episodic. Commercial real estate. While we can claim no originality, our analyses currently emphasize borrower and collateral types to identify sectors more exposed to COVID-19 countermeasures.We recognize, though, that this can obscure important distinctions.For example, hotels reliant on conference attendance likely are more exposed than properties serving interstate highway stopovers.Further, we expect that the pandemic will alter behavior, or accelerate trends already underway, in ways that affect CRE borrowers, whether that is businesses normalizing Zoom calls instead of in-person meetings or consumers shifting permanently from in-store to on-line shopping.In the Great Financial Crisis, banks located in more rural areas often outperformed, from a credit standpoint, their metropolitan peers, especially if they avoided purchasing out-of-market loan participations.This often reflected a tailwind from the agricultural sector.It would not be surprising if this occurs again.Agriculture has struggled for several years, weeding out weaker, overleveraged borrowers. Additionally, to the extent that the inherent geographic dispersion of more rural areas limits the spread of the coronavirus, along with less dependence on the hospitality and tourism sectors, rural banks may again experience better credit performance.“They fancied themselves free, and no one will ever be free so long as there are pestilences.”The Plague (1947) by Albert Camus describes an epidemic sweeping an Algerian city but often is read as an allegorical tale regarding the French resistance in World War II.Sales of The Plague reportedly have tripled in Italy since the COVID-19 pandemic began, while its English publisher is rushing a reprint as quarantined readers seek perspective from Camus’ account of a village quarantined due to the ravaging bubonic plague.As Camus observed for his Algerian city, we also suspect that banks will not be free of asset quality concerns so long as COVID-19 persists.Another source of perspective regarding the credit quality outlook comes from the rating agencies and SEC filings by publicly-traded banks:Moody’s predicts that the default rate for speculative grade corporate bonds will reach 14.4% by the end of March 2021, up from 4.7% for the trailing twelve months ended March 31, 2020.This represents a level only slightly below the 14.7% peak reaching during the 2008 to 2009 financial crisis.1Fitch projects defaults on institutional term loans to reach $80 billion in 2020 (5% to 6% of such loans), exceeding the $78 billion record set in 2009.2Borrowers representing 17% of the commercial mortgage-backed security universe have contacted servicers regarding payment relief.Loans secured by hotel, retail, and multifamily properties represent approximately 75% of inquiries.Fitch also questions whether 90-day payment deferrals are sufficient.3Delinquent loans in commercial mortgage backed securities are projected to reach between 8.25% and 8.75% of the universe by September 30, 2020, approaching the peak of 9.0% reported in July 2011.4The delinquency rate was 1.3% as of March 2020.Fitch identified the most vulnerable sectors as hotel, retail, student housing, and single tenant properties secured by non-creditworthy tenants.Among these sectors, Fitch estimates that hotel and retail delinquencies will reach approximately 30% and 20%, respectively, relative to 1.4% and 3.5% as of March 2020.The prior recessionary peaks were 21.3% and 7.7% for hotel and retail loans, respectively.For multifamily properties, Fitch projects that bad debt expense from tenant nonpayment will exceed 10%.However, Fitch notes that its delinquency estimates do not consider forbearances.Fitch estimates that hotel loans with a pre-pandemic debt service coverage ratio (DSCR) of less than 2.75x on an interest-only basis are at risk of default.Guarantor support may limit the ultimate default rate, though.Retail and multifamily loans with a pre-pandemic DSCR of less than 1.75x and 1.20x, respectively, on an interest-only basis are at risk of default.Fitch did not apply any specific coronavirus stresses to office or industrial properties.5Among banks releasing industry exposures, Western Alliance Bancorp (WAL) reported the largest hotel concentration at 8.5% of total loans.Data provider STR reported a 79% year-over-year decline in revenue per available room for the week ended April 18, 2020, reflecting a 64% decline in occupancy (to 23%).6First Financial Bancorp (FFBC) reported the largest retail concentration among banks reporting such granular detail at 16% of total loans.Numerous other banks reported concentrations between 10% and 15% of total loans.7Banks tend to be senior lenders in borrowers’ capital structure; thus, the rating agency data has somewhat limited applicability.Shadow lenders like business development companies and private credit lenders likely are more exposed than banks.Nevertheless, the data indicate that the rating agencies are expecting default and delinquency rates similar to the Great Financial Crisis.As for Camus’ narrator, the ultimate duration of the pandemic will determine when normality resumes.Lingering credit issues may persist, though, until well after the threat from COVID-19 recedes.ConclusionCommunity banks rightfully pride themselves as the lenders to America’s small business sector.These small businesses, though, often are more exposed to COVID-19 countermeasures and possess smaller buffers to absorb unexpected deterioration in business conditions relative to larger companies.Permanent changes in how businesses conduct operations and consumers behave will occur as new habits congeal.This leaves the community bank sector at risk.However, other factors support the industry’s ability to survive the turmoil:Extensive governmental responses such as the PPP loan program provide a lifeline to small businesses until conditions begin to recover.The industry enters this phase of the credit cycle with fewer apparent imbalances than prior to the Great Financial Crisis.A greater focus since the Great Financial Crisis on portfolio diversification and cash flow metrics proves that lessoned were learned.The smaller, more rural markets in which many community banks operate may prove more resilient, at least in the short term, than larger markets.Permissiveness from regulators regarding payment modifications will allow banks to respond sensitively to borrower distress.Nonetheless, credit losses tend to be episodic for the industry, occurring between long stretches of low credit losses.The immediate issue remains how high this cycle’s losses go before returning to the normality that ensues in Hemingway and Camus’ work after war and pestilence.1 Emmanuel Louis Bacani, “US Speculative-Grade Default Rate to Jump Toward Financial Crisis Peak – Moody’s,” S&P Global Market Intelligence, April 24, 20202 Fitch Ratings, U.S. LF/CLO Weekly, April 24, 2020.3 Fitch Ratings, North American CMBS Market Trends, April 24, 2020.4 Fitch Ratings, U.S. CMBS Delinquencies Projected to Approach Great Recession Peak Due to Coronavirus, April 9, 2020.5 Fitch Ratings, Update on Response on Coronavirus Related Reviews for North American CMBS, April 13, 2020.6 Jake Mooney and Robert Clark, “US Banks Detail Exposure to Reeling Hotel Industry in Q1 Filings,” S&P Global Market Intelligence, April 24, 20207 Tom Yeatts and Robert Clark, “First Financial, Pinnacle Rank Among Banks with Most Retail Exposure,” S&P Global Market Intelligence, April 27, 2020 Originally published in Bank Watch, April 2020.

A Reshaping Landscape

March 2020 probably will prove to be among the most dramatic months for financial markets in US history.Likewise, the fallout for banks may take a year or so to fully appreciate.Nonetheless, in this issue of BankWatch, we offer our initial thoughts as it relates to the industry.Market Performance U.S. equity markets have entered a bear market, the definition of which is a drop of at least 20%.As of March 27, 2020, the S&P 500 had declined 21% year-to-date and the Russell 2000 was down 32%.Not surprisingly banks have fared worse with the SNL Large Cap Bank Index falling 39% given the implications for credit because of the government’s mandated shutdown of broad swaths of the economy due to COVID-19.Bear markets vary in length and depend upon the severity of the economic downturn, the value of assets before the downturn started, and policy responses among other factors.The 2001 recession, which was shallow, started in March and ended in November according to government statisticians; however, the bear market for equities as measured by the S&P 500 was brutal (-49%) that ran from March 2000 to November 2002. Banks trended modestly higher during 2000-2002 because they entered the downturn cheap to their late 1990s valuations and because real estate values did not fall. The Great Financial Crisis (“GFC1”) that ran from August 2007, when the Bear Stearns hedge funds failed, through year-end 2009 entailed a bear market that saw a 57% reduction in the S&P 500 between October 2007 and the bottom on March 9, 2009.Economists tell us the recession occurred from year-end 2007 throughJune 30, 2009.Unlike 2000-2002, banks were a disaster for investors because credit losses were high, and many had to raise equity at low prices to survive.We do not know how much further bank stocks may fall if at all from late March in what we are taking liberty to define as GFC2.Figure 1 provides perspective on how banks—here defined as SNL’s Small Cap US Bank Index—performed in the two-year period ended March 9, 2009, and March 27, 2020. During GFC1 the bank index fell almost 70% to when the bear market ended. (March 9 was near the date when FASB eased mark-to-market rules and the Obama Administration signaled it would not nationalize the banks.)By contrast the bank index traded sideways between March 2018 and early 2020 before plummeting about 40% at the lowest point in March as investors rushed for the exits as economic activity crashed. Massive intervention in the markets by the Fed has arrested the decline in financial assets for now, but in doing so the important market function of price discovery and therefore capital allocation has been distorted. Revaluation of BanksRelative to history banks are cheap, but that does not mean they cannot get cheaper.Alternatively, valuation multiples may rise because EPS and TBVPS fall more than share prices fall or even trade sideways or higher from here.Presumably GFC2 will be like GFC1 and most bear markets in which prices fall in anticipation of earnings that will decline later as the market discounts fundamentals that are expected to prevail 6-18 months in the future.As of late March, bank stocks were cheap to long-term average multiples with small cap banks trading for 9.4x trailing 12-month earnings and 105% of TBV compared to 7.9x and 122% for the large cap bank index.Dividend yields around 4% are enticing, too, but the downturn could be sufficiently severe to force widescale dividend cuts.We do not know and will not know until the future arrives. Interestingly, small cap banks as of March 27 were trading below the March 9, 2009, bottom at 105% of TBV vs. 118% nine years ago.Net Interest Margins—Lower for LongerPerhaps one of the more depressing expectations for banks is not that credit losses will increase but the Fed promise that short-term rates will remain anchored near zero for the foreseeable future.As shown in Figure 3, the market expects 30/90 day LIBOR to fall from current distressed levels in excess of 1.0% to around 0.3% within a few months and remain anchored there for a couple of years.Those who follow the forward curves know that forward rate expectations can change quickly.Nonetheless, the market today expects LIBOR benchmark rates (and SOFR) to fall toward the Fed Funds target range.Our expectation is that NIMs may fall below the last cycle low of ~3.5% recorded in 1H09 because asset yields are much lower today than in 2008 when the GFC1 was gathering steam.Likewise, deposit rates can be cut somewhat but they, too, are much lower now than was the case in 2008.By way of comparison the NIM for banks with $1 billion to $10 billion of assets in 4Q06 was 3.74% according to the FDIC.By 1H09 the NIM for the group had declined to less than 3.4%.As of 4Q19 the NIM was 3.67%.Credit—Regulatory Forbearance PossibleWe do not know how high credit costs will go.According to the FDIC, losses approximated 2% of loans in 2009 for banks with $1 billion to $10 billion of assets and 3% for banks with $10 billion to $250 billion of assets.Losses were especially high in C&D portfolios because residential mortgage was the epicenter of the last downturn.This time more asset classes look to be at risk because a deflationary shock has been unleashed on the global economy. The hardest hit sectors within most bank loan portfolios will be hotels and restaurants as part of the travel and leisure industry that has been impacted the most by COVID-19.Among a subset of banks in the Southwest, Dakotas and Appalachia potentially will be sizable losses in energy-related credits as oil and gas are at the epicenter of this deflationary shock. Retail CRE will see more problem assets, too, as the shutdown accelerates the shift to digital commerce. An unknown element is how shifts in consumer and business behaviors may impact credit losses.One surprise from the last recession was the move by consumers to pay auto and credit card loans while defaulting on mortgages in order to commute to work and maintain access to revolving credit.Previously consumers would default on other borrowings to save the home. The behavior was an admission by many consumers that they overpaid for houses and were willing to return to renting. In this downturn maybe consumers will let auto loans go because the average auto loan is much larger and has a longer duration than a decade ago, and ride sharing lessens the need for a car.Businesses may decide that much less office space is needed as employees become more adept at working remotely.In short, it is easy to construct a scenario in which credit losses are higher than those experienced during 2008-2010, but it is too early to know for certain.One interesting market data point arguing perhaps not is high yield bonds.The option-adjusted spread (“OAS”) on the ICE BofA High Yield Index peaked on March 23 at 1087bps versus 1988bps in November 2008.If credit losses are notably higher than what was experienced in 2008 then an informal form of regulatory forbearance may be allowed in which losses are slowly recognized to protect capital.Past precedence includes the Lesser Developed Country (“LDC”) crisis of the early and mid-1980s in which money center banks took 5-6 years to write-off large exposures to LDCs as a result of a collapse in oil and commodity prices.Capital and DividendsAs shown in Figure 5, US banks are much better capitalized today than at year-end 2006 immediately before GFC1 began.Ironically, the severely adverse scenario in the DFAST-mandated stress tests will be tested given the magnitude of the economic shut-down.All 18 large-cap banks that were subjected to the Fed’s 2019 test passed with leverage ratios bottoming over an eight-quarter period in the vicinity of 6-7%.Results can be found at the following link http://mer.cr/2JswW1d.A secondary issue is the outlook for common and preferred dividends.We expect first quarter and perhaps second quarter dividends to be paid; however, beginning in the third quarter dividend reductions and omissions are possible if not probable once a better estimate of losses is developed.Aside from written agreements with regulators that preclude payments we assume sub debt coupon payments will continue to be made because a missed coupon payment is an event of default unlike trust preferred securities that provided issuers 20 quarters to miss a payment without tripping a default.M&A—Down but Eventual UpturnFinally, M&A will become more imperative among commercial banks as NIMs go much lower.Executives of Truist Financial Corporation likely are relieved that the respective boards of directors of SunTrust and BB&T had the courage to combine to extract significant cost savings on what will be a lower run-rate of revenues than originally envisioned.As for investors and M&A participants, the challenge as always will be first to think about earning power rather than next year’s estimate and what is a reasonable valuation in terms of earning power.That, of course, is easier said than done when markets are rapidly repricing for a new order. Originally published in Bank Watch, March 2020.

Uncharted Valuation Territory: What Is A Barrel Or An Acre Worth Today?

Even with Saudi estimations of a 20-million-barrel supply cut, times are tumultuous for the oil and gas industry. News earlier this month was met with no rise in West Texas Intermediate pricing at the time. It hovered around $20.00 per barrel. Last week it fell to the seemingly unconscionable negative territory. It was worse in other places. In Western Canada heavy select oil was around $4.50 per barrel and dropped to $0 last week. It went negative as well.That was not a typo. (The only beacon of “normalcy” was Brent was still trading above $25 per barrel.)World demand for oil has dropped somewhere between 20% and 35% by some estimations, and excess supply has been building for weeks. Thus, we may not even be at the nadir of the market shock. When the smoke clears from this explosive market disruption, there will possibly be some major market ripple effects such as swaths of the Canadian oil market (1.5 million barrels per day) and U.S. backyard “stripper” wells (representing 10% of total U.S. production) permanently going offline, representing a material change in U.S. supply going forward.Something must give, and something will. While global supply and demand imbalance has the industry scrambling in unseen territory, how does this convert to what upstream companies and reserves are worth amid the situation? Is it a 1:1 price to value change ratio? Depending on perspective, the answer is both simple and complicated.Not surprisingly, most potential or actual sellers of upstream assets and companies are praying that they don’t have to find out. Translation: they hope the market will correct itself before they choose (or have) to sell. The reasons for this are multifold. The obvious rationale is that the value of today’s production could fetch the lowest relative prices seen in decades. Secondary rationale is that tomorrow’s production, i.e. reserves, are being hit even harder. Those reserves represent the optionality, expectations, and hopes of an investor for a brighter market tomorrow. Therefore, sellers don’t want to give that up, whilst on the other side of the coin, buyers aspire to acquire the potential opportunity. What is the likely result? Wide bid-ask spreads and little to modest market activity. Put another way – the asset and transaction market could go dark until restructuring transactions hit the market.Navigating Today’s Upstream EconomicsThere are still indicators that can shed light on a dark market. Those include public valuations, reserve metrics, production metrics, and cash flow metrics. In terms of reserve metrics, value erosion usually starts in the bottom categories of a reserve report and moves upwards. Possible and probable reserves typically diminish in value first, then up to the proven categories, and finally to producing reserves. This makes sense because producing reserves are less risky and less expensive to produce, and thus are more value resilient in lower price environments. Consider the costs to produce an existing barrel of oil. In West Texas, this averages about $26 per barrel – some can produce cheaper and others more expensively. This means the average producer is losing $5-6 per barrel today on existing wells. What’s also notable is that these costs are much lower than they were just a few years ago for U.S. shale producers, but still aren’t low enough. Compared to the rest of the world, Saudi Arabia and Russia have the lowest production costs (of which we won’t expound on the reasons why here) and thus the rawest economic ability to weather this low-price environment. [caption id="attachment_31065" align="alignnone" width="619"]Source: Dallas Fed Energy Survey, Reuters, Seeking Alpha[/caption] However, when it comes to undeveloped reserves the costs are much higher. Even in the most efficient areas of Texas, oil prices need to be at least $46 per barrel to profitably drill a new well. This illustrates why even proven undeveloped (“PUD”) reserves are worth relatively (and often significantly) less than developed reserves.Therefore, upstream producers are de-incentivized to drill new wells, leading to the value of new inventory decreasing at an even proportionally higher rate. This dynamic has been exacerbated by the market’s focus on cash flows in priority to reserves in recent years. Investors had already been pulling valuations down as their standard tilted more towards shorter-term returns as opposed to longer-term reserves. To be sure, producers have reduced capital expenditures by historic amounts in the past 45 days or so. Extending that perspective, some might think non-producing reserves are worthless. However, they would be wrong. There is an optionality value to those future reserves, also known as acreage, that bears out in the marketplace and is evidenced by transaction prices. Valuations are based on future expectations, and many people believe that prices will not stay low permanently. Therefore, the market is willing to pay a relative premium to immediate economics to account for potential future upside. It also shows up in implied public market valuations as well.Ceding Latitude To Public ValuationsImplied valuations of public companies can provide a living proxy for market values, assuming efficient market theory. There are several metrics that investors and the industry utilize as potential benchmarks including cash flows such as EBITDA and EBITDAX. However, I note in this instance that the first quarter 2020 earnings have not been released yet, so trailing cash flow metric indications are not concurrent. Other metrics can be followed more contemporaneously such as enterprise value per flowing barrel of production. In addition, the drop in equity values push debt ratios higher, thus potentially triggering bank covenants.Predictably, valuations have been in a free fall. What may be unexpected is how those valuations have changed relative to prices or even other companies that are operating in different basins. Mercer Capital tracks groups of public oil and gas companies and categorizes them according to focus. There are integrated global producers, non-integrated global producers, North American focused producers, and even basin focused producers. Mercer Capital follows several valuation-related data points, but some key ones include enterprise value per flowing barrel which shows a company’s publicly traded enterprise value relative to its daily production. The table below shows the median results from those groups and from the entire sample.It's notable that general North American and basin-focused companies typically traded at a relative discount to global companies with one key exception – Permian focused companies. This group, including names such as Concho, Pioneer, and Diamondback, traded at multiples closer to its global counterparts. It’s also notable that debt ratios for most companies were between 30% - 40%, a reasonable historical range. Then the chaos hit, and recent valuation metrics look gaunt comparatively.As of the end of the first quarter, while WTI oil prices per barrel dropped from $61 to $21 or a 66% decline, price per flowing barrel fell only 47% in Mercer Capital’s group indicating that enterprise and asset values were more resilient than short term price fluctuations. This is, in part, a function of the previously mentioned reserve optionality. However, it’s also notable how much equity was lost and how relative debt ratios skyrocketed. The Bakken (Continental, Whiting and Oasis Petroleum) group’s debt ratios were the hardest hit, which may be a response to its pre-existing leverage issues relative to other groups.Finding Transactional DirectionAlthough the merger and acquisition market is likely to reveal limited information, it doesn’t mean that there are no transactions. In fact, just this month there were a few transactions announced that give a glimpse into how valuations are being set from a production and acreage value perspective. Value per acre is another metric that ranges based on numerous factors. However, in recent years depending on those factors, many deals traded around $8,000 to $12,000 per acre. In the Permian Basin, deals often traded above $20,000 per acre. Below is a sample of transactions in 2019 in the Eagle Ford shale area that illustrate this:In the past few weeks, there have been three transactions announced across the SCOOP-STACK area of Oklahoma, the Permian Basin in West Texas and New Mexico, and the Barnett Shale area in North Texas with some revealing financial disclosures. Potential motivations vary in these deals ranging from bankruptcy to prior strategy commitments. They also show why sellers are not incentivized to divest assets right now:Although this is not an apple to apple basin analogy, the contrast is stark. As can be seen in comparison, acreage values have slunk relatively further down than price per flowing barrel metrics indicating more erosion from the bottom of a company’s reserve report. There is a clear disconnect between PV-10 figures and the GAAP-driven Standardized Measure figure compared to market values at present.Destination Unknown?So where does this leave us? Lost? The market could potentially recover the sooner that economies open again. Each day that passes without positive indicators, the state of uncertainty continues. Many small producers can’t hang on much longer. During the Dallas Fed’s recent survey, nearly 40% of respondents would remain solvent for less than two years if prices stayed at $40 per barrel. Figuratively, that was a long time ago.Banks may extend credit lifelines since so many producers are in the same boat. Historically banks have preferred to leave the oil and gas business to their clients, however, this time around may be different as it is reported that major banks are setting up oil companies to operate seized assets. The question is – how realistic and pragmatic is that option? Even so, asset valuations may find a bottom near these prices. Even with today’s bloodbath, the valuation metrics from March 31st appear to be holding. Upstream prices are holding up much better than forward month oil futures. One other note – the oil market is not the only energy sector impacted. Renewable projects have been hammered as well and their economics are not as established as the oil industry. This could set back oil’s energy competition for some time as well. We’ll see.Originally appeared on Forbes.com.

RIA M&A Amid COVID-19

Down But Not Out

The outlook for RIA M&A has changed rapidly since 2020 began. Coming off of a record year, DeVoe postulated in January that "RIA M&A could hit over 40 transactions per quarter in 2020” saying that “the pace of deals was a testament to the health of the industry.” Until late February, DeVoe’s estimation seemed feasible as industry experts contemplated what the Franklin/Legg Mason deal and Morgan Stanley’s purchase of E-Trade meant for the industry, and we wrote about Creative Planning’s sale of a minority interest to PE firm General Atlantic.Today, however, as many of us work from makeshift home-offices, RIA principals have shifted their focus from strategic planning including M&A to ensuring their workforce is safe and healthy, their client service is unwavering, and their firm still exists on the other side of this bear market.In this post, we look back at RIA transactions that occurred in Q1 2020 and venture what M&A will look like over the rest of the year.Review of M&A in Q1 2020According to Fidelity Investments, there were thirteen deals between wealth managers in January totaling $18.9 billion in client assets. The largest of these deals by AUM was Fiduciary Trust Company’s acquisition of Athena Capital, which has $5.8 billion of AUM. This deal pales in comparison to Fiduciary Trust Company’s parent, Franklin Templeton’s, acquisition of Legg Mason (LM), with $1.5 trillion in AUM, for approximately $4.5 billion. These two deals highlight the differing motivations driving transactions in the RIA space.Partnering with those who already have relationships in a target market is often a faster growth strategy.Fiduciary Trust Company’s acquisition of Athena allowed the company to strengthen its foothold in New England where it already has about $2 billion in client assets. Many RIAs seeking to grow geographically have turned to acquisitions rather than growing organically. Since wealth management is a relationship-driven business, partnering with those who already have relationships in a target market is often a faster growth strategy than building these relationships in new markets on your own. Additionally, Fiduciary Trust Company’s acquisition expanded its product offerings for high net worth and ultra-high net worth clients.The Franklin/LM deal highlights one of the biggest drivers of M&A in the investment management space: achieving scale. There is significant operating leverage in the asset management business, and the Franklin/LM combination created a $1.5 trillion money manager poised to take advantage of this. While management of both companies asserted that there would be no personnel changes after the deal was finalized, back office synergies will likely lead to cost savings that will increase returns to investors.Additionally, in the first quarter of 2020, we continued to see deals driven by RIA consolidators such as Focus Financial and Beacon Pointe who are able to provide scale through back office integration and a solution for ownership succession planning.Outlook for RIA M&A By the end of the first quarter, the tone of discussions in the industry had changed. As of March 31, 2020, the S&P 500 had fallen by 20% since the beginning of the year, and publicly traded RIAs suffered their worst quarter since the financial crisis. The outlook for RIAs depends on a number of factors, but the one commonality is that RIAs are all impacted by the market. The decline in the market, and in turn, in RIAs’ revenue has led industry commentators to ponder the likely impact on deal volume and valuations.Pace of M&A Activity After thirteen wealth manager deals were announced in January, activity slowed with seven deals in February and three deals in March 2020. Although deals become riskier in volatile and bear markets, they don’t happen overnight. The deals that closed in March were likely being negotiated in November and December of 2019. Given the lag between deal negotiations and the signing/closing of a transaction, it’s likely that the decline in deal volume from January to March doesn’t fully reflect the new market reality.While we do not expect deals that are in the final stages of negotiations to be canceled, we do expect there to be a slowdown in new deal activity in 2020 as firm principals, RIA consolidators, and outside investors try to conserve capital and project the length of the downturn and the associated impact on RIA revenues and profit.While financial markets are currently suffering, markets are not down because of blemishes within our financial systems.Historically, recessions have corresponded with lower deal volume. According to McKinsey, “Since 1980, U.S. recessions have led to steep declines in the value of global M&A activity—typically, of around 50 percent during the first year.” We saw this in 2008 as deal activity slowed at the start of the last recession. However, it is important to recognize the limitations of comparing the current market downturn to the last recession, which was caused in part by excess leverage and a lack of regulation in the financial industry. Credit markets essentially collapsed and funding for M&A was suddenly much harder to come by. While financial markets are currently suffering, markets are not down because of blemishes within our financial systems.Deal activity in the RIA industry during this market downturn could be propped up by recent expansion of available capital in the space. M&A volume has increased in recent years as RIAs have gained more access to capital, both equity and debt. It is still too early to know if access to capital will decline. A recent article by Financial Planning predicts that PE money will not dry up. Rather, Echelon founder Dan Sievert believes, PE funding is “going to save the industry.” He predicts PE investors will continue to invest in RIAs and “[S]woop up any companies that are falling on hard times.”There may still be some difficulty finding financing for very large transactions. In 2008, not a single “mega-deal” (value of over $10 billion) was announced. Understanding that “mega-deals” within the RIA space may be defined slightly differently, we still expect there to be a slowdown in larger deals, of which we saw many over the last twelve months. Further, consolidators may reduce the size of their typical transaction as financing for these smaller deals is easier to come by, and a multitude of smaller deals instead of singular larger deals can serve as a means to diversify risk in this volatile operating environment.You Name the Price, I’ll Name the TermsWhile deal multiples may not fall, we do expect deal structures to change.The RIA Deal Room, published by Advisor Growth Strategies before the COVID-19 pandemic, recently asked if “valuations [were] rising due to better financial results, expanded multiples, or both?” They found that “the data suggest that valuations increased for 90% of RIA firms due to sustained financial performance. […] From 2015 - 2018, the median adjusted EBITDA multiple was 5.1, and there was less than 10% positive or negative variation in the yearly median results.”We don’t expect multiples to decline drastically, instead we expect that deals will be structured to more evenly distribute risk between the buyer and the seller through the use of earnouts.A decline in announced deal value in 2020 will likely come as a result of a decline in performance driven by an overall decline in the market, rather than a decline in deal multiples. As Matt Crow explained in a recent podcast, we don’t expect multiples to decline drastically. Instead, we expect that deals will be structured to more evenly distribute risk between the buyer and the seller through the use of earnouts.More than 70% of RIA transactions in 2019 were structured with some form of an earnout and, on average, sellers paid 30% of total deal proceeds as an earnout. Of those deals structured with an earnout, the payments were typically made over three years or less. Given the new uncertain operating environment for RIAs, we expect that more deals will involve some form of contingent consideration and less of the deal consideration will be paid at closing.Additionally, given the current volatility, we expect there will be an increase in the number of deals structured as stock deals. In a volatile operating environment, it can be easier to close a stock deal since the price (value of the shares) essentially moves as the market does.ConclusionIn summary, we expect that deal volume will slow over the next few months, but as Think Advisor recently noted, this slowdown is not necessarily bad news for the industry. During the slowdown “RIAs should take the opportunity to consider how M&A efforts perpetuate the broader objectives of an advisory firm.”Although we expect activity to slow, M&A activity will not come to a grinding halt. Owners of RIAs who find themselves near retirement and without a succession plan will still consider selling their firm. Additionally, the need for operating leverage that is achievable through scale becomes more pronounced in bear markets.The less leveraged RIA consolidators are uniquely positioned to partner with RIAs in bear markets as they are able to offer more operating leverage through back-office infrastructure. Additionally, as these consolidators are often PE-backed, they should still be able to find funding in a bear market.

A Deeper Dive into the Impact of COVID-19 on Auto Dealerships

Auto dealers are in a unique situation. While technically categorized as consumer “discretionary” items, many people rely on their cars to navigate their busy daily lives. With activity grinding to a halt amidst stay-at-home orders, cars are tipping more towards discretionary items (despite many dealerships being deemed essential businesses).While more practical than other expensive purchases, like a designer handbag, automobiles become less of a priority when budgets are trimmed, particularly when people are staying at home. All told, this will likely lead consumers to delay their purchases of cars, particularly those who want to peruse their options by walking a lot and test driving various makes and models.While other retail industries have fallen prey to the “Amazon effect,” auto dealers have avoided this fate because many consumers are not yet comfortable making such a significant investment without first getting behind the wheel. However, this means sales activity is even more adversely impacted by the current environment. Consumers with disposable income are more likely to spend it on other high-end items that require less personal inspection for style and feel before buying. As we’ll discuss, this is just one of the impacts the coronavirus is having on the auto industry.How Long Will COVID-19 Last?The key questions for auto dealers, and all other business owners, are how long this period will last and how COVID-19 will impact consumer spending on the other side.While lack of wear and tear will delay many timelines, people will still need cars.Buying a car is a significant investment that many consumers will simply delay as staying inside doesn’t require much car travel. In fact, some auto insurers will issue rebates as they expect claims to decline during this period.While lack of wear and tear will delay many timelines, people will still need cars. Significant mileage or a wreck are the most obvious reasons someone would require a new car, but not all purchases are necessitated by the status of a prior vehicle. Getting married, having a child, or turning 16 are life milestones that tend to increase car sales, and these are not necessarily going to be halted by the pandemic. However, if the economic reverberations cause consumers to forego rather than simply delay their automobile purchase as budgets are slashed on the backside of this, a permanent loss in demand would likely prove extremely detrimental to auto dealers.How Will the Auto Industry Respond to COVID-19?While the proliferation of the Internet may not have fully infiltrated the auto dealer business model before the pandemic, the impact of the coronavirus on the way people shop has likely forced dealers to reconsider their digital strategy. Tech-savvy consumers were already using services like TrueCar and Kelley Blue Book to increase price transparency and lower gross margins. While dealers have dipped into e-commerce to varying degrees, dealers have largely been thrust into it now.While dealers have dipped into e-commerce to varying degrees, dealers have largely been thrust into it now.Aside from ramping up web presence, dealers must also consider how they will collectively respond to the reduced demand.Contrast auto to another significantly impacted industry: restaurants. Restaurants can significantly decrease prices in order to keep customers coming through their doors. While they are sacrificing some profits by offering it cheaper, restaurants have plenty of turnover, and customers tend to return to their favorite places frequently. Auto dealers operate differently. Given the relatively long vehicle shelf life, dealers do not frequently experience near-term repeat customers (except for service and maintenance operations).Dealers can get creative with their inventory to get cash infusions, though many will opt to offer increased incentives to boost sales. However, front-loading sales with incentives to make it through the tough times could have negative impacts on industry volumes as well as profits down the road. This pain will be particularly acute if some shoppers accelerate their purchases to take advantage of falling prices when they otherwise may have tried to delay a big expenditure by servicing their aging vehicle instead.Incentive spending hit an all-time peak at $4,800 per vehicle in March, which supported the SAAR (a seasonally adjusted measure of Light-Weight Vehicle Sales) from dropping even further than it did. While annual sales have been above 17 million since 2014, this has included significant increases in incentives which come at the detriment of profitability. Gross profit is a much more relevant metric than revenue in the auto dealer industry, and revenues and volumes propped up by incentives that do not translate to improved gross profits will ultimately hurt dealership valuations as earnings deteriorate.Government ResponseGovernment response to this pandemic has come through both fiscal and monetary policy. Congress’ efforts on the fiscal side have been more visible, culminating with President Trump signing a $2.2 trillion economic package (the “CARES” Act) into law on March 27. Stimulus checks have started to roll in and the small business loan program, Paycheck Protection Program or “PPP”, has already reached its $349 billion limit. On Thursday, April 24th, Congress passed an additional $484 billion economic package with $320 billion replenishing the PPP, $60 billion in additional SBA disaster relief funds, and $100 billion to support hospitals and increased testing.Government Response Impact on DealershipsMany auto dealers, even those with significant top-line revenues, will qualify for small business grants and forgivable loans. For those on the fence about maintaining their workforce due to sharp decreases in demand for their services, these programs are structured to incentivize dealers to retain their staff.The PPP is likely to boost morale for dealers able to retain their full staff during this time; this also saves future costs of having to train new staff when activity ramps back up. Still, tough decisions will have to be made, and auto dealers may be forced to cut costs they hadn’t considered during the long bull market that categorized the past decade.The auto industry isn’t likely to receive the extensive aid being provided to airlines, but the small business loans won’t be the only impact the CARES Act has on dealerships. The $1,200 payments to consumers are unlikely to motivate people to go out and buy a car, but it could provide enough money to make car payments and get tune-ups or other necessary maintenance.ConclusionAt this point, there are likely more questions than answers. The first order and second order effects of the virus are being measured in real time, and we likely won’t be able to fully understand its impacts until we have the benefit of hindsight. Government responses are likely to continue, though it is unclear the form of future actions.What we do know is that many consumers are staying indoors, and odometers have slowed. Dealers must do what they can to maximize this downtime by increasing their digital presence and managing expenses and working capital. While dealers may need to sell at lower prices, they will have to balance near-term needs with long-term impacts. We have been impressed by the outpouring of support dealers have shown for their communities. We encourage everyone to continue checking in with family, friends, employees, customers, suppliers, and our local communities.

Evaluating the Buyer’s Shares

Jeff K. Davis, CFA and Jay D. Wilson, Jr., CFA, ASA, CBA along with DeVan Ard Jr. (Reliant Bank) originally presented the session "Evaluating the Buyer’s Shares" at the 2020 Acquire or be Acquired (AOBA) Conference in Phoenix, Arizona. A short description of the session can be found below.Although M&A is usually focused on the price (and valuation) sellers realize in a transaction, consideration paid to sellers that consists of the buyer’s common shares raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be as obvious as it seems, even when the buyer’s shares are actively traded.

RIAs Suffer Worst Quarter Since the Financial Crisis

Most RIA Stocks are Now in Bear Market Territory

Last quarter we blogged about how great 2019 was for the RIA industry. Recent events have rendered that blog post largely irrelevant, as discussions in the industry are now centered on how the COVID-19 global pandemic has impaired RIA valuations. You can tune into Matt Crow and Mindy Diamond’s podcast for a more in-depth discussion on COVID’s impact on the industry, but this post summarizes the effect it has likely had on RIA valuations.The chart below shows there was nowhere to hide last quarter, as all four components of the RIA industry dipped into bear market territory. The primary driver behind the decline was the decline in the market itself, as most of these businesses are primarily invested in equities, and the S&P was down 20% over the quarter. The aggregators are down a bit more since their models rely on debt financing, which exacerbates losses during times of financial strain.Pre-COVID, the industry was already facing numerous headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. The 11-year bull market run masked these issues (at least ostensibly) as AUM balances largely rose with equities over this time. Finally faced with a market headwind, the bull market for the RIA industry came to a grinding halt last month.Regardless, this bear market has to be placed in proper context. It’s hard to believe, but the industry (excluding the consolidators) is pretty much right where it was a year ago in terms of market caps. We basically just gave up the gains made in the back half of last year though the decline was far more rapid.As valuation analysts, we’re typically more concerned with how earnings multiples have changed over this time since we often apply these cap factors to our subject company’s profitability metrics (after any necessary adjustments) to derive an indicated value. These multiples show a similar decline in Q1 after a sizeable increase in the fourth quarter of last year.There are a number of explanations for this variation. Earnings multiples are primarily a function of risk and growth, and risk has undoubtedly risen in the last couple of months while growth prospects have diminished. Specifically, future earnings are likely to decline with AUM and revenue, so the multiple has pulled back accordingly. Conversely, the run-up in Q4 reflected the market’s anticipation of higher earnings with rising AUM and management fees. The multiple usually follows ongoing revenue, which is simply a function of current AUM and effective fee percentages, as discussed in last week’s post.Implications for Your RIAYear-to-date, the value of your RIA is most likely down; the question is how much. Some of our clients are asking us to update our year-end appraisals to reflect the current market conditions. There are several factors we look at in determining an appropriate level of impairment.One is the overall market for RIA stocks, which is down 20% in the first quarter (see chart above). The P/E multiple is another reference point, which has declined 22% so far this year. We apply this multiple to a subject RIA’s earnings, so we also have to assess how much that company’s annual AUM, revenue, and cash flow have diminished over the quarter while being careful not to count bad news twice.We also evaluate how our subject company is performing relative to the industry as a whole. Fixed income managers, for instance, have held up reasonably well compared to their equity counterparts. We also look at how much a subject company’s change in AUM is due to market conditions versus new business development net of lost accounts. Investment performance and the pipeline for new customers are also key differentiators that we keep a close eye on.Diminishing OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market. Their product is, after all, the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has generally diminished with market conditions over the last couple of months. AUM is down with the market, and it’s likely that industry-wide revenue and earnings declined with it. April has been kinder, but volatility remains.If the bid-ask spread between you and your partners has been too high to get a deal done, it may time to re-examine your price expectations. The next generation of ownership may be enticed by more attractive valuations and return to the negotiating table, so knowing your firm’s worth may be more important than ever. We’re happy to walk you through that.

March 2020 SAAR

When Might Things Return to Normal?

The term “24-hour news cycle” doesn’t do justice to the rate at which new information becomes available and is consumed by people trying to understand the significant impact COVID-19 is having on all of us. Stay-at-home orders have created a huge demand shock, which is particularly harmful to a largely service-based economy. In this post, we contextualize some of the fallout that has been experienced and try to answer the question “when will things return to normal?”.March SAARSAAR came in at 11.372 million, the lowest level since April 2010.As expected, SAAR (a measure of Light-Weight Vehicle Sales: Autos and Light Trucks) declined considerably in March as the early effects of COVID-19 began to impact just about every industry across the globe. SAAR came in at 11.372 million, the lowest level since April 2010. This also represented a decline of 32.4% from February. The 32.4% decline was only the fourth time since 1976 (when the SAAR was first recorded) that a 30% month-over-month decline has occurred. The first two instances were during a 6-month period of extreme volatility between September 1986 and February 1987, including three monthly increases of over 22% and two declines of 31.6%. Despite these anomalies, the only other significant month-over-month decline occurred in September 2009 when SAAR declined 35.8%. However, SAAR had increased by 14.2% and 28.1% in the two preceding months, so that September’s steep decline was only 6.1% below the preceding June.While the huge drop in volumes in March was certainly historic, it included a couple of weeks that were relatively unscathed by stay-at-home orders. April is likely to show further declines with significant uncertainty about when we will reach the bottom.Putting it in PerspectiveWhile there have been many sharp one-month declines in the SAAR, we note that even seasonally adjusting the data can fail to capture certain calendar anomalies, specifically when one month has an extra selling weekend. In looking at other significant events, such as the stock market crash in ’87 and 9/11, the drop caused by the market crash was relatively short-lived and auto volumes actually spiked in the month following 9/11 as the country braced for war. To better understand where we might be headed and when things might return to some level of “normal,” we analyzed prolonged declines, focusing on the 1981-1982 recession, the Persian Gulf War, and the Great Recession. Though these events do not align perfectly with COVID-19, observing how periods of economic turmoil affect the industry and examining the length of recovery time historically can provide future insight as we seek to climb out of the current crisis.There are numerous ways to measure recovery. For purposes of this post, we measure “recovery” as how long it takes to return to a “steady state” of vehicle sales. We use a steady state figure of 15.6 million annual sales from a 2015 paper written by Austan D. Goolsbee (University of Chicago) and Alan B. Krueger (Princeton University). The paper analyzed the restructuring of General Motors and Chrysler. The inputs into the regression model used in the paper include:Real GDP GrowthThe unemployment ratePopulation growthThe Federal Reserve’s Senior Loan Officers’ Survey (SLOOS) measuring willingness to lend to consumersLog of average real price of a gallon of gasoline (for the preceding quarter)Standard deviation of gas prices over the preceding four quarters In every year since the paper was published, industry sales have surpassed 17 million, indicating the steady state may be biased upwards if rerun today. However, the data stops in 2007 just before the Great Recession, and because auto sales are procyclical, any increase in the steady state figure would likely be due in part to the longest economic expansion in the country’s history over the past 11 years. Further, since vehicle sales are positively correlated with population growth, we would expect a long-term figure to be higher than early years and lower than more recent years. Ultimately, we find a steady state figure of 15.6 million to be reasonable for this analysis. A Long Term View of SAAR A long-term view of SAAR is presented in the graph below: [caption id="attachment_30880" align="alignnone" width="940"]Source: FRED and Princeton University[/caption] The 1981 RecessionAt the time, the 1981 recession was the worst economic downturn in the U.S. since the Great Depression. Triggered by a combination of monetary and global energy issues, unemployment reached 11%. While the effects of the recession were widespread, the manufacturing, construction, and auto industries were particularly affected. Auto manufacturers ended 1982 with 24% unemployment. The industry saw 4 straight years of year-over-year declines in sales from 1979 to 1982 with the largest annual decline in 1980 at 19%. SAAR bottomed out in October 1981 with only 9,209,000 annualized vehicle sales; from there, SAAR increased 17% in both 1983 and 1984. SAAR reached over 15.6 million sales in August 1985, approximately 7 years after it first dropped below this threshold in September 1978.As noted previously, population growth likely indicates the 15.6 million is a high threshold for this period, particularly since SAAR was only above this for a brief period in 1978. The precipitous decline at the beginning of 1980 appears to have been restored by the end of 1983, indicating just 4 years before recovery.The Persian Gulf WarThe Persian Gulf War, precipitated by Iraq’s invasion of Kuwait, caused the oil shock of 1990. Though less severe than oil shocks that occurred in the 1970s, oil prices initially soared from a pre-invasion price of around $18 a barrel to above $40 in the late fall of 1990, leading to declining revenues for the auto industry. At the same time, the Fed was tight on interest rates, endangering an already weak economy. This combination of oil prices and economic policy brought the U.S. into a recession that hit the auto industry particularly hard. Vehicle sales declined each year from 1989 through 1991, with the biggest decrease in 1991 at 11%. It took until April 1994 for SAAR to reach 15.6 million again, about 4 years after it first began to drop.The Great RecessionArguably the most impactful event on the industry in recent history was the Great Recession (2007-2009). Precipitated by a financial crisis caused by a severe contraction of liquidity in global markets, businesses were forced to reduce their expenses and investments and layoffs resulted. From December 2007 to June 2009, real GDP declined by 4.3% and unemployment increased from 5% to 9.5%, peaking at 10% in October 2009.The auto industry and other industries reliant on consumer loans (e.g., housing) suffered significant losses. In 2006 and 2007, vehicle sales volumes decreased about 2.5% consecutively, and the auto industry hourly workforce was reduced from over 90,000 to approximately 40,000. Conditions worsened through 2008 and 2009, as sales declined 18% and 21%, which is the largest year-over-year decrease of any time period. SAAR dropped to just a little over 9 million in February 2009, 6.6 million below the steady state SAAR. However, through the assistance of the government in the Troubled Asset Relief Program (TARP) and the end of the recession in 2009, the industry survived and returned to its steady state of 15.6 million vehicle sales in 2013, 5 years after it first dropped below that level in January 2008.COVID-19There are some positive takeaways from looking at these past events.Although economic conditions currently point to a difficult period of uncertain length, there are some positive takeaways from looking at these past events. Periods of high growth have followed periods of low sales as consumers who delayed purchases in rough times returned to the market. SAAR increased 17% consecutively in both 1983-1984, following the 1981 recession. There were increases of 8% in both 1993 and 1994 following the Persian Gulf War. Finally, the auto industry experienced 5 years of expansion following the Great Recession, reaching similar sales as before the crisis and further set new highs in the 5 years after that.Again, it may take a while to return to the 17 million in sales seen in the past few years, but that is above the long-term average and should not necessarily be the level from which we measure recovery. NADA expects it could take three or more years to return to this level, which would be reasonable given historical recovery times.ConclusionThe auto dealer industry is resilient through tough times. We hope dealers are once again able to navigate both the known and unknown problems facing us today. Dealers must grapple with how to continue to pay their employees, alter their sales channels on the fly, and potentially even help teach their children at home.Mercer Capital stands ready to partner with dealers in their time of need. Prior to the nationwide lockdowns, we were anxiously awaiting the NADC Conference in Florida at the end of April as well as the TAA/KYADA Conferences in June. We had hoped to launch this blog in happier times, but we still plan to offer our unique perspective as valuation experts as the pandemic impact unfolds. Working from home, we have more time to write these blogs, and we hope they are interesting to you. Feel free to reach out to us if you have valuation questions as to how your dealership may be affected.Mercer Capital is a financial services firm specializing in business valuation. We also provide litigation support and transaction advisory services for clients big and small. Contact one of our professionals to discuss your needs in confidence. And stay safe.

Saudi Arabia, Russia, or the United States – Did One of the Players Blink?

It’s been a truly dizzying time in the world of international oil production over the last five weeks. With so much macroeconomic activity, twists and turns, it’s been easy to fall behind as to “what’s gone on”, and for even those who’ve been paying reasonably good attention, you may not be sure what all has occurred. What suggestions were made? What deals were cut? What cooperation was gained? What threats were made, and who, if anyone, “blinked”? To some extent, we may never know the answers to all those questions.How We Got HereSo, what occurred in the last few months that got us to this very dynamic point in time? To summarize:January-February 2020 – The coronavirus “goes” pandemic, spreading throughout the world. While the full extent of damage from the pandemic remains unknown, it’s expected that at least 2 million people will contract the virus, the death toll will easily surpass 120,000 and the economic damage will be of a magnitude that hasn’t been seen in several generations. Due to the need for quarantines, travel restrictions, forced business shutdowns and stay-at-home orders to limit the spread and speed of the spread, oil demand plunged and oil prices sagged.March 6, 2020 – The three-year OPEC+ (OPEC represented by Saudi Arabia and “+” effectively meaning Russia) production/price cooperation pact, set to expire on March 31, fell apart when Moscow refused to support Riyadh’s demand for additional production cuts aimed to offset the reduced demand for oil resulting from the coronavirus pandemic.March 8, 2020 – So what do two strong-willed centrally-run countries do when their oil production control negotiations (for the purpose of supporting oil prices, on which both countries rely) break-down? Keep negotiating? Give-in a little for their mutual good? No. Instead they purposefully shove their thumb into the other party’s eye by boosting production? Make sense? Not really. Unless there are ulterior motives in-play such as, curbing the U.S. shale revolution that buoyed the U.S. to energy/oil independence and the top spot in world oil production. Not a certain motivation, but a potential motivation that has a lot of people talking about the possibility. Late March 2020 – At this point, Covid-19 has significantly reduced oil demand. In the meantime, the Saudis and the Russians have boosted oil production and oil prices have tanked. The U.S.’s shale producers are in free fall with bankruptcies staring them in the face. U.S. energy independence and oil production leadership are in the crosshairs and the Saudis and Russians are showing no signs of any rational behavior on energy production. Here’s where the geopolitical, oil-production-tied-relationships game starts to get “interesting”. What’s a Newly Leading Oil Producer With a Threatened Leading Position to Do?It’s at this point that all sorts of possible actions on the part of the U.S. begin to be discussed. Various suggested actions include:Lure Saudi Arabia away from OPEC and into a production-setting relationship with the U.S. – This one was simply a bit hard to imagine having much of a chance at all. First, the U.S. has always been very critical of production controlling cartels, and production setting with the Saudis would be the exact opposite of our long-held free-market values. Second, U.S. anti-trust laws simply wouldn’t allow the U.S. government to engage in limiting production, or oil companies to join together for the purpose of controlling oil production.That being said, the Wall Street Journal reported in late March that officials at the Energy Department were seeking to convince the Trump administration to push for Saudi Arabia to quit OPEC and work with the U.S. to stabilize oil prices. At the same time, Hart Energy was reporting that Energy Secretary Dan Brouillette had indicated that he didn’t know if a U.S.-Saudi oil alliance was going to be presented as a path forward in any formal way as a part of the public policy process, and that no decisions regarding any such alliance had been made. However, it was also reported that the Trump administration would soon send a special energy representative from the Energy Department, to Saudi Arabia, in order to improve talks between the two countries. Brouillette also indicated that the Trump administration would at some point engage in some sort of diplomatic effort with Saudi Arabia and Russia on oil production levels and that he would work with Secretary of State Mike Pompeo and other officials on that effort. This all left the likelihood U.S.-Saudi cooperation open to individual interpretation.U.S. Production Limits Via the Texas Railroad CommissionAlthough the U.S. government may be prohibited from entering into oil production agreements by anti-trust laws, that’s not the case for individual states. In late March, reports began to surface of the Texas Railroad Commission having been approached by two major Texas oil producers with the idea of negotiating for production limits with OPEC. The Texas Railroad Commission? Despite the Commission’s name, it long ago ceased any regulation pertaining to the railroads, however, its regulation of Texas oil production (control granted to it back in 1919) continues to this day. Although the Commission has long had a reputation for markedly lenient regulation of production levels, the current crisis has powerful voices calling for the Commission to consider working with OPEC to reduce production levels in order to save the U.S. oil industry from the devastating impact of sub-$25/barrel oil prices.While this may pose a “workable” process, it comes with multiple layers of required cooperation and agreements. Does the Commission address OPEC directly, or through the Trump administration? OPEC itself requires member cooperation, and the Commission would need the cooperation of other U.S. oil producing states. After all, if the Commission limited production in Texas, but such limits simply triggered higher output in other U.S. states, the effort would be for naught. President of the Texas Oil & Gas Association (TXOGA), Todd Staples, commented on that very matter indicating that if Texas oil and gas operators cut back production in isolation, that reduced production would likely be filled by operators producing in other states.Even if the Commission’s involvement gained the necessary cooperation from the Trump Administration, OPEC and other states, the idea faces headwinds both from a purely practical standpoint and from those that simply don’t want the Commission involved in the production quotas. Some additional items on the practical side of things:Wayne Christian, the Commission’s Chairman, noted that the Commission hasn’t imposed such limits in more than 40 years, the Commission doesn’t have staff with any experience in implementing production limits, the Commission would have to track production across thousands of independent producers, and the Commission’s technological capabilities for handling such a process are quite limited.The Commission’s next meeting was, at that time, weeks away on April 21st, meaning that no action in pursuit of limiting production levels would occur for some time.Other high oil producing states, unlike Texas, don’t have similar regulatory bodies to the Texas Railroad Commission. Without such regulatory bodies, those states may not have the ability to effectively limit in-state oil production. Even if these practical barriers could be overcome, there remain powerful voices that are opposed to any moves that go beyond market forces. Mike Sommers, the CEO of the American Petroleum Institute, has pushed back against proposals that would involve U.S. officials negotiating a joint production cut with OPEC and Russia. Sommers noted that the U.S. has always supported the market as the determinant of oil prices, and that during times of crisis, those principles shouldn’t be abandoned. Sommers was particularly opposed to the proposal from a Texas Railroad Commission commissioner, that would regulate oil production within Texas. Commissioner Sommers further indicated that any such proposal would be damaging to our posture in the world, and that imposing a production quota on Texas produced oil would penalize the most efficient producers while supporting less efficient companies. Frank Macchiarola, Senior Vice President of Policy, Economics and Regulatory Affairs at the American Petroleum Institute echoed Sommers sentiments indicating that the Institute's position is very simple– quotas are bad. He added that quotas have been proven to be ineffective and harmful, and that there’s no reason at this time to be imitating OPEC. However, Texas Railroad Commission commissioner Ryan Sitton noted that he’d already spoken with OPEC Secretary-General Mohammad Barkindo regarding an international agreement that would ensure economic stability as the world recovers from the coronavirus outbreak. Sitton stated that Barkindo had invited the commissioner to OPEC’s meeting in June to further discuss the matter. Commissioner Sitton further noted that international cooperation was absolutely necessary if Texas were to decide to limit production. He commented that if Texas limited production as part of an international agreement to balance the markets, he thought the odds of success would be very good. However, he further noted that if reductions were only implemented by Texas, without collaboration with others, the odds of success were near zero.Forget the “Carrot”, Use the StickOf course, there’s always those in favor of the straight-forward approach to motivating others to a preferred course of action through of the “stick”, rather than the “carrot”. Especially those that view the Saudi-Russian production spikes as an overt attempt to damage the U.S. shale oil industry. Senators, including Lisa Murkowski of Alaska and John Hoeven of North Dakota, noted that the American people are not without recourse in responding to the Saudi-Russian actions. They’ve noted that tariffs and other trade restrictions, investigations, safeguard actions, sanctions, and much else are within the arsenal of potential responses. Another similarly minded suggestion is to remove U.S. armed forces from the Saudi kingdom.Others, such as oil industry analyst Ellen Wald indicate that the best option for U.S. in this situation is for the Trump administration to pursue diplomatic efforts to settle things down. Wald noted that sanctions and embargoes aren’t realistic and will having a negative impact for the United States. Sitton seemed to concur with Wald’s position indicating that a diplomatic solution and planned production cuts would be better for everyone. He added that although the Trump administration could embargo Russian and Saudi oil as a form of punishment, his hope was that we don’t end-up going there.Interestingly, suggested use of these more “stick” type actions have not been coming from the Trump administration. Instead, President Trump has remained more measured in his comments, only noting that if the Saudis and Russians didn’t resolve the matter on their own in short-order, that he would get involved at the appropriate time.The Art of the DealPresident Trump, ever the deal-maker, may be looking to a solution that avoids violation of the U.S. anti-trust laws, sidesteps brokering a deal on behalf of the Texas Railroad Commission and doesn’t include the actual application of any “stick” – although maybe using the threat of the “stick.” Within the last week, President Trump tweeted that he expected Russia and Saudi Arabia to agree to cut production by millions of barrels a day. Although the Kremlin soon thereafter denied any talks with the Saudis, officials from the kingdom then noted that they would consider significant production cuts as long as other members in the G-20 group of nations were willing to join the effort. On April 9, OPEC and Russia announced plans to reduce their oil production by more than 20%, albeit also indicating that they expect the U.S. and other top producers to join the effort to prop-up prices. U.S. officials noted that while they had not committed to any specific cuts in production, expectations were that U.S. output would fall substantially over the next two years, sounding ever so much like the U.S. is on-board with participating in the reductions, albeit without crossing the line into anti-trust law triggering commitments. However, one sticking point to the agreement was Mexico, who on April 10 balked at the plan. Mexican President Lopez Obrador refused to sign-off on the agreement as it would necessitate putting his plans for Pemex’s revival on hold. That resulted in Obrador getting a call from President Trump from which the U.S. seemed to be offering to take part of Mexico’s required production cut with some sort of undefined “repayment” to occur at a later date. Ultimately, a deal was reached, with OPEC+ nations agreeing to reduce output by 9.7 million barrels per day, representing approximately 10% of global demand before the coronavirus pandemic. However, with demand down an estimated 35%, the cut does not fully balance supply and demand. Oil prices were largely unchanged on the news of the agreement.Conclusion, or Lack ThereofAs we indicated, it’s been a truly dizzying time in the rough-n-tumble world of oil production. Like they say, if you miss a day, you miss a lot. For now, it at least appears that someone may have just blinked. The Trump administration seems to be on the verge of a truly historic deal to cut worldwide oil production and bring oil prices up to a modestly workable level. And that with the U.S. not committing to forcing domestic producers to cut production levels but indicating that U.S. production would “naturally” decline without the government’s intervention. That coupled with a potential side-deal with Mexico to “cover” part of the production decrease that was being sought from that country, but that Mexico is unwilling to shoulder on its own. Will it work? Will the deal be accomplished?Although an agreement was reached to reduce oil production in light of demand destruction caused by the coronavirus pandemic, oil markets appear to remain oversupplied. Will OPEC+ and other nations agree to another deal to further reduce production? Will U.S. production decline faster than anticipated due to low oil prices? Will the Texas Railroad Commission implement proration orders for Texas producers? All we can say is, stay tuned – and expect the unexpected.

Don’t Waste This Crisis

Tune Your Business Model for Greater Resiliency

Travel is one of the freedoms of normal life which I miss these days. One of the earliest celebrations of the great American road trip was a series of shows from the television comedy, “I Love Lucy.” In those episodes, the Ricardos and their neighbors, the Mertzes, drive from their home in New York to Los Angeles, where Ricky Ricardo is embarking on a film career. The 3,000-plus mile journey would have taken nearly two weeks in the pre-interstate 1950s. The couples traveled in style in a gorgeous 1955 Pontiac Star Chief convertible, but the search for gas stations, food, and lodging along the way were more than a challenge without smartphones or GPS.Where Are We?These days, the RIA industry is on its own road trip, and everyone’s searching for “the” map (Hint: there isn’t one). In the third week of March, I think I heard from every single media outlet that covers the investment management industry, wanting to know how the current crisis (COVID-19 pandemic, market swoon, and consequent recession all rolled into one) would threaten RIA valuations and M&A activity. I talked to lots of reporters and said lots of things. No one really asked about the challenges firms face these days just to operate their businesses, and that is the most important topic for now. Valuation and M&A will sort themselves out over time.Road Work Ahead To put it mildly, the operating environment for RIAs of every stripe is disorienting. Equity markets took a 30+% plunge, and now (as I write this), we’ve retraced about half of that. Debt markets have been even more erratic than equities, and many commodities markets have experienced even greater price fluctuations than debt. (Does anyone else notice that the relative asset volatility in the global capital stack seems backward?) It’s hard to find anyone who thinks there’s a quick way out of this, despite the Treasury Department carpet bombing the economy with money. The perma-bears are the only happy people in finance because they’ve been invited back on CNBC. Meanwhile the press is debating what letter of the alphabet best represents the future of the markets (value-added stuff).How Are You Doing?The value of RIAs and the future of transactions in the industry ultimately comes down to the health of the individual firms. Fortunately, there is a relatively straightforward way to assess the financial well-being of your firm, and ways of taking corrective action if your firm’s future is threatened.RIAs have a unique business model in that it is possible, on any given day, to assess whether or not a firm is profitable. Doing so simply requires an assessment of ongoing revenue and expenses.Start with your current expense base. The easiest way to do this is to take your last month’s P&L. Your biggest expense is labor and benefits; it’s not unusual to see labor costs comprising two-thirds or more of an RIA’s total operating costs. For the purpose of this exercise, just look at the fixed cost of salaries and benefits. Leave out discretionary bonuses or other personnel-related costs that are unlikely to be realized in a bear market. Once you’ve quantified total personnel costs, look at other fixed costs like rent, research, compliance, technology, systems, etc. Adding all of that together will derive your annualized expense base.Most businesses can compute a run-rate of expenses, but the beauty of the RIA model is that you can also know, on any given day, what annualized revenue is. Take closing AUM as of the most recent trading day, filter it through your fee schedule, and you can tell, based on that day’s market pricing of your client assets under management, what annualized revenue is.With annualized revenue and expenses calculated, you know whether or not you’re profitable, and by how much.Margin for ErrorProfit margins have a number of functions, but one which is often forgotten is that margins enable a business to sustain itself during a downturn. Most RIAs have lots of “operating leverage” in their P&Ls which allows them to retain a considerable degree of upside in revenue as profitability. Symmetrically, though, operating leverage means that most investment management firms also lose profitability on a near dollar-for-dollar basis as revenues decline. The good news is that the degree of operating leverage in different types of investment management firms tends to be offset by their level of “normal” profit margin.Wealth management (and independent trust company) margins tend to be more modest than those of asset managers and hedge funds, but the impact of a bear market on wealth managers is usually moderated by portfolios with healthy allocations to fixed income securities. In a market decline like we’ve had recently, a fixed income allocation might effectively hedge about a third of the loss in AUM and revenue. Asset managers focused solely on equities, on the other hand, are positioned to face the full fury of a bear market. Fortunately, asset managers usually start with higher profit margins, which allows them to better absorb the loss of revenue. Note that, in both examples, salaries comprised half of revenue in the base case (pre-bear market). Investment management is labor intensive, and we commonly see substantial fixed compensation expense. The real operating leverage for asset managers comes from non-personnel related costs, which are usually fairly minor as a percentage of revenue. In any event, this is a good time to stress-test your profitability to see, on a day-to-day basis, what kind of market activity threatens the sustainability of your firm. Then you can decide what to do about it.Never Waste a Good CrisisIf you check your ongoing margin and it isn’t what you’d like, then what? We won’t try to forecast how deep this bear market will go, or how long it will last. Regardless of the forward look, the magnitude of the current situation presents an opportunity to build some flexibility into your business model that makes it more adaptable to any environment.In the credit crisis of 2008-09, we had more than one client cut compensation across their ranks, usually more for upper level staff and partners than for more junior members of their team. One client went so far as to use the opportunity to reset relative levels of compensation, restoring salary levels for some employees but not others after the market recovered.To us, the current environment illustrates the value of flexible compensation plans, with bonus compensation tied to the profitability of the business. To pick up on the examples shown above, if our example wealth management firm were to reduce fixed compensation by half, and then split half of pre-bonus profits with staff in the form of quarterly bonuses, compensation expense could then adjust to market conditions and margins would become more stable. This example is a little extreme (cutting salaries by 50% is rarely an option), but it illustrates how tying an RIA’s largest expense at least partially to profitability can improve the resiliency of the firm and, ultimately, the job security of the firm’s employees.The Ultimate Road TripEvery bear market is scary in its own way, but the current one threatens our physical health as well as our financial health, so it wears on our psychology much more than most economic downturns. We hope that all of our blog’s readers are safe and well. And while you’re at home, take a moment to think about what unique opportunities might present themselves in the age of COVID-19.No doubt the cast of “I Love Lucy” wouldn’t try to spend two weeks traveling together in the middle of this pandemic, but one team realized that the currently uncrowded roads of America offered the chance for a new coast to coast speed record, and drove a modified Audi A8 from New York to Los Angeles in 26 hours and 38 minutes, quite a bit faster than the Ricardos and the Mertzes. We would urge our clients to find other outlets for their ingenuity.Photo of the anonymous team car that just set the “Cannonball Run” record (New York to Los Angeles) (roadandtrack.com)

Looking Back to Look Forward

Lessons for the Auto Dealer Industry

My colleague, Travis Harms, published an article on his Family Business Director Blog entitled “Looking Back to Look Forward” earlier this month making observations from companies that survived the Great Recession. Travis analyzed data from 554 operating companies for two-year periods before the Great Recession (2006 and 2007), two years during the Great Recession (2008 and 2009) and two years following the Great Recession (2010 and 2011). Travis concluded five observations from the data analyzed:Operating leverage can be managedWorking capital really is a source of cash during a downturnCompanies become more disciplined investorsBorrowers reduce debt levelsDividends are much less affected than share buybacks The pool of selected companies included operating businesses thus excluding financial institutions and real estate companies that were more adversely impacted by the Great Recession. While the search didn’t specifically include auto dealers, several of the observations/lessons can be applied directly to the specific operations and challenges that auto dealers are facing in today’s COVID-19 economic climate. We focus on the first three of these observations as they related more directly to auto dealers.Operating Leverage Can be ManagedThe data from Travis’ study illustrated that the companies experienced a 15.6% revenue decline in 2009, but EBITDA margin only fell slightly by 0.5%. How was that possible? Companies were able to mitigate the decline in revenue from falling to the bottom line by making conscious efforts to reduce expenses. The Auto Dealer revenue model consists of new vehicle sales, used vehicle sales, parts and service, and finance and insurance. As we’ve written about and discussed in this space, new vehicle sales as illustrated by SAAR, have fluctuated with the economic cycle. In times of declining new vehicle sales, successful dealerships have shifted focus to their other profit sources. Additionally, dealerships have focused internally on managing and reducing internal operating costs. In 2019, light vehicle sales in declined in the US, and industry executives were highlighting other aspects of their business model mitigating declining volumes as indicated by SAAR before the spread of the virus. Dealerships already had an eye on monitoring costs from sluggish performance times in the past, and managers can lean on their experience from the Great Recession in terms of finding which costs can be cut.Working Capital Really is a Source of Cash During a Downturn The companies in Travis’ sample reduced working capital by $20.8 billion to mitigate lost revenues of $175 billion. Those in the auto dealer industry know that working capital is dictated and monitored by the manufacturer with requirements usually listed on the front page of the dealer financial statement. If auto dealers aren’t afforded the luxury of reducing their working capital, how can it become a source of cash during a downturn? Throughout the last month, one of the mantras that I’ve heard repeatedly in the auto dealer space is that dealers need to maximize any source of revenue or equity at the dealership. One such place is the inventory – auto dealers should become acutely aware of the economics of every unit on their lot. Most auto dealers obtain floor plan financing for all of their new vehicles and at least a portion of their used vehicles. However, not all auto dealers finance their used vehicles or the entire portion that their lender will allow. During these economic times, auto dealers should consider contacting their lenders to discuss the financing terms on their used vehicles that have yet to be financed. For example, if a dealer currently finances 50% of the value of their used vehicles, but the lender will allow 80%, why not finance the additional 30% to create cash flow?When auto dealers are scouring their lot for used vehicles that aren’t being financed, another strategy they should consider is expediting the sale of aging used vehicles that are not selling in the retail market. Opting to move these vehicles through the wholesale or auction market can turn idle inventory into cash flow, which is key for auto dealers in the coming months.Companies Become More Disciplined Investors The figures from Travis’ study concluded that total investment spending from the companies in the sample declined nearly 80% during the analyzed period. Auto dealers have image and real estate upgrade requirements from the manufacturers. As we’ve previously covered in this space, the quality/condition of real estate is one of the key value drivers in the valuation of a particular store. Successful dealerships have already been maintaining their real estate and image requirements, so they should hopefully be able to minimize their capital expenditures over the remainder of 2020. Manufacturers are also likely to be less forceful in compelling dealers to upgrade their facilities until the economic environment improves. Adding different brands/rooftops is another way an auto dealer can add value, giving consumers more options and spreading overhead costs over more sales. Dealers are less likely to make these investments during economic uncertainty, though it may also entice some local competitors to seek to exit the business, which could provide an opportunity given a mutually beneficial circumstance.ConclusionsAuto dealers are a resilient, adaptable group by nature. It’s one of the reasons many have been able to survive economic hardships or sluggish industry conditions in the past. While we haven’t witnessed the unique totality of the conditions that are present today, auto dealers can adopt some of the principles from the Great Recession to try and mitigate the challenges during the survival mode portion that we currently face.

1st Quarter 2020 Oil & Gas Industry Overview

In the first quarter of 2020 oil benchmarks ended arguably their worst quarter in history with a thud. The concurrent overlapping impact of (i) discord created by the OPEC / Russian rift and resulting supply surge; and (ii) the drop in demand due to COVID-19 related issues was historic. Brent crude prices began the quarter around $67 per barrel and dropped to $50 per barrel by early March before plummeting to $19 per barrel by the end of March. WTI pricing behaved similarly although it continues to trail Brent pricing by a narrowing margin (about $5 per barrel) at the end of the quarter. In some areas of the Permian, local spot prices were as low as $7 per barrel towards the end of March. Natural gas, however, has trended downward, but has been more stable in the U.S. as its pricing has become increasingly more regionally tied and relatively less dependent on world oil price drivers. We will examine the macroeconomic factors that have affected prices in this first quarter.Global Economics: OPEC+ Production Growth Collides With Covid-19 Demand DestructionOn March 5th OPEC and its allies (often referred to as OPEC+) held a meeting in Vienna. The result of that meeting was no agreement on additional production cuts beyond the end of March 2020. This was unexpected and immediately pushed prices downward about 10%. In the meantime, the COVID-19 outbreak has continued to escalate. Worldwide measures have been put in place such as quarantines, shut-ins, social distancing and other actions. This has slowed much economic activity to a crawl and, in a matter of weeks, has led to worldwide demand destruction for oil leading to the collapse of oil prices. Impacts and ripple effects abound, however many of them have yet to be easily observed. This development has upended nearly all prior market estimations from organizations such as the IEA, EIA, research institutions, and investment banks as to demand expectations. As of the end of Q1, worldwide consumption decline in 2020 is now very likely. New and revised estimations were still being developed as this has taken the market by surprise.Logistical Consequences: Physical Markets and Force MajeureOne of the clear indicators that this situation is not simply a supply glut is that refinery margins and oil prices declined simultaneously. A dynamic such as this demonstrates demand decline. Another factor to consider is since COVID-19 originated in China, and China is a demand marker for oil and refined products, how was demand impacted there? In February, Chinese oil demand dropped by about 3 million barrels per day out of about 13 million barrels per day – a 20% drop.This turn of events leads to some potential temporary logistical issues such as tanker demand and ultimately shut-ins if the price doesn’t move upwards soon. Storage capacity is very limited in most exporting nations, perhaps two to three months of storage ability at this pace, so there are not many places the excess supply can go. Therefore, producers may have to consider and analyze whether the cost to shut down is less than the cost to produce. Canadian oilsands may be one of the first to start this potential trend. However, even the lowest cost producer, Saudi Arabia, was struggling to find buyers for its excess supply by the end of March. This excess supply battle between Russian and Saudi Arabia will play out prominently in Europe, where Russia could possibly lose hundreds of thousands of barrels a day of production.Additionally, back in January, the International Maritime Organization (IMO) began enacting the Annex VI of the International Convention for the Prevention of Pollution from Ships (MARPOL Convention), which lowers the maximum sulfur content of marine fuel oil used in ocean-going vessels from 3.5% to 0.5%. The implementation of MARPOL will see the marine fuels landscape change significantly as over 95% of the current market will be displaced. This disruption was already happening beforehand, impacting tanker supply and market share for liquids.On the gas front, LNG import deliveries have been suffering from oversupply and a warm winter. There is no “gas-OPEC” to proffer a supply agreement either. China’s CNOOC has declared force majeure to turn away LNG shipments, even though China reached an accord with the U.S. to reduce tariffs on LNG imported from the U.S.U.S. Production Headed Towards DeclineIn September 2019, the U.S. became a net petroleum exporter, marking the first net export month ever since monthly records began in 1973. This may change soon. Capital expenditures for exploration and production companies immediately fell hard. Rystad expects this to drop by as much as $100 billion worldwide, the most in at least 13 years. With the steep decline curves of existing U.S. shale wells, production should drop in a matter of months.In addition to the investment decline, another historic thing happened in March. The Texas Railroad Commission began engaging with Russian Energy Minister, Alexander Novak about trimming oil output. This kind of thing hasn’t happened in Texas or the U.S. since the 1970’s. However, this is necessary for the U.S. Production costs for oil in the U.S., particularly shale oil, are higher than either Russia or Saudi Arabia. The upstream industry’s existing well base in the U.S. are underwater at low 20’s per barrel pricing. That was happening at the end of March.Sources: Dallas Fed Energy Survey, Reuters, Seeking Alpha However, even though Russia and Saudi Arabia can operate existing wells in this environment, it does not mean that this is sustainable for very long. No one knows how long this price war will last. That said, even a few months of this pricing environment could create chaos for the U.S. energy sector. It had already severely impacted stock prices and demonstrated even day to day volatility in public markets.The CARES ActIn March, the President indicated that the U.S. government may become a material buyer for about 30 million barrels of U.S. produced oil in order to fill the strategic petroleum reserve. However, the funding was not authorized by congress in the CARES Act. Congressional Republicans pushed for it, but Democrats did not want to include a “bailout for big oil.” This could hasten bankruptcy acceleration for leveraged energy companies, however since this is a global event and potentially temporary, banks may table defaults and foreclosures and instead better collateralize their exposures and add more commodity price hedges according to an analyst call by UBS.Interest RatesThe U.S. Federal Reserve cut interest rates twice in the month of March. On March 3, the Fed made an emergency decision to cut interest rates by 0.5% in response to the foreseeable economic slowdown due to the spread of the coronavirus. This cut was anticipated and largely shrugged off by the markets as interest rates continued their precipitous decline.Benchmark rates were again cut on March 15 by a full percent to near zero. The central bank also stated that it would increase bond holdings by $700 billion on the same day. These rate cuts however failed to tame oil and gas markets as Brent fell by 10% and U.S. crude fell below $30. Lower interest rates and new bond repurchasing programs are ineffective in a weak demand environment, and prices continued to plummet through the remainder of the month.ConclusionThe shockwave effects of these events have likely surprised even Russia and Saudi Arabia. However, even though these countries have more ability to weather low prices (see chart above), it is not in their best interest to do so. On April 2, the POTUS tweeted optimism about a 10-million-barrel production cut. This was only speculation, but markets reacted quickly and positively. Middle East, U.S. and Russian tensions will be a highlight going into the next OPEC+ meeting, which as of today has been delayed. Increased disruption could significantly affect global oil demand and price and lead to a flood of bankruptcies. In the meantime, prior expectations of U.S. production growth and exports have been tabled. The situation is dynamic, and much could change in the days and weeks to come. Stay tuned.At Mercer Capital, we stay current with our analysis of the energy industry both on a region-by-region basis within the U.S. as well as around the globe. This is crucial in a global commodity environment where supply, demand, and geopolitical factors have varying impacts on prices. We have assisted clients with diverse valuation needs in the upstream oil and gas industry in North America and internationally. Contact a Mercer Capital professional to discuss your needs in confidence.

Second Quarter 2020 | Segment Focus: Building Materials

Construction designated as an “essential” sector throughout most of the country, allowing construction companies to continue to work although in the face of a multitude of disruptions. Signs of economic fallout started to appear in late 1Q20 data but 2Q20 demonstrated a more comprehensive picture of the effects of the virus on economic barometers.

E&P Second Quarter 2020

Permian Basin

Permian Basin // WTI front-month futures prices increased over 90% during the second quarter of 2020, though it was a bumpy road getting there.

Transportation & Logistics Newsletter

Second Quarter 2020

The trucking industry has recently been shaken by a series of large accident-related litigation verdicts, also known as nuclear verdicts. The definition of what constitutes a nuclear verdict can vary; however, the most common definition is verdicts in excess of $10 million. No matter how they are defined, nuclear verdicts are causing upheaval in the trucking industry. Trucking companies have historically only had to insure drivers for $1 million each, amplifying the effect of significantly larger verdicts.

Eagle Ford Update

Production and Activity LevelsEagle Ford production grew approximately 2% year-over-year through March, lagging behind the Permian (18%), Bakken (6%) and Appalachia (5%). This is driven, in part, by the maturity of the Eagle Ford play relative to other areas, as well as the Eagle Ford’s relatively high proportion of gas production. The rig count in the Eagle Ford at March 20th stood at 67, down 18% from the prior year. This decline is more severe than reductions seen in the Bakken and Permian, though better than Appalachia and the overall US rig count. The Eagle Ford’s rig count has also seen a strong bounce back from November’s lows. However, rig counts are a lagging indicator, so may fall further in light of recent commodity price declines. The Eagle Ford is also seeing gains in new-well production per rig. While this metric doesn’t cover the full life cycle of a well, it is a signal of the increasing efficiency of operators in the area. New-well production per rig in the Eagle Ford increased 8% on a year-over-year basis through March, compared to increases of 15%, 13%, and -18% in the Bakken, Permian, and Appalachia, respectively. Commodity Prices Fall Amid Coronavirus Outbreak and Russian / Saudi Price WarAfter hitting recent highs in early January, oil prices generally declined in January and February as the spread of the coronavirus raised investor concerns regarding oil demand due to potential travel restrictions and declining economic activity. The decline accelerated on March 6, as Saudi and Russia could not come to an agreement regarding production cuts in light of declining demand, sending WTI futures down 10% to $41.28. The feud escalated over the weekend as Saudi Arabia slashed its official crude oil selling prices and indicated its intent to ramp up production. WTI futures fell an additional 25% the following Monday, March 9. Since then, prices continued to decline, with WTI front month futures settlement prices hitting $20.83 on March 18. Prices have rebounded somewhat from this level but remain extremely volatile. Financial PerformanceAll Eagle Ford E&P operators analyzed have had year-over-year stock price declines. EOG and Magnolia outperformed the broader E&P universe (XOP), though Penn Virginia and Silverbow are both down more than 90%. Despite this financial performance, no Eagle Ford operators have filed for bankruptcy in the immediate wake of the price downturn. However, the commodity price environment has impacted the restructuring processes for Eagle Ford operators that entered bankruptcy in 2019. According to bankruptcy proceedings, Sanchez Energy may not be able to repay its debtor-in-possession (DIP) loan, which would result in no recovery for any legacy creditors. EP Energy announced in early March that its restructuring plan had been approved by the bankruptcy court. However, the deal was called off later in the month as lenders for the company’s exit financing pulled their support. InfrastructureOne of the Eagle Ford’s key advantages is its proximity to Gulf Coast refineries and export infrastructure. However, that benefit is eroding as demand for refined products is tanking (though storage costs are surging) and some importers are seeking to invoke force majeure clauses to reject LNG shipments.This also comes at a time when new pipelines are coming into service to carry Permian production to the Gulf Coast. The EPIC crude pipeline entered service in February, carrying oil volumes from Orla, Texas, to Corpus Christi. In September 2019, Kinder Morgan’s Gulf Coast Express was placed in service, transporting natural gas from the Permian to Agua Dulce (just southwest of Corpus Christi). Early next year, Kinder Morgan’s Permian Highway natural gas pipeline is expected to come online, carrying volumes from the Permian’s Waha hub to the Gulf Coast. While this infrastructure build-out is helping make energy markets more efficient, it is diminishing the Eagle Ford’s previous marketing advantages.ConclusionCommodity prices are putting immense strain on E&P companies, and there is little relief in sight. The Eagle Ford’s maturity means that many of the lowest-cost, highest-return locations have already been drilled. The basin’s marketing advantages are eroding as new pipeline infrastructure transports surging Permian volumes to the Gulf Coast. With two Eagle Ford operators already in bankruptcy (Sanchez and EP Energy) and unable to exit, we’ll see if anyone joins them over the next twelve months.We have assisted many clients with various valuation needs in the upstream oil and gas space in both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

Auto Dealership Valuation 101

Valuation of a business can be a complex process requiring certified business valuation and/or forensic accounting professionals. Valuations of automobile dealerships are unique even from the valuation of manufacturing, service and retail companies. Automobile dealership valuations involve the understanding of industry terminology, factory financial statements, and hybrid valuation approaches. For these reasons, it’s important to hire a business valuation expert that specializes in automobile dealership valuation and not just a generalist business valuation appraiser.TerminologyUnlike most valuations used in the corporate or M&A world, cash flow metrics such as Earnings Before Interest, Taxes and Depreciation (“EBITDA”) are virtually meaningless in automobile dealership valuations. Instead, this industry communicates value in terms of Blue Sky value and Blue Sky multiples. What is Blue Sky value? Any intangible/goodwill value of the automobile dealership over/above the tangible book value of the hard assets is referred to as Blue Sky value. Typically, Blue Sky value is measured as a multiple of pre-tax earnings, referred to as a Blue Sky multiple. Blue Sky multiples vary by franchise/brand and fluctuate year-to-year.Another unique aspect of automobile dealership valuations is the reported financial statements. Unlike valuations in other industries where the preferred form of financial statements might be audited/compiled or reviewed financial statements, most reputable valuations of automobile dealerships rely upon the financial statements that each dealer reports to the franchise/factory, referred to as Dealer Financial Statements. Why are Dealer Financial statements preferred? Dealer Financial statements provide much more detailed information pertaining directly to the operations of the dealership than any audited financial statement. Valuable information includes the specific operations and profitability of the various departments including, new vehicle, used vehicle, parts and service, and finance and insurance. Each department is unique and has a different impact on the overall success and profitability of the entire dealership. Automobile dealerships are required to report these financial statements to the factory on a monthly basis. However, an experienced business valuation expert knows to request the 13th month dealer financial statements. If a year only has twelve months, then what are the 13th month dealer financial statements? The 13th month dealer financials typically include the year-end tax adjustments such as adjusting the value of new/used vehicles to fair market value by reflecting current depreciation and other adjustments.Valuation Approaches Asset-Based ApproachThe asset-based approach is a general way of determining a value indication of a business or a business ownership interest using one or more methods based on the value of the assets net of liabilities. Asset-based valuation methods include those methods that seek to adjust the various tangible and intangible assets of an enterprise to fair market value. In automobile dealership valuations, the asset method is utilized to establish the fair market value of the tangible assets. This value is then combined with a Blue Sky “market” approach to conclude the total fair market value of the automobile dealership.Income ApproachThe income approach is a general way of determining a value indication of a business or business ownership interest using one or more methods that convert anticipated economic benefits into a single present amount.The income approach can be applied in several different ways. Valuation methods under the income approach include those methods that provide for the direct capitalization of earnings estimates, as well as valuation methods calling for the forecasting of future benefits (earnings or cash flows) and then discounting those benefits to the present at an appropriate discount rate. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market.How is the income approach unique to the automobile dealership industry? First, projections are rarely produced or tracked by automobile dealers, so historical capitalization methods are mostly used. Second, most automobile dealerships are dependent on the national economy, and sometimes to a larger degree, their local economies. What impact does this have on the income approach? Business valuation appraisers need to analyze and understand the dependence of each automobile dealership to the national and local economy which usually affects the seasonality/cyclicality of operations and profitability. Once again the automobile dealership is unique in that it can experience seasonal/cyclical fluctuation in a given year, or more importantly, it fluctuates over a longer period of more like five to seven years.Market Approach The market approach is a general way of determining the value indication of a business or business ownership interest by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold.Market methods include a variety of methods that compare the subject with transactions involving similar investments, including publicly traded guideline companies and sales involving controlling interests in public or private guideline companies. Consideration of prior transactions in interests of a valuation subject is also a method under the market approach.In the automobile dealership industry, traditional market approaches are basically meaningless. While there are a few publicly traded companies in the industry, they are large consolidators and own numerous dealership locations of many franchises in many geographic areas. Private transactions exist, but generally not in a large enough sample size of the particular franchise of the subject interest to provide meaningful comparisons.So how does a business valuation expert utilize the market approach in the valuation of automobile dealerships? The answer is a hybrid method utilizing published Blue Sky multiples from transactions of various franchise dealership locations. Two primary national sources, Haig Partners and Kerrigan Advisors, publish Blue Sky multiples quarterly by franchise. As discussed earlier, these multiples are applied to pre-tax earnings and indicate the Blue Sky or intangible value of the dealership. When combined with the tangible value of the hard assets determined under the Asset Approach, an experienced business valuation expert is able to conclude a total value for the dealership using this hybrid approach and communicate that result as a multiple of Blue Sky that will be understood and accepted in this industry.ConclusionsThe valuation of automobile dealerships can be more complex than other valuations due to their unique financial statements, varying cost structures and profitability of departments, different terminology, and hybrid valuation methods. Hiring a business valuation expert that specializes in this industry rather than a generalist business valuation appraiser can make all the difference in providing a reasonable valuation conclusion.

Eagle Ford M&A

Steady Transaction Activity Restrained by Unforeseeable Circumstances

Over the last year, deal activity in the Eagle Ford Shale was relatively steady, picking up towards the end of 2019 and carrying into early 2020. The recent uncertainty caused by the coronavirus pandemic and the Saudi-Russian oil production level conflict, however, has hindered M&A activity in the region, and frankly everywhere else. WTI closed below $23/bbl on March 18 with futures prices indicating a depressed price environment persisting for the near term. Although deal count has decreased as of late, the M&A landscape has the potential to ramp up as some companies will need to sell assets in order to bolster their balance sheets amid the challenging commodity price environment, though wide “bid/ask” spreads between buyers and sellers may be difficult to overcome.Recent Transactions in the Eagle FordA table detailing E&P transaction activity in the Eagle Ford over the last twelve months is shown below. Relative to 2018, deal count decreased by six transactions and the average deal size declined by roughly $650 million.Ensign Natural Resources Entering, Pioneer Natural Resources ExistingEnsign Natural Resources made its first acquisition as a company in May of 2019, acquiring Eagle Ford acreage from Pioneer Natural Resources. Brett Pennington, President and CEO of Ensign, explained that the assets included meaningful production and attractive drilling inventory. Pioneer on the other hand, was ready to become a pure-play Permian operator. In total, Pioneer has sold approximately $1 billion of assets located outside the Permian Basin. Pioneer seemed to make it clear that they are throwing all of their eggs in one basket.Callon Petroleum Expanding their FootprintThe biggest deal, in terms of dollars, was Callon Petroleum’s acquisition of Carrizo Oil & Gas. Callon, a Permian Basin focused company, expanded its position in the Permian and entered the Eagle Ford with the acquired acreage. The deal terms had to be revised after significant investor pushback. The amended agreement stated that Callon shareholder would own approximately 58% (up from 54% initially) of the combined company and Carrizo shareholders will own approximately 42% (down from 46% initially). It should be noted that this deal is not pure Eagle Ford shale. Carrizo’s asset details included 76,500 acres in the Eagle Ford with roughly 600 undrilled locations and 46,000 acres in the Delaware Basin with about 1,400 undrilled locations. The combined assets will include 120,000 net acres in the Permian and 80,000 net acres in the Eagle Ford. The core positions in the Permian and Eagle Ford plan to produce over 100,000 boe/d of pro forma production. Joe Gatto, president, and CEO of Callon, explained his vision of the larger company, which is to employ a more efficient scaled development model that aims to drive a lower cost of supply. The multibillion-dollar merger officially closed in December of 2019, and now seems like unfortunate timing due to the current price environment.Repsol S.A. Picking Up Where Equinor Left OffEquinor, a Norway based petroleum refining company, agreed to sell its Eagle Ford assets to Repsol for $325 at the end of 2019. The agreement gives Repsol, a Spain headquartered oil & gas company, 100% control of the asset while making them the operator. In 2017, Equinor took an $850 million impairment on the asset due to lower than expected output. In 2018, Equinor also released that part of their acreage lies on areas with high water stress variables. Repsol expressed that the acquisition will give their producing assets portfolio a boost while taking advantage of operating synergies and efficiencies. The acquisition is also aligned with Repsol’s intentions to expand in North America. The deal plans to increase total production for Repsol in the Eagle Ford to approximately 54,000 boe/d.ConclusionM&A transaction activity in Eagle Ford was fairly consistent throughout 2019, as companies focused to acquire valuable acreage with production potential. However, no one can ignore the tough current conditions in the energy industry. Acquisitions that closed at the end of last year seem like the least of worries, as companies are simply trying to avoid bankruptcy. If conditions allow only the strongest to survive, it could lead to an increase in transaction activity ahead.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Energy Valuations: Freefall Into Bankruptcy Or Is This Time Different?

This post originally appeared on Forbes.com on Monday, March 9, 2020. Energy valuations are taking an epic pummeling. Considering declining demand amid COVID-19 concerns, the initial fallout to the Saudi-Russia feud was predictable. Within hours, prices had dropped like an anchor (to $33 a barrel as of this morning). Several companies have already announced cutbacks, including Diamondback Energy, as they dropped two additional drilling crews. Parsley Energy made a similar announcement and more are sure to follow. Perhaps even more draconian, SM Energy’s unsecured bonds fell to $0.42 on the dollar and pushed the yield up to around 25%. These bonds traded above $0.90 as recently as February 24th. Trading has been halted this morning amid the panic. Whether the market fallout has hit rock bottom remains to be seen. Regardless of what Russia may have been thinking, the geopolitical climate has put more pressure on U.S. producers and bankers. Operators who were contemplating hedging production at $50 per barrel but waiting to act are kicking themselves today. Energy and related bankruptcies that were estimated to rise in 2020 will likely accelerate a few notches. According to Haynes and Boone’s Oilfield Services Bankruptcy Tracker, there were six (6) new bankruptcies in the oilfield services area in the fourth quarter of 2019. Up until this point in 2020, Pioneer Energy Services is the only major oilfield services company to enter Chapter 11 bankruptcy. That’s almost undoubtedly going to change soon. As upstream companies have vowed to spend within their cash flow, oilfield services will take the biggest brunt of this at first. However, producers with high leverage capital structures could quickly follow. Gas prices have held their ground but they’re so low anyway, it’s hard to know how much lower they could go.Can Banks Hold On?The looming factor for companies is how banks will go about determining borrowing bases this year. It’s a tough position to be in at this point. Bankers at the Hart Energy Capital Conference in Dallas last week did their best to portray patience towards the upstream sector, but were also clear about expectations. Those expectations were that borrowers can meet their obligations, and that borrowing bases will shrink with valuations. One of the speakers, Tom Petrie, expressed concern about $110 billion in debt coming due in the next decade for the energy market.As working interest values for producing interests dive, the expected returns have changed from PV10 to closer to PV20. This has degraded credit quality. The mix of below-investment grade debt has worsened in the past year. In high yield markets, CCC or below is the most common rating according to some recent data.High Yield Debt Rating MixSOURCE: JP MORGAN CORPORATE ENERGY & POWER PRESENTATION Even if bankers lending on reserves maintain their lending ratios, the borrowing bases will shrink accordingly. However, based on recent indications, lending ratios have and will continue to shrink alongside values. Debt-to-EBITDA ratios which used to often float in the 3.5x to 4.5x range are now, not surprisingly, in the 2.5x to 3.5x range. Enterprise values for upstream producers were often between 6.0x to 8.0x EBITDA too. That is in the past.Shifting Credit RatiosSOURCE: OCC GUIDELINES AND AMEGY BANK PRESENTATION Impacts appear bad and immediate. However, this plunge could, ironically, buy the market a little more time. The founder of OnyxPoint Global Management, L.P., Shaia Hosseinzadeh, told Bloomberg just last week that “Things are so bad now, that the banks can kick the can down the road and say ‘there’s no point of rushing everybody into bankruptcy, we’ll wait until October.’ But if it’s business as usual, it’s going to be a horror show.” That may be a prescient thought. Another consideration is that fewer banks are even lending to energy companies anymore. The rise of the environmental, social, and governance (“ESG”) movement, alongside weak returns, have pushed many bankers and other investors out of the space. There isn’t as much capital to go around, not that it’s cheaply available right now anyway.Due to valuations being so low, the recovery for bankers coming out of Chapter 7 situations may be less attractive, especially on the oilfield service side. The market value of intangible assets is so depressed compared to other times in the commodity cycle, that it may not make economic sense to rush into the process for some.Can Values Recover?This prognostication about delayed bank behavior may be a moot point if liquids values can’t recoup over time. This is an undercurrent that has been a factor in keeping values down recently. Electrification trends and the idea that liquids demand will wane have proffered the notion that demand for liquids will be flat to even shrinking in the future, all while supply becomes bountiful. Some project the electrical passenger car trends to reach around 20% by the end of this decade. However, while the short-term appears bleak, many projections about the medium- and longer-term remain more optimistic for upstream producers and servicers. J.P. Morgan Cazenove recently suggested that the oil industry may be under-equipped to meet demand recovery in 2021 and beyond. Another way of putting that is downward pressure on prices could be its own cure in the medium term. Capex budgets have been slashed and continue to be. Over 200 oil drilling rigs (and counting) have been shut down in the past six months. Production will suffer, even with drilling and production efficiencies achieved in recent years. Especially in the U.S. shale markets, declines on existing wells drop off so fast, that their effect on supply will show up sooner rather than later.Producers are hopeful for this. Regardless of the market’s relentless pounding down on reserve values, producers know that, particularly proven reserves are next year’s production. They do not want to sell or unload them for the pennies on the dollar (or less) that implied valuation multiples suggest right now. Intrinsically, they have much more value than inferred by market capitalizations. Management teams believe that enterprise values shouldn’t be trading at a fraction of PV10 values over a long period of time. At a minimum, many producers believe there is an optionality to their future drilling inventory.The question remains, could that happen fast enough to save a bankruptcy slog this year? Only time will tell.

Trends with Independent Trust Companies

Independent trust companies are a growing segment of the trust industry. While trust divisions of banks still represent about 84% of the trust industry, there’s been a trend towards independence that parallels that seen in the wealth management industry. In this post, we highlight some of the trends impacting independent trust companies.FeesOver the last decade, there has been a broad-based decline in pricing power across the investment management industry. Assets have poured into low fee passive products, driving down effective realized fees for asset managers. Wealth managers have been more resilient, but the threat of robo-advisors remains. Virtually all discount brokerages were forced to cut trading fees to zero. Consider the relationship between effective realized fees and revenue growth over the last five years for US asset/wealth managers (shown in the chart below). The message is clear. Assets across the financial services industry are gravitating towards lower-fee products.So how have trust companies fared in this environment? Despite the pricing pressure in the broader industry, trust companies have fared remarkably well. According to Wealth Advisor’s 2019 pricing survey, trust company fees are actually heading higher. For many of our independent trust company clients, the story has been similar. Realized fees have remained steady or even increased over the last five years, while assets under administration have grown through market growth and net inflows.Market MovementsThe recent coronavirus induced sell-off will have a significant negative impact on the top line for trust companies, as it will for all investment managers that charge a percentage of assets under management. As of the date of this post, the S&P 500 is down over 20% from its all-time high on February 19, 2020. Trust company revenue will take a big hit. The effect on trust company profitability will depend on the length and severity of the economic slowdown caused by the pandemic and containment policies. The range of likely scenarios is beyond the scope of this post, but it suffices to say that there is still significant uncertainty regarding the impact on people, markets, and economic activity.Unlike many asset and wealth management firms, trust companies often have revenue sources that aren’t based on AUM (e.g., tax planning, estate administration fees) which should provide some protection during a market downturn. This, combined with a resilient fee structure, should help trust companies weather the pandemic.DemographicsTrust companies primarily serve high net worth and ultra-high net worth clients, and demographic trends in these markets are favorable for the continued growth of the trust company industry. The number of high net worth individuals (net worth > $1 million) in the United States has grown significantly over the last decade. According to Credit Suisse’s Global Wealth Report 2019, there were over 18 million millionaires in the United States in 2019, nearly double the number in 2010.Additionally, the impending wealth transfer as baby boomers age should spur growth in trust assets. Roughly $30 trillion is expected to change hands between baby boomers and younger generations during the coming years. To the extent that this wealth is transferred via trusts, trust companies stand to benefit.Regulatory Trends As trust law has developed, a handful of states have emerged as being particularly favorable for establishing trusts. While the trust law environment varies from state to state, leading states typically have favorable laws with respect to asset protection, taxes, trust decanting, and general flexibility in establishing and managing trusts. Opinions vary, but the following states (listed alphabetically) are often identified as states with a favorable mix of these features.AlaskaDelawareFloridaNevadaSouth DakotaTennesseeTexasWashingtonWyoming Over the last several decades, many states such as Delaware, Nevada, and South Dakota have modernized their trust laws to allow for perpetual trusts, directed trustee models, and self-settled spendthrift trusts (or asset protection trusts). The directed trust model in particular is a major change in the way trust companies manage assets, and it has been gaining popularity among trust companies and their clients. Under the directed trust model, the creator of the trust can delegate different functions to different parties. Most frequently, this involves directing investment management to an investment advisor other than the trust company (this could be a legacy advisor or any party the client chooses). The administrative decisions and choices related to how the trust’s assets are used to enrich the beneficiary are typically charged to the trust company. The directed trustee model leads to a mutually beneficial relationship between the trust company, the investment advisor, and the client. The trust company avoids competition with investment advisors, who are often their best referral sources. The investment advisor’s relationship with their client is often written into the trust document. And most importantly, this model should result in better outcomes for the client because its team of advisors is ultimately doing what each does best—its trust company acts as a fiduciary, and its investment advisor is responsible for investment decisions.The directed trustee model leads to a mutually beneficial relationship between the trust company, the investment advisor, and the client.Technology Trust administration is labor-intensive and requires extensive tax, accounting, legal and compliance expertise. Trust companies typically employ CPAs, estate planning attorneys, financial advisors, and trust officers, among other professionals. Many of our trust company clients have spent substantial amounts of money developing software and systems to reduce the administrative and compliance burden on these employees and enable fewer employees to manage more assets. We expect this trend to continue as trust companies seek to reduce overhead expenses and improve profitability. Trust company clients should benefit as well from reduced friction and improved client experience.SuccessionThe ownership profile at independent trust companies is often similar to that seen at asset and wealth management firms. Ownership is often concentrated among the founders, with younger partners owning small pieces of the company. We’ve written in the past about buy-sell agreements for wealth management firms, and much of that discussion is applicable to independent trust companies as well. In short, the dynamic of a multi-generational, arms-length ownership base can be an opportunity for ensuring the long-term continuity of the firm, but it also runs the risk of becoming a costly distraction. As the trust company profession ages, we see transition planning as either a competitive advantage (if done well) or a competitive disadvantage (if disregarded).Looking ForwardMany trust companies have performed remarkably well over the last decade, aided by the recently ended 11-year bull market and the trends discussed above. The current market environment is one of incredible uncertainty, and the outlook for trust companies and the economy as a whole will continue to evolve rapidly over the coming months. Beginning next week, we have planned a series of blog posts to explore the impact of the current market environment on investment managers.

February 2020 SAAR

SAAR came in at 16.833 million for February 2020, down about 0.5% from January’s revised figure, but up 1.9% from February 2019. However, part of this gain is attributable to calendar quirks as not only was 2020 a leap year, but this extra day fell on a Saturday, providing the first February since 1992 with five selling weekends. Through February, 2.49 million light vehicles have been sold in 2020, up 4.5% from last year. This increase comes entirely from light trucks, as year-to-date volumes have increased 11% for this segment while autos have declined 11% over the same period. Trucks have made up 74% of light vehicle sales so far in 2020, up from 70% last year and continuing a trend since 2012 when trucks were just under 50%.As seen above, SAAR has been below 17 million in eight of the past twelve months with an average of 16.938 million. Solid performance in the first two traditionally slow months of the year puts 17 million units within reach for the year, though expectations in the range of 16.5 million to 16.8 million certainly seem plausible. February’s performance may not be duplicated in March due to uncertainty surrounding the impact of COVID-19, commonly known as the Corona Virus.On the supply side, the key question will be how the virus impacts automotive manufacturers and their abilities to source products. Shutdown of Chinese plants has caused manufacturers to find alternative means, which can add to costs. If problems linger, the ramifications would likely decrease volumes globally, as Goldman Sachs recently downgraded its outlook on 2020 global auto sales to a 3.5% decline from 2019 per the Wall Street Journal. Vehicle sales in China were down a whopping 80% in February compared to the prior year. Similar effects were felt in countries where the disease has begun to spread with South Korea, Japan, and Italy, down 20%, 10.7%, and 8.8%, respectively. While the impact on the U.S. has thus far been much lower than these countries, sales volumes are likely to be adversely affected. While the mortality rate is estimated at or below 1%, the economic fallout has already proved to be significant due to the uncertainty and panic.As for demand, there is little data available to determine the preliminary affects of the virus. However, should foot traffic decline with consumers limiting their social exposure, sales would likely decrease as internet sales have increased but the online experience remains far from substituting the experience of test drives. As discussed above, selling weekends are particularly important to the industry, which are in jeopardy if consumers opt to stay at home.On March 3, the Fed opted to cut rates 50 basis points to support the economy while citing domestic economic strength. This rare inter-meeting rate cut was the first such cut since October 2008, but this did little to ease markets as the S&P 500 still finished the day down 3%. According to interest rate futures, an additional 25 basis point cut is nearly certain at the meeting on March 19-20 with a greater than 50% chance this cut is 50bps.Lowering interest rates seeks to induce economic activity, and specific to the automotive sector, this cut in part seeks to induce consumers into purchasing vehicles. While discounts may make people buy more on their weekly trip to the grocery store, a relatively small reprieve in ongoing interest payments is unlikely to change the decision of whether to make such a significant purchase as a car for most consumers. Lower funding costs also seek to encourage business expansion, though dealerships’ position in the supply chain (last stop before consumer) limits the impact rate cuts will have on their decision making. Dealers rely on their manufacturers for inventory, who in turn rely on the companies building these parts which means dealers’ supply will feel second-order impacts with minimal ability to navigate these changing market dynamics. However, lower interest rates should reduce floor-plan costs, which represents a nice benefit. If volumes are adversely affected, floor-plan costs will drop even further with less inventory on the lot. But as business owners are acutely aware, not all operating expenses are tethered to activity, and prolonged sluggish activity would weigh on dealerships, like many other businesses, particularly those with significant debt burdens. Like everyone else, we will continue to monitor the situation.The global uncertainty and equity market volatility resulting from COVID-19 may present investors with an opportunity to buy at a depressed valuation. Similarly, auto dealer owners who are bullish on the long-term investment merits of their business may see this as an opportunity to transfer their interests to future generations in a tax-efficient manner. The professionals of Mercer Capital can assist in the process. For more information or to discuss an engagement in confidence, please contact us.

Current Commodity Price Environment May Lead to Next Round of OFS Bankruptcies

When I was given the assignment to author this blog post this week, I thought "Could one possibly 'draw' a more timely assignment?" Several weeks ago, Mercer Capital’s Energy Team noted that we should consider the current condition of the oilfield services ("OFS") industry as the topic of one of our upcoming blog posts. The price for West Texas Intermediate ("WTI") had been declining since mid-February, due largely to decreased demand related to the coronavirus, and the Russia-Saudi Arabia failure to reach an agreement on production cuts. Industry participants were growing a least somewhat concerned – and then came the March 6 news that the Russian-Saudi negotiating difficulties might lead to an actual price war – and then came the March 9 actual start of the price war.More Possible OFS Bankruptcies? How Did We Get "Here"?By way of "background," the U.S. OFS industry went through a major round of bankruptcies following the late 2014 drop in oil prices. From the WTI peak in June 2014 at $106/bbl, prices fell to $58/bbl in mid-December 2014 and on to $30/bbl in January 2016. While there were a couple of upward moves in WTI in April and August of 2015, those were short-lived with the "trend" remaining a fairly clear path downward. Data provided in Haynes and Boone, LLP’s Oilfield Services Bankruptcy Tracker report (January 2020) show the annual number of identified OFS bankruptcies rising from 33 in 2015, to 72 in 2016, before easing to 55 in 2017 and 12 in 2018. Although the WTI price was generally rising during 2016, the price remained below $55/bbl with the impact of the fall from $60+/bbl pricing continuing to ripple through the industry well into 2017. During 2018 – through October – WTI had generally ranged between $61 and $74/bbl. OFS bankruptcies slowed, but the industry was hardly prospering. Many industry participants were more accurately described as "hanging-on" or "maintaining operations" – hoping for a rise in demand, or a drop in supply, to lift prices and move the industry to more favorable profitability. However, in November 2018, rising worldwide inventories caused by global supply running well ahead of demand, fueled in part by the continuing growth in U.S. production, resulted in prices dipping to a low point of $43/bbl in December. While pricing improved somewhat in 2019, with WTI generally between $54 and $64/bbl, the loss of $62+/bbl pricing led to an uptick in the number of OFS bankruptcies late in 2019. Source: Haynes and Boone, LLP Recent Events – Industry and Non-IndustryAs we entered 2020, there didn’t seem to be any specific indications of change ahead for oil prices. Few had ever heard the term coronavirus and no one was anticipating a Russian break from OPEC+, or using the term "price war" in regard to the Russian-Saudi failure to reach an agreement on OPEC+ production cuts. The World Health Organization’s China office had begun receiving reports in December of an unknown virus that had led to cases of pneumonia in Wuhan, a major city in eastern China, but the term "outbreak" wasn’t being used.Within eight weeks that had all changed markedly. By late February we had already gone beyond "outbreak" and had moved on to regularly hearing of the possibility of a pandemic. People and countries began to react. Multiple countries were significantly limiting travel in order to slow the spread of what we all now know as the novel coronavirus, or Covid-19. Quarantines, self-imposed and government-imposed, were reducing economic production and travel, thereby reducing the level of demand for transportation fuels and fuels as a means of production. In addition, it was becoming clear that the Russian-Saudi disagreement on production cuts was more than a minor matter. The possibility of a split in the Russian-Saudi production alliance to maintain oil prices was being actively discussed as having real potential. Oil prices naturally responded with a downward turn, reaching as low as $45/bbl near the end of February.On Friday, March 6th, it was reported that Moscow had outright refused to reduce its crude production in order to offset the fall in demand related to the coronavirus. Over the subsequent weekend, rumors swirled as to the magnitude of the impasse. Then, on Monday, March 9th, the worst possible scenario for oil prices became more than a possibility. An actual price war was initiated as both Russia and Saudi Arabia announced production increases. The anticipated glut immediately pitched prices into a dive with the WTI falling from $41/bbl to $31/bbl by day’s end for a single-day decline of 24%.What to ExpectAs to what we can expect going forward from here, we don't know. The coronavirus, now a pandemic, is obviously spreading. How much and how far are the unknowns, along with how large the impact will be on the U.S. and global economy, and thus, the demand for oil. What is know is that oil demand will be down for a time. What’s also known is that the outbreak will eventually be contained and the economic impact reversed when things return to "normal."So, What About Oil Supply?Well, we have two very significant oil exporters, formerly allied on oil production levels, now markedly un-allied on oil production. Not only un-allied, but both purposefully increasing production levels, in the face of lower demand, for the purpose of causing economic pain to each other. Unfortunately, that economic pain radiates, by extension, to all oil producers and the businesses that provide equipment and services to the oil producers. What does that mean for U.S. OFS market participants in the near term? Pain. Economic pain. For those that have more economic "wriggle-room," better margins, lower financial leverage, more defendable market position, it won’t be good. For those with less of that economic wriggle-room, it could go well beyond "not good." If the alliance break isn’t remedied fairly quickly and the two belligerents remain belligerent, the production glut could last long enough that a new round of OFS bankruptcies could be in the making.What’s absolutely certain is the uncertainty of it all – and at least some very real OFS industry economic pain if either the virus impact, or possibly the Russian-Saudi dust-up, lasts long enough to keep oil prices down at the new current level, or an even worse scenario, lower than the current level.

Early Impact of Coronavirus on the Trucking Industry

(Through March 31, 2020)

The trucking industry has hit several major speed bumps during the last several years. The required implementation of electronic logging devices (“ELDs”), changes to Hours-of-Service, and continuing driver shortages met with falling demand in 2019. The uncertainty introduced by the U.S.-China trade war resulted in lower demand. As of March 2020, COVID-19 is looking to be a significantly larger speed bump than the others.

Today’s Independent Trust Company

How Does Your Trust Company Measure Up?

Historically, the role of a trust was simply for one party (the trustee) to hold property for the benefit of another (the beneficiary). Over time the role of trust companies has expanded to include managing the distribution, administration, and investment of trust assets. Fifty years ago, most local banks had a trust officer who performed these services. Consolidation in the banking industry, changing consumer preferences, and favorable trust law changes in states such as Delaware, Nevada, and South Dakota have led many bank trust officers to leave their local bank and start independent trust companies. (This shift parallels the shift from the broker-dealer to independent RIA model.)As trusts have become more sophisticated, independent trust companies have become increasingly specialized with respect to trust administration. Many independent trust companies today focus on specialized types of trusts or beneficiaries. As part of this trend, trust companies are increasingly outsourcing investment management in order to focus on fiduciary issues.More trust companies are now shifting to a directed trustee model, which absolves the trustee of certain fiduciary responsibilities. With a directed trust an investment advisor is named on the account so that investment decisions are made by the appointed advisor rather than the trust company. This allows the trust company to focus on fiduciary issues related to trust and estate administration rather than investment management. Typically, a directed trustee model calls for slightly lower fees, but much less liability for the trust company.The alternative is a delegated trustee model, where the trustee can delegate fiduciary authority to an investment advisor, as they see fit. However, in this model, the trustee is responsible for properly vetting the investment advisor and supervising their decisions.The Typical Independent Trust CompanyA trust company’s revenue is a function of assets under administration and its fee schedule. Expenses generally consist of personnel expenses and fixed overhead costs.AUA. Over $120 trillion of assets are administered by domestic trust companies /departments. It is estimated that approximately $18 trillion of assets are administered by independent trust companies, with each, on average, administering $1.5 billion. Generally, assets under administration (AUA) growth has been highest within the non-managed (delegated or directed) trustee model.Fees. While the rest of the investment management industry has been dealing with fee compression, trust fees have been increasing. Independent trust companies have typically been more willing than bank’s trust departments to increase fees. Thus, as customers move assets from trust departments to independent trust companies, we expect fees across the industry will continue increasing.Wealth Advisor reported that on average companies charge around 50 basis points per year for vanilla trust services. Trust companies typically don’t require minimum account sizes, but instead require minimum annual fees, which can range from $1,000 to $20,000 depending on the services offered. Fees are typically structured on a sliding scale, where the first million could be charged 60 bps, the next million could be charged 50 bps, and the next million 40 bps, etc. If the trust company also manages the underlying assets, fees will of course be higher. However, larger clients tend to receive discounts, which can correspond to low fees by industry standards, but substantial revenue given the size of the account.Expenses: The relationships between independent trust companies and their clients require the time and energy of a dedicated staff. Thus, most of a typical independent trust company’s expenses are personnel expenses, which include salaries, bonuses, and other benefits for employees and officers. Compensation generally tracks revenue fairly closely, making operating leverage more pronounced with overhead costs than compensation related expenses.Overhead costs for trust companies are generally fixed in nature, which allows trust companies to take advantage of operating leverage over time. Overhead costs include the cost of compliance, technology, and marketing expenditures all which have been increasing over the last few years. We have seen an increased focus on branding as trust companies seek to connect with clients on a more personal level. Additionally, corporate trusts can have significant litigation costs from year to year.How Does Your Trust Company Measure Up? Bringing everything together, the average trust company’s income statement looks similar to the one outlined below.Charging slightly under 50bp on $1.5 billion in assets, the average trust company generated $7 million in revenue in 2019. With an average operating margin of approximately 37%, the average independent trust company had $2.6 million in operating profit, which it could distribute out to its ownership base or invest in new technology or marketing initiatives.A Better ModelAlthough some view the trust industry as mature, the industry has changed significantly over the last decade. The average client today looks different than the average client did ten years ago, which means the average trust company has changed as well. The interests of trust companies and their clients are better aligned today than they were when trust officers worked for the local bank rather than the client. More time is being spent addressing the actual needs of clients, as technological advancements have freed up time and improved service offerings. This new directed trustee model benefits both the client and the trust administrator which is evidenced by the increase in dollars under administration in non-managed trusts.

What Does Tesla’s Share Price Soaring Mean for My Auto Dealership?

Tesla, the custom luxury and electric vehicle company, has seen significant fluctuations in its share price in the past few months. On October 24th, the Company announced its first quarterly profit (of $143 million) after losing over $1 billion in the first two quarters. It followed this up with $386 million profit in Q4, including a jump in gross margin from 4.1% to 18.8%. If the company can sustain profitability over four quarters (including profitability in Q2 2020), Tesla will meet the minimum criteria to join the S&P 500 Index. It is approximately the 50th largest company in the US (as of March 6, 2020), and after its recent runup and automotive-adjacent Uber Technologies languishing, Tesla is currently by far the largest US company not included in the large-cap index. Should the company’s profitability remain, its share price may elevate even further as investors buy in advance of its addition to the index, a strategy called “index front running.”While Tesla may or may not qualify later in the year, this isn’t the only trading quirk to exogenously impact the company. Share price skyrocketed to $887 at close on February 4th (up 56% in a week and 180% in three months) due in part to a short squeeze where traders faced margin calls and were forced to close their positions at a loss. There are about 18.4 million shares sold short, or about 12.6% of its float (shares outstanding excluding those held by insiders). While Tesla has accumulated a cult following of people both for and against, its share price likely has little to do with the value of franchised dealerships in the US.How is Tesla Different?Tesla has significant differences from dealerships with established brands across the spectrum such as BMW, Toyota, and Ford. These dealerships buy inventory through their auto manufacturers, whereas Tesla uses a direct sales strategy. The dealer franchise strategy has allowed for a large geographic footprint for other manufacturers whereas Tesla has been less able to mass produce. While less ubiquitous, the Tesla brand has benefited from its exclusivity. Further, its direct sales strategy has eliminated any conflict of interest between manufacturer and dealer. One example of this friction is when manufacturers overproduce and push inventory onto the lots of dealers, increasing floor-plan interest costs and oversupply can limit pricing growth.Tesla’s cars are also unique beyond the initial sale. Unlike other cars, Tesla’s cars cannot be fixed by third-party service providers as easily. Whereas a consumer may opt to go a local body shop for their Ford truck, a Tesla owner is more likely to go to a Tesla related service department, which tends to be a higher margin business for dealers. This represents an opportunity for Tesla, provided it can properly address the service needs particularly as its manufacturing operations continue to scale. While not typically viewed as maintenance, Tesla’s power source is also unique. For electric vehicles, consumers can charge their cars at home or at Supercharger stations instead of gas stations. While electric vehicles are viewed as cheaper and more eco-friendly, adoption of EVs relies on an increasing network effect where charging options approach the abundance and accessibility as gas stations.Future of Electric Vehicles (EV)Tesla did not invent the electric vehicle, nor will it appeal to all consumers as electric vehicles have range limitations particularly on road trips. There are also large upfront costs both for the vehicle and in-home charging stations. Further, numerous brands also offer electric vehicles including Kia, Hyundai, Chevy, Nissan, VW, Audi, Jaguar, and BMW, the latter of which just recently released it's latest and greatest. While the EV market is expected to increase over time, Tesla will clearly not be the only benefactor despite its ability to garner headlines, due in part to their enigmatic founder, Elon Musk. The company’s share price may represent a long-term bet on this power source, though Tesla is not likely to harvest all of the benefits. Still, dealerships and more importantly their manufacturers will do well to keep up with shifting consumer preferences including both EVs and the increasingly prevalent SUVs (particularly the cross-over segment).If Not Tesla, Where Do I Look for Valuation Insights for My Dealership?For dealer principals looking to keep up with the current trends, monthly releases of SAAR give an indication of volumes in the US that is frequently quoted as a barometer for the market. However, this does not factor in a variety of considerations including the level of incentives to induce these purchases. Further it tells little to nothing about a dealership’s service department, where a significant portion of gross profit is made. Public auto dealers, such as Auto Nation and Asbury Auto Group, indicate how investors in public equities view dealerships. However, these are limited comparisons for dealerships that are more geographically concentrated, may carry fewer brands, and have limited access to capital markets. Looking at stock prices and valuations like Tesla or other manufacturers such as Ford and GM may give a look into the overall health of the auto sector but will be even more limited for dealers.Transactions tend to be a reliable indication of value as it shows what someone was willing to pay for a dealership, not just a small, non-controlling fraction of it. Resources such as Haig Partners and Kerrigan Advisors publish quarterly indications of Blue Sky (value of a dealership in excess of net asset value, expressed as a multiple of pre-tax earnings) which cull transaction data. While frequently quoted in the industry, it is unlikely that buyers would simply apply such a blue sky multiple without rigorous due diligence to understand the idiosyncratic aspects of cash flow, risk, and growth, inherent in a target dealership.At Mercer Capital, we provide a variety of services for owners of car dealerships and dealer principals. We analyze 13th month dealer financial statements, evaluate facilities (including rent factors, lots, and service bays) and develop independent and reliable valuation appraisals and calculations for a variety of needs and circumstances including buy-sell agreements, litigation, and more. For an understanding in how your dealership is performing along with an indication of what your dealership may be worth, contact a professional at Mercer Capital to discuss your needs in confidence.

Themes from Q4 Earnings Calls

The energy sector gained slight momentum in the fourth quarter as crude prices steadily increased from $54 per barrel at the beginning of October to $61 at the close of 2019. The gradual increase in prices was fueled partly by optimistic market expectations in early 2020, and the announcement of the United States and China Phase One trade deal. In early December, OPEC announced their intent to deepen production cuts through March 2020, applying upward pressure on prices. However, $60 pricing was short-lived in 2020 as concerns regarding the coronavirus, and its impact on global growth and energy demand, sent WTI prices to the $40s. In this post, we examine some of the most discussed items and trends from the Q4 earnings calls, specifically E&P companies and those in the mineral aggregator space.E&P CompaniesOperators experienced a positive earnings quarter to close 2019 as many beat expectations on both EPS and revenue. Cost reductions coupled with an increase in oil production fueled organic growth and allowed E&Ps to produce a level of free cash flow to investors. Participants on the calls were curious on the outlook for 2020, as topics discussed centered around the coronavirus and ESG (environmental, social, and governance) efforts moving forward.Global Health Affecting Supply and Demand Due to the calls occurring in early 2020, participants seemed inclined to question the outlook of the energy sector in light of recent news regarding the coronavirus. Operators, Pioneer Natural Resources and Continental Resources commented on the subject.“Obviously, more bullish, especially with U.S. shale essentially slowing its growth significantly going in 2020 once we get through the coronavirus demand issues. I'm more optimistic that we're going to see a much higher price deck over the next five years.” – Scott Sheffield, President and CEO, Pioneer Natural Resources“We see the oil and gas market as fundamentally oversupplied, with demand even further impacted by the coronavirus. By preserving our high-quality asset for a more structurally sound market; we are further enhancing future value for shareholders.” – Harold Hamm, Chairman, Continental Resources The Wall Street Journal recently reported that that the coronavirus has sent natural gas prices to their lowest level in years, as natural gas futures for April delivery closed at $1.756/MMbtu. Operators remain optimistic, however, that the outlook of the industry remains positive, assuming the virus is contained.ESG Efforts Intensifying“I want to highlight Continental's continued commitment to ESG. As one of the leaders of the horizontal American energy renaissance and a major contributor to U.S. energy independence we are proud to be a part of the approximately 15% rollback in CO2 emissions that has occurred since 2006, thanks to the affordability and availability of clean-burning natural gas and light sweet crude oil produced as a result of horizontal drilling.” – Harold Hamm, Chairman, Continental Resources“Every individual’s compensation is going to be tied to ES&G metrics. Things like water recycle, spill control, total recordable incidence rate, flaring, those are not subject to discretion. Those are quantitative measures that we will incentivize you know a better performance on. That's one thing that we've proven at Diamondback is, what gets rewarded gets done and we intend to do that in our scorecard.” – Travis Stice, CEO, Diamondback Energy“When you look at Slide #23, where the lowest of our peers in emissions intensity where Pioneer on both greenhouse gas intensity and also methane intensity. And what are the major changes we're making in our ESG in regard to compensation, we're increasing that these from 10% to 15% going forward in 2020.” – Scott Sheffield, President and CEO, Pioneer Natural ResourcesMineral AggregatorsAs we discussed in a previous post, mineral aggregators have continued to attract equity capital in the energy space amid depressed investor sentiment regarding the industry as a whole. While some mineral aggregators centered their attention on acquisitions heading into 2020, others were quiet and reiterated their patience that we covered in our third quarter earnings call post. In the fourth quarter, Kimbell Royalty Partners declared a record financial performance along with their acquisition of the Springbok assets in the Delaware Basin. On the other hand, Brigham Minerals emphasized their patient strategy, in search for larger mineral packages to meet their strict investment guidelines. As the price environment remains uncertain, aggregators are being questioned with their strategy moving forward.Uncertain Price Outlook Leading to Alternative Strategies“That is primarily to give us more exposure to the upside when the gas markets do come back when – if they do, we’re – and also on the downside, adding cash flow to the system in 2021 and 2022 to hedge distributions. So we’re really – we’re playing it in a hedged manner. We’re going to keep a fair amount of exposure to the upside, but we’re also going to put some acreage into play now." – Tom Carter, Chief Executive Officer, Black Stone Minerals“We have received approval to add hedging to our program. We certainly if these prices aren’t going to be hedging oil but some sort of protection on both the spread side or even the gas Waha spread side given the outlook for permitting gases is pretty dire here in 2020. I think we're looking to take that risk out of the Viper story. So we'll be looking at the market and now have approval to hedge from a downside and spread protection perspective.” –Kaes Van’t Hof, President, Viper Energy Partners“It's opportunities like this that only present themselves every three years to four years in terms of being a little consolidate and take advantage of this type of situation where people are concerned about crude oil prices. So, there is some time that has to go by. But I think our message is, if people are panicky, we can be patient and picky in terms of what we buy.” – Robert Roosa, Chief Executive Officer, Brigham Minerals“Oil, natural gas, and natural gas liquids revenues in the fourth quarter increased 18% compared to the fourth quarter of last year to $27.2 million. This increase reflects strong performance from acquisitions made in the past 12 months despite the decrease in realized commodity prices. While current pressures persist for many exploration and production companies operating in the U.S., our broad-based, high-quality asset portfolio continues to outperform expectations.” – David Ravnaas, President and Chief Financial Officer, Kimbell Royalty Partners The difficult price environment in the energy industry is leading mineral aggregators to plan for the future. The topics discussed revolved around strategies, particularly hedging and reinvestment, to capitalize on the unpredictable nature of the industry over the next few years.

What Can We Make from All This M&A Activity?

Recent Deal Flurry Highlights Investor Appetite for Cost Savings and Recurring Revenue

February was a record month for headline transactions in the RIA industry. Peter Mallouk sold a substantial stake in Creative Planning to PE firm General Atlantic on February 12. Less than a week later, Franklin Templeton agreed to buy rival asset manager Legg Mason for $6.5 billion, and Morgan Stanley purchased online broker E-Trade for $13 billion just a few days ago.Interestingly enough, the smallest and least heralded deal, General Atlantic’s minority interest purchase of Creative Planning, is probably the most notable from our perspective since our clients are typically more similar to CP than Franklin, E-Trade, and LM in terms of size and product offering.Still, we can’t dismiss the implications of these larger transactions and what they say about two sectors of the investment management industry that many analysts believe are dying – active management and discount brokerage. The Franklin / Legg deal was touted as being more about “offense not defense” according to Franklin chief Jenny Johnson, who said the acquisition was about building “an all-weather product line-up and world-class distribution platform.” While that may be the case, the reality is that both firms had suffered significant outflows and increased competition from passive funds. Combining both firms is expected to generate $200 million in cost savings and stem the tide of waning profit margins.Morgan Stanley’s purchase of E-Trade was likely also a defensive maneuver anticipated to yield approximately $400 million in expense reductions for the Wall Street giant. It may have also been Morgan Stanley’s counter to Goldman’s purchase of United Capital last Spring in their bid to enter the mass affluent space. E-Trade’s recent financial woes are primarily attributable to falling commission revenue, which, like active management fees, have been in free fall for quite some time.Both E-Trade’s and LM’s stock price rose over 20% upon announcement, and it naturally leads us to wonder if smaller active managers or broker businesses can expect such a windfall from a prospective acquirer. Scale still matters for most asset management firms, so consolidation rationales are always going to be there especially for an industry looking to cut costs. Brokerage firms’ commission revenue is less proportional to client assets, so bulking up just for the sake of it doesn’t make a whole lot of sense. Many of these businesses are already transitioning to an asset-based revenue model anyways, so we’re seeing fewer acquisitions of brokerage firms in general.Even with asset manager deal-making holding up, the sector’s recent uptick in M&A activity is largely attributable to a growing interest in wealth management firms. The driving force behind this increase is strong demand from RIA consolidators, PE firms, and strategic acquirers that are drawn to the sector’s recurring revenue model and sticky clientele base. The lack of internal succession planning is another catalyst as founding partners look to outside buyers to cash out.Despite this uptick, there are still numerous challenges to sustaining this level of M&A growth for the RIA industry. Consolidating RIAs, which are typically something close to “owner-operated” businesses, is no easy task. The risks include cultural incompatibility, lack of management incentive, and size-impeding alpha generation. Minority interest acquisitions (à la Creative Planning) sidestep some of these challenges, but the risks are harder to avoid in control acquisitions. Well-structured deals and effective integration strategies can help mitigate risks and align interests, but only to an extent.And yet, with over 12,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back-office efficiencies. Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth and margin compression. An aging ownership base is another impetus.The performance of the broader market will also be a key consideration for both buyers and sellers in the coming year. The current downturn from the Coronavirus could curtail the recent momentum or spur buyers to negotiate lower pricing. We’ll let you know how it all shakes out.

Mercer Capital's 2019 Energy Purchase Price Allocation Study

Have you downloaded Mercer Capital’s 2019 Energy Purchase Price Allocation Study yet?The study provides a detailed analysis and overview of valuation and accounting trends in these subsectors of the energy space. It enables key users and preparers of financial statements to better understand the asset mix, valuation methods, and useful life trends in the energy space as they pertain to business combinations under ASC 805 and GAAP fair value standards under ASC 820. Download here.

Don’t Get Distracted by Franklin/Legg and MS/E-Trade

Creative Planning’s Minority Sale is the Most Consequential RIA Deal So Far in 2020

Stop and reflect on the significant financial news of the past month - what do you remember? Coronavirus? Warren Buffett’s annual shareholder letter? Morgan Stanley merging with E-Trade? Franklin Templeton buying Legg Mason?It’s hard to imagine, but the most significant deal in the RIA community so far this year happened less than three weeks ago and is already nearly forgotten: Peter Mallouk sold a minority stake in his firm, Creative Planning, to private equity firm General Atlantic. The transaction is easily one of the largest minority transactions in the history of the RIA industry, and potentially provides a blueprint for others to follow.Deal specifics were not given, and we don’t have any inside knowledge of how the transaction was structured. What we do know is that Creative Planning reported just under $50 billion in AUM at year-end 2019, twice the size of United Capital when it was acquired outright last year by Goldman Sachs.Creative Planning’s fee structure is not atypical for the industry, and no doubt some fees on upper-end clients are negotiated. But while we cannot say with certainty what their effective fee schedule is across their overall business, it wouldn’t be unreasonable to assume that Creative Planning realizes 65 to 75 basis points on that $50 billion, for total revenue in the $300 to $400 million range. Stop and take that in for a moment, as very few investment management franchises have achieved a similar scale.We strongly suspect that the margin Mallouk realizes is enviable. Creative Planning posts a smaller headcount than United Capital, despite having twice the assets under management. Investment management is a labor-intensive business, but Creative Planning is efficient, and probably boasts an EBITDA margin north of 25%, maybe as much as 35% (and possibly more). This suggests that the firm makes on the order of nine figures per year in distributable cash flow. Of note, prior to this transaction, Mallouk was the sole owner.We strongly suspect that the margin Mallouk realizes is enviable.As for the multiple paid, we remember the high-teens multiples bandied about last year for the Goldman/United deal and the sale of Mercer Advisors. Mallouk was interviewed by Barry Ritholtz in December and mentioned he was entertaining an offer to sell part of his firm. In the conversation, Mallouk suggested that an appropriate multiple for a minority stake in a firm was 25% less than if it were a change of control transaction. If we benchmark that discount off of the major transactions for similarly scaled franchises last year, we estimate that Creative Planning fetched a low double-digit multiple of EBITDA. That would value Mallouk's business, even on a minority interest basis, at ten figures. The implication of all this is Mallouk sold a “mid-teens” percentage interest in Creative Planning for nine figures, and possibly as much as a quarter-billion dollars. Mallouk says he’s keeping all this cash in the business, as a cushion to protect his firm in the event of a bad market. More likely, in our opinion, is that the cash will serve as a war chest to fund growth in the event of market stress. If Mallouk did draw a strong multiple in a strong market and is now prepared to buy market share and hire talent in a downturn, this transaction will go down as one of the best in the history of investment management. As this bull market approaches its twelfth year, it's worth noting how firms are positioning and repositioning for the long term. And it’s worth considering what isn't happening as well. Mallouk didn’t sell the firm outright, and he didn’t go public. He says he sees upside in independence, and he's putting his money where his mouth is. Mallouk didn’t sell the firm outright, and he didn’t go public.The Creative Planning transaction is very different than the more widely reported deals from February. The Morgan Stanley acquisition of E-Trade is interesting for brand extension into the mass affluent space (a la Goldman/United), and we're curious to see if the Franklin/Legg Mason deal delivers promised expense savings as a larger franchise (we are skeptical). In both cases, though, the firms are managing their downside from changes (fee compression) in the market – which is not characteristic of the operating environment for Registered Investment Advisors. The Creative Planning transaction is about taking advantage of the remarkable upside available in the RIA space. It's the kind of deal we hope to see more of.

An Overview of Salt Water Disposal

Part 3 | Valuation Considerations

Our previous posts on salt water disposal covered provided an overview of the sector and detailed the economics of the industry. In this post, we’ll be taking a deeper dive into specific considerations that are critical to understanding the value of salt water disposal companies.What Does the Valuation Process Entail?There are three commonly accepted approaches to value: asset-based, market, and income. In the realm of business valuation, each approach incorporates procedures that may enhance awareness about specific economic attributes that may be relevant to determining the final value. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value for the subject interest under consideration.The Asset-Based ApproachThe asset-based approach can be applied in different ways, but the general idea is that the equity value of a business is given by subtracting the market value of liabilities from the market value of assets. However, the value of these assets is not always readily available and must be established through other methods, such as the market approach and the income approach. These values can also sometimes be proxied by replacement costs or build multiples, though location and intangible items (like permits and contracts) can make the asset-based approach challenging.The Income ApproachThe income approach can be applied in several different ways. Generally, analysts develop a measure of ongoing earnings or cash flow, then apply a multiple to those earnings based on market risk and returns. An estimate of ongoing earnings can be capitalized in order to calculate the net present value of an enterprise. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market through the use of a capitalization rate. Stated plainly, there are three factors that impact value in this method: cash flows, growth, and risk. Increasing the first two are accretive to value, while higher risk lowers a company’s value.As discussed in our previous post, cash flows are generally a function of disposal fees and the volume of water processed (with some incremental potential revenue coming from selling oil “skimmed” from the water), less cash operating costs.While some cash flow growth may be driven by operational efficiencies and increasing utilization rates, there is less potential for organic growth relative to other industries given capacity limitations and permitting requirements. Most growth will come in the form of increasing capacity, which requires capital expenditures. And as the sector continues to be the recipient of significant public and private capital, the economics of new projects may deteriorate.The riskiness of the cash flows is determined in part by the contract mix and location. Longer contracts with minimum volume commitments or take-or-pay requirements serve to reduce the risk of the cash flow stream. Uncontracted volumes or shorter contracts based on acreage dedications serve to increase the risk of the cash flow stream. Additionally, salt water disposal operators are subject to a host of regulatory and environmental risks, including concerns regarding potential links between SWD wells and seismic activity.The Market ApproachThe market approach utilizes pricing multiples from guideline transaction data or valuation multiples from a group of publicly traded companies to develop an indication of a subject company’s value. In many ways, this approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.In many industries, there are ample comparable public companies that can be relied on to provide meaningful market-based indications of value. While there are numerous publicly traded companies with salt water disposal operations, none are “pure play.”In fact, the salt water disposal sector sits at an interesting nexus between three oil & gas verticals: exploration & production, midstream, and oilfield services. Rattler Midstream went public in 2019 as a carve-out of E&P company Diamondback Energy. Most of Rattler’s revenues are attributable to salt water disposal operations. NGL Energy Partners was a traditional midstream company providing pipeline transportation for crude oil, NGLs, and refined products. However, over the past several years, it has transitioned its focus to water, with water solutions expected to generate over half of the company’s EBITDA going forward. Select Energy Services is an oilfield services company that provides water-focused services including flowback and well testing, water storage, and fluids handling, but is increasingly investing in pipeline infrastructure and SWD wells.As such, there must be careful consideration of the appropriateness of using public company multiples given operational, size, and geographic differences, among other factors.Fortunately, there have been numerous acquisitions of smaller, private companies in the sector, and valuation multiples can be derived from these transactions. However, this data is often self-reported, and there can be inconsistencies across transactions for both the implied transaction values (e.g., treatment of earnouts) as well as the earnings measure (e.g., does EBITDA include substantial pro forma adjustments from historical levels?) used to derive multiples.The market-based approach is not a perfect method by any means. Industry transaction data may not provide for a direct consideration of specific company characteristics. Clearly, the more comparable the transactions are, the more meaningful the indication of value will be.Synthesis of Valuation ApproachesA proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations. This is why industry “rules-of-thumb” (be they some multiple of revenue or earnings, or other) are dangerous to rely on in any meaningful transaction. Such “rules-of-thumb” fail to consider the specific characteristics of the business and, as such, often fail to deliver insightful indications of value. A business owner executing or planning a transition of ownership can enhance confidence in the decisions being made only through reliance on a complete and accurate valuation of the business.ConclusionMercer Capital has long promoted the concept of managing your business as if it were going to market. In this fashion, you promote the efficiencies, goals, and disciplines that will maximize your value. Despite attempts to homogenize value through the use of simplistic rules of thumb, our experience is that each valuation is truly unique given the purpose for the valuation and the circumstances of the business.Mercer Capital has experience valuing businesses in the oil and gas industry. We hope this information, which admittedly only scratches the surface, helps you better shop for business valuation services and understand valuation mechanics.We encourage you to extend your business planning dialogue to include valuation, because sooner or later, a valuation is going to happen. Proactive planning and valuation services can alleviate the potential for a negative surprise that could complicate an already stressful time in your personal and business life.For more information or to discuss a valuation or transaction issue in confidence, do not hesitate to contact us.

Q1 2020 Call Reports

M&A Opportunities a Focus Point for Public Companies

As deal activity continues to accelerate into 2020, M&A opportunities remain an area of focus for public asset and wealth management companies. Notably, however, there is a growing gap in the multiples for private vs public companies which may prove a challenge to M&A for public companies. At the macro level, there are several trends which continue to impact the industry, including fee pressure, the continued bull market, regulatory overhang, and technology advancements. As we do every quarter, we take a look at some of the earnings commentary from investment management pacesetters to scope out the dominant trends. Theme 1: Many public asset and wealth managers are eyeing M&A opportunities, particularly in the wealth management industry.[I]t's always been a goal of ours within M&A to increase the size. But I think there's just a few more opportunities today with some of the pressure on smaller firms, keeping up, keeping pace with technology spending and services that are required for their investors. So we're just seeing a few more opportunities for roll-ups. -Greg Johnson, Chairman & CEO, Franklin Resources[W]e're seeing a lot of [M&A] opportunities out there. We have always had a strong interest in private wealth businesses. We find that private wealth businesses are attractive on many fronts particularly because the assets are very sticky, and it dovetails well with what we've been doing around here for 2.5 decades at our Trust company. So we've seen a lot in that area, and we've seen a lot of teams that are stranded, that are looking for a home. And for us, we'd be particularly interested in a firm that has private wealth and has some of the capabilities that we don't currently have such as fixed income. -Brian Casey, President, CEO, & Director, Westwood Holdings GroupAs we have discussed previously, the current M&A environment for wealth management firms remains both active as well as expensive. Silvercrest, however, is involved in multiple conversations at any given time … Regardless of the environment, Silvercrest will opportunistically seek to effectively deploy capital to complement our organic growth … There is a possibility down the road that as the RIA business matures and professionals find themselves unhappy at much larger roll-up type firms or in that situation, they may start to look around the way some of their colleagues are at the brokerages, which is not a fertile hunting ground for us and our business model. It's possible that down the road, that there could be some RIA-type lift outs, but we're not running around seeking those. If you look at the business, the wealth management side with RIAs is highly concentrated. It's not a large number of firms that control a majority of the AUM, Silvercrest being lead among them. -Richard Hough, Chairman, President, and CEO, Silvercrest Asset Management GroupTheme 2: While public companies see opportunities in wealth management M&A, high pricing is a key consideration particularly in light of historically low multiples for publicly traded asset and wealth managers.Of course, we know that private equity and other wealth managers in the mass affluent wealth space are very, very active. And some of the EBITDA multiples being discussed here in the 15x, 16x-plus area, even in businesses that don't actually have the acquisitions closed yet, for example. So it is a very highly competitive space from a rollout perspective because the economics just make so much sense. -Matthew Nicholls, Executive VP & CFO, Franklin Resources We're certainly looking in [the wealth management] space, and we are keen observers of the price and multiple escalations that's going on there. As we think about our wealth management business and M&A opportunities there, it's really about driving scale. -Ben Clouse, Senior VP, CFO, Treasurer, Waddell & Reed Financial One of the challenges is that the public multiples and the private multiples still do have a disconnect … We really have to think about strategically and long term and creating value for those transactions that would make sense, we would definitely think about it. Obviously, our view is that the multiples that publicly traded managers are trading at are not in line with historical multiples. So we look at it long term. We look at it what is the right way to build value for the future in terms of that. But again, we're disciplined in terms of how we assess those alternatives. -George Aylward, President, CEO & Director, Virtus Investment PartnersTheme 3: Macro trends like fee pressure, the continued bull market, regulatory overhang, and technology advancements continue to shape the industry. I think we are likely to see more pressure on top line, driven by continuing price competition in the business. At some point, we'll see an equity downturn that will put more pressure on companies. We're -- we think we enter that environment from a position of clear strength with not only a number of market-leading franchises, but also strong balance sheet, strong culture, strong leadership, continuity of approach, focus on this business, great relationships in the market, history of innovation … So we're not all that optimistic at the moment about near-term trends in our industry, but are quite optimistic about our relative position within asset management. -Thomas Faust, Chairman, CEO, & President, Eaton Vance 2019 was marked by heightened geopolitical and trade tensions which created volatility in financial markets. Uncertainty around the U.S. and China trade negotiations, Brexit and other concerns about a slowdown in global growth all impacted investor sentiment, driving industry flows into safer fixed income and cash strategies, cash assets throughout the year … Macro forces are impacting the wealth industry, including a more challenging market environment, heightened customer expectations, more regulation, technology advancements. And this is driving demand for a deeper portfolio -- analytical and risk transparency, portfolio construction, product and scale. -Larry Fink, Chairman & CEO, BlackRock I regularly speak about the changing distribution landscape: the rise of the wealth channel and relative decline of the traditional institutional market; the importance of reaching people digitally; globalization, a buyer's market in terms of fee structure and vehicle preference; demand for customization and tailored solutions. -Eric Colson, Chairman, President, and CEO, Artisan Partners Asset Management Value investing, as we practice it at Pzena Investment Management, is the process of studying businesses whose stocks have collapsed, of gathering enough data to make a reasoned judgment about whether the history of the business and industry remains a useful guide for estimating future earnings and for investing when the range of outcomes skew solidly in our favor. We sit at one of those moments where a small number of market darlings have driven market returns to record levels and caused enormous dispersion between value and growth strategies. And yet, we judge that with an opportunity set that looks as good or better than it did a decade ago, the odds of our deep value approach succeeding in the next 10 years seems like a much better place to be than to bet that the winners of the past decade continue to defy analysis. -Richard Pzena, Chairman, CEO, and Co-Chief Investment Officer, Pzena Investment Management I do think that in an environment where fees are decreasing and costs are increasing, a lot of firms have to sort of think about, particularly in the smaller end, will they be better off partnering. I think the better firms are not in a situation where they have to do something, but they'll certainly consider looking at that. And then on the demand side, there are probably fewer firms that have the financial flexibility to be in the market. -George Aylward, President, CEO & Director, Virtus Investment PartnersSummaryEarnings calls this quarter brought to light the varying challenges and opportunities that asset and wealth management firms face.On the asset management side, macro trends like the shift from active to passive investing have forever changed the active asset management industry, and asset managers are having to re-think their cost structure in order to stay competitive. Increasing operating leverage through acquisitions and outsourcing has allowed asset managers to protect their margins despite declining fees.For smaller wealth managers, an active M&A market and high private market multiples provide an attractive alternative for owners seeking exit options. Interestingly, there is a growing gap between private and public company multiples. The higher multiples we’ve seen for relatively small wealth managers are seemingly at odds with some of the historically low smaller public company multiples, which begs the question of whether mean reversion is on the horizon.

Understanding Oilfield Services Companies & How to Value Them

New Whitepaper

Understanding the value of an oilfield services (OFS) company is by its very nature a complex matter. As participants in the greater energy industry, situated between the exploration and production (E&P) companies and midstream companies, the OFS sub-sector is quite broad. It includes, businesses that have the commonality of their connection to oil and gas prices, but also the significant differences between service providers and equipment manufacturers. It also includes businesses that focus on technology advantages and those that focus on relationships, those that specialize in narrow service/product niches and those that provide a broad range of services/products. Not to mention the differences in the economics that drive OFS companies with a focus on existing production, as opposed to those that focus on exploration. Also, the differences between those that focus on services that are particular to conventional oil versus unconventional oil, oil versus gas, shale versus tight sands.Having a firm grasp on the many similarities and distinctions is crucial in performing valuations of these businesses. That understanding plays into the choice of which valuation approaches and methods are to be applied, and which of those approaches and methods are more reliable, or less reliable, depending on the subject company’s positioning and where the industry is in it’s potentially wide ranging cycles.As part of any OFS company appraisal, one must consider expectations for both shorter-term and longer-term operating results. Industry cyclicality creates challenges in evaluating expectations that can lead to material over-valuations, or under-valuations, unless one has the depth of experience and industry understanding to navigate the many considerations that impact OFS companies.In our latest whitepaper, Understanding Oilfield Services Companies & How to Value Them, we provide invaluable guidance in regard to these aspects of the OFS industry. Click below to download whitepaper.>>Download Whitepaper

WHITEPAPER | Understanding Oilfield Services Companies & How to Value Them

Understanding the value of an oilfield services (OFS) company is by its very nature a complex matter. The unpredictable cyclicality of the oilfield services industry requires careful consideration of many industry-wide and company-specific factors in developing a reasonable forecast of future operating results. While consideration of such factors should be part of the analysis in the appraisal of businesses in all industries, the impact of these considerations is magnified in highly cyclical industries such as that served by OFS businesses.This whitepaper provides invaluable guidance in regard to these aspects of the OFS industry.

RIA “Comps” Don’t Always Tell the Same Story

Divergent Performances of LM, TROW, BEN, and AMG Show Industry’s Susceptibility to Company Specific Events Over Market Forces

As valuation analysts, we often look to comparable publicly traded businesses (“comps”) to glean an appropriate range of valuation metrics and multiples for the companies we value. Calling them “comps,” however, is often a stretch, since it is rare that we can find public companies that are truly comparable to the private company we’re trying to value. The publics are often too large and diverse to be labeled as comps, so we usually seek public companies that are in a similar line of business and call them guideline companies instead.While it’s not unusual for companies in the same guideline group to have divergent share price performance despite facing the same industry headwinds (or tailwinds), publicly traded RIA stock performance can vary dramatically.The past twelve months have been no exception, especially for T. Rowe Price (ticker: TROW), Franklin Resources (BEN), Legg Mason (LM), and Affiliated Managers Group (AMG). TROW and LM have bested the market and asset manager index while AMG and BEN have fallen well short.Performance Over the Last Twelve MonthsSource: S&P Global Market Intelligence So what’s driving this disparity? Much of it can be explained by performance net of expectations. T. Rowe Price and Legg Mason have consistently beat consensus EPS over the last several quarters on steady gains in revenue and earnings. AMG and BEN have missed Street estimates and recent financial performance has been more volatile. While we would not ordinarily include these businesses in a guideline group (our clients are typically much smaller than these companies), there is a key takeaway from all this variation in stock performance. Our recurring clients are often surprised when AUM, revenue, and earnings are up year-over-year, yet our valuation of their company goes down. This usually occurs when these key financial metrics fall short of forecast expectations, and the outlook for the business gets revised accordingly. This may happen to your clients’ stock holdings, and it’s no exception for the value of your business. We’re sometimes surprised by the variations in RIA share price performance since their revenues are so highly correlated with market conditions. The reality is that these businesses are unique, and their values can diverge widely on variations in financial performance and the outlook for earnings. On the qualitative side, new business development, personnel changes, variations in investment performance, and regulatory changes can all drive a wedge in how your business performs relative to your competition. The market certainly has an impact, but there are many other factors that you and your employees can control. Still, we don’t typically see a 40%+ increase in value (TROW) and a ~25% decline in a bull market (AMG) for two businesses in the same industry, so this disparity is worth a second look. T. Rowe Price was able to lever a market tailwind with cost-cutting initiatives and net client inflows to its mutual fund business unlike many of its competitors. AMG, on the other hand, has struggled with the many headwinds facing asset managers and the consolidators that invest in them. Your firm’s value has probably not changed this much over the last year. You’ve likely benefited from strong market conditions, but industry headwinds persist, particularly on the asset management side. It’s difficult to assess the net impact of a lot of conflicting forces, especially if you have little or no background in business valuation or corporate finance. This is why we recommend hiring a valuation firm to appraise your business on a regular basis to gauge your progress and have a feel for what your company could sell for when that day comes. We’re here to help.

Aggregators Continue to Attract Equity Capital

In previous posts, we have delineated between royalty trusts and mineral aggregators and discussed the valuation implications of prevailing high dividend yields of public royalty trusts. Yields remain elevated, and these trusts have declined in their usefulness from a valuation benchmarking perspective. In this post, we focus on mineral aggregators. We also offer insights on the investment landscape at large and particularly as it relates to the minerals subspace by providing an update on the most recent IPO, Brigham Minerals (MNRL).Market Data for Aggregators and TrustsThe following tables provide some critical market data for valuation purposes. Since our last update, SandRidge Mississippian Trusts I and II (SDT and SDR, respectively) were delisted in mid-November as the stocks fell below $1.00 in May and traded below that mark for six months. All else equal, public royalty trusts are expected to decline in value as investors get their return almost exclusively from yields because production declines over time. Thus, trusts eventually being delisted is not a surprising outcome due to restrictions on acquiring additional acreage or wells. Given the eponymous operator SandRidge Energy’s struggles, it’s even less surprising these two trusts were delisted. SandRidge Permian Trust has avoided this fate for the time being, due in part to its attachment to the prolific Permian and sale to Avalon Energy, but the trust has also been put on notice. Unlike public royalty trusts, mineral aggregators are not restricted from acquiring additional interests, which makes them more of a going concern by comparison. This is among many reasons investors have increasingly turned towards mineral aggregators. Long-time readers of the public mineral interest portion of our blog will note the revamped look at value drivers and key benchmarks for mineral aggregators. Public Markets Unreceptive of Energy SectorThe stock market has been booming over the past decade as the economy has ridden the longest expansion in history. Investors in the energy sector, however, have not experienced the same joyful ride. In 1990, energy made up 15% of the S&P 500 sector weightings, but in 2019, that figure was down to 5%. Ironically, over the same period, the United States’ oil and gas production surpassed all countries and claimed the top of the leaderboard, becoming the world’s largest producer. Depressed commodity prices have also likely aided valuations for companies in other sectors as transportation costs are lower in an increasingly globalized economy with two-day shipping becoming common place.The graph below shows the relationship between the Vanguard Energy ETF, created in 2004, and the SPY Index over a 15-year period. Slow economic growth coming out of the recession caused Energy to outperform, but commodity price declines in late 2014 began a reversal that has widened since 2017.Energy vs. S&P 500 There are many reasons that this story has unfolded such as diminishing return on investment, fluctuation in commodity prices, and oversupply, but we do not dive into that in this post. Instead, we want to illustrate the ways in which mineral aggregators have been able to manage some of these issues. Mineral aggregators are constructed to diversify capital among many superior plays and specific operators. This niche in the energy market allows investors to capitalize on both current yield and capital appreciation with the aggregators’ reinvestment capabilities. Crucially, royalty holders do not bear operating and drilling costs as these costs are paid by upstream E&P companies. Brigham Minerals articulates the benefits of the business model as follows: “There are many advantages of the mineral acquisition model, including no development capital expenditures or operating costs, no exposure to fluctuating oilfield service costs and higher margins than E&P operators without associated operational risks.”Mineral aggregators receive a royalty based on revenue and are thus isolated from a number of field-level economic issues. This is not unlike the restaurant industry, where franchisors command a much higher valuation than the operators to whom they franchise. Declining same-store sales figures in that industry are hurting profitability for operators grappling with the necessity for capital expenditures to fund future growth while those collecting royalties off the top can prosper with their asset-light models. Sound familiar?Brigham Minerals Seasoned Equity OfferingIn a previous post, we discussed the much-anticipated Brigham Minerals’ IPO in April 2019. The upsized offering was sparked by higher than expected demand. Many saw the IPO as an investment opportunity that promoted cash flow, something that operators in the market were not providing. There was speculation that additional mineral companies would likely IPO over the course of 2019 given the demand for Brigham Minerals, but that turned out not to be the case. In December of 2019, however, Brigham Minerals announced in an S-1 a seasoned equity offering of 11 million common shares. The Company offered 6 million new shares of its common stock, and some selling shareholders sold an additional 5 million shares. Shares were priced at $18.10, likely a psychological threshold, as it was priced just ten cents above the IPO price only eight months prior. Credit Suisse, Goldman Sachs, and RBC Capital Markets acted as lead booking-running managers for the offering, and they were granted a 30-day greenshoe option totaling an additional 1.65 million shares though these were not exercised as the share price remained above the issuance price, averaging $19.70 for the first month of trading. Generally speaking, 2019 was a poor year for IPO’s with ride-share companies Uber and Lyft among the high-profile unicorns that floundered. Peloton opened 6.9% below its trading price and multiple companies, perhaps most notably WeWork, decided to scrap the IPO altogether. Brigham’s IPO success and perhaps more importantly its ability to issue additional equity just eight months later may encourage private equity firms invested in minerals companies to test the IPO market.ConclusionMineral aggregators appear to have supplanted public royalty trusts as a key means for investors to get exposure to the sector while avoiding costly drilling expenses. While functionally related to drilling activity and well performance, aggregators allow investors to avoid cost burdens. As such, valuations for the aggregators behave differently than other participants in the energy sector.We have assisted many clients with various valuation and cash flow questions regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.

Community Bank Valuation (Part 5): Valuing Controlling Interests

To close our series on community bank valuation, we focus on concepts that arise when evaluating a controlling interest in another bank, such as arises in an acquisition scenario. While the methodologies we described with respect to the valuation of minority interests in banks have some applicability, the M&A marketplace has developed a host of other techniques to evaluate the price to be paid, or received, in a bank acquisition.In the Valuing Minority Interests segment of this series, we discussed that valuation is a function of three variables: a financial metric, risk, and growth. From a buyer’s standpoint, the ultimate goal of a transaction, of course, is to enhance shareholder value, which would occur if the target entity can, on balance, enhance (or at least not detract from) the buyer’s financial metrics, risk, and growth. This can be achieved in several ways:The direct earnings contribution of the target, or the accretion to the buyer’s earnings per share if the consideration consists of the buyer’s stock. In a bank M&A scenario, this accretion often derives from cost savings resulting from eliminating duplicative branches, back office functions, and the like.An acquisition can provide diversification benefits, such as different types of loans, additional geographic markets, or new funding sources. If these characteristics of the target reduce any concentrations held by the buyer, the acquirer’s overall risk may lessen. However, numerous buyers have regretted entering lines of business or new markets via acquisition with which the buyer’s management team lacked the requisite familiarity.Accessing new markets or lines or business lines through acquisition gives the buyer more “looks” at new customers and transactions. For many banks, moving the needle on asset size or growth means looking outwardly beyond its existing markets or products, and the needle moves faster with an acquisition strategy versus a de novo market expansion strategy. These benefits are not without risks, though. Some of the more significant acquisition risks include:Credit surprises. One or two unexpected losses usually do not affect the underlying rationale for a transaction, although it may create some uncomfortable conversations with investors regarding the buyer’s due diligence process. A more significant risk is that the buyer’s risk tolerance differs from the seller’s approach, leading to a potentially significant disruption to future revenues as risk appetites are synchronized. However, credit surprises often cannot be detached from the prevailing economic environment. In a post mortem, many transactions closed in the 2006 time frame look ill-advised given the subsequent financial crisis. Ultimately, factors outside the buyer’s control may have the most impact on post-transaction credit surprises.Cultural incompatibility. While sometimes difficult to detect from the outside, differences small and large between the cultures of the buyer and target can jeopardize the anticipated post-merger benefits. More often than not, this is manifest in personnel issues. Mergers are like chum in the water to competitors; buyers can expect competitors to look for any opening to attract personnel from the target bank.Similarities to Valuations of Minority InterestsThe previous installment of this series introduced the comparable company and discounted cash flow methods to bank valuations. Both of these methods remain relevant in assessing a controlling interest in a bank, meaning an interest of sufficient size to dictate the direction of the bank. Most often, controlling interest valuations arise in the context of an acquisition.Comparable Transactions MethodIn a controlling interest valuation, the comparable company method can be used. However, the resulting values often would be adjusted by a “control premium”, which is measured by reference to the value of historical M&A transactions relative to a publicly-traded seller’s pre-deal announcement stock price. This approach has the advantage of synchronizing the controlling interest valuation to current market conditions, which can be a drawback of the comparable transactions approach.More often, though, the comparable company method morphs into the comparable transactions method in an M&A setting. Comparable M&A transactions can be identified by reference to geography, asset size, performance, time period, and the like. Ideally, the transactions would be announced close in proximity to the date of the analysis; however, narrowly defining the financial or geographic criteria may mean accepting transactions announced over a longer time period. The computation of pricing multiples, such as price/earnings or price/tangible book value, is facilitated by the widespread data availability regarding targets and the straightforward deal structures that usually allow analysts to identify the consideration paid to the sellers. That is, contingent consideration, like earn-outs, is rare. However, deal values are not always publicly reported for transactions involving privately-held institutions.While the comparable transactions approach is intuitive – by measuring what another buyer paid for another entity in an industry with thousands of relatively homogeneous participants – the most significant limitation of the comparable transactions method is created by market volatility. Buyers’ ability to pay is correlated with their stock prices, and most bank M&A transactions include a stock component. Deals struck at a certain price when bank stocks traded at 16x earnings would not occur at that same price if bank stocks trade at 12x earnings without crushing dilution to the buyer. Thus, prices observed in bank M&A transactions need to be viewed in light of the market environment existing at the time of the transaction announcement data relative to the valuation date.Discounted Cash Flow MethodWe introduced the discounted cash flow method as a forward-looking approach to valuation reliant upon a projection of future performance. In an M&A scenario, buyers usually start with the target’s stand-alone forecast, unaffected by the merger. Acquirers then add layers to the forecast reflecting the impact of the transaction, such as:Expense savings. In a mature industry, realization of cost savings typically is a significant contributor to the transaction economics, with buyers often announcing cost savings equal to 30% to 40% of the target’s operating expenses. These are derived primarily from eliminating duplicative branches, back office functions, and the like. As the expense savings estimates increase, there often is a rising risk of customer attrition, with cuts going beyond the back office into activities more noticeable to customers, like branch hours or staffing. While buyers may expect a certain level of expense savings, it is not clear that buyers “credit” the seller with all of the expense savings the buyer takes the risk of achieving. That is, the risk of achieving the expense savings effectively is split between the buyer and seller, with the favorability of the split in one direction or the other dictated by the negotiating power of the buyer and seller.Revenue enhancements. Buyers may expect some revenue enhancements to occur from the transaction, such as if the buyer has a more expansive product suite than the target or a higher legal lending limit. However, buyers often loathe to include these in transaction modeling, and revenue enhancements are seldom reported as a driver of the EPS accretion expected from a transaction.Accounting adjustments. While fair value marks on assets acquired and liabilities assumed should not drive the economics of a transaction, they can affect the near-term earnings generated by the pro forma entity. Therefore, buyers usually are keenly aware of the accounting implications of a transaction. One advantage of a discounted cash flow approach is that it allows the buyer to evaluate, for a given price, the level of earnings contribution needed from the target to justify that price. While if you torture the numbers long enough they will confess to anything, as a statistics professor of mine was fond of saying, buyers should not lose sight of the reality of implementing the modeled business strategies.Additional ConsiderationsWhile the comparable transactions and discounted cash flow models crossover – no pun intended with another valuation approach we describe below – from a minority interest valuation environment, several valuation techniques are unique to M&A scenarios.Tangible Book Value Earn-BackAfter the financial crisis, investors became focused on the tangible book value per share earn-back period, sometimes to the point of seemingly ignoring other valuation metrics. There are several ways to compute this, but the most common is the “crossover” method. This requires two forecasts:The buyer’s tangible book value per share, absent the acquisitionThe buyer’s pro forma tangible book value per share with the target The analyst then calculates the number of periods between (a) the current date and (b) the date in the future when pro forma tangible book value per share exceeds stand-alone tangible book value per share. Ultimately, the earn-back period is driven by factors like:The price/earnings or price/tangible book value multiples of the buyer’s stock relative to the multiples implied by the transaction valueThe extent of the merger cost synergies The tangible book value earn-back method also exacts a penalty for deal-related charges, as a higher level of deal charges extends the earn-back period. From an income statement standpoint these charges often are treated as non-recurring and, in a sense, neutral to value. However, these charges represent a real use of capital, which the TBV earn-back approach explicitly captures. Investors often look favorably upon transactions with earn-back periods of fewer than three years, while deals with earn-back periods exceeding five years often face a chilly reception in the market. The earn-back period often is the real governor of deal pricing in the marketplace, which investors often like because it overcomes some limitations posed by EPS accretion analyses.Earnings per Share AccretionAs for the tangible book value per share earn-back period analysis, an EPS accretion analysis requires that the buyer forecast its EPS with and without the acquired entity. EPS accretion simply is the change in EPS resulting from the transaction. The attraction of this analysis lies in the correlation between EPS and value. For a buyer trading at 12x earnings, a deal that is $0.10 accretive to EPS should enhance shareholder value by $1.20 per share, holding other factors constant.But how much accretion is appropriate? Should a deal be 1% accretive to be a “good” deal, or 10% accretive? It is difficult to answer this question in isolation. This is especially true for a deal comprised largely of cash, where the buyer is forgoing the use of its capital for shareholder dividends or share repurchases in favor of an M&A transaction. Recent deal announcements often indicate EPS accretion in the mid to high single digits with fully phased-in expense savings.Contribution AnalysisA contribution analysis is most useful in transactions involving primarily stock consideration. It compares the buyer and seller’s ownership of the pro forma company with their relative contribution of earnings, loans, deposits, tangible equity, etc. In a merger of equals transaction, where the two merger parties are roughly similar in size, this type of analysis is important in setting the final ownership percentages of the two banks.ConclusionA valuation of a controlling interest may take many forms; fortunately, the strengths of certain valuation methods described here offset the weaknesses of others (and vice versa). Value ultimately is a range concept, meaning that there seldom is a single value at which a deal fails to make economic sense. There are good deals, reasonable deals, and dumb deals. Evaluating a number of valuation indications puts a buyer in the best position to slot a transaction into one of these three categories and to negotiate a deal that accomplishes its objective of enhancing financial performance, controlling risk, and developing new growth opportunities. It is crucial to remember, though, that deals are tougher to execute in reality than in a spreadsheet.This concludes our multi-part series examining the analysis and valuation of financial institutions. While approximately 5,000 banks exist, the industry is not monolithic. Instead, significant differences exist in financial performance, risk appetite, and growth trajectory. No valuation is complete without understanding the common issues faced by all banks – such as the interest rate environment or technological trends – but also the entity-specific factors bearing on financial performance, risk, and growth that lead to the differentiation in value observed in both the public and M&A markets.

Beauty is in the Eye of the Beholder

Drivers of Valuation in Wealth Management M&A

Fidelity recently published a study on M&A activity in the wealth management industry highlighting sellers’ ambitious expectations of the value of their firms. Fidelity found that sellers today expect EBITDA multiples of between 8x and 10x, even though median deal multiples “are still reasonably close to where they were over the five-year period between 2012 and 2017” - around 5x. What is causing the discrepancy? Sellers often focus on “exceptional, highly publicized transaction multiples.”Over the last year, some mergers and acquisitions in the RIA space have touted impressive deal valuations, which many media outlets have highlighted. Echelon Partner’s RIA M&A Deal Report features “deals and dealmakers of the year” with estimated transaction multiples of 8x to 22x EBITDA. The deal sizes, however, ranged from $600 million to $26 billion. By contrast, roughly two-thirds of registered investment advisors have under $100 million in AUM.There is typically more information available about these larger transactions than for the sale of a $100 million manager. 5.0x EBITDA doesn’t make as compelling a headline as 18x EBITDA. But the valuation multiples shown above are by no means normal. Most smaller deals go unreported, which results in inflated averages for reported deal valuations and inflated expectations for sale prices.Additionally, reported deal values often include a contingent consideration which may never be fully realized. An excerpt from our whitepaper on The Role of Earnouts in Investment Management M&A illustrates how this can impact seller expectations.ACME Private Buys Fictional Financial On January 1, 20xx, ACME Private Capital announces it has agreed to purchase Fictional Financial, a wealth management firm with 50 advisors and $4.0 billion in AUM. Word gets out that ACME paid over $100 million for Fictional, including contingent consideration. The RIA community dives into the deal, figures Fictional earns a 25% to 30% margin on a fee schedule that is close to but not quite 100 basis points of AUM, and declares that ACME paid at least 10x EBITDA. A double-digit multiple brings other potential deals to ACME and crowns the sellers at Fictional as “shrewd.” Headlines are divided as to whether Fictional was “well sold” or that ACME was showing “real commitment” to the wealth management space, but either way the deal is lauded. The rest of the investment management world assume their firm is at least as good as Fictional, so they’re probably worth 12x EBITDA. To the outside world, everybody associated with the deal is happy.The reality is not quite so sanguine. ACME structures the deal to pay half of the transaction value up front with the rest to be paid based on profit growth at Fictional Financial in a three year earn-out. Disagreements after the deal closes cause a group of advisors to leave Fictional, and a market downturn further cuts into AUM. The inherent operating leverage of investment management causes profits to sink faster than revenue, and only one third of the earn-out is ultimately paid. In the end, Fictional Financial sold for about 6.5x EBITDA, much less than what the selling partners wanted for the business. Other potential acquisition targets are disappointed when ACME, stung with disappointment from the Fictional transaction, is not willing to offer them a double-digit multiple. ACME thought they had a platform opportunity in Fictional, but it turns out to be more of an investment cul-de-sac.The market doesn’t realize what went wrong, and ACME doesn’t publish Fictional’s financial performance. Ironically, the deal announcement sets the precedent for interpretation of the transaction, and industry observers and valuation analysts build an expectation that wealth management practices are worth about 10x EBITDA, because that’s what they believe ACME paid for Fictional Financial. The example above supports Fidelity’s conclusion: sellers of investment management firms often “don’t entirely understand what drives valuation.” RIA transaction data is haphazard at best. It’s no wonder why seller’s expectations are inflated if they look only to media sources to understand valuation. In this post we hope to provide insight to the owners of wealth management firms on how likely buyers value their firm.Cash Flow, Growth, and Risk Valuation firms think of value as a function of cash flow, growth, and risk (or cash flow times a multiple).Sustainable Cash FlowThe first part of the equation is simple. Higher cash flow (or EBITDA) implies a higher price tag. But margins have to be real. Disguising partner compensation as distributions to inflate profitability won’t sell, as buyers are typically sophisticated enough to know there will be a replacement cost for selling partners who retire and want to hand over their responsibilities to someone new. Low margins are a more obvious red flag, as heavy overhead is difficult to scale down and makes firms vulnerable in down markets.So, margin has most value within what a buyer considers to be a normal range. Fidelity reported the “median operating margin of firms/deals in the past two years was 28%, with respondents saying the ranges for operating margins fell typically between 20 to <30% on the lower end, and between 30 to <40% in the upper end.”There is more mystery involved in the multiple, but it ultimately depends on the growth trajectory and risk profile of your company. The multiple (and thus the firm’s value) is positively correlated to expected growth and inversely related to risk.Meaningful GrowthAll else equal, a buyer will pay more for an investment manager that is expected to double assets under management in five years, than one in which AUM is expected to double in ten. Higher growth implies higher future cash flows.Over the past year, AUM at most wealth managers increased significantly as markets surged. However, AUM growth that is entirely a consequence of market activity is not sustainable over the long run. Investment performance does impact value, but buyers of wealth managers view growth in terms of net positive inflows of assets. Growth driven by market conditions brings short term increases in cash flow. But growth driven by a new marketing strategy, increased market share driven by a failing local competitor, or a new investment strategy drives long term value. Manageable Risk A buyer will pay more if the future cash flows are relatively certain but less if there is significant risk that your cash flow could deteriorate post acquisition.In general, there is more risk associated with smaller companies. Small investment managers typically have a more concentrated client base, are more dependent upon key individuals to generate business, and have less developed marketing and technology infrastructure to support and grow their business.This size/value relationship even exists in firms with much larger scale than the typical RIA. Looking at the implied valuation multiples of publicly traded investment managers, the multiples of managers with under $100 billion of AUM are generally lower than those of investment managers with over $100 billion in assets. This is why highly publicized deal multiples of massive investment managers don’t serve as a reliable benchmark for your firm. Unfortunately, most of the risks outlined above are only truly solved with scale. Customer concentrations are reduced with more assets. Key man dependencies are lessened by hiring well-trained investment processionals (which is expensive) or by training younger professionals (which takes time). Investments in scalable technology are often too costly for small managers. However, formalizing investment processes and establishing a succession plan with a proper buy-sell agreement can reduce the risk of cash flows deteriorating if key individuals depart post acquisition. What Will a Buyer Pay for Your Firm?Unfortunately, there is not a simple formula to value your firm.A highly concentrated client base may overshadow the high growth potential of your firm. On the other hand, a stable client base, with a higher probability of recurring revenue, can raise your valuation despite mediocre growth prospects.Many business owners suffer from familiarity bias and the so-called “endowment effect” of ascribing more value to their business than what it is actually worth simply because it is well-known to them or because it is worth more to them simply because it is already in their possession. In any event, just as physicians are cautioned not to self-medicate, and attorneys not to represent themselves, so too should professional investment advisors avoid trying to be their own appraiser.The first step of any transaction should be to obtain a valuation to establish decision-making baselines and to set transaction expectations. Mercer Capital’s Investment Management team provides asset managers, wealth managers, and independent trust companies with business valuation and financial advisory services. Call us today to discuss your valuation needs in confidence.

Do Win/Loss Records Affect Major League Baseball Revenues and Attendance?

Many people believe that the win/loss ratio doesn’t have much effect on revenues and attendance. They believe the local team has loyal fans who will attend games despite their performance. We investigate that assumption in this article focusing on Major League Baseball (MLB) by sampling a top tier, middle tier, and lowest tier team.We analyze average season attendance of the league over the last five years and then track the three-team sample’s attendance and on-field performance.We have selected three teams to review their attendance vs. winning percentage, along with their playoff and World Series performance. Our sample consists of the Los Angeles Dodgers, the Texas Rangers and the Miami Marlins.As a reference point, average season attendance for the MLB reached a peak in recent years at 2.5 million in 2007 for the American League and 2.8 million for the National League. The MLB averages dropped in the subsequent years and were finally steady around 2.3 million for the A.L. and 2.5 million for the N.L. during the next ten years. League attendance average declined, however, by 140,000 to 2,161,376 in 2018 and 2,039,521 in 2019.Los Angeles DodgersThe Dodgers attendance in 2007 was 3.9 million and stayed above 3.4 million for three years. This figure dropped to 2.9 million in 2011 yet returned to 3.7 million by 2013. Recently, season attendance has slowly climbed to approximately 4 million in 2019, marking an all-time team high.This growth was greatly influenced by the Dodgers being in the World Series in 2017 and 2018, which helped push 2019 to a record high attendance. (See Table 1 for details)Texas RangersThe Texas Rangers have experienced a different attendance history. They peaked in 2012 at 3.5 million after playing in the World Series in 2011 and the playoffs in 2012. The team didn’t make the playoffs in 2013 and 2014 and attendance dropped to 3.2 million and 2.7 million, respectively. The win/loss record dropped significantly from about 59% in 2011 to 41% in 2014.Attendance followed the same trend by dropping 450,000 to 2.7 million in 2014. Even when the team made the playoffs in 2015, attendance fell to 2.5 million as a result of their poor record in 2014. The team’s 2015 win/loss ratio was near 59% and they made the playoffs, but not the World Series. In the following year, attendance increased to 2.7 million. The win/loss ratio dropped below 50% in 2017 to 2019 and they missed the playoffs each year. As a result, attendance dropped steadily to 2.1 million in 2019, a decrease of over 1.3 million people, or 38% from their peak in 2012. (SeeTable 2 for details)Miami MarlinsThe Miami Marlins clearly represent the bottom tier of the MLB in many categories. They built a brand-new state of the art ballpark in 2012 and attendance averaged about 1.7 million from 2014 to 2017. In the fall of 2017, the Derek Jeter group bought the team. and the new owners quickly traded notable high-priced players to other teams, including the NY Yankees, in order to reduce their losses. The new ownership group was hoping to stabilize attendance near the 1.7 million mark, but instead dropped to 811,000 in both 2018 and 2019; 367,000 less than the next worst attendance in MLB, which was Tampa Bay, and about 500,000 less than the third worst team, the Baltimore Orioles. (SeeTable 3 for details)ConclusionWithout attempting to do a statistical analysis, what does the data mean? Yes, the quality of the players counts – especially if the win/loss record corresponds, however, winning percentage also impacts the ability to get into the playoffs and ultimately the World Series. It is clear from our experience and from the three-team sample that win/loss ratios have a major effect on MLB home stadium attendance.

Exploration & Production Purchase Price Allocations

A Review of E&P Transactions Analyzed in Mercer Capital’s 2019 Energy Purchase Price Allocation Study

Last week, Mercer Capital released its 2019 Energy Purchase Price Allocation Study. In this post, we’ll be taking a deeper dive into the Exploration & Production transactions reviewed in the analysis.The E&P sector had the lowest average allocation to intangible assets, at just 2% of total purchase consideration. In fact, only two of the eleven transactions analyzed had any intangible allocation at all. Oasis Petroleum recorded a small ($1 million) intangible asset related to a non-compete agreement in connection with its acquisition of Forge Energy. The major outlier was Concho Resources, which recorded over $2.2 billion of goodwill related to its acquisition of RSP Permian.Exploration & Production is not an intangible asset-driven business model. These companies sell a commodity, so there is no real brand value leading to trademark or trade name allocations. Bill Barrett and Fifth Creek rebranded as HighPoint Resources after their merger, and recently two E&P companies (Ovintiv, formerly Encana, and Battalion Oil Corporation, formerly Halcon Resources) changed names, the latter likely influenced by its emergence from bankruptcy.The commodity is generally sold at market hubs, so specific customer relationships have minimal value. (To the extent the company has derivatives that result in above-market pricing realizations, that asset is captured separately.)And while E&P companies tout their technical prowess, few outside of the majors spend meaningfully on R&D or have protected intellectual property. None of the transactions analyzed in this year’s study included allocations to Developed Technology or In Process Research & Development.Ultimately, the value of an E&P company is driven by its reserves, and purchase price allocations generally reflected that. Based on the transactions reviewed in our analysis, ~90% of purchase consideration was allocated to reserves.Again, the outlier in the data is Concho’s acquisition of RSP Permian, in which over $2.2 billion was allocated to goodwill. In its 2018 10-K filing, Concho rationalized the goodwill value as follows:Goodwill recognized is primarily attributable to the following factors: (i) operating and administrative synergies and (ii) net deferred tax liabilities arising from the differences between the purchase price allocated to RSP’s assets and liabilities based on fair value and the tax basis of these assets and liabilities. For the operating and administrative synergies, the total consideration for the RSP Acquisition included a control premium, which resulted in a higher value compared to the fair value of net assets acquired. There are also other qualitative assumptions of long-term factors that the RSP Acquisition creates for the Company’s stockholders, including additional potential for exploration and development opportunities and additional scale and efficiencies in basins in which the Company operates.Despite the headwinds faced by the E&P sector since the Concho / RSP transaction, Concho has indicated that this goodwill value has not been impaired. The company’s most recent 10-Q indicates that quantitative impairment tests were performed as of July 1, August 29, and September 30, 2019. (However, Concho did take an $81 million goodwill impairment charge related to certain New Mexico Shelf acreage that was divested in 2019.)In an environment of increasingly complex fair value reporting standards and burgeoning regulatory scrutiny, Mercer Capital helps clients resolve financial reporting valuation issues successfully. We have the capability to serve the full range of fair value valuation needs, providing valuation opinions that satisfy the scrutiny of auditors, the SEC, and other regulatory bodies. Contact our Energy Industry or Financial Reporting Valuation teams to discuss your valuation needs in confidence.

Are Sponsor-Backed Initiatives Distorting RIA M&A?

Barbarians at the Gate 2 – Electric Boogaloo

Reading up on the commentary about the record number of RIA transactions last year, I’m struck by how simple the predominant narrative is: everybody wants in, valuations are up, and deal-flow continues to flourish.Headlines have their own wisdom, but the underlying reality of M&A activity is necessarily nuanced – especially as we approach the twelfth year of this bull market. If transaction activity is higher and vectoring to grow from here, what is the catalyst? Investment management is a great business. Firms that don’t need to sell, don’t sell. If transaction activity is up, does this mean that more firms need to sell? If pricing and deal terms are better, are the transactions available today really that much more attractive than those available a few years ago? And is the culture of consolidation that has emerged in the RIA community sustainable? The Go-Go 90s I’m no Marcel Proust, but these days take me back to the closing months of an earlier bull market that, in many ways, set up where we are today.1999 was a big year for me in what is now called “adulting.” I turned 30, became a CFA charterholder, and celebrated my fifth anniversary of employment (deployment) with the same firm where I, stubbornly, still work. I became an uncle for the first time, and I was about to become a father as well.My colleagues and I watched in disbelief as equity markets rose relentlessly in 1999, and I vividly remember saying that one day we would look back and talk about the “go-go 90s.” It was exciting, but it also made me uncomfortable. Warning signs were everywhere. Nosebleed multiples. Pets.com. Nickelback. The handwriting really hit the wall when I saw that the keynote address at the major business appraisal conference that October was to be given by the authors of a then hot but now forgotten book: Dow 36,000.Cap Rates and CouponsDow 36,000 is a clever fairy tale written by a journalist, James Glassman, and an economist, Kevin Hassett. The authors assert that the bull market of the 1990s was fueled, in part, by multiple expansion that would persist as investors came to understand that stocks were no riskier than treasuries. Stock and bond capitalization rates would eventually converge and - voila! - the Dow would quadruple from the levels at which it was then trading. The book was panned by grouchy economists like Paul Krugman and perma-bears like Robert Shiller, the CAPE-crusader who has since predicted at least nine out of the last two financial catastrophes. Dow 36,000 forecast a sharp rise in the DJIA within three to five years. It’s been two decades, and we still aren’t there – at least in the public equity markets. In the private markets, though, I’m starting to wonder if Glassman and Hassett’s fanciful outlook on valuation has finally been realized.Adjusted RealityWhen the bull market of the 1990s abruptly ended in 2000, one casualty was an energy trading firm with very empathetic accountants. The death of Enron, and the subsequent murder of its auditor, Arthur Andersen, set a regulatory buildup into motion which made it generally disadvantageous to be a public company. 20 years later, the number of U.S. public companies has been nearly halved, and out of the ashes of the public markets rose the phoenix that is private equity.Private equity can be as much about marketing as it is about markets: convince equity investors to lock up their money for a decade, then convince entrepreneurs to take the money. Cheap debt brings both parties to the table, goading risk-averse investors to chase returns, and teasing sellers with bigger payouts.Twenty years post-Enron, sponsors have raised the art of “heads I win, tails I win more” to a science. A smorgasbord of cheap debt has enabled financial intermediaries to routinely outbid strategic buyers for three years now. Hockey-stick projections have been supplanted by higher order land-grab economics: the first idea to gain monopoly status wins. Banks compete to lend to sponsors buying asset-light businesses based on EBITDA “addbacks.” LPs look the other way as reality-check IPO exits have been replaced by mark-to-model fund-to-fund transactions. And the SEC is talking about relaxing the requirements to be considered an Accredited Investor. What could possibly go wrong?Barbarians at the Gate 2 – Electric BoogalooThe distorted reality of the sponsor community is having an impact on the RIA space as well.The null hypothesis of the RIA community is that investment management is a relationship business that cannot be scaled. What we are witnessing today is big money trying to disprove that power rests within the advisor/client relationship through ensemble practices, roll-ups, robo-advisors, etc.The trouble is the current PE model of raising billions to create a monopoly around some lifestyle essential doesn’t work in investment management. Investment management is fragmented for a reason. It is an owner-operator business model. It is a lifestyle business.Further, what is there to buy? If RIAs only sell when they have to, are consolidators just collections of failed firms? Are they optimized for a bull market? Is it possible to stress-test these models for the next downturn? We’ve recently been passing around a ten-year-old article on consolidation pains in the RIA space that is required reading for anyone who wants to learn from the past, or at least not be blindsided by it.Is there a sustainable consolidation model? Joe Duran scored big with deliberate, strategic acquisitions of local RIAs into one, nationally branded firm – but the cost of being deliberate is time, something that sponsor-backed enterprises don’t have. The sale of United Capital to Goldman Sachs is viewed by many (not necessarily me) as capitulation, maybe an admission that competing for deals with overcapitalized sponsor-backed initiatives was pointless. Some dismiss the strategic importance of the deal because, for Goldman, the $750 million it paid for United wasn’t much money. That may be true, but Goldman doesn’t do many deals, and didn’t have to do this one.The brains behind the United Capital acquisition model, Matt Brinker, is now at Merchant Investment Management. Merchant has more of a co-invest mindset, and permanent capital, which says a lot about what the brains of the industry think is a successful consolidation strategy. The co-invest model, in which a financial partner shares with management in equity ownership on a control or, usually, a minority interest basis, seems to have the most traction. We think that approach can work, so long as returns to equity are clearly delineated from returns to labor.We may have already reached a tipping point. Deal volume was up last year, but deal value was down. The pace of transaction activity established early in 2019 didn’t sustain itself in the fourth quarter – usually a big one. The most visible acquirer in the RIA community, Focus Financial, was called out last summer for becoming over-leveraged. Focus management disputed this, but since then their acquisition announcements have been few.…like it’s 1999The song that Prince recorded about 1999 isn’t about the good times; it’s a song about the end-times. As 1999 drew to a close, people weren’t as concerned about the Mayan calendar or Nostradamus as they were about the disastrous consequences of global IT systems locking up because of bad date programming – a fake crisis brilliantly marketed by the IT consulting community to sell their services. The only real crisis was a missed opportunity to have a good time.My wife and I went out on New Year’s Eve 1999 to a very underattended extravaganza. 80% of the invited guests stayed home, afraid of what I don’t know. Instead of the big blowout that most of us expected in the years leading up to the new millennium, the reality was that partying in 1999 meant withdrawing into a quiet paranoia. If you cringe every time someone talks about selling a company for a big multiple of adjusted EBITDA, you get the idea.

Quality Of Earnings Study: The “Combine” to Help Harvest Top FinTech Acquisition Targets

As we find ourselves at the end of the decade, many pundits are considering what sector will be most heavily influenced by the disruptive impact of technology in the 2020s. Financial services and the potential impact of FinTech is often top of mind in those discussions. As I consider the potential impact of FinTech in the coming decade, I am reminded of the Mark Twain quote that “History doesn’t repeat itself but it often rhymes.”A historical example of technological progress that comes to mind for me is the combine, a machine designed to efficiently harvest a variety of grain crops. The combine derived its name from being able to combine a number of steps in the harvesting process. Combines were one of the most economically important innovations as they saved a tremendous amount of time and significantly reduced the amount of the population that was engaged in agriculture while still allowing a growing population to be fed adequately. For perspective, the impact on American society from the combine’s invention was tremendous as roughly half of the U.S. population was involved in agriculture in the 1850s and today that number stands at less than 1%.As I ponder the parallels between the combine’s historical impact and FinTech’s potential, I consider that our now service based economy is dependent upon financial services, and FinTech offers the potential to radically change the landscape. From my perspective, the coming “combine” for financial services will be not from one source or solution, but from a wide range of FinTech companies and traditional financial institutions that are enhancing efficiency and lowering costs across a wide range of financial services (payments, lending, deposit gathering, wealth management, and insurance). While this can be viewed as a negative by some traditional incumbents in the space, it may be a saving grace as we start the decade with the lingering effects of a prolonged historically low and difficult interest rate environment, and many traditional players are still laden with their margin dependent revenue streams and higher cost, inefficient legacy systems. Similar to the farmers adopting higher tech planting and harvesting methods through innovations like the combine, traditional incumbents like bankers, RIAs, and insurance companies will have to determine how to selectively build, partner, or acquire FinTech talent and companies to enhance their profitability and efficiency. Private equity and venture capital investors will also continue to be attracted to the FinTech sector given its potential.As the years in the 2020s march on, FinTech acquirers and traditional incumbents face a daunting task to evaluate the FinTech sector. Reports vary but generally indicate that over 10,000 FinTechs have sprouted up across the globe in the last decade and separating the highly valued, high potential business models (i.e, the wheat) from the lower valued, low potential ones (i.e., the chaff) will be challenging. Factor in the complicated nature of the regulatory/compliance overlay and investors, acquirers, and traditional incumbents face the daunting task of analyzing the FinTech sector and the companies within it.As a solution to this potential problem, the efficient operations and historical lessons learned in the agricultural sector from the combine may again provide insights for buyers of FinTech companies to learn from. For example, the major professional sports leagues in the U.S. all have events called combines where they put prospective players through drills and tests to more accurately assess their potential. In these situations, the team is ultimately the buyer or investor and the player is the seller. Pro scouts are most interested in trying to project how that player might perform in the future for their team. While a player may have strong statistics in college, this may not translate to their future performance at the next level so it’s important to dig deeper and analyze more thoroughly. For the casual fan and the players themselves, it can be frustrating to see a productive college player go undrafted while less productive players go highly drafted because of their stronger performance at the combine.While not quite as highly covered by the fans and media, a similar due diligence and analysis process should take place when acquirers examine a FinTech acquisition target. This due diligence process can be particularly important in a sector like FinTech where the historical financial statements may provide little insight into future growth and earnings potential for the underlying company. One way that acquirers are able to better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE). In this article, we give a general overview of what a QoE is as well as some important factors to consider.What is a Quality of Earnings Study? A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer in order to assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors. Ongoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long term growth can be expected. This estimate of earning power typically considers trying to assess the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-back; (2) Non-recurring items; (3) Pro-forma adjustments/synergiesCustomer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysisBusiness and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring These areas are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis For high growth technology companies where the analysis and valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the some of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers perception for the company and its products. This article discusses a number of considerations that buyers may want to assess when performing due diligence on a potential FinTech target. While the ultimate goal is to derive a sound analysis of the target’s earning power and potential, there can be a number of different avenues to focus on, and the QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers. Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers. Leveraging our valuation and advisory experience, our quality of earnings analyses identify and focus on the cash flow, growth, and risk factors that impact value. Collaborating with clients, our senior staff identifies the most important areas for analysis, allowing us to provide cost-effective support and deliver qualified, objective, and supportable findings. Our goal is to understand the drivers of historical performance, unit economics of the target, and the key risk and growth factors supporting future expectations. Our methods and experience provide our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows. Our methodologies and procedures are standard practices executed by some of the most experienced analysts in the FinTech industry. Our desire is to provide clients with timely and actionable information to assist in capital budgeting decisions. Combined with our industry expertise, risk assessment, and balanced return focus, our due diligence and deal advisory services are uniquely positioned to provide focused and valued information on potential targets. Originally published in Mercer Capital's Value Focus: FinTech Industry Newsletter, Year-End 2019.

Coming Soon: Mercer Capital’s 2019 Energy Purchase Price Allocation Study

We at Mercer Capital love movies. One fun aspect of a movie is the anticipation for new releases that comes from watching movie trailers, which inform and tease simultaneously. If done well, they can build anticipation for the show to come. While not quite a movie trailer, we wanted to introduce you to a new study from our energy team that we are excited about: Mercer Capital’s 2019 Energy Purchase Price Allocation Study.This study is unlike any other in terms of energy industry specificity and depth.Valuation, by nature, is an inherently forward-looking exercise. However, as we are still unable to see the future, history remains the window through which we look to gauge it. As we plunge forward into a new year and a new decade, we take this opportunity to look back at the energy sector through the lens of transactions and GAAP financial reporting. This study researches and observes publicly available purchase price allocation data for four sub-sectors of the energy industry: (i) exploration and production; (ii) midstream; (iii) oilfield services; and (iv) refining. We are excited about this study because we think you’ll find it useful, informative, and helpful. We are also excited because our study is unlike any other in terms of energy industry specificity and depth.Mercer Capital’s upcoming 2019 Energy Purchase Price Allocation Study provides a detailed analysis and overview of valuation and accounting trends in these subsectors of the energy space. This study enables key users and preparers of financial statements to better understand the asset mix, valuation methods, and useful life trends in the energy space as they pertain to business combinations under ASC 805 and GAAP fair value standards under ASC 820. We utilized transactions that closed and reported their purchase allocation data in calendar year 2018.This study is a useful tool for management teams, investors, auditors, and even insurance underwriters as market participants grapple with ever-increasing market complexity. This study provides data and analytics for readers seeking to understand undergirding economics and deal rationale for individual transactions. The study also assists in risk assessment and underwriting of assets involved in these sectors. Further, it helps readers to better comprehend financial statement impacts of business combinations. Intangible assets comprised approximately 84% of the S&P 500s market value in 2018, according to a Ponemon Institute study. Other studies suggest that the energy sector’s concentration of intangible assets approximates less than half of that. Averages from year’s study across a total sample of 33 transactions bracket those estimates and they vary by sub-sector: When we prepared this analysis, we came across a few noteworthy items: Exploration and production transactions were primarily allocated to reserves, and particularly more proved reserves than unproved reserves. Only one transaction recorded goodwill.Oilfield services transactions had the most diverse set of allocations to intangibles.Midstream transactions (gathering/disposal, processing, compression and terminals) had the highest concentration within the sector groups of customer-related intangible assets as a percentage of purchase consideration.Useful life reporting varied, but oilfield services transactions tended to have longer remaining lives (10 years or longer) ascribed to them. There is a lot to learn from this study as it illuminates some key industry aspects which we will be discussing and referencing in future posts. In the meantime, we hope the upcoming study will come to serve as a valuable reference. Get your popcorn ready, you won’t want to miss the premiere.

RIA Consolidators Drive Record Deal Activity in 2019

Asset and Wealth Manager M&A Continues Decade-Long Upward Trend

Asset and wealth manager M&A continued at a rapid pace during the fourth quarter of 2019, rounding out a record year by many metrics. Total deal count in 2019 rose 6% over 2018, reaching the highest level seen over the last decade. While reported deal volume declined by 50% in 2019, this metric can be a less reliable indicator of transaction activity given the lack of disclosed deal terms and the influence of large transactions (the Oppenheimer/Invesco deal accounted for about a quarter of 2018 reported deal volume, for example).The rise of the RIA consolidator model continues to be a theme for the wealth management sector. Wealth management firms saw a significant uptick in consolidation activity during 2019, which was attributable in large part to strategic consolidators. According to Fidelity’s December 2019 Wealth Management M&A Transaction Report, there were 139 wealth management transactions in 2019 (43% more than 2018) representing $780 billion in assets (38% more than 2018). Some of the more active consolidators included Focus Financial, Mercer Advisors, Wealth Enhancement Group, HighTower Advisors, and Dynasty Financial Partners—each of whom acquired multiple RIAs during 2019.RIA consolidators now account for about half of wealth management acquisition activity—and that percentage has been increasing.RIA consolidators now account for about half of wealth management acquisition activity—and that percentage has been increasing. These consolidators are, in general, well-funded (often by PE backers) and have a mandate from their investors to grow rapidly via acquisitions. They’re also not shy about knocking on doors to source deals, and given the demographics of the wealth management industry, their pitch for an exit plan often finds a receptive audience.Sub-acquisitions by consolidator-owned RIAs are a further driver of M&A activity for the sector. These acquisitions are typically much smaller and are facilitated by the balance sheet and M&A experience of the consolidators. For some RIAs acquired by consolidators, the prospect of using buyer resources to facilitate their own M&A may be a key motivation for joining the consolidator in the first place.There have also been several significant transactions of the consolidators themselves, which illustrates the broad investor interest in the consolidator model. One of the largest deals of 2019 was Goldman Sachs’s bid to enter the mass-affluent wealth management market through its $750 million acquisition of RIA consolidator United Capital Partners. Also during 2019, Mercer Advisors’ PE backers sold a significant interest to Oak Hill Capital Partners.Consolidation Rationales Building scale to enhance margins and improve competitive positioning are typical catalysts for consolidation, especially on the asset management side. One way to stem the tide of fee pressure and asset outflows is to cut costs through synergies to preserve profitability as revenue skids. The lack of internal succession planning is another driver as founding partners look to outside buyers to liquidate their holdings.Consolidating RIAs, which are typically something close to “owner-operated” businesses, is no easy task. The risks include cultural incompatibility, lack of management incentive, and size-impeding alpha generation. Many RIA consolidators structure deals to mitigate these problems by providing management with a continued interest in the economics of the acquired firm while allowing it to retain its own branding and culture. Other acquirers take a more involved approach, unifying branding and presenting a homogeneous front to clients in an approach that may offer more synergies, but may carry more risks as well.M&A OutlookThe record transaction activity in 2019 marks a decade-long run of steadily increasing consolidation activity in the sector. In 2020, we expect the trend to continue as many of the forces that shaped the industry over the last decade remain in place. Consolidation pressures in the industry are largely the result of secular trends. On the revenue side, realized fees continue to face pressure as funds flow from active to passive and clients become increasingly fee conscious. On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs. The continuation of these trends will pressure RIAs to seek scale, which will, in turn, drive further M&A activity. With over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies. Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth and margin compression. An aging ownership base is another impetus. The performance of the broader market will also be a key consideration for both buyers and sellers in 2020.

Wealth Management: Then and Now

How the Wealth Management Industry has Transformed Over the Last Decade

As we enter the new decade, rather than taking time for self-reflection, we prefer to take a step back and reflect on the transformation of the wealth management industry over the last decade.According to the Investment Advisor Association’s 2010 publication, SEC registered Investment Advisors reported $38.6 trillion in assets under management that year. Today, that number has more than doubled to $83.7 million. The number of SEC registered investment advisors, however, has only increased by 12% (11,643 in 2010 and 12,993 today). This means that the average advisor is managing more money today than they were ten years ago, as shown in the graph below.In 2010, advisors reportedly served approximately 30 million clients compared to 43 million today, suggesting that the increase in assets managed by each advisor is a result of having both more and larger clients.These statistics suggest it’s been smooth sailing for wealth managers. However, the investment management industry has changed radically over the last ten years, and wealth managers have been forced to adapt in order to maintain their client base and remain profitable. While these changes have not been easy, they have transformed the industry into one more focused on its clients’ needs and better regulated to ensure the safety of its clients’ assets.BackdropThe popularity of passive funds increased in 2009 when the current bull market began. In 2010, about 30% of U.S. assets were held in passively managed funds; last year, we crossed the 50% mark. While active versus passive may still be an intellectual debate, there’s no debate that trillions of dollars are managed passively today at much lower fees than they were a decade ago. The chart below demonstrates the decline in publicly traded investment managers’ effective fees over the last ten years.Wealth managers, however, have largely side-stepped fee pressure so far, and we don’t hear many instances of wealth management firms bending their stated pricing schedules because of client pushback. However, to justify higher fees in a low fee environment, wealth managers have had to differentiate themselves by providing more specialized solutions for their clients. Ten years ago, Westwood Holdings, a publicly-traded wealth management firm, described themselves as follows on their website:Westwood is built upon one investment philosophy of controlling overall portfolio risk while providing superior, risk-adjusted returns for our clients.Today Westwood’s website touts:At Westwood, we will champion your values and help make your intentions a reality.Wealth managers have changed their marketing strategy to highlight their more tailored investment solutions (with the underlying message that specialized services are worth the higher fees). But their ability to maintain their fee schedules will likely depend on their capacity to continue servicing clients’ evolving needs while connecting with their next generation.The trade-off with more specialized investment management is the cost. Providing tailored investment solutions, takes more time, i.e. more human capital. One area where the asset management model beats wealth management is scalability. You can build a bigger wealth management firm, but it usually requires a corresponding increase in advisors and planners. Additionally, as compliance and technology costs have increased over the last decade, wealth managers have had to pay closer attention to their expense base then they had to ten years ago.At the same time, many principals of wealth management firms reached retirement age over the last decade, often with no plan in place to transition their business. Succession planning has been an area of increasing focus in the RIA industry, particularly given what many are calling a looming succession crisis. In Schwab’s 2019 benchmarking study, which surveyed 1,300 RIAs, a full 92% of respondents indicated that they were considering internal succession, but only 38% of firms have a documented path to partnership. The options for succession planning for aging principals have exploded over the last decade. Debt financing providers have bettered the terms for RIAs, private equity firms are giving more attention to the industry, and M&A opportunities have increased as RIAs try to achieve scale.Most notably, however, is the increase of consolidators in the space. RIA consolidators have seized the opportunity to address both the needs of retiring shareholders and continuing principals, by offering liquidity for founders as well as back-office infrastructure. Consolidators can provide selling partners with substantial liquidity at close, an ongoing interest in the economics of the firm, and a mechanism to transfer the sellers’ continued interest to the next generation of management. Additionally, they can offer back office services such as IT, compliance, and human resources which allows RIAs to preserve their margins despite the cost of hiring more advisors.2020 VisionLooking forward, wealth managers will have to continue streamlining back office processes so that they can prioritize spending on compensation. Investments in technology and compliance will continue to require additional resources. Wealth managers must make conscious decisions about where they will find cost saving efficiencies without sacrificing superior service for their clients.Going forward, more and more RIAs will have to evaluate offers from consolidators and decide whether this kind of partnership right for them. Planning ahead for the eventual transition of your business will set you up with more options for retirement and a better understanding of where you are willing to make concessions.

Q4 2019 Global Macro Review

U.S. Production Hits Milestones Amid Continued Global Political Tensions

Brent crude prices began the quarter around $59 per barrel and have steadily risen to around $68 to close out 2019. WTI pricing has risen at a similar pace although it continues to trail Brent pricing by about $7 per barrel. Natural gas, however, has been trending in the opposite direction as prices have steadily declined since the end of October. In this post, we will examine the macroeconomic factors that have affected prices in the fourth quarter.Global SupplyOPEC conducted its 177th meeting on December 5th to take note of oil market developments since its last meeting in July and to review the oil market outlook for 2020. Press reports leading up to the meeting indicated that OPEC would extend the existing supply cuts, helping support crude oil prices. Ultimately, the group went a step further, deepening production cuts by 0.5 million b/d. However, the cuts were not extended and only run through the end of March 2020. According to the EIA’s latest Short-Term Energy Outlook (“STEO”), OPEC production is expected to fall in 2020. This is largely related to production restraint from most OPEC members amid concerns of rising oil inventories, continuing sanctions on Iran, and ongoing declines in Venezuela’s crude oil production. EIA forecasts that increased non-OPEC production will more than offset those declines and that global liquid fuels supply will rise by 1.5 million b/d in 2020.International Maritime Organization 2020Beginning on January 1, 2020, the International Maritime Organization (IMO) is set to enact the Annex VI of the International Convention for the Prevention of Pollution from Ships (MARPOL Convention), which lowers the maximum sulfur content of marine fuel oil used in ocean-going vessels from 3.5% to 0.5%. The implementation of MARPOL will see the marine fuels landscape change significantly as over 95% of the current market will be displaced. The EIA demonstrates the recent shifts in share of OECD Europe oil imports. These trends could continue in 2020 based on the IMO 2020 regulations. The EIA expects U.S. crude oil production to provide approximately two-thirds of total global liquids growth next year. It is also important to note that U.S. crude oil tends to be a light, sweet grade, which will likely see an increase in global demand due to the implementation of the IMO 2020 regulations, further tilting market share. U.S. Production Hits All-Time High in Q4In September 2019, the U.S. became a net petroleum exporter, marking the first month ever since monthly records began in 1973. To be exact, the U.S. exported 89,000 b/d more crude oil and petroleum products than it imported in the month of September. Increasing U.S. crude oil production has resulted in a decrease in U.S. crude oil imports as well as the number of import sources. Despite the reversal in September, the U.S. remains a net importer of crude oil, however, and 60% of imports come from Canada and Mexico.The EIA expects U.S. crude oil production to average 13.2 million b/d in 2020, a slight increase from the 2019 level. According to the STEO, slowing crude oil production growth results from a decline in drilling rigs over the past year, which is slated to continue into 2020. Although the rig count is forecast to decline, the EIA forecasts an increase in production as rig efficiency and well-level productivity rises.U.S. – China Trade Deal Phase OneIn early December, the U.S. and China agreed on the first phase of a trade deal. The Phase One agreement means the U.S. is suspending tariffs that were planned on $160 billion in Chinese imports. In addition, the U.S. halved the September tariffs from 15% to 7.5%. As a part of the Phase One deal, President Trump said Beijing has agreed “to many structural changes and massive purchases of Agricultural Product, Energy, and Manufactured Goods, plus much more.” With regard to the trade deficit, U.S. officials signaled that China agreed to increase purchases of U.S. products and services by at least $200 billion over the next two years. Phase One also addressed specific concerns subject to China’s intellectual property practices. President Trump explained that the U.S. and China would begin negotiations over the second phase of the trade deal rather quickly. On the other side, China confirmed that a deal was reached and that the deal will be signed on January 15, 2020.Interest RatesBy the end of October, the Fed had made three rate cuts in 2019 due in part to trade policy uncertainty. In early November, following the last round of cuts, the Fed decided to hold rates steady. After their meeting in early December, the Fed kept the federal funds rate between 1.5% and 1.75%. The Federal Reserve remained optimistic about economic stability but emphasized that their actions will depend on future events. Long-term interest rates began to rise over the quarter from the low of 1.47% for the 10-year Treasury in September. Looking ahead to early 2020, rates are expected to remain flat with quiet Fed activity.Middle East TensionsAn airstrike at the Baghdad Airport on January 3 killed top Iranian military commander, Major-General Qassem Soleimani. Per the Department of Defense, the airstrike was conducted by the U.S. military at the direction of the President. WTI and Brent prices spiked nearly 4% on the breaking of the news. Although further escalations are uncertain, moderate to low-level incursions in the first quarter of 2020 may be possible. Analysts believe that Iran may resume targeting and harassment of oil shipping vessels in the Strait of Hormuz through which almost 25% of global oil consumption passes. Iran sits at a natural choke point on the Strait, and has threatened to close Hormuz in times of heightened tension. Disruption of this level of shipping could have large consequences on global oil demand and spikes in pricing if the U.S. and Iran continue to escalate military responses.ConclusionThe next OPEC meeting is scheduled to occur on March 5, 2020, so decisions on increased, steady, or reduced production cuts on the supply side will not be made until the end of the first quarter. Middle East tensions will be a highlight going into the 178th meeting if the Iran and U.S. conflict escalates. Increased disruption could significantly affect global oil demand and price. In the meantime, strong U.S. production is expected to continue in early 2020, and it is unclear whether the U.S. – China Phase One Trade Deal will lead to continued negotiations and cooperation between the two global players.At Mercer Capital, we stay current with our analysis of the oil and gas industry both on a region-by-region basis within the U.S. as well as around the globe. This is crucial in a global commodity environment where supply, demand, and geopolitical factors have varying impacts on prices. We have assisted clients with diverse valuation needs in the upstream oil and gas industry in North America and internationally. Contact a Mercer Capital professional to discuss your needs in confidence.

All Classes of Investment Management Firms Outperformed the Market in Q4

2019 Was Also a Bull Market for the RIA Industry

As good as the fourth quarter was for the S&P, it was even better for the RIA industry. All classes of investment management firms bested the market, which was up 10% for the quarter. Continued gains in the equity markets have allowed these firms to more than recover from last year’s correction, and many of these businesses are now trading at or near all-time highs. Despite these gains, the asset management industry is facing numerous headwinds, chief among them being the ongoing pressure for lower fees. Alt managers, on the other hand, are perhaps more insulated from fee pressure due to the lack of passive alternatives to drive fees down. These headwinds have contributed to a decline in EBITDA multiples for traditional asset managers over the last few years despite the recent uptick in stock price performance. As shown below, EBITDA multiples for these businesses remain well below historical norms, although they have recovered from their low point in December of 2018. Expanding the performance chart over the last year reveals an upward trend in pricing for most classes of RIAs. Over this longer timeframe, alt managers are still the strongest category, although performance has been volatile. Other pure play managers have generally moved in lockstep with the broader market while the aggregators lagged with AMG and FOCS’s performance. The relative underperformance of the aggregator and multi-boutique index may come as a surprise given all the press about consolidation in the industry and headline deals for privately held aggregators. Over the last year, there have been two significant deals for privately-held wealth management aggregators: United Capital was bought by Goldman Sachs for $750 million, and Mercer Advisors’ PE backers sold a significant interest to a new PE firm, Oak Hill Capital Management. Both the United Capital and Mercer Advisors deals reportedly occurred at high-teens multiples of adjusted EBITDA. Implications for Your RIAWith EBITDA multiples for publicly-traded asset managers still well below historical norms, it appears the public markets are pricing in many of the headwinds the industry faces. It is reasonable to assume that the same trend will have some impact on the pricing of privately-held asset managers as well.But the public markets are just one reference point that informs the valuation of privately-held RIAs, and developments in the public markets may not directly translate to privately-held RIAs. Depending on the growth and risk prospects of a particular closely-held RIA relative to publicly-traded asset and wealth managers, the privately-held RIA can warrant a much higher, or much lower, multiple.Improving OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market. Their product is, after all, the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs appears to have improved since the significant market drop in December 2018. Since then, industry multiples have rebounded somewhat, and the broader market has recovered its losses and then some—which should have a positive impact on future RIA revenues and earnings.More attractive valuations could entice more M&A, coming off the heels of a record year in asset manager deal making. We’ll keep an eye on all of it during what will likely be a very interesting year for RIA valuations.

Appalachian Gas Valuations: The Bad, The Ugly, (And The Good)

U.S. dry gas consumption will finish at an all-time high of 84.3 Bcf per day in 2019 and that figure will continue to grow into 2020. However, if gas investors are celebrating, no one knows where the party is. In reality, the investing atmosphere is gloomy with commodity prices consistently below $3.00 per MMcf on the NYMEX and even lower in some locations. The valuation environment is dispiriting for many investors in Appalachia. It doesn’t take long to get buried in a cavalcade of adverse indicators, corporate overhauls, depressed EBITDA multiples and state sized swaths of uneconomic acreage. Data suggests some producers could spend the foreseeable future languishing in shareholder jail or bankruptcy court.How can economics get this jilted in arguably the largest gas field in the world? Perhaps it’s better to wonder why, at this point, would anyone even believe the dry gas investment premise at all? These are fair questions that investors and the broader stock market are asking themselves. Interestingly, there may be fair answers to them that, when analyzed closely, might chart a tough, disciplined course and perhaps eventually even position the Marcellus and Utica to be a globally superior gas field.The BadThere’s no question that valuations are floundering at relative historic lows. Mercer Capital’s group of public Appalachian gas producers has dropped approximately 50% since last year. It’s the largest collective decline of any other publicly traded U.S. basin group. Of the publicly traded Appalachian-based gas producers, some are trading at the bottom of EBITDA multiple ranges, and nearly all trade at the bottom from a price per flowing barrel metric.[caption id="attachment_29435" align="alignnone" width="750"] Mercer Capital's Selected Public Company Information Source: Bloomberg[/caption] Transaction activity has been quiet as equity markets are closed and management teams are concerned with stewardship of their existing asset base. Deals that did close were production-oriented; some transacting at higher expected rates of return compared to historical norms (15% or even 20% rates of return). It’s notable to point out that gas prices haven’t fallen nearly by the magnitude that stock prices have. So, what is happening to create such an investor flight? Consider recent developments. Corporate WranglingTrials are front and center for independent producers. They have been pronounced at Gulfport and EQT, where management and shareholders engaged in some tumultuous struggles this year. Gulfport had board turnover and suspended a share repurchase program that it had initiated only earlier this year (in order to switch to a debt buyback program at a discount). At EQT, corporate governance has also been volatile. Toby and Derek Rice, whose eponymous company merged with EQT in November 2017, waged a successful proxy battle this year, proposing a business plan in September which included a 23% reduction in employees alongside a logistical and strategic overhaul of its drilling plan.Throwing In A Major TowelTrouble in Appalachia is not confined to the independents. Chevron recently announced a $10 - $11 billion write-down. More than half of its impairment is attributable to its Marcellus/Utica assets. Chevron’s large position and presence in the region is now mulling an exit from the play.Cash Flow ChallengesDue in part to the lack of available capital, early projections show capex reductions of 23% in 2020.[caption id="attachment_29436" align="alignnone" width="640"] 2020 Drop in CAPEX (millions) Source: Shale Experts[/caption] This strategy cuts both ways. It can conserve cash in the short-term to allocate towards debt repayment or share buybacks, but it can also hamstring growth and production in future years, compounding problems with languishing prices. This is top of mind for many producers as they grapple with how to keep investors happy and stay out of bankruptcy court. Some producers are better positioned than others in this aspect, particularly Cabot. The chart below shows the relationship between the total amount of debt principal due over the next five years as compared to trailing levered free cash flow. It shows that some companies have some real challenges in that area. [caption id="attachment_29437" align="alignnone" width="640"] Cash Flow vs. 5-Year Debt Repayment Source: Capital IQ[/caption] Strangulation Via RegulationThe Marcellus and Utica Shale plays possess one of the best unused potential advantages in the natural gas world – proximity to the Northeast United States. One of the biggest potential consumers of the vast gas reserves is neighbor to the Marcellus, yet so little of it makes its way to its natural customer base. Why is this? One word: regulation. For example, the Constitution pipeline, approved by FERC in 2014, has been in regulatory purgatory since that time in the state of New York. Fracking is banned in New York and the regional political climate is frigid towards the natural gas industry, to say the least. In the meantime, New York-area utilities are struggling with gas pressure shortfalls for new customers. Also, in a twist of irony, increasing appetite for natural gas in Massachusetts is being met, at least partially, by Russian (yes, Russian) imports. Thus, Appalachia’s oversupply of gas continues to search for markets while the Northeast gets it from elsewhere. When a Russian LNG tanker pulls into Boston Harbor in the winter…that’s a bad sign.The UglyThe near-term doesn’t look any prettier when examining broader economic and commodity trends. In fact, some of it is downright ugly. Supply exceeds demand, futures prices remain anemic and huge areas of quality drilling acreage currently have minimal market value ascribed to them. These factors are putting a boot to the throat of producers and keeping valuations from even getting off the ground.Get Production For Nothing And Reserves For FreeAs we consider the supply and demand imbalance right now, we can change the refrain in one of Dire Straits classic songs to “Get Production for Nothing and Reserves for Free.” It can hardly be understated how much the reserves of dry gas in the U.S. have been turned on its head in the past decade. Flippant investors, to the chagrin of some, now view undrilled reserves as a dime a dozen. This was unheard of not long ago. This points out the most fundamental economic driver to these low valuations – oversupply. This hamstrings acreage valuations. According to the 2018 Year End Proved Reserve report which was released in early December, Appalachian dry gas has nearly doubled since just 2015. Even production gain metrics, which surged 48% over this same period, sit in the vapor trail of reserve growth. There is simply too much of a good thing, and it has cheapened gas for everyone else in the Marcellus’ short reach (especially the consumer).[caption id="attachment_29438" align="alignnone" width="640"] Appalachia (PA, WV, OH) Source: EIA[/caption] Gas Price LimboEven years out, NYMEX gas futures look so flat, it can hardly be called a curve. Like a frantic swimmer getting pulled by an undertow, producers struggle to breathe in this environment. To make matters worse, Appalachia’s regional market constraints make its supply and demand even more imbalanced, leading to consistently wide pricing differentials. What little midstream capacity does come online gets filled too fast to influence pricing power. This has been and remains an Achilles heel for Appalachia.[caption id="attachment_29439" align="alignnone" width="640"] Natural Gas Prices / Mcf Source: Bloomberg[/caption] Acreage Values Battling Irrelevancy At these prices, there are hundreds of thousands of Marcellus and Utica acres that are simply uneconomic. According to a recent analysis by Antero Resources, nearly half (45%) of the needed gas supply in the next four years is currently non-economic at strip prices below $2.48. While that price point doesn’t appear sustainable in the long run, it illustrates why values are so gaunt when it comes to acreage and undrilled reserves. Another way to look at this is to examine companies’ enterprise values as compared to the PV10 values of their proved reserves (including undeveloped reserves), a standardized industry metric. [caption id="attachment_29440" align="alignnone" width="640"] Current EV / PV10Source: Capital IQ[/caption] None of the companies even gets very close to a ratio of 1:1. Some companies are trading around production reserve values only. Either way one slices it, future drilling inventory does not appear to be particularly valuable in the market’s view at this juncture. When going through the laundry list of problems that the industry is facing, it can be difficult to see any upside, silver lining or diamonds in the rough. However, if one subscribes to rational market theory, then there are some things, hidden in plain sight, that could make an investor’s journey worth the long ride. The GoodIntrinsically, Appalachia remains one of the most strategically important gas plays in North America. Eventually, amid all the obstacles it faces, it has arguably the most potential of any shale gas field and could develop into one of the most profitable shale gas fields in the world for decades to come.Retrenching – Diet And Exercise PayOffThese challenges are certainly testing the mettle of Appalachian producers. Producers’ intense focus on cash flow has multiple long-term benefits. First, it strengthens balance sheets and makes bankruptcy a more remote concern. Second, the limitations on production growth set a course towards price correction. Third, if and when prices do drift upward, more and more acres become economic. Companies are optimistic about their future. It is notable that Appalachian shareholder returns are manifesting themselves mostly in the form of share buybacks as opposed to dividends. That demonstrates companies believe they are intrinsically undervalued. Remember, the geology and hydrocarbons are there, the question is how cheaply they can be produced. Possibly the most challenging gas environment has forced Appalachian producers to have among the lowest development and operating costs anywhere. Therefore, if producers can survive this, then they can survive and thrive almost anywhere. That’s good because in the future this gas will have places to go.Oversupply Doesn’t Mean Lack Of DemandOne constant positive for Appalachian producers is that the demand is strong and growing. Platts Analytics estimates that around 80 Tcf of new supply is needed in the U.S. through 2023. Appalachia is expected to supply 38% of that figure. Even with all of the associated gas produced in the Permian right now (which also has logistics issues), it’s not enough. Gas will flow into the Gulf Coast and Appalachia will help lead the way. Globally, natural gas is the only fossil fuel expected to grow in global demand all the way through 2035.Exports And The LNG Market – A Brass Ring Worth ChasingThe enduring upside for valuations in Appalachia is capitalizing on what’s already in motion: U.S. domination of the worldwide LNG market. It’s not there today, but it is on its way. Between 2017 and 2027, LNG export capacity in the U.S. will have grown tenfold from around 3 Bcf per day to approximately 34 Bcf per day. Price relief for producers could just be a tanker away. Wallowing at $2.50 per MMcf domestically is tough; selling LNG to end markets at up to $9.00 per MMcf is much easier. Global prices are expected to average around $7.00 per MMcf going forward. How does the U.S. fit in this global market? Well, worldwide LNG production growth is flagging, just in time for the U.S. to fill the gap.[caption id="attachment_29441" align="alignnone" width="640"] Natural Gas Trade Source: U.S. Energy Administration[/caption] The Chinese will need energy to engage in any trade wars and American LNG producers will likely supply it over the next 30 years. The U.S. will make up 67% of the growth in global LNG exports through 2024 and China will be the biggest buyer. Looking again at the Appalachian pricing chart overlaid with historical LNG export prices, the opportunity becomes clear. [caption id="attachment_29442" align="alignnone" width="640"] Natural Gas Prices / McfSource: Bloomberg[/caption] A drawback is that compared to the gas basins more proximate to the Gulf Coast, Appalachia has fewer LNG export options. The Elba Island LNG facility is operational, and Cove Point has some capacity, but this pales in comparison to Gulf Coast capacity. At the same time, there are other demand sources, such as Mexico, that will keep overall gas export demand high. Those factors should allow Marcellus and Utica producers more latitude to meet regional demand for east coast population centers. Even if pipeline constraints remain at a minimum, perhaps a tanker with U.S. gas pulls into Boston Harbor instead of a Russian one. Final ThoughtsOne potential wildcard is the possibility of a renewable energy breakthrough. There is certainly a strong sustained desire by many people for this option. However, economically, there are just no alternative sources that can fill the gap in time to meet domestic and international energy and electricity demand. The gap filler is natural gas, and the basin with long-term solutions is primed to be Appalachia. This is the intrinsic valuation premise keeping long-term investors on board.Originally appeared on Forbes.com.

The Best of 2019

Energy Valuation Insights' Top Blog Posts

As we plan for a new year and a new decade, we look back at 2019 to see what was popular with you – our readers. Below is a list of the top posts of 2019. Instead of a standard top 10 list, we’ve grouped the posts by topic (Transactions, Saltwater Disposal, Oilfield Services Companies, Royalty and Mineral Markets, and Basin-Specific posts). If you missed one or two posts during the year, now is the time to catch up on your reading.We look forward to 2020 and appreciate your interest in this blog. May you and your family enjoy a happy and prosperous year.TransactionsComstock's Acquisition of Covey Park: A Valuation Analysis of the Multibillion-Dollar Haynesville Deal (Posted 08/02): On July 16, 2019, Comstock Resources, Inc (NYSE: CRK) finalized its acquisition of Haynesville operator Covey Park Energy LLC. Announced on June 10, 2019, the companies entered into an agreement under which Comstock would acquire Covey Park in a cash and stock transaction valued at approximately $2.2 billion, including assumption of Covey Park’s outstanding debt and retirement of Covey Park’s existing preferred units (totaling approximately $1.1 billion). For the purposes of this post, we examine this deal from a few different vantage points and review the fair value of the various components that make up total deal value. We also look at how this transaction compares to industry valuation metrics and what kind of strategic advantages Comstock may have a result of the deal.Parsley's Acquisition of Jagged Peak Highlights Key Consolidation Trends (Posted 11/21): On October 14, 2019, Parsley (PE) announced that it was acquiring Jagged Peak (JAG) in an all-stock transaction valued at $2.27 billion. The market’s reaction to the announcement was generally negative, as Parsley closed down more than 10% on the date of the announcement. This appears to be driven, at least in part, by investors’ desire for Parsley to be acquired rather than be the acquirer.Brigham Minerals IPO Brings Spotlight to Oil & Gas Market (Posted 05/06):Mineral aggregators are leading the forefront in an underwhelming energy sector. Brigham Minerals (MNRL) is the latest mineral acquisition company to go public following a trend of other large mineral rights and royalty companies to IPO in recent years.Saltwater DisposalAn Overview of Salt Water Disposal (Posted 04/19):Over the last 12 years the oilfield waste water disposal industry has grown exponentially, both on an absolute basis, and by rank of its importance/size among the oilfield services. This growth has been largely driven by the increased volumes of waste water generated in the production of oil from shale plays. This post discusses the basics of salt water disposal which has become so important given the rise of hydraulic fracturing.An Overview of Saltwater Disposal | Part 2: Economics of the Industry (Posted 08/19): In this post, we look at the economics of the saltwater disposal industry and the trends that impact its economics. The outlook for the industry is quite favorable although the economics are, and will continue to be, in a state of flux as the industry grows and matures. Despite some potential detrimental market dynamics along the way, the overall direction points to strong benefits to investors as the business of saltwater disposal continues to evolve away from being a cost center for operators, to a cash flow generating third-party service provider to operators.Do Oil and Water Mix? The Biggest Energy IPO Of 2019 Might Answer That Question (Posted 09/19):The capital markets in the upstream sector are leaving companies and investors in the lurch right now. Saltwater disposal and integrated water logistics companies have attracted a higher proportion of the sparsely available capital flowing into the sector, highlighted by the largest energy IPO of this year: Rattler Midstream LP. The continuing austerity trend toward cash flow sustainability for shale oil companies has provided limited attractive options for investors. In the meantime, drilling activity (particularly in West Texas) continues to grow, and therefore efficiency and scale grow ever more important across the board for upstream companies to remain competitive. One of the challenges producers face is handling the enormous amounts of water that have become part and parcel to the Delaware and Midland Basins. This is where saltwater disposal enters the picture. (Originally appeared on Forbes.com)Oilfield Services CompaniesWhat Is an Oilfield Service Company? (Posted 05/24):In this post, we describe what an oilfield services company does and who its customers are, how oilfield services companies fit in the broader oil and gas industry and identify the key drivers of the oilfield services industry.How to Value an Oilfield Service Company (Posted 06/03):When valuing a business, it is critical to understand the subject company’s position in the market, its operations, and its financial condition. A thorough understanding of the oil and gas industry and the role of oilfield service companies is important in establishing a credible value for a business operating in the space. Our blog strives to strike a balance between current happenings in the oil and gas industry and the valuation impacts these events have on companies operating in the industry. After setting the scene for what an oilfield service company does and their role in the energy sector, this post gives a peek under the hood at considerations used in valuing an oilfield service company.How to Perform a Purchase Price Allocation for an Oilfield Services Company (Posted 10/25):When performing a purchase price allocation for an oilfield services company, careful attention must be given to both the relevant accounting rules and the specific nuances of the oil and gas industry. We address both in this post.Forecasting Future Operating Results for an Oilfield Services Company (Posted 06/10):In this post, we address the special considerations that must be given attention in the appraisal of oilfield services companies. The unpredictable cyclicality of the oilfield services industry requires careful consideration of many industry-wide and company-specific factors in developing a reasonable forecast of future operating results.Royalty & Mineral MarketsRoyalty MLP Is Delivering Yield Against Backdrop of Energy Sector Struggles (Posted 11/25):Right now, exploration and production companies and oilfield service providers are grappling with austerity measures that investors are demanding. Most other upstream areas are struggling too; however, publicly-traded royalty and mineral aggregators are performing relatively better than their operating counterparts. While equity prices have dropped by approximately 30% for producers (according to SPDR Oil and Gas ETF), six publicly-traded royalty aggregators outperformed the SPDR Index.Royalty and Mineral Value Proposition Highlights Otherwise Underperforming Energy Sector (05/17):The burgeoning mineral market is leading the way for an energy sector that has lagged in returns for several years now. The interest in the segment has been undergirded by the attractive cash returns coupled with fewer liability risks, operating risks, and expense burdens. In addition, royalty owners retain ownership rights to perpetuity. These characteristics of royalty and mineral plays have drawn investors in as compared to the market’s negative response to upstream management teams merely seeking to beef up the size of their reserve reports.Basin-SpecificPipeline Bottlenecks and Worthless Acreage: The Downsides Of World-Leading Oil Production (Posted 10/31):In this post, we discuss pipeline capacity and flagging prices for undeveloped acreage, specifically in the Bakken. (Originally appeared on Forbes.com)Valuations in The Permian: Gearing Up for the Long Haul or Running in Place? (Posted 07/12):When it comes to the oil patch, the word “growth” can be a vague term. It’s a word that can be masqueraded around to suit the perspective of whomever utters it. What does it mean in an industry whose principle resources are constantly in a state of decline? When it comes to the Permian Basin these days, growth applies to resources, drilling locations, and production. Unfortunately, the same can’t be said for profits, free cash flow or new IPOs. Don’t misunderstand, the Permian is the king of U.S. oil plays and by some measures could be taking the crown as the biggest oil field in the world. However, various economic forces are keeping profits and valuations in check. (Originally appeared on Forbes.com)2019 Eagle Ford Shale Economics: Challenging for Valuation Title Belt (Posted 04/30):Investors and boxing fans have some things in common. First, they both prefer champions. Second, there tends to be attention on heavyweights, when the best fighters may be in a different class. In the oil patch’s proverbial basin battle of economics and relative value, the Eagle Ford Shale is coming on strong. Granted, the Eagle Ford Shale may not reside in the same heavyweight class as the Permian Basin; however, from a pound for pound well economics standpoint, the Eagle Ford Shale is currently a formidable challenger to the Permian due to several advantages in key areas: breakeven prices, well costs, certain productivity metrics and proximity. These attributes put it among the most profitable shale basins in the U.S. Some well-known operators such as BP and Chesapeake have noticed and are putting big money behind this play. (Originally appeared on Forbes.com)Bryce Erickson Writing for Forbes.comIn case you’ve missed it, Bryce Erickson, leader of Mercer Capital’s Oil & Gas industry group, is a regular contributor to Forbes.com. He addresses industry developments, economic trends, and the impact on valuation for companies operating in the Permian, Eagle Ford, Bakken, and Marcellus & Utica regions, among others. Additionally, he covers these issues as they pertain to mineral rights and royalty interest owners.

2020 Outlook: Good Fundamentals, Moderate Valuations but Limited EPS Growth

Bank fundamentals, which are discussed in more detail below, did not change a lot between 2018 and 2019; however, bank stock prices and the broader market posted strong gains as shown in Table 1 following a short but intense bear market that bottomed on Christmas Eve 2018. Our expectation is that 2020 will not see much change in fundamentals either, while bank stocks will require multiples to expand to produce meaningful gains given our outlook for flattish earnings.Fed Drives the Market ReboundThe primary culprit for the 4Q18 plunge and subsequent 2019 rebound in equity prices was the Fed, which has a propensity to hike until something breaks according to a long standing market saw. A year-ago the Fed had implemented its ninth hike in short-term policy rates that it controls despite the vocal protests of the President and, more importantly, the credit markets as reflected in widening credit spreads and falling yields on Treasury bonds and forward LIBOR rates.One can debate how much weight the Fed places on equity markets, but it has always appeared to us that they pay close attention to credit market conditions. When the high yield bond and leverage loan markets shutdown in December 2018, the Fed was forced to pivot in January and back away from rate hikes after forecasting several for 2019 just a few months earlier. Eventually, the Fed was forced to reduce short rates three times and resume expansion of its balance sheet in the fourth quarter after halting the reduction (“quantitative tightening”) in mid-year.Markets lead fundamentals. Among industry groups bank stocks are “early cyclicals,” meaning they turn down before the broader economy does and tend to turn up before other sectors when recessions bottom. One take from the price action in banks is that the economy in 2020 will be good enough that credit costs will not rise dramatically. Otherwise, banks would not have staged as strong a rebound as occurred.Likewise, somewhat tighter spreads on B- and BB-rated high yield bonds relative to U.S. Treasuries (option adjusted spread, “OAS”) since the Fed eased is another data point that credit in 2020 will not see material weakening. The stable-to-tighter spreads in the high yield market today can be contrasted with 2007 when OAS began to widen sharply even after the Fed began to cut rates and the U.S. Treasury curve steepened as measured by the spread between the yield on the two-year and 10-year notes.Bank FundamentalsBank fundamentals are in good shape even though industry net income for the first three quarters of 2019 increased nominally to $181 billion from $178 billion in the comparable period in 2018. On a quarterly basis, third quarter earnings of $57 billion were below the prior ($63 billion) and year ago ($62 billion) quarters. Not surprisingly, earnings pressure emerged during the year as what had been expanding NIMs during 2017 and 2018 began to contract due the emergence of a flat-to-inverted yield curve, a reduction in 30/90-day LIBOR which serves as a base rate for many loans, and continuation of a highly competitive market for deposits. Also, loan growth slowed in 2019—especially for larger institutions.As shown in Table 2, core metrics such as asset quality and capital are in good shape, while profitability remains high. Our outlook for 2020 is for profitability to ease slightly due to incrementally higher credit costs and a lower full year NIM although stabilization seems likely during 2H20. Nonetheless, ROCE in the vicinity of 10- 11% and ROTCE of 13-14% for large community and regional banks seems a reasonable expectation.EPS growth will be lacking, however. Wall Street consensus EPS estimates project essentially no change for large community and regional banks, while super regional banks are projected to be slightly higher at 3%. Money center banks (BAC, C, GS, JPM, MS, and WFC) reflect about 6% EPS growth, which seems high to us even though the largest banks tend to be more active in repurchasing shares relative to smaller institutions where excess capital is allocated to acquisitions, too.The Fed—Presumably on HoldIn the December 2018 issue of Bank Watch we opined it was hard to envision the Fed continuing to raise short-term rates even though the Fed forecasted further hikes. We further cited the potential for rate cuts. Our reason for saying so was derived from the market rather than economists because intermediate- and long-term rates had decidedly broken an uptrend and were heading lower.As the calendar turns to 2020, the Fed has indicated no changes are likely for the time being. The market reflects a modest probability that one more cut will be forthcoming, but to do so in an election year probably would require long rates to fall enough to meaningfully invert the Treasury curve unlike the nominal inversion which occurred in mid-2019.As it relates to bank fundamentals, the impact on NIMs will depend upon individual bank balance sheet compositions. Broadly, however, a scenario of no rate hikes implies NIMs should stabilize in 2H20 as higher cost CDs and wholesale borrowings rollover at lower rates. Also, if the Fed continues to expand its balance sheet (presently it is doing so through only purchasing T-bills through support of the repo market) then assets may remain well bid. All else equal, stable to rising prices in the capital markets usually are supportive of credit quality within the banking system.Bank Valuations—Rebound from Year-End 2018 “Bargains”A synopsis of bank valuations is presented in Table 3 in which current valuations for the market cap indices are compared to year-end 2018 and year-end 2017 as well as multi-year medians based upon daily observations over the past 20 years. The table illustrates the important concept of reversion to the mean. Valuations were above average as of year-end 2017 due to policy changes that occurred with the November 2016 national elections that culminated with the enactment of corporate tax reform in late 2017. One year later valuations were “cheap” as a result of the then bear market that reflected concerns the Fed would hike the U.S. into a recession. Despite the rebound in prices and valuation multiples during 2019, bank stocks enter 2020 with moderate valuations provided the market (and us) have not miscalculated and earnings are poised to fall sharply. Money center and super-regional banks are trading for median multiples of about 10x and 11x consensus 2020 earnings. Regional and large community banks, which include many acquisitive banks, trade for respective median multiples of 12x and 13x. An important point is that valuation is not a catalyst to move a stock; rather, valuation provides a margin of safety (or lack thereof) and thereby can provide additional return over-time as a catalyst such as upward (or downward) earnings revisions can cause a multiple to expand or contract. Looking back to last year one might surmise the rebound in valuations reflects the market’s view that the Fed avoided hiking the U.S. into recession. Bank M&A—2020 Potentially a Great yearM&A activity has been robust with bank and thrift acquisitions since 2014 exceeding 4% of the industry charters at the beginning of each year. It appears once the final tally is made, upwards of 275 institutions will have been acquired in 2019, which would represent almost 5% of the industry. With only a handful of new charters granted since the financial crisis the industry is shrinking fast. As of Sept. 30, there were 5,256 U.S. banks and thrifts, down from about 18,000 in 1985.While activity was steady at a high level in 2019, the most notable development was market support for four merger-of-equals (“MOE”) in which the transaction value exceeded $1.0 billion. The largest transaction closed Dec. 9 when BB&T Corp. and SunTrust merged to form Truist Financial Corp. Others announced this year include tie-ups between TCF Financial Corp./Chemical Financial Corp., First Horizon National Corp./IBERIABANK Corp., and Texas Capital Bancshares Inc./Independent Bank Group Inc. Although not often pursued, we believe MOEs are a logical transaction that if well executed provide significant benefits to community bank shareholders.The national average price/tangible book multiple eased to 157% from 173% in 2018, while the median price/earnings (trailing 12 months as reported) declined to 16.8x from 25.4x (~21x adjusted for the impact of corporate tax reform). The reduction was not surprising given low public market valuations that existed at the beginning of 2019 because acquisition multiples track public market multiples with a lag.We see 2020 shaping up as a potentially great year for bank M&A. The backdrop is an M&A trifecta: buyer and seller earnings will likely be flattish primarily due to sluggish loan growth and lower NIMs; asset quality is stable; and stock prices are higher, meaning buyers can offer better prices (but less value) to would-be sellers. Also, the capital markets remain wide open for banks to issue subordinated debt and preferred equity at very low rates to fund cash consideration not covered by existing excess capital.Summing it UpThis year appears to be the opposite of late 2018 in which a strong market for bank stocks is predicting continuation of solid fundamentals and possibly better than expected earnings. Nonetheless, an environment in which earnings growth is expected to be modest at best likely will result in limited gains in bank stocks given the rebound in valuations that occurred in 2019.Originally published in Bank Watch, December 2019.

First Quarter 2020 | Segment Focus: Residential Construction

Construction has been designated as an “essential” sector throughout most of the country, allowing construction companies to continue to work in the face of a multitude of disruptions. A lower housing supply entering the pandemic, low mortgage rates, and government program support such as the CARES Act have helped support the housing market in the initial phase of the crisis.

E&P First Quarter 2020

Eagle Ford

Eagle Ford // In the first quarter of 2020 oil benchmarks ended arguably their worst quarter in history with a thud.

Transportation & Logistics Newsletter

First Quarter 2020

‘Twas the Blog Before Christmas…

2019 Mercer Capital RIA Holiday Quiz

'Twas the blog before Christmas and throughout our staff Analysts were separating wheat from the chaffAs midtown Manhattan glistened with snow We sighed as our Bloombergs warmed us with their glowHedge-funders grinned, computing their carry While raising a glass to the 2 & 20 fairyWith the yield curve corrected, and cap rates back down It’s hard to find a real estate guy with a frownLong-onlys dreamt active would once again pay Before President Warren comes to tax it awayWealth managers gathered at bars with their peers All hoping a Santa-rally soon would appearBut whatever your alpha, this is still a great biz So celebrate the season with our RIA quiz!If you're having trouble viewing the survey below, click here.(function(t,e,s,n){var o,a,c;t.SMCX=t.SMCX||[],e.getElementById(n)||(o=e.getElementsByTagName(s),a=o[o.length-1],c=e.createElement(s),c.type="text/javascript",c.async=!0,c.id=n,c.src=["https:"===location.protocol?"http://":"http://","widget.surveymonkey.com/collect/website/js/tRaiETqnLgj758hTBazgd8FDSSK_2BdJwgb90HhEfWcrQ3mXQw84VAAdJcw4qiJQXV.js"].join(""),a.parentNode.insertBefore(c,a))})(window,document,"script","smcx-sdk");

Appalachia M&A

Rangebound Gas Prices and Preoccupied Management Teams Cause Slowdown in Activity

It was a quiet year for M&A in Appalachia as only a handful of transactions occurred. Surging associated gas production in places like the Permian and Bakken have kept a lid on gas prices, which have largely remained between $2 and $3/mmbtu for the year. Near term expectations aren’t much better, with futures prices below $3 through 2029. Management teams were likely preoccupied with various corporate and capital structure issues instead of changes to the underlying reserve base. However, a bright spot is the easing of takeaway constraints that previously plagued the region.Recent Transactions in AppalachiaA table detailing E&P transaction activity in Appalachia during 2019 is shown below. Overall, deal count and average deal size declined relative to 2018. Diversified Gas & Oil’s acquisition of HG Energy II was the only non-royalty transaction of meaningful size during the year. Cabot recently announced a $256 million divestiture of its 20% interest in NextEra Energy’s Meade Pipeline, though that transaction is not included in the E&P transactions listed below.Range Resources ORRI SalesRange Resources was the most active market participant in the basin with two overriding royalty interest (ORRI) sales and the sale of 20,000 non-producing acres in Pennsylvania. The company intends to use the proceeds to paydown debt, offsetting much of the lost cash flow from the assets with decreased interest expense. The company also announced a $100 million share repurchase program.Diversified Gas & Oil Acquisition of Unconventional Assets from HG Energy IIDiversified Gas & Oil acquired 107 gross producing wells and related surface rights from HG Energy II. The acquisition is consistent with the company’s strategy of buying mature, low-decline PDP assets in Appalachia. However, the transaction does represent somewhat of a departure from the company’s historical focus on conventional (non-shale) assets. Management indicated that the transaction would be accretive on various per-share metrics including earnings and free cash flow.Operators Focused on Changes to Corporate and Capital Structure Rather than Asset BaseWhile it has been a quiet year in Appalachia on the M&A front, it was a tumultuous year for management teams and board members.Toby and Derek Rice’s proxy battle for control of EQT made headlines during the first half of the year. The Rice brothers cited EQT’s poor operational performance after its acquisition of Rice Energy as a reason to shake up management and the board. The brothers proposed a business plan which they indicated would generate an estimated incremental $400 - $600 million of pre-tax cash flow and unlock shareholder value. They succeeded in July with Toby Rice replacing Robert McNally as President and CEO of EQT. An organizational streamlining was announced in September, which included a 23% reduction in employees.Gulfport Energy, which has been targeted by activist investor Firefly Value Partners, announced a $400 million stock repurchase program in January 2019. However, the company suspended the program in November, citing “current market conditions and a weak near-term gas price outlook.” The same press release also announced that the company reduced its headcount by 13%, two board members were stepping down, and the chairman of the board would not seek re-election at the next shareholder meeting.Diversified Gas & Oil Company announced a novel financing transaction that may pave the way for other E&Ps looking for creative ways to fund operations. The company created a special purpose vehicle that issued non-recourse, asset-backed securities collateralized by a working interest in the company’s PDP assets. The company plans to utilize the proceeds from the financing to pay down borrowings on its existing revolving credit facility.Antero Resource’s midstream affiliate, Antero Midstream (AM), completed one of the more complicated MLP simplifications earlier in 2019. In June, after Warburg Pincus divested its remaining ownership interest in the company, Warburg’s two board members resigned, reducing Antero’s board to just seven directors. In December, Antero announced a $750 million to $1 billion asset sale program, which the company kicked off by selling $100 million of AM shares back to the midstream affiliate. Management indicated that future asset sales could consist of “lease acreage, minerals, producing properties, hedge restructuring or sale of AM shares to Antero Midstream.” As management teams work to fix capital structures through potential asset sales, 2020 might be a more active year for transactions in the basin.ConclusionM&A transaction activity in Appalachia was muted in 2019 as gas prices remained rangebound and management teams focused on corporate and capital structure issues rather than M&A. However, with operators feeling the pressure from sustained low gas prices, and Antero’s announced asset sale program, 2020 will hopefully be a more active year.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Will Your Succession be Successful?

A Few Things RIAs Need to Know

We’ve hesitated to put together a whitepaper on succession planning because so many people have already written excellent commentary on the topic. Nonetheless, when we surveyed what had been written about succession for RIAs, we didn’t see the kind of nuts and bolts explanation of the corporate finance aspects of succession.The industry is facing at least three major factors: an aging ownership base, an aging bull market, and – paradoxically – an exponential increase in the sources of capital to sell, grow, or transition. Despite the headline emphasis on consolidation, investment management is still an apprenticeship business model and, therefore, internal succession will be the order of the day for most firms.We hope you will find our whitepaper on the topic both unique and useful. We are here to help you succeed at succession. Click the whitepaper below to download.>>Click Here to Download<<

Succession Planning for Investment Management Firms

WHITEPAPER | Succession Planning for Investment Management Firms

Themes from Q3 2019 Earnings Calls

The energy sector in the third quarter has experienced a general decline as crude prices have exhibited volatility and have remained depressed relative to last year. U.S. producers continue to cut rigs and capital expenditures due to continued excess supply and concerns of declining demand. In this post, we examine some of the most discussed items and trends from the Q3 earnings calls, specifically E&P companies and those in the mineral aggregator space.E&P CompaniesE&Ps experienced mixed earnings although many beat expectations and were cash flow positive as the industry has been trending in this direction. The two major topics discussed in E&P earnings calls have been capital discipline and treatment of free cash flow.Capital Discipline: Doing More with LessWe also want to highlight our capital discipline. Third quarter non-acquisition CapEx came in slightly lower than the second quarter and almost 10% lower than the first quarter. As we look to the fourth quarter, we continue to expect CapEx to be significantly lower around $550 million. Each quarter it's been lower throughout the year. This is by design as we expect to be roughly in line with CapEx expectations for the year. -John Hart, CFO, Continental ResourcesI'm happy to report that the third quarter operating cash flow before working capital changes of $706 million exceeded exploration and development capital of $670 million. This marks an important return to free cash generation for the company primarily driven by better capital cost. -Jack Harper, President, Concho ResourcesAs we move forward as a combined company, our commitment to capital discipline and returning capital to shareholders remains unchanged. We remain on track to spend within our full year pro forma combined capital budget of $8.6 billion, excluding Africa. Furthermore, we have established a capital budget for 2020 that we expect will fully optimize free cash flow and position us to grow production in a capital-efficient manner while maintaining the safety of our dividend. -Cedric Burgher, SVP & CFO, Occidental Petroleum Corp The topic of capex budgets and spending has been a major talking point for E&P companies since the oil and gas market took a big hit at the end of 2018. Rising prices for the first three quarters of 2018 begat exuberance, and producers below through their budgets only to see prices fall precipitously. Uncertainties surrounding future commodity prices as well as diminishing capital outlays from the public and private markets forced companies to trim capital budgets and rigidly stick to them to ensure that free cash flow generation was positive.Uncertainties surrounding future commodity prices as well as diminishing capital outlays has forced companies to trim capital budgets.Many of these companies for the first six months of the year were near or over budget in capital spending. And while capital expenditures may be frontloaded for various reasons, a consequence of trying to remain in bounds of the budget has been decreasing active rig counts during the year.However, the reduction in rigs counts for several companies has allowed for more strategic capex dollars to be spent on target infrastructure resulting in improvements in cost per foot. Overall the efficiencies and cost savings have enabled companies to be free cash flow positive for the third quarter.Where is Free Cash Flow Going?As of October 29, we have repurchased 5.5 million shares for $187 million. We plan to continue prioritizing our share buybacks with our excess cash. We see tremendous value in the acquisition of our stock as our share price does not reflect our strong earnings, cash flow and the deep oil-weighted inventory we have for future growth. -John Hart, CFO, Continental Resources, Inc.Well, we're going to look at primarily toward, what is our free cash flow and our free cash flow and I'm debating, I'm still traveling around, we're going to go out and see all of our long shareholders again early next year. But we're trying to determine a long-term strategy of what's best between share buybacks in regard to in addition to increasing the dividend, whether or not to go to variable dividend and balance sheet… we have roughly approximately over the next several years about $5 billion. And so we're trying to come up with the ideal plan to disperse that in regard to all three of those. Obviously, with two-thirds of that going toward shareholder friendly measures such as buybacks and dividends. -Rich Dealy, EVP & CFO, Pioneer Natural Resources…on the how we balance dividend versus stock buybacks. I would say that it would kind of laid out a framework for where we think the free cash flow could be under the different side boards. And I think philosophically you'll see us kind of increase the dividend more in a systematic way and in a way that we can sustain forever. And then every other dollar that's available especially at this price, I'm going to be buying stock back. -Tim Leach, CEO, Concho ResourcesOur consistent industry-leading operational results, combined with our ability to fully deliver on value capture, positions us for a full cycle success and enhances our ability to generate increased excess free cash flow to reduce debt and to return cash to shareholders. Returning excess capital to our shareholders is a part of Oxy's DNA. In the third quarter, we returned approximately $600 million to shareholders. -Vicki Hollub, CEO, Occidental Petroleum Corp. E&P’s appear to be answering the longtime demands from investors of capital return in the form of dividends and share repurchases. Many companies are continuing large stock repurchase programs through combinations of free cash flow generation and ongoing asset sales. This treatment of free cash flow is a result of the strict capital discipline seen across the industry and may prove to be a worthwhile investment should commodity prices improve going into 2020. External and political changes could help (or mute) this effort.The trade-off for increased free cash flow is slower production growth.However, the trade-off for increased free cash flow is slower production growth. Many companies are putting “caps” on growth in order to achieve their desired levels of free cash flow generation. Vicki Hollub of Occidental says in their latest earnings call, “Our intent is to cap our annual production growth at an average of 5% as we balance the vast opportunities in our portfolio with growing free cash flow.”It's clear that E&P’s believe that their current stock valuations do not reflect the intrinsic value they think they bring to the table, particularly as commodity prices bounced back from year-end 2018 lows but stock prices received less of a boost. However, excessive share buybacks may put limitations on growth and future production, straining growth of cash flow yield should the commodity environment remain depressed.Mineral AggregatorsMineral aggregators had mixed earnings in the third quarter of 2019, but were more stable than E&Ps. While Kimbell Royalty Partners realized a record-breaking performance in the quarter, others such as Brigham Minerals seem more concerned with future performance in the face of underwhelming past performance.Mineral aggregators have had to answer a number of questions regarding potential acquisitions. Although acquisition and divestiture activity is the defining characteristic of the aggregator space, companies among the group seem hesitant to make acquisitions that are perceived as too aggressive at this juncture. The consensus is that it will be worth the wait.Acquisition Opportunities and Strategies: Playing the Waiting GameWe are actively searching for those larger transactions and working with those, dialoguing with individuals. And so, I think what's going to happen is over time and then whether that's in the next, say, 3-months to 12-months or so, we'll find that larger transaction, be able to use our equity to acquire with. -Rob Roosa, Founder and CEO, Brigham MineralsThe macro environment is, frankly, tough right now. And in response to that, we've pulled in our horns, some on acquisition–on the acquisition front and are being more selective. We haven't seen anything that we can't live without. We're being a bit more defensive at the moment. And while we're in that mode, we'll prioritize paying down the revolver, which will position us for future acquisitions or share repurchases. -Thomas Carter, Chairman and CEO, Black Stone MineralsLastly, the acquisition market remains robust, and we continue to evaluate opportunities across our many basins. We continue to see great value for acreage outside of the Permian Basin, even considering dramatically reduced drilling activity in 2020 and beyond. So while just about everyone else is focused on the Permian and although we continue to evaluate the Permian, we are having more success in other basins with significantly less competition. –Bob Ravnaas, Chairman and CEO, Kimbell Royalty PartnersThat said, in this environment, and with the asset base that we have and the operators we have and the clear growth that's immediately in front of us, it seems for us inappropriate to dilute that with acquisitions. -Daniel Herz, CEO and President, Falcon Minerals Although they have an increasingly specific appetite for acquisitions, mineral aggregators have emphasized their preference for larger packaged transactions. Travis Stice, CEO and Director of Viper Energy Partners, demonstrates this strategy as they expanded their footprint in the Permian via large acquisitions during the third quarter. Large swaths of contiguous acreage continue to be more valuable to aggregators, which opens up the market opportunity for larger players to come in and consolidate some of these mineral owners and sell the combined acreage at a premium. It will be interesting to monitor the transactions space to determine whether the waiting game will pay off.

Debt Financing for RIAs

How to Finance an Ownership Transition

As noted in a recent post, there are many viable options for RIA principals when it comes to succession planning. One way to transition ownership while maintaining independence is to sell internally to key staff members. The most obvious roadblock when planning for internal succession is pricing. But once you establish a price, how does the next generation pay? An internal transition of ownership typically requires debt and/or seller financing as it’s unlikely that the next generation is able or willing to purchase 100% ownership in a matter of months. In this post, we consider the expanding options for RIAs seeking debt financing and the typical terms they can expect.Is Debt Financing the Right Solution? Debt financing has become a more practical option for RIA principals working on succession planning as more specialty lenders have entered the market. Some of the benefits of debt financing are outlined below.Debt financing, as opposed to seller financing, allows the exiting shareholder to make a clean break with the business. This benefits both the exiting shareholder and the remaining principals. Exiting shareholders, who are likely at retirement age, receive liquidity at close that they can use to diversify their personal holdings, and the remaining principals don’t have ownership lingering in the hands of a former employee.Debt financing, as opposed to equity financing, allows the remaining principles to maintain autonomy. Excluding loan covenants, lenders have no control over your business. On the other hand, equity partners usually require more intrusive oversight such as a board seat and/or budget approval, which remaining shareholders may not tolerate.Debt financing is cheaper than equity financing. Equity investors, who are subordinated to debtholders, require an additional premium over the average cost of debt.Interest payments are tax-deductible. Interest payments can reduce the borrower’s tax burden during the amortization period. Despite these benefits, debt financing does increase the remaining shareholders’ personal risk. Debt financing is an obligation to repay the money acquired through it, unlike equity financing which typically does not require repayment. Debt financing for RIAs also typically includes a personal guarantee, which many borrowers are opposed to. Borrowers are also more exposed to their own business by levering up to purchase an equity stake.Increasing Number of Specialty Lenders for RIAsAs Financial Planning explained, “the market for RIA-friendly lending options has exploded” over the last two years. Looking back, Live Oak Bank was one of the first to address the specific needs of RIA principals when they began providing favorable terms to independent advisory firms in 2012. As explained on their website, “where most banks look for tangible collateral when they lend money, Live Oak Bank lends on cash flow to companies (like advisory firms) which have little to no collateral.” Prior to this, most RIAs had to turn to local banks, who generally were not comfortable with the asset-light balance sheets and fee-based structure of RIA firms.RIAs now can turn to a growing number of specialty lenders who are accustomed to working with RIAs. Some of the firms offering debt financing specifically for RIAs include Oak Street Funding, Merchant Credit Partners, PPC Loan, and SkyView Partners.Typical Terms for RIAsAdditionally, one provision may be contingent upon another. For example, a higher origination fee could reduce the need for a pre-payment penalty. At the risk of providing an example of terms that may be unachievable for some RIAs, we have outlined terms RIA principals can generally expect when seeking debt financing.Most lenders require a personal guarantee, which is a legal promise by the partners to repay the loan made to their business in the event the business defaults. While it is typical that lenders to small businesses require this additional layer of protection, it is important to understand how a personal guarantee works and what it could mean for your personal finances.Because RIAs do not have fixed assets to use as collateral, a personal guarantee gives your lender the right to pursue your personal assets if your business defaults on the loan. The SBA is of the opinion that a personal guarantee “ensures that the borrower has sufficient personal interest at stake in the business.” Notably, a personal guarantee is not released if you sell the business. While you can ask your lender to replace your personal guarantee with a personal guarantee from a new owner, the lender is typically not required to do so.ConclusionSimilar to evaluating mortgage options, it is important to talk to multiple lenders to guarantee the most favorable terms for your business transition. Having a knowledgeable advisor to manage this process can allow remaining ownership to stay focused on running the business while ensuring consideration of all appropriate options.

Community Bank Valuation (Part 4): Valuing Minority Interests

In the June 2019 BankWatch we began a multi-part series exploring the valuation of community banks. The first segment introduced key valuation drivers: various financial metrics, growth, and risk. The second and third editions described the analysis of bank and bank holding company financial data with an emphasis on gleaning insights that affect the valuation drivers. We now conclude our series by assembling these pieces into the final product, a valuation of a specific bank.While it would streamline the valuation process, there is no single value for a bank that is applicable to every conceivable scenario giving rise to the need for a valuation. Instead, valuation is context dependent. This edition of the series focuses on the valuation of minority interests in banks, which do not provide the ability to dictate control over the bank’s operations. The next edition focuses on valuation considerations applicable to controlling interests in banks that arise in acquisition scenarios.Valuation ApproachesValuation specialists identify three broad valuation approaches within which several valuation methods exist:The Asset Approach develops a value for a bank’s common equity based on the difference between its assets and liabilities, both adjusted to market value. This approach is less common in practice, given analysts’ focus on banks’ earnings capacity and market pricing data. In theory, a rigorous application of the asset approach would require determining the value of the bank’s intangible assets, such as its customer relationships, which introduces considerable complexity.The Market Approach provides indications of value by reference to actual transactions involving securities issued by comparable institutions. The obvious advantage of this approach is the coherence between the goal of the valuation itself (the derivation of market value) and the data used (market transactions). The disadvantage, though, is that perfectly comparable market data seldom exists. While we will not cover the topic in this article, transactions in the subject bank’s common stock, which often occur for privately held banks due to their frequently widespread ownership and stature in the community, may serve as another indication of value under the market approach.The Income Approach includes several methods that convert a cash flow stream (such as earnings or dividends) into a value. Two broad subsets of the income approach exist – single period capitalization methods and discounted cash flow methods. For bankers, a single period capitalization is analogous to a net operating income capitalization in a real estate appraisal; it requires an earnings metric and a capitalization multiple. Alternatively, bank valuations often use projection-based methodologies that convert a future stream of benefits into a value. The strengths and weaknesses of a projection-based methodology derive from a commonality – it requires a forecast of future performance. While creating such a forecast is consistent with the forward-looking nature of investor returns, predicting the future is, as they say, difficult. The following discussion focuses on the valuation methodologies used most commonly for banks, the comparable company method and the discounted cash flow method.Comparable Company MethodBank analysts are awash in data, both regarding banks’ financial performance but also market data regarding publicly traded banks’ valuation. Table 1 presents a breakdown by trading market of the number of listed banks in November 2019. To narrow this surfeit of comparable company data, analysts often screen the publicly traded bank universe based on characteristics such as the following: Size, such as total assets or market capitalizationProfitability, such as return on assets or return on equityLocationAsset qualityRevenue mix, such as the proportion of revenue from loan sales or asset management feesBalance sheet composition, such as the proportion of loans or dependence on wholesale fundingTrading market or volume Even after applying screens similar to the preceding, it remains doubtful that the publicly traded banks will exactly mirror the subject bank’s characteristics. This is especially true when valuing smaller community banks, as a relatively limited number of publicly traded banks exist with assets of less than $500 million that trade in more liquid markets. Ultimately, the analyst must determine an appropriate valuation multiple based on the subject bank’s perceived growth opportunities and risk attributes relative to the public companies. For example, analysts can compare the subject bank’s historical and projected EPS growth rates against the public companies’ EPS growth rates, with a materially lower growth outlook for the subject bank suggesting a lower pricing multiple. Part 1 of this community bank valuation series described various valuation metrics applicable to banks, most prominently earnings and tangible book value. It is important to reiterate that while bankers and analysts often reference price/tangible book value multiples, the earning power of the institution drives its value. Chart 1 illustrates this point, showing that price/tangible book value multiples rise along with the core return on tangible common equity. This chart includes banks traded on the NASDAQ, NYSE, or NYSEAM with assets between $1 and $10 billion. Since banking is a more mature industry, bank price/earnings multiples tend to vary within a relatively tight range. Chart 2 provides some perspective on historical price/earnings and price/tangible book value multiples, which includes banks traded on the NASDAQ, NYSE, or NYSEAM with assets between $1 and $10 billion and a return on core tangible common equity between 5% and 15%. Trading multiples in the first several years of the analysis may be distorted by recessionary conditions, while the multiples reported for 2016 and 2017 were exaggerated by optimism regarding the potential, at that time, for tax and regulatory reform. The diminished multiples at yearend 2018 and September 30, 2019 reflect a challenging interest rate environment, marked by a flat to inverted yield curve, and the possibility for rising credit losses in a cooling economy. Discounted Cash Flow MethodThe discounted cash flow (DCF) method relies upon three primary inputs:A projection of cash flows distributable to investors over a finite time period » A terminal, or residual, value representing the value of all cash flows occurring after the end of the finite forecast periodA discount rate to convert the discrete cash flows and terminal value to present value1. Cash FlowFirst, a few suggestions regarding projections:For a financial institution, projecting an income statement without a balance sheet usually is inadvisable, as this obscures important linkages between the two financial statements. For example, the bank’s projected net interest income growth may require a level of loan growth not permitted by the bank’s capital resources.Including a roll-forward of the loan loss reserve illustrates key asset quality metrics, such as the ratios of loan charge-offs to loans and loan loss reserves to loans. The level of charge-offs should be assessed against the bank’s historical performance and the economic outlook.Key financial metrics, both for the balance sheet and income statement, should be assessed against the bank’s historical performance and peer banks.While projections can be prepared on a consolidated basis, we prefer developing separate projections for the bank and its holding company. This makes explicit the relationships between the two entities, such as the holding company’s reliance on the bank for cash flow. For leveraged holding companies, a sources and uses of funds schedule is useful. In preparing a DCF analysis for a bank, the most meaningful cash flow measure is distributable tangible equity. The analyst sets a threshold ratio of tangible common equity/tangible assets or another regulatory capital ratio based on management’s expectations, regulatory requirements, and/or peer and publicly traded comparable company levels. Equity generated by the bank above this target level is assumed to be distributed to the holding company. After determining the holding company’s expenses and debt service requirements, the remaining amount represents shareholder cash flow, which then is captured in the DCF valuation analysis.2. Discount RateFor a financial institution, the discount rate represents the entity’s cost of equity. Outside the financial services industry, analysts most commonly employ a weighted average cost of capital (WACC) as the discount rate, which blends the cost of the company’s debt and equity funding. However, banks are unique in that most of their funding comes from deposits, and the cost of deposits does not rise along with the entity’s risk of financial distress (because of FDIC insurance). Therefore, a significant theoretical underpinning for using a WACC – that the cost of debt increases along with the entity’s risk of default – is undermined for a bank. Analytical consistency is created in a DCF analysis by matching a cash flow to equity investors (i.e., dividends) with a cost of equity.A bank’s cost of equity can be estimated based on the historical excess returns generated by equity investments over Treasury rates, as adjusted by a “beta” metric that captures the volatility of bank stocks relative to the broader market. Analysts may also consider entity-specific risk factors – such as a concentration in a limited geographic market, elevated credit quality concerns, and the like – that serve to distinguish the risk faced by investors in the subject institution relative to the norm for publicly traded banks from which cost of equity data is derived.3. Terminal ValueThe terminal value is a function of a financial metric at the end of the forecast period, such as net income or tangible book value, and an appropriate valuation multiple. Two techniques exist to determine a terminal value multiple. First, the Gordon Growth Model develops an earnings multiple using (a) the discount rate and (b) a long-term, sustainable growth rate. Second, as illustrated in Chart 2, bank pricing multiples tend to vary within a relatively tight range, and a historical average trading multiple can inform the terminal value multiple selection.Correlating the AnalysisIn most analyses, the values derived using the market and income approaches will differ. Given a range, an analyst must consider the strengths and weaknesses of each indicated value to arrive at a final concluded value. For example, earnings based indications of value derived using the market approach may be more relevant in “normal” times, as the values are consistent with investors’ orientation towards earnings as the ultimate source of returns (either dividends or capital appreciation). However, in more distressed times when earnings are depressed, indications of value using book value assume more relevance. If a bank has completed a recent acquisition or is in the midst of a strategic overhaul, then the discounted cash flow method may deserve greater emphasis. We prefer to assign quantitative weights to each indication of value, which provide transparency into the process by which value is determined.Relative Value AnalysisThe analysis is not complete, however, when a correlated value is obtained. It is crucial to compare the valuation multiples implied by the concluded value, such as the effective price/earnings and price/tangible book value multiples, against those reported by publicly traded banks. Any divergences should be explainable. For example, if the bank operates in a market with constrained growth prospects, then a lower than average price/earnings multiple may be appropriate. A higher return on equity for a subject bank, relative to the comparable companies, often results in a higher price/tangible book value multiple. As another reference point, the effective pricing multiples may be benchmarked against bank merger and acquisition pricing to ensure that an appropriate relationship exists between the subject minority interest value and a possible merger value.ConclusionThere are many valuation issues that remain untouched by this article in the interest of brevity, such as the valuation treatment of S corporations and the discount for lack of marketability applicable to minority interests in banks with no active trading market. Instead, this article addresses issues commonly faced in valuing minority interests in any community bank. A well-reasoned valuation of a community bank requires understanding the valuation conventions applicable to banks, such as pricing multiples commonly employed or the appropriate source of cash flow in a DCF analysis, but within a risk and growth framework that underlies the valuation of all equity instruments. Relating these valuation parameters to a comprehensive analysis of a bank’s financial performance, risk factors, and strategic outlook results in a rigorous and convincing determination of value. In the next edition, we will move beyond the valuation of minority interests in banks, focusing on specific valuation nuances that arise when engaging in a valuation for merger purposes.Originally published in Bank Watch, November 2019.

Private Equity’s Silent Push into the RIA Space

Is Private Equity the Solution to Your Succession Planning Needs?

Private equity pervades the RIA industry, but most of their recent interest is through consolidators or roll-up firms. In this week’s post, we’ll discuss the implications of this trend and other considerations for RIA owners’ contemplating the PE route. You may have not heard much about private equity firms’ addition of RIAs to their portfolios in recent years. But that doesn’t mean they’re not interested. The reality is that PE firms collectively have established an indirect interest in hundreds of RIAs via their investments in RIA consolidators. This strategy enables private equity to achieve diversification and scale in a single purchase rather than buying dozens of investment managers and hoping a majority will work out. Many of the leading RIA consolidators are or have been backed by PE. Recent examples include investments made by Stone Point Capital (Focus Financial), Thomas H. Lee Partners (HighTower Advisors), TA Associates (Wealth Enhancement Group), and Oak Hill Capital Partners (Mercer Advisors). Since private equity firms are increasingly interested in growing their RIA exposure, there has been a lot of pressure for these PE-backed consolidators to increase their portfolio holdings via acquisition. This has largely been positive for wealth manager valuations as consolidators bid up their pricing to grow AUM and appease their PE backers. Private equity firms have gained broad exposure to the RIA space in recent years through this portal of indirect ownership. Like any other prospective buyer, there are pros and cons associated with a private equity partnership.Does this mean they’re not interested in making a direct investment in your firm? Not necessarily; but remember that their primary objective (perhaps more than any other type of buyer) is to generate large returns to investors, which may be hard to achieve with an RIA with less than $1 billion under management. Larger investment managers, though, do offer the scale, (usually) higher margins, and predominantly recurring revenue models that have captured the attention of many PE firms over the years.Like any other prospective buyer, there are pros and cons associated with a private equity partnership. At the moment, many PE firms are flush with capital and willing to pay a substantial portion of the total consideration in cash up front. Most can afford to buy a majority interest and typically do so to assume control over future operations. Sellers generally appreciate the down payment but are less enthusiastic about relinquishing control. Many RIA owners aren’t comfortable with the latter, so these discussions sometimes don’t get past the initial call.Private equity, however, is not a permanent solution. PE firms aim to grow their investment as much as possible over the next five to seven years before flipping it to a new buyer at two or three times what they initially paid. This scenario means they often put pressure on RIAs to take on more clients and/or reduce costs, so they can maximize profitability for a prospective sale. Additionally, this means a new owner with new demands will take over in the not so distant future.Is a Private Equity Investment the Right Solution for You? Private equity is sometimes used to cash out a former partner or outside investor when the current owners don’t have the capital or desire to take on this additional investment personally. Selling (outside) partners usually favor this type of investment because PE firms can pay more up front. Principals remaining in the business usually don’t want any ownership lingering in the hands of former employees, but in this scenario, they’ve effectively swapped one outside investor for another. There’s no guarantee that the second one will be any better.Private equity can also be a relatively straightforward path to diversification for existing principals. In many cases, a significant portion of an RIA principal’s net worth is tied up in his or her business with no immediate access to liquidity. PE firms allow these owners to take some cash off the table and reduce their dependency on the business. RIA principals will have to weigh the benefits of diversification and instant liquidity with the costs of losing control to outside ownership.Your due diligence on the prospective buyer is just as important as their due diligence on you.On balance, private equity’s interest in the space has been good for the RIA industry. They’ve likely had a positive effect on wealth manager valuations and are a significant source of liquidity for an otherwise illiquid business. This doesn’t necessarily mean they’re a good partnership for your firm, so you still need to consider what you’d be giving up in a sale and how it could impact other employees and stakeholders. Even if the price is right, it still may not be a good fit for you and your team. Your due diligence on the prospective buyer is just as important as their due diligence on you.We strongly recommend hiring a team of experienced and trusted advisors to help navigate this process.

Issue No. 5 | Data as of Year-End 2019

When Might Things Return to Normal? and A Deeper Dive into the Impact of COVID-19 on Auto Dealerships

Are Wealth Management Margins About to Get Buried?

SchwabiTrade isn’t the Only Threat to the Most Consistent Profit Stream in the RIA Community

Last week I was planning a trip to watch my younger daughter compete in a horse show in Birmingham when the news broke about Charles Schwab acquiring TD Ameritrade. For those of you who don’t have fragile but determined children who ride stout but stupid equines over fences, a hunter/jumper competition typically means hundreds of miles of travel and days of standing around in moderately bad weather to watch your dearest risk paralysis for a few minutes in the saddle. It’s 99% utter boredom punctuated by brief moments of tangible panic. In other words, it’s not unlike the relationship most RIAs have with their custodian.Custodial relationships were boring until last week. By now you’ve read plenty about the Schwab/TD Ameritrade deal. Some have questioned whether or not the transaction will be prohibited by anti-trust regulation, but – in the current political environment – I wouldn’t count on that. Together, SchwabiTrade will custody on the order of 75% of RIA assets, and while some RIA pundits are concerned about the service that RIAs, especially smaller ones, will receive from such a behemoth, they might also want to look into the cost of these relationships, not to mention what Schwab’s end-game really is.If RIAs were David and the wirehouse firms were Goliath, Schwab engineered the slingshot.Schwab is credited with helping create the RIA space, having launched Schwab Advisor Services over 25 years ago effectively as a plug-and-play custodial offering for independent advisors. If RIAs were David and the wirehouse firms were Goliath, Schwab engineered the slingshot. Schwab relentlessly drove down the costs of its RIA backbone over the years, embracing technology and efficiency to build scale and lower fees. There was room for Schwab and TD Ameritrade (its longtime competitor in serving RIAs) in the investment management space, but that was when the industry was expanding and margins were widening. Now zero commissions and cheap money may be prompting a new plan of action for Schwab that extends beyond this merger. David may be facing a new Goliath.The last decade has been witness to oligopolistic consolidation and consequent behaviors across many service industries. Amazon upended retail. Uber (and Lyft) decimated local cab companies and car rental companies. Airline consolidation has raised fares and cut service for many markets, including my hometown. Without debating the merits or evils of creative economic destruction, what is indisputable is that the rise of modern oligopolies has been tough on incumbent industry stakeholders: owners, workers, and (sometimes) customers.It’s hard to see the advent of SchwabiTrade as a good thing for the RIA community – especially the wealth management community. If Schwab is looking to recapture margins from zero commission trading and low rates on sweep accounts, it need look no further than the ten thousand plus RIAs now in its eco-system. Changes will likely be slow and subtle, kind of like how the airlines gradually devalue frequent flyer miles while touting “improvements” to their loyalty programs. Fees drift up. House brands replace independent products. Service declines. And, eventually, Schwab finds a way to go straight at RIA clients – with proprietary technology and their own advisor force. The best thing for Schwab is that they can use revenues from the RIA community to fund the strategy, and they have control of the data to know what will work most effectively.Schwab may not be successful. The sequel to most real-life versions of “The Empire Strikes Back” is indeed “Return of the Jedi.” WeWork’s abject failure is probative insight into the folly of oligopolistic thinking in industries that cannot be cornered, like office space. The advisor community is vast and nimble. Schwab has a huge market share, though, and a forty-year head start. That’s worrisome.Can RIAs escape this by moving to the Fidelity platform, or BNY Mellon, or Raymond James? It’s worth looking into, and no doubt this moment is a huge opportunity for other custodians to grab market share. After the dust settles, though, if Schwab increases fees to “remain competitive,” others will at least try to follow.Real economic profits attract competition.And this isn’t the only existential threat facing wealth management. Goldman Sachs is trying to figure out how to extend their brand to the mass-affluent, and they aren’t the only private bank pursuing this. Other discount brokers and robo-advisors are trying to move upmarket. Suddenly, it seems like everyone has noticed that the stickiest revenue and most reliable margins in the investment community are wealth management firms. Real economic profits attract competition.None of this offers a very upbeat message for Thanksgiving week in an industry that has enjoyed considerable success in recent years. We should all be grateful for the opportunities afforded by a great business. My concerns may be alarmist and unfounded. But I couldn’t stop thinking about how abrupt the advent of SchwabiTrade is as I was sweeping the leaves off my windshield last weekend. This is probably the biggest news to hit the RIA community in 2019. If we’re not paying attention, we’ll all be driving blindly.

Royalty MLP Is Delivering Yield Against Backdrop Of Energy Sector Struggles

Energy commodity cycles can sometimes proffer interesting market dynamics. At various points, participants along the energy chain can benefit or suffer from the natural consequences of these changes. In the long run, commodity prices ultimately drive economics. Right now, exploration and production companies and oilfield service providers are grappling with austerity measures that investors are demanding. Most other upstream areas are struggling too; however, publicly-traded royalty and mineral aggregators are performing relatively better than their operating counterparts. While equity prices have dropped by approximately 30% for producers (according to SPDR Oil and Gas ETF), six publicly-traded royalty aggregators relatively outperformed the SPDR Index. These Royalty MLP’s (a bit of a misnomer as all are not partnerships) have tracked closer to crude oil prices, anchored by sizeable dividend payments, thus buoying sliding equity prices. If dividend yields are added back, some of them have been outperforming crude prices.Upstream Producers Thirsting For CapitalAt recent industry conferences, panelists and management teams for exploration and production companies have consistently lamented the dearth of available capital. As banks re-evaluate their credit facilities, some analysts estimate a 10%-25% reduction in reserve-based lending capacity. Investors have communicated a sink or swim message to the sector and the term “capital discipline” is echoed frequently. Producers must subsist on their own cash flow for the foreseeable future and performance must improve before capital flows back upstream. This trend partially explains why energy currently comprises less than 5% of the sector weighting value of S&P Index, a historical low. It is notable and somewhat ironic that part of the success of the remaining 95% of the S&P has been attributable directly or indirectly to the cheap energy prices being delivered by the energy sector.[caption id="attachment_28934" align="aligncenter" width="813"]Source: S&P 500[/caption] E&P’s Primed For Consolidating? Bankruptcy Bargains?Cost control and efficiencies are on the top of the industry’s mind. In response, the consolidation trend for upstream producers is underway. Parsley’s acquisition of Jagged Peak and Comstock’s acquisition of Covey Park are examples of this, with more likely to come. Consolidation will occur through bankruptcy sales as well. According to Haynes and Boone bankruptcies in the oil patch have consistently ticked up with nearly $13 billion in new debt under bankruptcy in 2019. Therefore, Section 363 sales to consolidators should be available among other things. The big problem circles back to where this article started – where to obtain the funds to buy them? Those with pocketbooks at this time may be able to unearth some bargains and returns down the road to show for it. In fact, Comstock may be back in that distressed market as there are reports about negotiations for buying Chesapeake’s Haynesville Shale assets.Royalty MLP Subsector Still Has Capital Flowing InMeanwhile, like a small oasis in this desert, Royalty MLP’s have been and continue to successfully attract capital flow to this sub-space. Brigham Minerals, for example, not only went public earlier this year but had its line of credit expanded. Recent third quarter call transcripts from these Royalty MLP’s all suggest that acquisitions and growth (while disciplined) will continue. Indeed, Kimbell Royalty Partners has had one of the biggest dividend boosts in the marketplace this year. The primary reason for this is simple, while benefitting from well production, royalty holders do not bear operating and drilling costs. Therefore, they can get the best of both worlds. Of course, returns are also predicated upon the cost to acquire. Even if Royalty MLP’s overpay for the acreage they acquire, this tends to limit or delay returns as opposed to zero or negative returns at the asset level.[caption id="attachment_28935" align="aligncenter" width="640"]Source: Capital IQ[/caption] Additionally, Royalty MLP’s will be the logical and likely recipient of larger packages of minerals as private equity firms, who flocked to this sector a few years ago, begin to monetize their funds. This is significant because it is beginning to change the nature of a typical mineral owner’s profile, mindset and holding period expectations. As more investment-minded participants enter the space, the sophistication and expectations of buyers and sellers change along the way. The public royalty firms are preparing for this, which is why their acquisition budgets are steady or growing as opposed to shrinking across the board for producers. On a side note, this is not isolated to only publicly traded mineral and royalty participants. From a more macro perspective, this growth dynamic can be observed right at the U.S. budget where billions more flow into government coffers. U.S. public lands drove a 30% increase in federal energy and minerals revenue disbursements in fiscal year 2019 to $11.69 billion. The biggest contributor to that boost is in the New Mexico portion of the Permian Basin. ConclusionOverall the upstream sector has challenges right now, but the royalty and mineral sub-sector is weathering the changes better than some other sub-sectors. Strong dividend payments, with the promise for more in the future aligns more with investor expectations right now. As always, the lynchpin to industry health is commodity prices. Crude prices dropped in the late spring and have been treading water for the past several months. Many industry observers suggest stagnant prices in the $50-$60 range for the foreseeable future. However, others suggest that while the industry tightens its belt, prices may creep back up into the $60-$70 range. If that happens, shareholder returns will accrue to more than just producers and royalty holders.Originally appeared on Forbes.com.

Parsley’s Acquisition of Jagged Peak Highlights Key Consolidation Trends

On October 14, 2019, Parsley (PE) announced that it was acquiring Jagged Peak (JAG) in an all-stock transaction valued at $2.27 billion. The market’s reaction to the announcement was generally negative, as Parsley closed down more than 10% on the date of the announcement. This appears to be driven, at least in part, by investors’ desire for Parsley to be acquired rather than be the acquirer. Despite the negative market reaction, we believe this transaction is emblematic of key trends we expect to see during the next wave of consolidation. All-Stock TransactionJagged Peak shareholders will receive 0.447 shares of Parsley stock per JAG share. Legacy Parsley shareholders will own 77% of the combined company, while legacy Jagged Peak shareholders will own 23% of the combined company.With equity capital markets largely closed to E&P companies and investor concerns regarding leverage, we don’t expect to see any cash/debt-financed acquisitions in the near future. The exception might be a transaction by a supermajor as Exxon and Chevron reported cash balances of $5.4 billion and $11.7 billion, respectively, at the end of September.Low- or No-Premium AcquisitionConsideration to Jagged Peak shareholders represented an 11.2% premium relative to JAG’s preceding closing price. However, given JAG’s recent stock price decline, the implied price was only a 1.5% premium to JAG’s 30-day VWAP. Investors are increasingly focused on metrics like return on capital employed and cash flow per share accretion/dilution. As an acquisition premium increases, these metrics worsen. After Callon announced its acquisition of Carrizo for 2.05 CPE shares per CRZO share, implying a 25% premium based on closing prices before the announcement (though the press release cited the lower 18% premium based on Carrizo’s 60-day VWAP), Callon faced intense investor pushback, especially by hedge fund manager John Paulson. Last week, Callon and Carrizo announced revised deal terms in which Carrizo shareholders will receive only 1.75 CPE shares per CRZO share, resulting in a more modest 11% premium based on prevailing prices. However, the press release again cited a lower premium, this time of 7% based on pricing just before the original transaction announcement in July. Low- or no-premium acquisitions are more palatable to sellers in all-stock transactions as they have the potential to realize the transaction’s synergistic benefits over time given their continued ownership interest in the combined entity. With an all-cash acquisition, benefits to the sellers can only be realized from the purchase price, so meaningful take-over premiums are typically necessary. Corporate, Rather than Asset, TransactionA&D activity recently has been modest, with wide bid/ask spreads separating buyers and sellers. However, with corporate transactions, public stock prices help align buyers and sellers on value. Also, the inherent G&A expense associated with a corporation gives the buyer an obvious target for synergies.Focus on Concrete Cost Synergies Rather than Nebulous Strategic RationaleIn the acquisition presentation, the “Synergy Scorecard” slide (page 10) clearly emphasizes the G&A and operational synergies that Parsley expects to realize from the acquisition. While the strategic benefits are also highlighted (and take up most of the real estate on the page), it is clear that these take a backseat to the tangible cost reductions.ConclusionParsley’s acquisition of Jagged Peak largely follows the playbook we expect to see in upcoming M&A announcements. Despite the expected cost synergies and strategic benefits, shareholders reacted negatively to the news. Even with the addition of Jagged Peak, Parsley’s status as the fourth largest operator in the Permian (based on rig count) would remain unchanged. This will likely cause management teams to re-evaluate their thoughts on optimal size and scale as they survey the acquisition landscape.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

What Should You Expect as an RIA Buyer or Seller?

Advisor Growth Strategies’ New Study Offers Insights into RIA Deal Mechanics

RIA M&A has been a well-publicized topic in the industry. There was a record level of RIA M&A in 2018, and so far in 2019 there are no signs that deal pace is slowing down. Against this backdrop, a new study conducted by Advisor Growth Strategies (AGS) and sponsored by BlackRock sheds light on the realities facing RIA buyers and sellers. Based on transaction information for over 50 RIA deals, the study examines the relationship between deal price and deal terms. The full study is available here.The study categorizes RIA deals based on purpose (short-term or long-term), size (small target or large target), and payment structure (certain or uncertain). The synthesis of these factors impacts the transaction multiple, as shown in the chart from the study below.[caption id="attachment_28869" align="aligncenter" width="493"]Source: Advisor Growth Strategies[/caption] While the deal multiple is a convenient short-hand way to summarize a transaction, as the chart above suggests, it does not tell the full story. Still, the deal price and multiples are what makes the headlines (if terms are publicly disclosed at all) because the nuances of an earn-out arrangement don’t make for an exciting press release. You Pick the Price, I’ll Name the TermsBecause of the lack of transparency and media focus on non-price deal terms, the market norms and trends for this important aspect of RIA M&A are often unfamiliar to first time buyers or sellers. However, non-price deal terms can be just as important or even more important than the deal price. This is particularly true in RIA deals, where buyer stock and/or contingent consideration may account for a significant portion of total deal value. The AGS study provides some insight into the state of deal terms in the RIA M&A market from the perspective of both buyers and sellers. We’ve highlighted some of the key takeaways from the study below.While there are many small (and successful) RIAs, the largest 5.4% of firms by AUM control 63.2% of AUM. The largest RIAs command premium multiples, but these firms are a minority. The study (which focused on smaller RIAs) found that the median adjusted EBITDA multiple for M&A transactions between 2015 and 2018 was 5.1x, and there was little variation over the period. RIAs must choose between pursuing scale through inorganic growth or maintaining a boutique approach.Large acquirers (e.g., Focus Financial, HighTower, CapTrust, Mercer Advisors) are setting the pace for deal terms. Given the proliferation of capital providers in the space, providing a successful long-term outcome is now the differentiator for these “acquisition brands.” Compared to smaller, less frequent RIA acquirers, the acquisition brands have a leg up based on their demonstrated and repeatable growth engine, robust human capital and technology, ability to add service diversification, and access to capital. For sellers, the turn-key offerings provided by acquisition brands are a benchmark for establishing rational expectations.RIA deal terms now provide an average of 60% of cash consideration at closing. For buyers, this means a high barrier to entry and critical need for a solid integration strategy. For sellers, liquidity at close is nice, but accepting a relatively high upfront payment may not maximize the overall valuation.While RIA cash flows have been increasing, multiples have remained relatively consistent between 2015 and 2018. Buyers must find a balance between price and terms based on the transaction’s purpose to get sellers to commit.Up to 40% of consideration is being paid in buyer stock. In general, larger deals saw a greater proportion of total consideration in the form of buyer equity. For buyers, this means that it is critical to demonstrate the merits of their business model and to articulate a path to liquidity (particularly for privately held acquirers). For sellers, the burden is on them to evaluate the investment merits of their acquirer. When buyer stock is part of the consideration, the buyer and seller are in the same boat after the transaction, so it is critical that both parties evaluate the investment merits of the combined entity.Buyers are assuming more of the risk in RIA transactions. 75% of the transactions in the study had less than 25% of the total consideration allocated to contingent consideration, and the contingent payments were relatively short-term (all were less than three years). Given these terms, buyers must be willing to assume some of the risk of the transaction and have a clear integration plan.M&A OutlookWith over 11,000 RIAs operating in the U.S., we expect that consolidation will continue and deal volume will remain strong. The AGS study suggests that, at least for most firms, multiples have been relatively consistent over the last several years. Without major changes to deal terms and structure, this may continue to be the case. Market forces have and will continue to impact non-price deal terms. Acquisition brands are a growing force in the industry, and their influence on deal terms will likely grow accordingly. At some point, every RIA will likely become either a buyer or a seller and will confront the tradeoffs between price and deal terms and other market realities as they exist at that time.

Q3 2019 Call Reports

Differentiated Strategies of Asset Managers, Wealth Managers, and RIA Consolidators

During Q3 2019, most classes of RIA stocks underperformed major equity markets, which are having their best year, so far at least, in more than two decades. In general, base fees for RIAs were up due to higher average AUM (driven by market growth), however, each sector experienced unique challenges. As we do every quarter, we take a look at some of the earnings commentary from investment management pacesetters to scope out the dominate trends.Theme 1: Asset managers are responding to fee pressure either through acquisitions to achieve scale or by outsourcing administrative tasks to reduce overhead.I've been in the investment business well over 30 years and there's never been a time when fee rates have been going up. How you grow and how you achieve attractive margins in this business tends to be based on scale, the ability to offset reductions in fee rates tied to per dollar of assets by growing the base of assets you manage and leveraging the spending in support of that asset management. […] We expect continued modest declines in our average fee rates. – Tom Faust, Chairman & Chief Executive Officer at Eaton VanceWe recognize the pressure that the industry is under, and it is very top of mind with all the senior management to look [at] every kind of saving that we can generate to continue to invest in the parts that we think are going to be incremental to getting inflows and in a few years. – Matthew Nicholls, Executive Vice President Chief Financial Officer at Franklin ResourcesMergers are more immediately accretive because of consolidation benefits. There are many transactions, you have all the obvious consolidation benefits that you would expect, which is office consolidations overhead maybe cross sell, pricing changes or other things here that you would see in a merger, but you wouldn't see in a holding company transaction. – Ruediger Adolf, Founder, Chief Executive Officer and Chairman at Focus FinancialWe always thought there'd be opportunity to save more than $475 million. By the time of the [Invesco - Oppenheimer] transaction closing we only had a clear line of sight regarding the $475 million of savings. After we closed the deal we were able to look deeper into the business and we started making significant progress on the integration. And we now see that we can run the business with this lower expense base. – Loren Starr, Chief Financial Officer at InvescoLeveraging our scale can also take different forms. In certain areas delivering partnerships with industry leading service providers through our affiliates can be more efficient and provide better outcomes, particularly where AMG's scale can improve pricing, access and service. For example, we've recently partnered with ACA Compliance Group to support affiliates seeking to lower their compliance cost and access a greater breadth of services. – Jay C. Horgen, President and Chief Executive Officer at Affiliated Managers GroupTheme 2: Wealth Managers, who are generally more resilient to fee compression, are growing the bottom line by increasing headcount rather than cutting costs.There's no question the resiliency of the overall fees for wealth management has been -- is pretty inelastic so far. We are starting to see some of the e-brokers charge much lower fees than the traditional wealth management platforms in terms of the overall advisory fee. But unquestionably when commissions are free, the investor is going to have to make a choice. Is […] the value proposition of having that advice worthwhile versus having a commission free relationship? And every client is going to have to make that assertion. – Laurence D Fink, Chairman and Chief Executive Officer at BlackRockWe've been staffing up our recruiting department over the last few months and the pipeline has been building. With regard to the advisors that we're focusing on […] the higher performing or higher producing type advisors that are more in line and more consistent with our current average productivity of advisors. […] So, we're continuing to see that expand as we move into 2020 and intend on hitting an inflection point from a growth perspective as we continue to progress forward as the pipeline continues to grow. – Shawn M. Mihal, Senior Vice President, Wealth Management at Waddell and ReedTheme 3: Consolidators attempt to ease investor concerns over their debt burden in the wake of a potential market correction.At the same time we continue to maintain a prudent level of leverage and have repositioned our balance sheet over the last several quarters extending duration while maintaining flexibility and capacity to capitalize on growth opportunities even in challenging markets. – Thomas M. Wojcik, Chief Financial Officer at Affiliated Managers GroupWe are looking at our capital management policy really to align with our overall strategy. We want to create flexibility and right now, our priorities are to delever. About 90% of our free cash flow has gone and probably will go toward delevering. We do have a small buyback program. We do have a small dividend program. We view these as ancillary parts to our strategy. We look at the buyback as a way to manage shares -- outstanding shares. So, we are going to focus on delevering. – David C. Brown, Chairman and Chief Executive Officer at VictoryAssuming constant markets, we anticipate that our net leverage ratio will remain essentially unchanged at 4.3 times from Q3 to Q4. We intend to delever gradually, starting in 2020 as we execute against this solid pipeline and satisfy earn outs associated with the transactions we have closed in the past, and plan to operate with a net leverage ratio between 3.5 and 4.5 times. We are comfortable that this range gives us the flexibility to pursue larger strategic transactions while also accelerating the growth of our existing partner firms in Focus and investing to drive organic growth. […] Please see [the earnings supplement] which provides a sensitivity analysis on the net leverage ratio impact of a material equity market correction. We will continue to manage our capital resources carefully while maintaining sufficient flexibility to invest in the growth of our business. – Ruediger Adolf, Founder, Chief Executive Officer and Chairman at Focus Financial Earnings calls this quarter brought to light the varying challenges and opportunities that different RIAs face. The shift from active to passive investing has forever changed the active asset management industry and asset managers are having to re-think their cost structure in order to stay competitive. Increasing operating leverage through acquisitions and outsourcing has allowed asset managers to protect their margins despite declining fees. Wealth managers are taking a different approach to increase cash flow. The wealth management industry, which depends on the advisor-client relationship, is staffing up as additional advisors can mean additional sales. Meanwhile, consolidators like Focus Financial, AMG, and Victory Capital are providing solutions to both asset managers, who hope to achieve scale, and wealth managers, who look to expand their reach.

Public Royalty Trusts: More Than Meets the Eye

Yield Traps, Depressed Commodity Prices, and Stage of Decline May Decrease Utility of Public Yields

In previous posts, we have discussed the relationship between public royalty interests and their market pricing implications to royalty owners. We have differentiated between mineral aggregators and public royalty trusts and introduced some other considerations for how to pick the appropriate comparable. In this post, we will discuss the prevailing high dividend yields of public royalty trusts. We will also offer some reasons for why these trusts may be declining not just in production but also their comparability, from a valuation perspective, to some privately held mineral interests.Market Data for Trusts and AggregatorsThe following tables gives some critical market data for valuation purposes:We note that the yields are significantly lower for mineral aggregators than the public royalty trusts, who also have significantly lower market caps. Previously, we’ve explained what a royalty trust is; however, to understand these recently elevated yields, we may need to back up and discuss why royalty trusts are started in the first place.Why a Royalty Trust?Royalty trusts represent a unique financing tool for E&P companies. Instead of holding onto wells and collecting revenue over a longer holding period, operators can monetize these wells upfront by selling the wells to a trust. This allows operators to reinvest the proceeds back into its operations in an industry where cash is key. Trust distributions are determined by the level of production of the wells and commodity prices. By selling the wells to a trust, the operator can avoid the need for hedging the price risk. Also, since production of the wells is expected to decline over time, operators can avoid the drawn out, declining marginal utility of the wells. This is particularly helpful considering a dollar today is worth more than a dollar down the road.Potential Pitfalls of Public Dividend Yields as a Proxy for RiskWe’ve discussed the importance of scrutinizing each royalty trust individually in order to determine the comparability with private interests. Some of these considerations include:Commodity mix (oil vs natural gas)Idiosyncratic issues with the operatorRegion/basin However, these are not the only considerations, and they may not provide the proper sanity check in the context of the elevated yields that have persisted in recent months.Some further considerations include:Stage of productionCalculation method of the dividend yieldFriction in equity market pricingOperating Expenses in a depressed commodity price environmentWhere are you on the Production Decline Curve?As oil and gas is extracted from a well, its production declines over time. As production declines, the yields tend to increase (more on this later). This can misrepresent the risk to reward opportunity as timing must line up. The value of a mineral interest that has been producing for an extended period of time should not be compared to a well that has just started production or is even still in the drilling or development stage. These situations are two different points on the production curve and represent different risk profiles. For a PDP (proved, developed, producing), there is less risk than any other stage (compared to PUD, P2 or P3). It is important to consider the relationship between these stages of production instead of simply looking to the public markets and being prisoners of the moment or uninformed of the differences between public trusts and a privately held interest. The stage of production and decline rate must reasonably reconcile to private interests to ensure that yields and commensurate risk are compared apples-to-apples.Trusts are frequently prohibited from acquiring additional wells to replace production, unlike E&P companies and mineral aggregators. With production declining, the share price of trust units tends to decline as well, and the return comes almost exclusively from the dividend yield, with minimal opportunity for capital appreciation. Yield is dividends divided by price, and a declining denominator can lead to higher yields. As production declines, the yields may begin to shift from a reasonable expectation of the risk associated with expected future cash flows to a reflection of the minimal life of the well.Different Dividend Calculations Can Lead to Significantly Different IndicationsThe calculation of dividend yield can also be crucial to understanding risk. Taking the dividends paid in the past year may not be representative of future dividends. While annualizing the most recent dividend may cause issues with seasonality, it may be more appropriate given the commodity price outlook. Annualizing the most recent dividend causes a significant divergence in the implied yield for more than half of the royalty trusts, while the yields change by less than 2% for all of the mineral aggregators.Take Prudhoe Bay (BPT) for example. Its 63% yield as of October 30th includes a $1 dividend per share in January 2019. However, distributions have only been only $1.23 in the next three quarters combined as its 10-K estimated a significantly declining outlook. Annualizing the most recent dividend of 34 cents per share drops the dividend yield closer to 28%, notably lower than 63%. While 28% may seem high even in the context of mature production, current commodity prices indicate the trust may cease payouts after January 2020. Calculating yields by annualizing more current dividends can help normalize yields to better indicate the underlying value of the trust’s production.Public Equity Markets May Complicate Intrinsic Value of Royalty TrustsIn theory, trading in a public marketplace gives public royalty trusts an indication of market value. There is friction, however, between the stock market price and the intrinsic value of the trust. It is common for public royalty trusts to have relatively small share prices. Also, as they age and decline over time, they will become less productive, and investors would be less likely to want to incur the trading costs to build up a position in a stock with little to no residual value. Investing in a small stock creates the need to load up on shares to make a meaningful investment. Doing so, however, can cause the price to move unfavorably. This is particularly the case if the stock is thinly traded.This problem can be compounded by float, that is, the number of shares actually available for trading. As an extreme example, Permianville Royalty Trust (PVL) has just over half of its shares free floating. These issues further complicate the ability to use yields from public royalty trusts as a proxy for risk for private interests.Operating Expenses Become Increasingly ImportantSince royalty trusts are not encumbered with production expenses, trust operating expenses tend to be fixed and minimal. However, revenue tends to be volatile with commodity prices. In the currently depressed commodity price environment, particularly for natural gas, these operating expenses become more pronounced. As we see with the SandRidge Trusts (SDT) (SDR) and ECA Marcellus Trust I (ECT), yields can be higher for trusts with higher operating expenses as a percentage of revenue. Lower prices make the sensitivity to operating expenses more apparent as margins are tighter.ConclusionWhen using it as a pricing benchmark for private royalty interests, there are many reasons to scrutinize the public royalty yields and their comparability. Further analysis is required to ensure these provide meaningful valuation indications. It is important to assess the implied shelf life of the interest and stage of production. Yield also must be considered both in the context of historical and expected future dividends; they must also consider the equity market ecosystem in which the trusts trade. Lastly, yield and implied risk must consider the prevailing commodity price environment and its impact on royalty trust’s operating expenses.We have assisted many clients with various valuation and cash flow questions regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.

Acquisitions of Consolidators Continue to Drive RIA Deal Activity

Asset and Wealth Manager M&A Keeping Pace with 2018’s Record Levels

Through the first three quarters of 2019, asset and wealth manager M&A has kept up with 2018, the busiest year for sector M&A during the last decade. Transaction activity is poised to continue at a rapid pace as business fundamentals and consolidation pressures continue to drive deal activity. Several trends which have driven the uptick in sector M&A in recent years have continued into 2019, including increasing activity by RIA aggregators and mounting cost pressures.Total deal count during the first three quarters is set to exceed 2018’s record levels. Reported deal value during the first three quarters was down, although the quarterly data tends to be lumpy and many deals have undisclosed pricing. Dollar value in 2018 was also boosted by Invesco’s $5 billion purchase of OppenheimerFunds. Acquisitions by (and of) RIA consolidators continue to be a theme for the sector. The largest deal of the second quarter was Goldman Sachs’s $750 million acquisition of RIA consolidator United Capital Partners. The deal is a notable bid to enter the mass-affluent wealth management market for Goldman Sachs. For the rest of the industry, Goldman’s entrance into the RIA consolidator space is yet another headline that illustrates the broad investor interest in the consolidator model and yet one more approach to building a national RIA brand. Acquisitions by (and of) RIA consolidators continue to be a theme for the sector.Mercer Advisors’ recent sale to Oak Hill Capital Partners is further evidence of growing interest in the RIA consolidator space. While deal terms weren’t disclosed, some industry analysts estimate a high teens EBITDA valuation that exceeded $500 million. These RIA aggregators have been active acquirers in the space with Mercer Advisors and United Capital Advisors each acquiring multiple RIAs during 2018 and the first three quarters of 2019. Sub-acquisitions by Focus Financial’s partner firms and other firms owned by RIA consolidators are further drivers of M&A activity for the sector. These acquisitions are typically much smaller and are facilitated by the balance sheet and M&A experience of the consolidators. For some RIAs acquired by consolidators, the prospect of using buyer resources to facilitate their own M&A may be a key motivation for joining the consolidator in the first place. For the consolidators themselves, these deals offer a way to drive growth and extend their reach into the smaller RIA market in a way that is scalable and doesn’t involve going there directly.Consolidation Rationales Sector M&A has historically been less than what we might expect given the consolidation pressures the industry faces.Building scale to enhance margins and improve competitive positioning are typical catalysts for consolidation, especially on the asset management side. One way to stem the tide of fee pressure and asset outflows is to cut costs through synergies to preserve profitability as revenue skids. The lack of internal succession planning is another driver as founding partners look to outside buyers to liquidate their holdings. While these factors are nothing new, sector M&A has historically been less than what we might expect given the consolidation pressures the industry faces.Consolidating RIAs, which are typically something close to “owner-operated” businesses, is no easy task. The risks include cultural incompatibility, lack of management incentive, and size-impeding alpha generation. Many RIA consolidators structure deals to mitigate these problems by providing management with a continued interest in the economics of the acquired firm while allowing it to retain its own branding and culture. Other acquirers take a more involved approach, unifying branding and presenting a homogeneous front to clients in an approach that may offer more synergies, but may carry more risks as well.Market ImpactDeal activity in 2018 was strong despite the volatile market conditions that emerged in the back half of the year. So far in 2019, equity markets have largely recovered and trended upwards. Publicly-traded asset managers have lagged the broader market so far in 2019, suggesting that investor sentiment for the sector has waned following the correction at the end of last year.M&A OutlookConsolidation pressures in the industry are largely the result of secular trends. On the revenue side, realized fees continue to decrease as funds flow from active to passive. On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs. The continuation of these trends will pressure RIAs to seek scale, which will, in turn, drive further M&A activity. With over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies. Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth and margin compression. An aging ownership base is another impetus. The recent market volatility will also be a key consideration for both buyers and sellers for the remainder of this year and the next.

Pipeline Bottlenecks And Worthless Acreage: The Downsides Of World-Leading Oil Production

Oil and gas production in the United States continues to grow. Last year a momentous occasion came and went when the U.S. unseated Russia and Saudi Arabia as the world’s leading oil producer on a daily production basis. The last time that happened was 1973, and a lot has changed since then. There were genuine concerns at the time that conventional oil recovery was at or near a peak. Back then, resources and drilling inventories were widely perceived as limited and thus investors paid a premium for companies that possessed more robust reserve reports while perceived demand for midstream assets waned. This has changed. Some side effects of this current market have included choke points in pipeline capacity and a precipitous drop in prices for undeveloped oil and gas acreage.While fracking techniques have existed in prior forms since the 1940s, the innovations in fracking technology have allowed companies to stimulate previously uneconomic wells. This revolutionized production and reframed mindset as to whether oil recovery was at a peak or not. In fact, production patterns improved so quickly over the past five years that infrastructure such as pipelines, processing and logistics has had trouble keeping up.The Bakken and Three Forks formations located in the Dakotas and Montana are a good example of this. For years, there has been a dearth of pipeline access to the formation and most of the oil produced has been transported out of the region by rail, a less efficient solution compared to pipelines. This issue has been even more acute for natural gas transportation. According to the EIA, in 2017 Bakken operators flared 88.5 billion cubic feet of gas, worth about $220 million and enough to heat 1 million homes.The Dakota Access Pipeline, which was much discussed in the news due to protests, opened in 2017 and is proposed to expand. It helped correct steep pricing differentials as compared to West Texas Intermediate crude pricing. There is still more to come (gas flaring is still prevalent), but constraints should lessen as time goes on.Another trend has been flagging prices for undeveloped acreage. We researched transaction data in the Bakken over the past two years and according to our research from the fourth quarter 2017 going into the fourth quarter 2019, average prices for acreage in the Bakken dropped from $14,250 per acre to $11,919 per acre. While limited in sample size, what’s particularly interesting about these statistics is that on a flowing barrel basis the average price for production increased ($53,338 per flowing barrel in the period entering the fourth quarter 2018 vs. $55,246 going into the fourth quarter 2019).[caption id="attachment_28685" align="aligncenter" width="640"]Source: Shale Experts[/caption] This indicates that current production valuations remain steady while acreage values for future production weaken. The explanation for this dynamic is layered yet connected, and it is not isolated to the Bakken area. At Hart Energy’s A&D Strategies and Opportunities Conference, industry participants emphasized a theme of seeking to buy current oil and gas production as opposed to longer term developmental acreage. This is a result of the capital discipline and returns that investors are demanding. Thus, with public markets struggling to show returns to many investors, acquisition and divestiture activity has slowed. The most prominent transaction oriented activity in the Bakken this year was ironically QEP’s decision to terminate a deal to sell its assets for $1.73 billion. Part of this is driven by public funding drying up. Some companies are turning to creative asset backed bonds to facilitate fundraising. This dearth of funding incentivizes investors to be particularly selective in their asset purchases and be more weighted to current returns. Thus, there is less capital available to invest in longer term drilling inventory. The valuation theory is straightforward: there is more sensitivity of the price paid today for drilling inventory that may not be monetized for 10 or 15 years or more from a net present value perspective. It’s not worth much in today’s dollars, and thus becomes challenging to justify the significant capital outlay considering alternative investments. Another factor driving declines in acreage values is large swaths of private equity backed properties that are considering monetizing their assets due to expiring fund holding periods. While perhaps up to $5 billion of non-operated oil and gas packages are potentially available in the Bakken, many aren’t currently transacting because of the low prices and wide bid-ask spreads. This may not last, and funds will eventually have to sell their assets. When that happens, acreage prices could drop even further if commodity prices or other fundamentals do not improve. It may not appear reasonable to some sellers, but it is fair in many buyers’ minds. It’s a somewhat unexpected side effect alongside a global shift in energy markets. Originally appeared on Forbes.com.

WeInvest?

The Best Business Model in the RIA Industry Depends Not on Who You Ask, but Who’s Asking

Earlier this month we had the pleasure of participating in a panel discussion on the value of wealth management firms in a transaction setting for the CFA Society of New York. In conversation after the event, one of the audience members asked me what I thought was the most successful business model to follow in the wealth management space. It’s a question we hear fairly often, and I try to avoid punting on the answer and saying “it depends.” In reality, though, it does depend. Because I don’t care about movies made about comic book characters, I don’t see many movies these days. Next month is the release of a movie I can’t wait to see, however. “Ford v Ferrari” is based on the true story of Ford Motor Company’s failed attempt to buy Ferrari in 1963. Discussions broke down when Enzo Ferrari realized that Ford expected the transaction to include Scuderia Ferrari, his racing team, and not just the road car manufacturer. Enzo’s business might have been selling cars, but his persona was racing cars. Scuderia Ferrari was not for sale. Henry Ford II was offended at having been rebuffed, and he vowed to build a car to end Ferrari’s dominance at the annual endurance races at Le Mans. The result was a grudge match at the 1966 24 Hours of Le Mans. Ford’s purpose-built car, the GT40, beat the Ferrari 330s decisively, the first win at Le Mans for an American team. Despite the win, Ford gave up competing at Le Mans a few years later, and no longer targets Ferrari on racetracks or in the showroom. The 1966 win did foretell a Ferrari challenger, though. The winning driver was Bruce McLaren, a New Zealander whose eponymous racing and road car company is today a major rival to almost everything Ferrari does.The Ford/Ferrari combination failed not just because of egos, but because of mismatched goals.Back to my discussion of business models. The Ford/Ferrari combination failed not just because of egos, but because of mismatched goals: Ford was a high-volume automaker that competed as a marketing gimmick (“race on Sunday, sell on Monday”). Ferrari was a low-volume automaker that sold road cars to finance Enzo’s racing teams. Ford wanted to make money. Ferrari needed to make money. It wouldn’t have been an easy marriage.In the investment management industry, the question of the best business model generally comes down to opinions about scalability. At the atomic level, an RIA is composed of the relationship between one advisor and one client. Building an RIA is a debate over the best way to grow the size of client relationships, the volume of client relationships, the volume of advisors, or some combination of the three. By “best” I mean finding the right balance of margin, growth, and sustainability.I think the “best” business model is different for different people, however. Ken Fisher built a twelve-figure AUM wealth advisory company by creating a social media marketing machine to funnel mass-affluent investors into a network of highly regimented advisors. Unfortunately for him, Fisher isn’t as regimented in his own professional interactions. Nonetheless, he proved that a high-volume, homogenous, and replicable approach to investment management is both possible and profitable.The “best” business model is different for different people.On the other end of the spectrum, a friend of mine retired from the hedge fund industry a few years ago and is building a boutique wealth management practice that caters to the needs of successful hedge fund managers. It is the opposite of the Fisher model: low-volume, highly specialized, and difficult to replicate. I don’t think either Fisher or my friend would be interested in pursuing the other’s approach to wealth management, but they both found models that worked for them.For some valuable extracurricular reading on this topic, don’t miss Scott Galloway’s blog post on margins, scalability and growth. Galloway’s August blog post opened the floodgates for criticism of WeWork, and is legendary in our world where frank investment analysis is all too rare.Galloway’s more recent post is a thorough and compact digression on the basics of business models and valuation. If, as he contends, the world really is shifting from a focus on growth to a focus on profitability, the investment management profession may stand to benefit in two ways: valuations should improve (much to the relief of every publicly traded RIA executive and shareholder) and value investing may finally regain its prominence (and, along with it, active management). We’ve seen “green shoots” suggesting the latter of these over the past few months in the form of an increase in active manager searches. It hasn’t shown up in public RIA share prices, though.[caption id="attachment_28540" align="aligncenter" width="819"] EBITDA multiples have sagged for smaller public RIAs in recent years. Is this the beginning of the end, or the end of the beginning?[/caption] Galloway also offers remarks that could be interpreted as throwing cold water on consolidation efforts in the RIA space. “Services businesses (high margin) usually involve the most unpredictable and messy of inputs — people — and are dependent on relationships (also not scalable).” I don’t know if Galloway would describe certain investment management firm roll-up models as “WeInvest,” but it’s something to consider. There may be no perfect business model, but there is a business model that’s perfect for you. The Ford v Ferrari competition today takes place on the Big Board. Globally, Ferrari sells about 8,500 cars per year, whereas Ford sells nearly twice that many cars per day. Despite the obvious scale differential, Ferrari (NYSE: RACE) sports a 50% higher earnings multiple, not to mention a 10% greater equity market cap, than Ford (NYSE: F). Advantage: Ferrari.

How to Perform a Purchase Price Allocation for an Oilfield Services Company

When performing a purchase price allocation for an oilfield services company, careful attention must be given to both the relevant accounting rules and the specific nuances of the oil and gas industry. Oilfield services companies can entail many unique characteristics that are not present in non-oilfield related businesses such as manufacturing, wholesale, non-energy related services, or retail. Our senior professionals bring significant experience in performing purchase price allocations in the oilfield services area where knowledge of these characteristics is crucial to determining the proper allocation among the subject company’s assets.For the most part, current assets and current liabilities are relatively straight forward. The unique factors of an oilfield services company are found in the fixed assets and intangibles: specialized drilling and production equipment, service contracts, proprietary technology (patented, or unpatented), methods, or software, in-process research and development assets (IPR&D), etc. In addition, the proper consideration of contributory asset charges in the appraisal of existing customer relationships or technology in the context of oilfield services companies requires a thorough understanding of how such contributory assets are utilized in generating the subject company’s expected operating results. We will explore the unique factors in future entries. In this blog post, we discuss the guidelines for purchase price allocations that all companies must adhere.The unique factors of an oilfield services company are found in the fixed assets and intangibles.Reviewing a purchase price allocation report can be a daunting task if you don’t do it for a living – especially if you aren’t familiar with the rules and standards governing the allocation process and the valuation methods used to determine the fair value of intangible assets. While it can be tempting as a financial manager to leave this job to your auditor and valuation specialist, it is important to stay on top of the allocation process. Too often, managers find themselves struggling to answer eleventh-hour questions from auditors or being surprised by the effect on earnings from intangible asset amortization. This guide is intended to make the report review process easier while helping to avoid these unnecessary hassles.It should be noted that a review of the valuation methods and fair value accounting standards is beyond the scope of this guide. Grappling with these issues is the responsibility of the valuation specialist, and a purchase price allocation report should explain the valuation issues relevant to your particular acquisition. Instead, this guide focuses on providing an overview of the structure and content of a properly prepared purchase price allocation report.General GuidanceWhile every acquisition will present different circumstances that will impact the purchase price allocation process, there are a few general rules common to all properly prepared reports. From a qualitative standpoint, a purchase price allocation report should satisfy three conditions:The report should be well-documented. As a general rule, the reviewer of the purchase price allocation should be able to follow the allocation process step-by-step. Supporting documentation used by the valuation specialist in the determination of value should be clearly listed and the report narrative should be sufficiently detailed so that the methods used in the allocation can be understood.The report should demonstrate that the valuation specialist is knowledgeable of all relevant facts and circumstances pertaining to the acquisition. If a valuation specialist is not aware of pertinent facts related to the company or transaction, he or she will be unable to provide a reasonable purchase price allocation. If the report does not demonstrate this knowledge, the reviewer of the report will be unable to rely on the allocation.The report should make sense. A purchase price allocation report will not make sense if it describes an unsound valuation process or if it describes a reasonable valuation process in an abbreviated, ambiguous, or dense manner. Rather, the report should be written in clear language and reflect the economic reality of the acquisition (within the bounds of fair value accounting rules). This can be particularly daunting if the reviewer of the purchase price allocation report does not have significant experience in working with oilfield services industry participants. The oilfield services industry is particularly strong in industry-specific terminology and jargon that can lead to a lack of understanding among purchase price allocation report reviewers that lack a deep industry background.Definition of AssignmentA purchase price allocation report should include a clear definition of the valuation assignment. For a purchase price allocation, the assignment definition should include:The definition of the valuation objective should specify the client, the acquired business, and the intangible assets to be valued.The purpose explains why the valuation specialist was retained. Typically, a purchase price allocation is completed to comply with GAAP financial reporting rules.Effective Date. The effective date of the purchase price allocation is typically the closing date of the acquisition.Standard of Value. The standard of value specifies the definition of value used in the purchase price allocation. If the valuation is being conducted for financial reporting purposes, the standard of value will generally be fair value as defined in ASC 820.Statement of Scope and Limitations. Most valuation standards of practice require such statements that clearly delineate the information relied upon and specify what the valuation does and does not purport to do.Background InformationThe purchase price allocation report should demonstrate that the valuation specialist has a thorough understanding of the acquired business, the intangible assets to be valued, the company’s historical financial performance, and the transaction giving rise to the purchase price allocation.Understanding of the BusinessThe purchase price allocation report should include a discussion related to the acquired company which demonstrates that the valuation specialist is knowledgeable of the company and has conducted sufficient due diligence for the valuation. The overview should also discuss any characteristics of the company that plays a material role in the valuation process. The description should almost always include discussion related to the history and structure of the company, the competitive environment, and key operational considerations.In the case of acquisitions within the oilfield services industry, the pertinent facts include a thorough understanding as to the demand for the subject company’s services across the various basins within the target market. Unlike many other industries, oilfield services businesses may provide services that are specific to certain basins. Therefore, expectations regarding the specific basins served may be of much greater importance than expectations for the overall oil and gas industry.Intangible AssetsThe discussion of the subject intangible assets should both provide an overview of all relevant technical guidance related to the particular asset and detail the characteristics of the assets that are significant to the valuation. The overview of guidance demonstrates the specialist is aware of all the relevant standards and acceptable valuation methods for a given asset.Upon reading this section, the reviewer of the purchase price allocation report should have a clear understanding of how the existence of the various intangible assets contribute to the value of the enterprise (how they impact cash flow, risk, and growth).Within the oilfield services industry, in particular, one may have to spend a significant amount of time in the determination of what intangible assets were acquired, what intangible assets should recognized as a separate asset from goodwill (based on the legal/contractual rights and separability considerations) and what intangible assets are likely to have a material value. These can differ markedly across industries and such considerations can be somewhat unique in the oilfield services industry.Past PerformanceThe historical financial performance of the acquired company provides important context to the story of what the purchasing company plans to do with its new acquisition. While prospective cash flows are most relevant to the actual valuation of intangible assets, the acquired company’s historical performance is a useful tool to substantiate the reasonableness of stated expectations for future financial performance.The historical financial performance of the acquired company provides important context to the story.This does not mean that a company that has never historically made money cannot reasonably be expected to operate profitably in the future. It does mean that management must have a compelling growth or turn-around story (which the specialist would thoroughly explain in the company overview discussion in the report).Understanding an oilfield services company’s past financial performance requires knowledge of industry-specific trends that can impact activity levels, pricing for particular services, competing service providers, and profit margins. The oilfield services industry is subject to potentially wide fluctuations in activity that can be driven by commodity prices and technological changes. A thorough understanding of these dynamics is necessary in order to correctly interpret past performance among industry participants.Transaction OverviewTransaction structures can be complicated and specific deal terms often have a significant impact on value. Purchase agreements may specify various terms for initial purchase consideration, include or exclude specific assets and liabilities, specify various structures of earn-out consideration, contain embedded contractual obligations, or contain other unique terms. The valuation specialist must demonstrate a thorough understanding of the deal terms and discuss the specific terms that carry significant value implications.Determination of ValueThe purchase price allocation report should provide an adequate description of the valuation approaches and methods relevant to the project. In general, the report should outline the three approaches to valuation (the cost approach, the market approach, and the income approach), regardless of the approaches selected for use in the valuation. This demonstrates that the valuation specialist is aware of and considered each of the approaches in the ultimate selection of valuation methods appropriate for the given circumstances.Any of a number of valuation methods could be appropriate for a given intangible asset depending on the specific situation. While selection of the appropriate method is the responsibility of the valuation specialist, the reasoning should be documented in the report in such a way that a report reviewer can assess the valuation specialist’s judgment.In the closing discussion related to the valuation process, the report should provide some explanation of the overall reasonableness of the allocation. This part of the purchase price allocation report should include both a qualitative assessment and quantitative analysis for support. While this support will differ depending on circumstances, the report should adequately present how the valuation “hangs together.”Within the oilfield services industry determination as to the reasonableness of the indicated allocation of value (purchase price) is often a factor of whether the subject company’s services are subject to proprietary technology, the level of fixed assets required to provide the subject company’s services and the level of personal interaction with customers. Based on such factors, the allocation of value might be reasonably expected to be skewed to particular types of assets, with higher, or lower, expected levels of goodwill.Keep in Mind, it’s Not a BlackboxA purchase price allocation is not intended to be a black box that is fed numbers and spits out an allocation. The fair value accounting rules and valuation guidance require that it be a reliable and auditable process so that users of financial statements can have a clear understanding of the actual economics of a particular acquisition. As a result, the allocation process should be sufficiently transparent that you are able to understand it without excessive effort, and the narrative of the report is a necessary component of this transparency.

Valuation Issues in Auto Dealer Litigation

In our family law and commercial litigation practice, we often serve as expert witnesses in auto dealership valuation disputes. We hope you never find yourself a party to a legal dispute; however, we offer the following words of wisdom based upon our experience working in these valuation-related disputes. The following topics, posed as questions, have been points of contention or common issues that have arisen in recent disputes. We present them here so that if you are ever party to a dispute, you will be a more informed user of valuation and expert witness services.Should Your Expert Witness be a Valuation or Industry Expert?Oftentimes, the financial and business valuation portion of a litigation is referred to as a “battle of the experts” because you have at least two valuation experts, one for the plaintiff and one for the defendant.In the auto dealer world, you are hopefully combining valuation expertise with a highly-specialized industry.It is critical to engage an expert who is both a valuation expert and an industry expert – one who holds valuation credentials and has deep valuation knowledge and also understands and employs accepted industry-specific valuation techniques.Look with caution upon valuation experts with minimal industry experience who utilize general valuation methodologies often reserved for other industries (for example, Discounted Cash Flow (DCF)or multiples of Earnings Before Interest, Taxes and Depreciation (EBITDA)) with no discussion of Blue Sky multiples.Does the Appraisal Discuss Local Economic Conditions and Competition Adequately?The auto industry, like most industries, is dependent on the climate of the national economy.Additionally, auto dealers can be dependent or affected by conditions that are unique to their local economy.The type of franchise relative to the local demographics can also have a direct impact on the success/profitability of a particular auto dealer.For example, a luxury or high-line franchise in a smaller or poorer market would not be expected to fare as well as one in a market that has a larger and wealthier demographic.In those areas that are dependent on a local economy/industry, an understanding of that economy/industry becomes just as important as an understanding of the overall auto dealer industry and national economy.Common examples are local markets that are home to a military base, oil & gas markets in Western Texas or natural gas in Pennsylvania, or fishing industries in coastal areas. There’s also a fine balance between understanding and acknowledging the impact of that local economy without overstating it.Often some of the risks of the local economy are already reflected in the historical operating results of the dealership.If There Are Governing Corporate Documents, What Do They Say About Value, and Should They Be Relied Upon?Many of the corporate entities involved in litigation have sophisticated governance documents that include Operating Agreements, Buy-Sell Agreements, and the like. These documents often contain provisions to value the stock or entity through the use of a formula or process.Whether or not these agreements are to be relied upon in whole or in part in a litigated matter is not always clear. In litigated matters, focus will be placed on whether the value concluded from a governance document represents fair market value, fair value, or some other standard of value.However, the formulas contained in these agreements are not always specific to the industry and may not include accepted valuation methodology for auto dealers.Two common questions that arise concerning these agreements are 1) has an indication of value ever been concluded using the governance document in the dealership’s history (in other words, has the dealership been valued using the methodology set out in the document)?; and 2) have there been any transactions, buy-ins or redemptions utilizing the values concluded in a governance document?These are important questions to consider when determining the appropriate weight to place on a value indication from a governance document.Some litigation matters (such as divorce) state that the non-business party to the litigation is not bound by the value indicated by the governance document since they were not a signed party to that particular agreement. It is always important to discuss this issue with your attorney.Have There Been Prior Internal Transactions of Company Stock and at What Price?Similar to governance documents, another possible data point(s) in valuing an auto dealership are internal transactions. A good appraiser will always ask if there have been prior transactions of company stock and, if so, how many have occurred, when did they occur, and at what terms did they occur? There is no magic number, but as with most statistics, more transactions closer to the date of valuation can often be considered as better indicators of value than fewer transactions further from the date of valuation.An important consideration in internal transactions is the motivation of the buyer and seller. If there have been multiple internal transactions, appraisers have to determine the appropriateness of which transactions to possibly include and which to possibly exclude in their determination of value. Without an understanding of the motivation of the parties and of the specific facts of the transactions, it becomes trickier to include some, but exclude others.The more logical conclusion would be to include all of the transactions or exclude all of the transactions with a stated explanation.What Do the Owner’s Personal Financial Statements Say and Are They Important?Most owners of an auto dealership have to submit personal financial statements as part of the guarantee on the floor plan and other financing.The personal financial statement includes a listing of all of the dealer’s assets and liabilities, typically including some value assigned to the value of the dealership. In litigated matters, these documents are important as another data point to valuation.One view of the value placed on a dealership in an owner’s personal financial statement is that no formal valuation process was used to determine that number; so, at best, it’s a thumb in the air, blind estimate of value.The opposing view is the individual submitting the personal financial statement is attesting to the accuracy and reliability of the financial figures contained in document under penalty of perjury.Further, some would say that the value assigned to the dealership has merit because the business owner is the most informed person regarding the business, its future growth opportunities, competition, and the impact of economic and industry factors on the business.For an appraiser, it’s not a good situation to be surprised by the existence of these documents. A good business appraiser will always ask for them.The dealership value indicated in a personal financial statement should be viewed in light of value indications under other methodologies and sources of information.At a minimum, personal financial statements may require the expert to ask more questions or use other factors, such as the national and local economy, to explain any difference in values over time.Does the Appraiser Understand the Industry and How to Use Comparable Industry Profitability Data?The auto dealer industry is highly specialized and unique and should not be compared to general retail or manufacturing industries.As such, any sole comparison to general industry profitability data should be avoided.If your appraiser solely uses the Annual Statement Studies provided by the Risk Management Association (RMA) as a source of comparison for the balance sheet and income statement of your dealership to the industry, this is problematic.RMA’s studies are organized by the North American Industry Classification System (NAICS).Typical new and used retail auto dealers would fall under NAICS #441110 or #441120. This general data does not distinguish between different franchises.Is there better or more specialized data available? Yes, the National Automobile Dealers Association (NADA) publishes monthly Dealership Financial Profiles broken down by Average Dealerships, which would be comparable to RMA data.However, NADA drills down further, segmenting the industry into the four following categories: Domestic Dealerships, Import Dealerships, Luxury Dealerships and Mass Market Dealerships.While no single comparison is perfect, an appraiser should know to consult more specific industry profitability data when available.Do You Understand Actual Profitability vs. Expected Profitability and Why It’s Important?Either through an income or Blue Sky approach, auto dealers are typically valued based upon expected profitability rather than the actual profitability of the business.The difference between actual and expected profitability generally consists of normalization adjustments. Normalization adjustments are adjustments made for any unusual or non-recurring items that do not reflect normal business operations. During the due diligence interview with management, an appraiser should ask does the dealership have non-recurring or discretionary expenses and are personal expenses of the owner being paid by the business? Comparing the dealership to industry profitability data as discussed earlier can help the appraiser understand the degree to which the dealership may be underperforming.An example of how normalizing adjustments work is helpful. If a dealership has historically reported 2% earnings before taxes (EBT) and the NADA data suggests 5%, the financial expert must analyze why there is a difference between these two data points and determine if there are normalizing adjustments to be applied. Let’s use some numbers to illustrate this point.For a dealership with revenue of $25 million, historical profitability at 2% would suggest EBT of $500,000.At 5%, expected EBT would be $1,250,000, or an increase of $750,000. In this case, the financial expert should analyze the financial statements and the dealership to determine if normalization adjustments are appropriate which, when made, will reflect a more realistic figure of the expected profitability of the dealership without non-recurring or personal owner expenses. This is important because, hypothetically, a new owner could optimize the business and eliminate some of these expenses; therefore, even dealerships with a history of negative or lower earnings can receive higher Blue Sky multiples because a buyer believes they can improve the performance of the dealership. However, as noted earlier, the dealership may be affected by the local economy and other issues that cannot be fixed so the lower historical EBT may be justified.For more information on normalizing adjustments, see our article Automobile Dealership Valuation 101.ConclusionThe valuation of automobile dealerships can be complex. A deep understanding of the industry along with valuation expertise is the optimal combination for general valuation needs and certainly for valuation-related disputes. If you have a valuation issue, feel free to contact us to discuss it in confidence. Originally published in the Value Focus: Auto Dealer Industry Newsletter, Mid-Year 2019.

Q3 2019 RIA Market Update

Asset and Wealth Management Stocks Languish in the Third Quarter

Broad market indices were generally flat over the last quarter, while most categories of publicly-traded asset and wealth manager stocks were off 5% to 10%.Our index of traditional asset and wealth managers ended the quarter down 5.4%, underperforming the S&P 500 which was up 0.4% over the same time. Aggregators and multi-boutique model firms declined 8.3%. Alt managers were the bright spot in the sector, up 3.5%. The asset and wealth management industry is facing numerous headwinds, chief among them being ongoing pressure for lower fees. Traditional asset and wealth managers feel this pressure acutely, which has likely contributed to their relative underperformance over the last quarter. Alt managers, which have been the sector’s sole bright spot during this time, are more insulated from fee pressure due to the lack of passive alternatives to drive fees down. These headwinds have contributed to a decline in EBITDA multiples for traditional asset/wealth managers, which in turn has resulted in lackluster stock price performance. As shown below, EBITDA multiples remain well below historical norms, although they have recovered somewhat from the low point seen last December. Expanding the performance chart over the last year reveals similar trends in asset/wealth manager performance relative to the broader market. Over this longer timeframe, alt managers are still the only category with positive returns, although performance has been volatile. Traditional asset/wealth managers generally moved in lockstep with the broader market until the third quarter of this year when relative performance declined significantly. Aggregators and multi-boutique have declined over 30%. The 30%+ decline in the aggregator and multi-boutique index may come as a surprise given all the press about consolidation in the industry and headline deals for privately held aggregators. Over the last year, there have been two significant deals for privately-held wealth management aggregators: United Capital was bought by Goldman Sachs for $750 million, and Mercer Advisors’ PE backers sold a significant interest to a new PE firm, Oak Hill Capital Management. Both deals reportedly occurred at high-teens multiples of adjusted EBITDA. It appears the market may have grown skeptical of the purely financial consolidator strategy.Meanwhile, stock of Focus Financial, a publicly traded wealth management aggregator, has declined significantly. On September 30th, Focus stock closed at $23.80, about half its price a year prior and about 35% below the price at its July 2017 IPO.So why has Focus stock languished while Mercer Advisors and United Capital have both sold significant interests at attractive valuations? One explanation is different business models. The latter two firms are more “true” consolidators, where acquired firms are rebranded and integrated, then presented to the market as a coherent whole. Focus, on the other hand, is a pure financial consolidator. Acquired firms continue to operate as they did before the acquisition, and the only real difference (other than some back-office integration) is how the economics of the firm are distributed. There are pros and cons to each model, but given the poor performance of Focus Financial’s stock since IPO, it appears the market may have grown skeptical of the purely financial consolidator strategy.Implications for Your RIAWith EBITDA multiples for publicly traded asset and wealth managers still well below historical norms, it appears the public markets are pricing in many of the headwinds the industry faces. It is reasonable to assume that the same trend will have some impact on the pricing of privately held RIAs as well.But the public markets are just one reference point that informs the valuation of privately held RIAs, and developments in the public markets may not directly translate to privately held RIAs. Depending on the growth and risk prospects of a particular closely-held RIA relative to publicly traded asset and wealth managers, the privately held RIA can warrant a much higher, or much lower, multiple.In our experience, the issues of comparability between small, privately held businesses and publicly traded companies are frequently driven by key person risk/lack of management depth, smaller scale, and less product and client diversification. These factors all contribute to the less-than-perfect comparability between publicly traded companies and most privately held RIAs. Still, publicly traded companies provide a useful indication of investor sentiment for the asset class, and thus, should be given at least some consideration.Improving OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market. Their product is, after all, the market.The outlook for RIAs appears to have improved since the significant market drop in December 2018.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth managers and traditional asset managers are vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations and create synergies.On balance, the outlook for RIAs appears to have improved since the significant market drop in December 2018. Since then, industry multiples have rebounded somewhat, and the broader market has recovered its losses and then some—which should have a positive impact on future RIA revenues and earnings.More attractive valuations could entice more M&A, coming off the heels of a record year in asset manager deal-making. We’ll keep an eye on all of it during what will likely be a very interesting year for RIA valuations.

M&A in the Bakken

Deals May Be Slow, But Production Remains Steady

Acquisition and divestiture activity in the Bakken for last twelve months has been minimal. The lack of deals, however, does not mean that activity or production hasn’t been meaningful. In fact, as mentioned in our most recent post, production has grown approximately 10% year-over-year through September with new well production per rig increasing over 29%. Also, while other major basins have been decreasing rig counts, the Bakken has remained steady year-over-year as of the end of September.While the fundamentals of this basin are strong, relatively few companies remain interested. As such, deal activity has largely involved the familiar faces in the region. Companies with smaller positions in the region have continued to divest “non-core” positions as they focus their efforts in other regions. Contrast this trend to the controlling acquisitions or takeovers like those that have been popular in the Permian.Recent Transactions in the BakkenDetails of recent transactions in the Bakken, including some comparative valuation metrics, are shown below.Balance Sheet Cleanup: Whiting and AbraxasA recurring theme observed throughout the year in multiple basins has been the optimization of assets. The theme continues in the Bakken for 2019 as transactions in the basin have primarily consisted of offloading portions of non-operated assets, the largest of which was the deal with Whiting Petroleum and an undisclosed buyer for $53 million. However, Whiting remains the third largest holder of net acreage in the basin.Abraxas Petroleum also sold approximately $16 million in non-operated assets in June. These assets were not part of Abraxas’ core Williston position. However, Abraxas appears to be open to conversations with parties interested in acquiring both operated and non-operated assets, as the company is seemingly in deal talks with Whiting Petroleum.Given the age of the basin and smaller number of players, consolidation and strategic deals between operators have been prevalent. Several players have left the Bakken for the Permian, and as a result, the top five net acreage holders account for roughly half of the existing operating acreage in the basin. Abraxas undertook a sizable debt load in 2018 to finance further capital expenditures and restructure debt maturities ($180 million due in 2020-20211). An exit from the Bakken to pay down its debt and expand their Permian operations does not seem unreasonable.Continued Non-Operator Acquisitions: Northern Oil and GasSimilar to trends observed in the Bakken last year, acquisitions by non-operators have continued into 2019. For instance, Northern Oil and Gas has made several deals in the basin and its acquisition of private equity-backed Flywheel Energy LLC in April 2019 was one of the largest of the year, and represents a continuance of this trend.Northern Oil and Gas has been the basin’s most consistent acquirer of non-operating interests. As a nonoperator, Northern can enjoy cash flows received from acreage without the operator risk that has become ever more prevalent in the current environment, and consequently, the company has the luxury of continuing to strategically consolidate acreage in the basin. Since the start of 2018, the company has made four large publicly announced transactions totaling more than $820 million.Below is a map of the acreage Northern Oil and Gas acquired in the Flywheel transaction as well existing acreage to show its overall footprint in the basin.ConclusionEven though transaction activity in the Bakken has been minimal compared to basins like the Permian, production is up, and rig counts are steady. Acquisitions for operators and non-operators alike have been strategic and pinpointed as the experienced players look to build and maintain their large positions relative to others in the area. Despite a slowdown of A&D activity in the back half of 2019, the operators and non-operators in the Bakken appear undeterred and are staying the course.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.1 Abraxas Petroleum Corporation Annual Report December 31, 2018

Tariff Time

Will they? Or won’t they? The imposition of tariffs and the broadness of their application has been a hot topic. Uncertainty over when they would come into effect, which countries would be subject to them, and which products or goods would be exempt, has contributed to market swings. As the health of the transportation and logistics industry is closely tied to the overall health of the economy, the impact of tariffs could be large.

Alternative Asset Managers

Performance Update

In May of this year, assets in passively managed funds equaled assets actively managed for the first time in history. As investors seek low-cost solutions, alternative managers are working to solidify their place in investors’ portfolios. Despite the headwinds the asset management industry faces, most investors still value the diversification offered by alternative assets, particularly late in the economic cycle. In this post, we take a closer look at how alternative asset managers are performing in light of the broader shift from active to passive management and increased fee pressure.Industry OutlookWhile hedge funds are not a perfect proxy for the broader alternatives industry, we can better understand the pressure the industry faces by analyzing hedge fund asset flows. Hedge funds recorded their fifth consecutive quarterly withdrawal in Q2 2019 and the largest semiannual outflow ($47.4 billion) since the second half of 2016. Despite this, hedge fund assets under management grew 4.4% since the end of 2018 as positive performance offset fund flows. While hedge funds have underperformed over the last decade (since 2009 the S&P 500 index has dwarfed the performance of hedge funds as measured by the HFRI Fund Weighted Composite Index), recent volatility has improved their performance on a relative basis. Hedge fund capital typically lags performance, so we expect to see asset outflows slow in the coming months as investors reallocate their portfolios in light of recent performance.Alternative assets typically serve to either increase diversification or enhance portfolio returns. In a near-zero interest rate environment, institutional investors have sought return generating assets. Over the last couple of years, pension funds have started diversifying their portfolios to include alternative assets in order to chase higher risk, higher return assets. It is typically more difficult for the average investor to gain exposure to alternative assets due to the often significant minimum investment requirements. While some efforts have been made to expand distribution to the retail market, institutional investors are still the primary target market for alternative managers. Over the last several years, alternative asset managers have been largely successful at securing a spot in institutional investors’ portfolios.In terms of diversification, investors have started positioning themselves for longer-term volatility due to increased geopolitical tensions and a slowing IPO market. While investor interest in uncorrelated asset classes such as alternatives fell during the longest bull market run in history, recent volatility could push investors back to the asset class.Practice ManagementToday, the main priority for most alternative asset managers is raising assets. Assets follow performance, especially in the alternatives space, and one way to directly impact investor returns is to reduce fees. After a decade of lackluster performance, reducing costs has become a key issue for alternative managers seeking to bring in new assets. Amidst fee pressure, alterative managers are deviating from the typical “2 and 20” model.While traditional asset managers have been able to reduce fees by achieving some measure of scale, alternative managers must be careful to not sacrifice specialization in key strategies for scale. Alternative managers have seen some success utilizing technology in the front office or outsourcing certain functions in order to reduce overhead and spare time for management to focus on asset raising.Industry ValuationsIn the eyes of market participants, the industry has performed well over the last year. Generally, alternative asset managers have been more resilient to price declines than traditional asset and wealth managers. Our alternative asset manager index is up 4.4% year-over-year, compared to our index of traditional asset and wealth manages which was down for the year. Price to LTM earnings multiples have recently increased for alternative asset managers as prices over the last year increased by a median of 16%. Current pricing is close to the 52 week high and forward multiples are noticeably lower than LTM multiples, suggesting that publicly traded alternative asset managers are currently trading at peak valuations and earnings are expected to increase over the next twelve months. Summary Despite improving performance over the last few years, the industry continues to face a number of headwinds, including fee pressure and expanding index opportunities. While the idea of passively managed alternative asset products seems like an oxymoron, a number of funds exist with a goal of imitating private equity returns. Innovative products are being made available to the investing public every day. And while there is currently no passive substitute to alternatives, we do believe that the industry will continue to be influenced by many of the same pressures that traditional asset managers are facing today despite the recent uptick in alt manager valuations.

Five Trends to Watch in the Medical Device Industry

The medical device manufacturing industry produces equipment designed to diagnose and treat patients within global healthcare systems. Medical devices range from simple tongue depressors and bandages, to complex programmable pacemakers and sophisticated imaging systems. Major product categories include surgical implants and instruments, medical supplies, electro-medical equipment, in-vitro diagnostic equipment and reagents, irradiation apparatuses, and dental goods.The following outlines five structural factors and trends that influence demand and supply of medical devices and related procedures.1. DemographicsThe aging population, driven by declining fertility rates and increasing life expectancy, represents a major demand driver for medical devices. The U.S. elderly population (persons aged 65 and above) totaled 49 million in 2016 (15% of the population). The U.S. Census Bureau estimates that the elderly will roughly double by 2060 to 95 million, representing 23% of the total population. The elderly account for nearly one third of total healthcare consumption. Personal healthcare spending for the population segment was $19,000 per person in 2014, five times the spending per child ($3,700) and almost triple the spending per working-age person ($7,200). According to United Nations projections, the global elderly population will rise from approximately 607 million (8.2% of world population) in 2015 to 1.8 billion (17.8% of world population) in 2060. Europe’s elderly are projected to reach approximately 29% of the population by 2060, making it the world’s oldest region. While Latin America and Asia are currently relatively young, these regions are expected to undergo drastic transformations over the next several decades, with the elderly population expected to expand from less than 8% in 2015 to more than 21% of the total population by 2060. 2. Healthcare Spending and the Legislative Landscape in the U.S.Demographic shifts underlie the expected growth in total U.S. healthcare expenditure from $3.5 trillion in 2017 to $6.0 trillion in 2027, an average annual growth rate of 5.5%. While this projected average annual growth rate is more modest than that of 7.0% observed from 1990 through 2007, it is more rapid than the observed rate of 4.3% between 2008 and 2017. Projected growth in annual spending for Medicare (7.9%) is expected to contribute substantially to the increase in national health expenditure over the coming decade. Healthcare spending as a percentage of GDP is expected to expand from 17.9% in 2017 to 19.4% by 2027.Since inception, Medicare has accounted for an increasing proportion of total U.S. healthcare expenditures. Medicare currently provides healthcare benefits for an estimated 60 million elderly and disabled people, constituting approximately 15% of the federal budget in 2018. Medicare represents the largest portion of total healthcare costs, constituting 20% of total health spending in 2017. Medicare also accounts for 25% of hospital spending, 30% of retail prescription drugs sales, and 23% of physician services. Owing to the growing influence of Medicare in aggregate healthcare consumption, legislative developments can have a potentially outsized effect on the demand and pricing for medical products and services. Net mandatory benefit outlays (gross outlays less offsetting receipts) to Medicare totaled $591 billion in 2017, and are expected to reach $1.3 trillion by 2028. The Patient Protection and Affordable Care Act (“ACA”) of 2010 incorporated changes that are expected to constrain annual growth in Medicare spending over the next several decades, including reductions in Medicare payments to plans and providers, increased revenues, and new delivery system reforms that aim to improve efficiency and quality of patient care and reduce costs. On a per person basis, Medicare spending is projected to grow at 4.6% annually between 2017 and 2027, compared to 1.5% average annualized growth realized between 2010 and 2017, and 7.3% during the 2000s. As part of ACA legislation, a 2.3% excise tax was imposed on certain medical devices for sales by manufacturers, producers, or importers. The tax had become effective on December 31, 2012, but met resistance from industry participants and policy makers. In late 2015, Congress passed legislation promulgating a two-year moratorium on the tax beginning January 2016. In January 2018, the moratorium suspending the medical device excise tax was extended through 2019.3. Third-Party Coverage and ReimbursementThe primary customers of medical device companies are physicians (and/or product approval committees at their hospitals), who select the appropriate equipment for consumers (patients). In most developed economies, the consumers themselves are one (or more) step removed from interactions with manufacturers, and therefore pricing of medical devices. Device manufacturers ultimately receive payments from insurers, who usually reimburse healthcare providers for routine procedures (rather than for specific components like the devices used). Accordingly, medical device purchasing decisions tend to be largely disconnected from price.Third-party payors (both private and government programs) are keen to reevaluate their payment policies to constrain rising healthcare costs. Several elements of the ACA are expected to limit reimbursement growth for hospitals, which form the largest market for medical devices. Lower reimbursement growth will likely persuade hospitals to scrutinize medical purchases by adopting i) higher standards to evaluate the benefits of new procedures and devices, and ii) a more disciplined price bargaining stance. The transition of the healthcare delivery paradigm from fee-for-service (FFS) to value models is expected to lead to fewer hospital admissions and procedures, given the focus on cost-cutting and efficiency. In 2015, the Department of Health and Human Services (HHS) announced goals to have 85% and 90% of all Medicare payments tied to quality or value by 2016 and 2018, respectively, and 30% and 50% of total Medicare payments tied to alternative payment models (APM) by the end of 2016 and 2018, respectively. A report issued by the Health Care Payment Learning & Action Network (LAN), a public-private partnership launched in March 2015 by HHS, found that 34% of payments were tied to APMs, a 5% increase from 2016 to 2017. Some expressed concern that the shift toward value-based care would encounter difficulties with the current administration. In November 2017, the CMS partially canceled bundled payment programs for certain joint replacement and cardiac rehabilitation procedures. However, indications are that the CMS supports value-based care and wants pilot programs to accelerate. Ultimately, lower reimbursement rates and reduced procedure volume will likely limit pricing gains for medical devices and equipment. The medical device industry faces similar reimbursement issues globally, as the EU and other jurisdictions face increasing healthcare costs, as well. A number of countries have instituted price ceilings on certain medical procedures, which could deflate the reimbursement rates of third-party payors, forcing down product prices. Industry participants are required to report manufacturing costs and medical device reimbursement rates are set potentially below those figures in certain major markets like Germany, France, Japan, Taiwan, Korea, China, and Brazil. Whether third-party payors consider certain devices medically reasonable or necessary for operations presents a hurdle that device makers and manufacturers must overcome in bringing their devices to market.4. Competitive Factors and Regulatory RegimeHistorically, much of the growth for medical technology companies has been predicated on continual product innovations that make devices easier for doctors to use and improve health outcomes for the patients. Successful product development usually requires significant R&D outlays and a measure of luck. However, viable new devices can elevate average selling prices, market penetration, and market share.Government regulations curb competition in two ways to foster an environment where firms may realize an acceptable level of returns on their R&D investments. First, firms that are first to the market with a new product can benefit from patents and intellectual property protection giving them a competitive advantage for a finite period. Second, regulations govern medical device design and development, preclinical and clinical testing, premarket clearance or approval, registration and listing, manufacturing, labeling, storage, advertising and promotions, sales and distribution, export and import, and post market surveillance.Regulatory Overview in the U.S.In the U.S., the FDA generally oversees the implementation of the second set of regulations. Some relatively simple devices deemed to pose low risk are exempt from the FDA’s clearance requirement and can be marketed in the U.S. without prior authorization. For the remaining devices, commercial distribution requires marketing authorization from the FDA, which comes in primarily two flavors.The premarket notification (“510(k) clearance”) process requires the manufacturer to demonstrate that a device is “substantially equivalent” to an existing device (“predicate device”) that is legally marketed in the U.S. The 510(k) clearance process may occasionally require clinical data, and generally takes between 90 days and one year for completion. In November 2018, the FDA announced plans to change elements of the 510(k) clearance process. Specifically, the FDA plan includes measures to encourage device manufacturers to use predicate devices that have been on the market for no more than 1o years. The FDA also announced in its statements plans to finalize guidance establishing an alternative 510(k) pathway in early 2019. This alternative pathway would allow manufacturers of certain “well-understood device types” to demonstrate substantial equivalence through objective safety and performance criteria.The premarket approval (“PMA”) process is more stringent, time-consuming and expensive. A PMA application must be supported by valid scientific evidence, which typically entails collection of extensive technical, preclinical, clinical and manufacturing data. Once the PMA is submitted and found to be complete, the FDA begins an in-depth review, which is required by statute to take no longer than 180 days. However, the process typically takes significantly longer, and may require several years to complete. Pursuant to the Medical Device User Fee Modernization Act (MDUFA), the FDA collects user fees for the review of devices for marketing clearance or approval. The current iteration of the Medical Device User Fee Act (MDUFA IV) came into effect in October 2017. Under MDUFA IV, the FDA is authorized to collect almost $1 billion in user fees, an increase of more than $320 million over MDUFA III, between 2017 and 2022.Regulatory Overview Outside the U.S.The European Union (EU), along with countries such as Japan, Canada, and Australia all operate strict regulatory regimes similar to that of the FDA, and international consensus is moving towards more stringent regulations. Stricter regulations for new devices may slow release dates and may negatively affect companies within the industry.Medical device manufacturers face a single regulatory body across the EU. In order for a medical device to be allowed on the market, it must meet the requirements set by the EU Medical Devices Directive. Devices must receive a Conformité Européenne (CE) Mark certificate before they are allowed to be sold in that market. This CE marking verifies that a device meets all regulatory requirements, including EU safety standards. A set of different directives apply to different types of devices, potentially increasing the complexity and cost of compliance.5. Emerging Global MarketsEmerging economies are claiming a growing share of global healthcare consumption, including medical devices and related procedures, owing to relative economic prosperity, growing medical awareness, and increasing (and increasingly aging) populations. As global health expenditure continues to increase, sales to countries outside the U.S. represent a potential avenue for growth for domestic medical device companies. According to the World Bank, all regions (except Sub-Saharan Africa and South Asia) have seen an increase in healthcare spending as a percentage of total output over the last two decades. Global medical devices sales are estimated to increase 6.4% annually from 2016 to 2020, reaching nearly $440 billion according to the International Trade Administration. While the Americas are projected to remain the world’s largest medical device market, the Asia/Pacific and Western Europe markets are expected to expand at a quicker pace over the next several years. SummaryDemographic shifts underlie the long-term market opportunity for medical device manufacturers. While efforts to control costs on the part of the government insurer in the U.S. may limit future pricing growth for incumbent products, a growing global market provides domestic device manufacturers with an opportunity to broaden and diversify their geographic revenue base. Developing new products and procedures is risky and usually more resource intensive compared to some other growth sectors of the economy. However, barriers to entry in the form of existing regulations provide a measure of relief from competition, especially for newly developed products.

Community Bank Valuation (Part 3): Important Relationships Between a Bank and Its Holding Company

The August 2019 BankWatch described key considerations in analyzing the financial statements of banks. However, we did not address one crucial set of relationships – those between a bank holding company (“BHC”) and its subsidiary depository institution.Most banks are owned by bank holding companies. While investors often state that they own an interest in a bank, this may not be legally precise. Usually, they own a share of stock in a bank holding company, which in turn owns a controlling interest in a subsidiary bank’s common stock. Where a bank holding company exists, this entity’s common stock generally is the subject of valuation analyses.Part 3 of the Community Bank Valuation series explores important relationships between banks and their holding companies, focusing particularly on cash flow and leverage.The Holding Company’s Balance SheetCompared to a bank’s balance sheet, a holding company’s balance sheet has fewer moving parts. The “left side” of its balance sheet, or its assets, usually is rather boring. The more intriguing analytical question, though, is how the bank holding company finances its investment in the bank. The following table presents a balance sheet for a BHC controlling 100% of the common stock of a bank with $500 million of total assets. Usually, the holding company’s assets consist virtually entirely of its investment in its subsidiary bank or banks, which equals the bank’s total equity. The investment in the bank is carried at equity, meaning that it increases by the bank’s net income and decreases by dividends paid from the bank to the holding company, among other transactions. Other material assets may include: Cash. BHCs with cash obligations paid at the holding company, such as interest payments or compensation, often will maintain a cash buffer to cover several months of operating expenses. In some cases, BHCs will maintain a larger cash position to react opportunistically if the bank subsidiary needs a capital injection for its growth or to repurchase BHC shares.Other Assets. Non-bank assets typically are relatively modest and consist of investments in other entities (such as an insurance agency), intangible assets related to acquisitions that were not “pushed down” to the subsidiary, or facilities. In periods marked by higher levels of nonperforming assets, BHCs may hold problem assets, which is one strategy to reduce the bank’s classified asset/ capital ratio. Interestingly, BHCs can borrow from banks – just not their bank subsidiary – and other capital providers. If the funds are downstreamed into the bank, the borrowings can be transformed from an instrument not includible in the BHC’s regulatory capital into Tier 1 capital at the bank. In order of seniority these funding sources include:Bank Stock Loans. These loans are collateralized by the subsidiary bank’s stock and typically are obtained from another bank. As a secured borrowing, these loans generally have a lower cost than other alternatives. However, in the event of a default, the lender can foreclose on their collateral (i.e., the bank stock).Subordinated Debt. After passage of the Dodd-Frank Act and the Basel III capital regulations, subordinated debt became a more prominent funding source, usually for organic growth or acquisitions. Various regulatory requirements govern subordinated debt offerings, but most community bank placements provide for a ten year term with the interest rate fixed for five years. The securities may be considered Tier 2 capital for the holding company.Trust Preferred Securities (“TruPS”). TruPS were created in the 1990s to combine the Tier 1 capital treatment of preferred stock with the tax deductibility of debt. Rightly or wrongly, this instrument was viewed negatively by some regulators after the financial crisis, and the Basel III regulations effectively nullified new issuances. Many BHCs still hold grandfathered TruPS, though, which often do not mature until the 2030s. TruPS generally have interest rates that float with LIBOR, are subordinated to all other BHC obligations, and provide the issuer the right to defer payments for up to five years without triggering a default. TruPS count as Tier 1 capital for BHCs with under $15 billion in assets that are considered to be “large” BHCs that fie Y-9LP and Y-9C call reports with the Federal Reserve. A BHC’s equity usually consists almost entirely of common stock, which generally must be the principal form of capitalization under BHC regulations. However, BHCs can issue preferred stock, and regulations view most favorably non-cumulative, perpetual preferred stock.Analytical ConsiderationsWhy do holding companies exist? First, they provide an efficient way to raise funds that can be injected as capital into the bank, thereby accommodating its organic growth. Second, they can facilitate acquisitions. Third, BHCs can more efficiently conduct shareholder transactions, such as repurchases.By using leverage, a BHC can enhance the bank’s stand-alone return on equity (or exacerbate the ROE pressure arising from adverse financial scenarios). As indicated in Table 2, BHC leverage magnifies the subsidiary bank’s 12.0% ROE to 12.9% after considering the cost of the BHC’s debt. As for a non-financial company, too much leverage can mean that the beneficial effect to shareholders of a higher ROE is swamped by the additional risk of financial distress. Various metrics exist to measure the holding company’s leverage, but one is the “double leverage” ratio, which is calculated as the investment in the bank subsidiary divided by the BHC’s equity. As indicated in Table 1 on page one, the BHC’s ratio is 113%, which is consistent with the median reported by all smaller BHCs at June 30, 2019 (112%, excluding some BHCs for which the BHC’s equity exceeds the bank investment). Cash FlowUnfortunately, BHC regulatory filings and audited financial statements do not provide a sources and uses of funds schedule, although some cash flow data is provided. Nevertheless, understanding the BHC’s obligations, and the cash required to service those obligations, is essential.Sources of funds consist principally of the following:Dividends from the bank subsidiary. The depth of this source of cash flow should be evaluated in light of the bank’s profitability, capital levels, and growth opportunities.Debt issuancesCommon stock salesIntercompany payments. For example, the bank may reimburse the holding company for certain expenses paid by the BHC. Additionally, banks and BHCs often have tax-sharing arrangements. If the holding company incurs expenses, then it may realize an offsetting tax benefit. Uses of funds include the following:Debt serviceShareholder dividendsShare repurchasesOperating expenses. Expenses such as compensation, directors’ fees, and certain insurance premiums may be recorded by the holding company Analysts should compare a bank’s ability to pay dividends, given its profitability level and need to retain earnings to fund its growth, against the BHC’s various claims on cash. Mismatches can sometimes arise due to changes in the bank’s performance or operating strategy. For example, consider a BHC that historically has paid high dividends to shareholders. If its subsidiary bank adopts a new strategic plan focused on organic growth, then the bank will need to retain earnings rather than pay dividends to the BHC and, ultimately, BHC shareholders. Additional borrowings could fund a short-term gap, but this is not a long-term solution to a BHC cash flow mismatch. Two other special circumstances arise when analyzing BHC cash flow:Acquisitions. Prior to entering into a transaction, the BHC’s plan for funding any cash consideration should evaluate the availability and desirability of dividends from the bank, debt offerings, and stock sales. Further, the cash acquired from the target BHC may provide another source of transaction funding.S Corporations. Shareholders in an S corporation rely on the BHC for distributions to offset their pass-through tax liability, while the BHC in turn relies on the bank for dividends to fund those tax payments. There are no special capital rules at the bank level that provide flexibility regarding the payment of dividends to offset BHC shareholders’ tax liability when other restrictions on dividends may exist. That is, C corporation and S corporation banks face the same capital regulations. Boards of S corporations may desire to operate, at the margin, with a greater capital buffer to avoid a situation where the shareholders have taxable income but the BHC is unable to make distributions.CapitalCapital requirements for BHCs vary based upon their asset size. Under current regulations, BHCs with assets below $3.0 billion are subject to the Federal Reserve’s Small Bank Holding Company Policy Statement. This regulation does not establish any specific minimum capital ratios for small BHCs; however, a debt/ equity ratio limitation exists for debt arising from acquisitions. Therefore, small BHCs have significant flexibility in managing their capital structure, although the Federal Reserve theoretically remains a check on their creativity.Large BHCs are subject to the Basel III regulations, which involve capital ratios calculated based on Tier 1 and total capital. Tier 1 capital generally is limited to common equity, non-cumulative perpetual preferred stock, and grandfathered TruPS. In addition to the allowance for loan losses, Tier 2 capital may include subordinated debt. Large BHC management can balance these capital sources to minimize the BHC’s weighted average cost of capital, maintain flexibility for unexpected events or opportunities, and ensure compliance with regulatory expectations.ConclusionWhile the subsidiary bank receives most of the analytical attention, the holding company on a standalone (or parent company) basis should not be overlooked. This is particularly true if the holding company has significant obligations to service debt or pay other expenses. By understanding the linkages between the bank and holding company, analysts can better assess a BHC’s potential future returns to shareholders and risk factors posed by the BHC that could jeopardize those returns.Originally published in Bank Watch, September 2019.

Bakken May Lack Flash, But Has Fundamentals

The economics of oil and gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Appalachia plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. In this post, we take a closer look at the Bakken Shale.Production and Activity LevelsBakken production grew approximately 10% year-over-year through September. While this growth rate lags behind the Permian, it is in line with production growth in Appalachia and meaningfully bests the Eagle Ford. The rig count in the Bakken at the end of September was unchanged from the year prior at 53. While not impressive at first glance, the total U.S. rig count declined nearly 20% over the same period. Eagle Ford, Permian, and Appalachia rig counts declined 22%, 15%, and 17%, respectively. The Bakken has also seen the biggest gain in new-well production per rig relative to our other coverage basins. While this metric doesn’t cover the full life cycle of a well, it is a signal of the increasing efficiency of operators in the area. New well production per rig in the Bakken increased 29% on a year-over-year basis through September, compared to increases of 2%, 12%, and 7% in the Eagle Ford, Permian, and Appalachia, respectively. Financial PerformanceBakken E&P operator financial performance was a mixed bag over the past year. Canada’s Crescent Point Energy (CPG) was the only positive performer of the Bakken-focused operators, up 23% year-over-year through September. While down 16%, Hess outperformed the broader S&P Oil & Gas Exploration & Production Index (XOP). However, this was likely attributable (at least in part) to positive developments out of Guyana, where Hess has a 30% interest in the massive Stabroek block. The Stabroek block is one of the largest offshore oil discoveries in the past decade, with more than 6 billion boe of discovered, recoverable resource. Continental, Whiting, and Oasis all unperformed the broader E&P index during the past year, with Whiting down a notable 85%. Oasis is funding its Permian development program with cash flows generated from its Bakken position, a strategy that has fallen out of favor with investors who now seek capital discipline and free cash flow generation. Whiting is down largely on concerns regarding leverage and inventory life. All three saw margin compression, with Whiting’s EBITDAX per boe down nearly 30% year-over-year. Despite this financial performance, the Bakken hasn’t been impacted by the recent batch of bankruptcies that have afflicted the Mid-Con (Alta Mesa, White Star), Eagle Ford (Sanchez, EP Energy), and even the Permian (Halcon). However, Whiting did announce a major restructuring in which it will terminate 254 positions (around one-third of the company’s workforce). As a result, the company anticipates approximately $50 million in annual savings. Commodity Prices Largely Unchanged in Aftermath of Saudi AttackOn September 14, a missile attack on Saudi Arabian oil production facilities took out 5.7 million barrels a day of production, amounting to about 5% of global production. Both WTI and Brent crude prices surged more than 10% in the immediate aftermath of the attack. However, the price reaction was short-lived, as the Saudis were able to bring 2 million bbl/d of production back online within days, with the remainder expected to be back online within weeks. WTI and Brent prices ended September lower than on the day prior to the attack. Realized pricing in the Bakken has improved markedly relative to last fall, when a combination of Midwest refinery turnarounds and a glut of Canadian production sent the Clearbrook Bakken / WTI differential to more than $20/bbl. At the end of September, the differential stood at approximately $2.50/bbl. While thinly traded, basis futures indicate expected differentials of $2.50 to $4.30/bbl over the next several years. Infrastructure IssuesThe Dakota Access Pipeline largely alleviated crude takeaway constraints out of the basin. And with a proposed expansion of the pipeline, the announced Liberty Pipeline, and excess crude-by-rail capacity, E&P operators likely won’t have issues getting crude to end markets.However, both Whiting and Oasis indicated that issues with natural gas processing infrastructure adversely impacted performance during the quarter.In the Q2 earnings call, Whiting CEO Brad Holly stated,To minimize flaring, we are producing some wells at constrained oil rates, while we focus on increasing gas capture through the installation of mobile combustion units, building out gathering systems, and completing our ray gas processing plant. Constraints also impacted the pace of planned operating activity.Oasis CEO Tommy Nusz put a finer point on his commentary, specifically stating that downtime at the company’s Wild Basin gas complex reduced 2Q19 production by 3,000 boe/d.These constraints should moderate, though, as additional natural gas infrastructure comes online in late 2019 and early 2020.MLP Simplification Trend ContinuesThe recent trend of MLP simplifications, driven in part by tax reform, FERC policy changes, cost of capital considerations, and a desire to reach a broader investor base, continues. Hess Midstream Partners (HESM) announced that it is acquiring Hess Infrastructure Partners (HIP) in a $6.2 billion transaction. HIP owns HESM’s General Partner (GP) units and Incentive Distribution Rights (IDRs), as well as an 80% interest in HESM’s oil and gas midstream assets. Unlike most simplifications that have occurred once GP/IDR distributions are “high in the splits” (with the GP/IDR holder typically taking 50% of incremental distributions above a certain threshold), HESM was only at the 25% split level.Fellow Bakken midstream operator Oasis Midstream Partners remains on a rapidly shortening list of MLPs that still have IDRs.ConclusionNow that the Bakken’s crude infrastructure issues have been (somewhat) resolved, the basin has seemed to take a backseat to other areas in terms of news coverage and investor attention. While the Bakken hasn’t kept up with the Permian’s growth, its static (rather than declining) rig count, higher oil to gas ratio, and sufficient crude takeaway capacity bode well for the basin relative to its domestic counterparts.We have assisted many clients with various valuation needs in the upstream oil and gas space in both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

Transitioning Your Business to the Next Generation of Leadership

Successful Succession for RIAs

Continuing with our succession series, this week’s focus is on internal transitions. If you’ve ever wondered why there aren’t more transactions in the RIA space, it’s largely because most of these businesses ultimately transition their ownership internally to younger partners at the firm. These deals typically don’t get reported, so you probably don’t hear about most of them. Still, it’s the most common type of transaction for investment management firms and probably something that’s crossed your mind if you’re approaching retirement.A gradual transition to the next generation is a good way to align your employees’ interests and grow the firm.These types of transactions are common for a reason. Most RIA owners like working for themselves and will eschew outside interference at all costs (unless the price is right). Because many clients enjoy working with a wholly independent advisor, internal transitions are a good way to accomplish this in the long run. Further, a gradual transition of responsibilities and ownership to the next generation is also usually one of the best ways to align your employees’ interests and grow the firm to everyone’s benefit.The most obvious roadblock when planning for internal succession is pricing. We recommend that all firms have a buy-sell agreement that specifies the terms and the price that shares are transacted at as an owner exits to retire. Because many wealth management firms are highly valuable, successors are often financially stretched to take over the founder’s interest in the firm. By establishing the price and terms at which the shares will be transacted, a buy-sell agreement mitigates any potential drama.In their recent book Success and Succession, Eric Hehman, Jay Hummel, and Tim Kochis examine the complexities of the leadership transition process and summarize their findings from their own experience:Both the founder and the successor need to be aware that firm-wide growth often declines in the first year following the change in management, as the founder-centric firm shifts its brand image and the successor takes on responsibility for creating new business. If a successor is unaware of this trend, he or she could feel additional stress regarding the financial burden he undertook when buying out the former owner. The founder could feel the need to resume full-time involvement in operations, fearing for his ongoing financial benefits from the firm. The authors advise both founders and successors to take a long-term view and not focus on this short-term pullback.Regardless of the firm’s performance in the first few years following succession, both the founder and the successor need to set definite (as in finite) expectations regarding the founder’s continued involvement or lack thereof. The founder should remain accessible as his or her guidance is crucial when the successor faces major issues early on. However, it should also be clear to everyone that the successor is now the one charged with minding the store.Though some things do need to change following a succession of management, the successor should avoid creating new positions to retain people who no longer fit into the firm’s long-term goals. One benefit of succession is that the new manager may have a fresh perspective on areas of the firm in which cost cutting measures or other efficiencies are possible. Although it may be difficult to assess which employees should remain after the transition, allowing those who are poor fits to remain with the firm does significant damage to the firm’s culture and does not set the proper tone for post-transition success.It is crucial to separate compensation for labor from profit share rewards as the exiting owner becomes less involved in the day to day management of the firm. This issue can be resolved through the establishment of a strict reinvestment versus distribution policy going forward. The authors even suggest that the founder employ an independent financial advisor in order to objectively estimate a fair amount of compensation following the sale.Though it is clear that the founder has taken on a significant amount of financial risk in the creation of the firm, it must be noted that the successor is also taking on risk in the amount of debt that he or she must incur to buy out the owner. Both parties have a lot to gain and a lot to lose in the process of succession, and both bear a significant emotional burden. The founder may perceive the transition as a loss of a personal identity that is tied to the firm, and the successor must now bear the responsibility of the ongoing success of the firm.Controversy over what is fair or what is “enough” in terms of a sale price can be resolved through a third-party valuation. While it might seem easier to rely on rules-of-thumb metrics or attractive examples, these tactics are purely short term solutions and can result in overly optimistic estimates. The financial terms of the valuation are already emotionally charged. A third party valuation can provide a much needed “reality dose.” Obviously, there’s a lot to think about, and this is certainly not an exhaustive list. It’s never too early to start planning for your succession. The longer you wait, the more likely you are going to fall short or have to make series concessions on pricing. Unfortunately, we see this more often than not, so don’t become another statistic. We’re here to help with the valuation and advisory aspects, but it’s up to you to get the ball rolling.

Planning to Succeed

In the late 1930s Henry Ford’s son, Edsel, commissioned a one-off convertible version of the Lincoln Zephyr to drive while he vacationed in Florida for the winter. While the initial design is said to have been penned in about an hour, legend has it that Edsel Ford kept tweaking the details and wearing out the engineers such that they finally locked him out of the shop to finish the car. Edsel Ford took his Lincoln, dubbed the “Continental,” to Florida, and came back with 200 orders. Ford suddenly had a halo car, and Lincoln became a durable brand for decades.The Continental story is significant for many reasons, one of them being that it was a big success for second-generation leadership at Ford Motor Company. Many businesses start and grow by force of the personality of the founder, and wither and die when there is no successor leadership to take over when the founder is no longer at the helm. Ford succeeded where many other automakers failed, which is why this blog post is starting with that company instead of Pierce-Arrow, Packard, or Duesenberg.Succession is as often discussed as it is misunderstood.If succession is difficult to achieve in a “products” company like an automaker, it is mind-numbing to engineer in a “services” business-like investment management. Riffing off the over-repeated metaphor to describe the substance of an RIA, if the assets get on the elevator and go home every night…does a change in assets mean a different company altogether?Succession is as often discussed as it is misunderstood. While many practice management issues revolve around industry expectations, regulations, client expectations, and basic economics, succession involves all of those things plus personality, culture, and skill sets. And while much has been written about succession in the RIA industry, we’ve seen plenty of topics get little, if any attention. This post is dedicated to some of the latter.Internal Succession is the Default Plan for Most RIAsDespite the headlines suggesting that there is a wave of strategic takeovers that will ultimately consolidate the investment management profession into a few large firms, the reality we’ve encountered suggests that most RIAs will transition ownership and leadership from one generation to the next internally. The reasons for this are fairly obvious.Even though there are on the order of 15,000 RIAs in the U.S. which are all generally in the same business (providing investment management consulting services in exchange for fees priced relative to the dollar amount of client assets), there are also about 15,000 business models. Investment management firms are idiosyncratic, with practices and cultures unique to the individuals involved in the practice and the market niche served by the practice.Staff who grow up, or whose careers develop, at a given firm understand, inherently, the values and expectations of their workplace, and are in the best position to perpetuate the business after the prior generation of leadership retires.Strategic Transactions Rarely Obviate the Need for Succession PlanningLeadership transition issues can loom large even in strategic transactions. We worked on a dispute situation a few years ago in which a strategic acquirer bought a substantial wealth management practice without even meeting the next generation of leadership. The ink was hardly dry on the purchase agreement when generation two started looking for the exit, knowing many of their clients would follow them. Litigation eventually resolved this in one respect, but most arms’ length observers would conclude that all parties (buyer, seller, and the second generation) were worse off as a result.RIAs often pride themselves on having a team-oriented atmosphere, which is great for serving clients, but not so great for negotiating succession issues. When team members become buyers and sellers, temperaments that were heretofore aligned become opposed. Arguments can easily break out between members of buyer and seller groups when goals diverge or perspectives on the future of the firm conflict.Some see strategic transactions as a way to avoid the uncomfortable conversations that accompany internal ownership transition. Not so. If the strategic transaction does not align with the priorities of the group responsible for leading the firm after the deal closes, then the likely outcome will be suboptimal.Continuity Planning is the Dog that Wags the Succession TailThe client doesn’t really care who owns your firm. The client cares about the firm serving their needs. It’s easy to forget this because…Succession is a Strategic Issue Often Mistreated as a Tactical IssueWhen managers at RIAs start thinking about succession, they immediately jump into who buys out whom at what price and terms. We would suggest, instead, that the starting point is strategic planning for the business.Ownership should be a consequence of the business strategy, not the other way around.Ownership is the single biggest distraction for most closely held businesses. But ownership should be a consequence of the business strategy, not the other way around. Think of the strategic priorities of an investment management firm in the same order they appear on the P&L.Revenue comes first. So, at a basic level, strategic planning for an RIA starts with growing client relationships and value provided to the clients to maximize revenue opportunities.Next comes operating expenses, which for an investment management firm consists mostly of employee compensation. Spending on talent and tools to achieve the strategic revenue goals form the organization to be owned.Profits are at the bottom of your P&L for a reason. They matter, of course, but returns to equity are the residual of client interaction and the organization formed to serve them. Ownership is a by-product of strategy, and, at best, can be structured to support strategic initiatives.Timing is Everything, and so is TimeAnother famous Lincoln, whose first name was Abraham, famously said that if he was given seven hours to chop down a tree, he’d spend six hours sharpening his axe. We would say this ratio of planning to implementation is about right for dealing with the issue of succession as well.

The Fair Market Value of Oil & Gas Reserves

Due to the historical popularity of this post, we revisit it this week. Originally published in 2017, this post helps you, the reader, understand how to determine the fair market value of oil and gas reserves. Oil and gas assets represent the majority of value of an E&P company. The Oil and Gas Financial Journal describes reserves as “a measurable value of a company's worth and a basic measure of its life span.” Thus, understanding the fair market value of a company’s PDP, PDNP, and PUDs is key to understanding the fair market value of the Company. As we discussed before, the FASB and SEC offer reporting guidelines regarding the disclosure of proved reserves, but none of these represent the actual market price. It is especially important to understand the price one can receive for reserves as many companies have recently sold “non-core” assets to generate cash to pay off debt and fund operations. The American Society of Appraisers defines the Fair market value as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.1The American Society of Appraisers recognizes three general approaches to valuation: (1) The Cost Approach, (2) The Income Approach, and (3) The Market Approach. The IRS provides guidance in determining the fair market value of an oil and gas producing property. Treasury Reg. 1.611–2(d) offers that if possible the cost approach or comparative sale approach should be used before a discounted cash flow analysis (DCF). When valuing acreage rights comparable transactions do provide the best indication of value. However, when valuing reserves, a DCF is often the best way to allocate value to different reserve categories because comparable transactions are very rare as the details needed to compare these specific characteristics of reserves are rarely disclosed.Cost ApproachThe cost approach determines a value indication of an asset by considering the cost to replicate the existing operations of an asset. The cost approach is used when reserves have not been proved up and there have been no historical transactions, yet a participant has spent significant time, talents, and investments into exploratory data on an oil and gas prospect project.Market ApproachThe market approach is a general way of determining a value indication of an asset by using one or more methods that compare the subject to similar assets that have been sold.Because reserve values vary between oil and gas plays and even within a single play, finding comparable transactions is difficult. A comparable sale must have occurred at a similar time due to the volatile nature of oil and gas prices. A comparable sale should be for a property that is located within the same play and within a field of similar maturity. Additionally, comparable transactions must be thoroughly analyzed to make sure that they were not transacted at a premium or discount due to external factors. Thus, the market approach is often difficult to perform because true comparable transactions are rare. However, the transaction method generally provides the best indication of fair market value for acreage and lease rights.Income ApproachThe income approach estimates a value indication of an asset by converting anticipated economic benefits into a present single amount. Treasury Reg 1.611 – 2(e)(4) provides a straightforward outline of how the approach should be used.In practice, this method requires that: The appraiser project income, expense, and net income on an annual basisEach year's net income is discounted for interest at the "going rate" to determine the present worth of the future income on an annual and total basisThe total present worth of future income is then discounted further, a percentage based on market conditions, to determine the fair market value. The costs of any expected additional equipment necessary to realize the profits are included in the annual expense, and the proceeds of any expected salvaged of equipment is included in the appropriate annual income. Although the income approach is the least preferred method of the IRS, these techniques are generally accepted and understood in oil and gas circles to provide reasonable and accurate appraisals of hydrocarbon reserves, and most closely resembles the financial statement reporting requirements discussed in our previous post. This method is the best indication of value when a seismic survey has been performed and reliable reserve estimates are available. In order to properly account for risk, we divide the reserves by PDP, PDNP, PUD, Probable, and Possible reserves. We will review the key inputs in a DCF analysis of oil and gas reserves below.Cash InflowsIn order to estimate revenue generated by an oil and gas reserve, we must have an estimate of production volume and price. Estimates of production are collected from Reserve reports which are produced by geological engineers.The forward price curve provides monthly price estimates for 84 months from the current date. Generally, the price a producer receives varies with the price of benchmark crude such as WTI or Brent. Thus, it is important to carefully consider a producers contract with distributors. For example, a company may sell raw crude to the distributor at 65% of Brent.Cash OutflowsMany E&P companies do not own the land on which they produce. Instead, they pay royalty payments to the land owner as a form of a lease payment. Royalty payments are generally negotiated as a percentage of the gross or net revenues derived from the use of the property. Besides royalty payments and daily operating costs, it is important to have conversations with management to understand future infrastructure maintenance and capital expenditures.DiscountOil and gas reserves can be based on pre-tax or after-tax cash flows. Pre-tax cash flows make reserve values more comparable as tax rates vary by location. When using pre-tax cash flows, we use a pre-tax cost of debt and pre-tax cost of equity to develop a WACC.Risk Adjustment FactorsWhile DCF techniques are generally reliable for proven developed reserves (PDPs), they do not always capture the uncertainties and opportunities associated with the proven undeveloped reserves (PUDs) and particularly are not representative of the less certain upside of the Probable and Possible reserve categories. A risk adjustment factor could be used to the discounted present value of cash flows according to the category of the reserves being valued to account for PUDs upside and uncertainty by reducing expected returns from an industry weighted average cost of capital (WACC). You could also add a risk premium for each reserve category to adjust a baseline WACC, or keep the same WACC for all reserves but discount the present value of the cash flows accordingly with comparable discounts to those shown below. The low oil price environment forced many companies to sell acreage and proved reserves in order to generate cash to pay off debt. In order to create a new business models in the face of low oil prices, it is critical for companies to understand the value of their assets. The valuation implications of reserves and acreage rights can swing dramatically in resource plays. Utilizing an experienced oil and gas reserve appraiser can help to understand how location impacts valuation issues in this current environment. Contact Mercer Capital to discuss your needs and learn more about how we can help you succeed. End Notes1 American Society of Appraisers, ASA Business Valuation Standards© (Revision published November 2009), “Definitions,” p. 27.

Fourth Quarter 2019 | Segment Focus: Nonresidential Construction

Nonresidential construction spending increased in 2019 led by public infrastructure, office, and transportation spending.

E&P Fourth Quarter 2019

Region: Appalachia

Region Focus: Appalachia // Crude prices steadily increased from $54 per barrel at the beginning of October to $61 at the close of 2019.

Do Oil And Water Mix? The Biggest Energy IPO Of 2019 Might Answer That Question

The capital markets in the upstream sector are leaving companies and investors in the lurch right now. Compared to 2018, equity and debt issuances have declined markedly and IPO’s in the sector have been relatively quiet apart from Brigham Minerals’ successful offering.[caption id="attachment_28082" align="alignnone" width="717"]Source: Shale Experts[/caption] Saltwater disposal and integrated water logistics companies have attracted a higher proportion of the sparsely available capital flowing into the sector, highlighted by the largest energy IPO of this year: Rattler Midstream LP. The continuing austerity trend toward cash flow sustainability for shale oil companies has provided limited attractive options for investors. In the meantime, drilling activity (particularly in West Texas) continues to grow, and therefore efficiency and scale grow ever more important across the board for upstream companies to remain competitive. One of the challenges producers face is handling the enormous amounts of water that have become part and parcel to the Delaware and Midland Basins. This is where saltwater disposal enters the picture. A horizontal well in the Delaware Basin can average four barrels (sometimes even up to 10 barrels) of water for every barrel of oil produced. Once produced, all that water must go somewhere and that somewhere is a saltwater disposal well. This is no new phenomenon as produced water has been an element of production for over 70 years. What is different in the Permian Basin is the higher ratio of water to oil (often called a “water cut”) that’s produced due to the native geology and today’s production techniques. Today’s U.S. oilfield water production is already around a colossal 50 million barrels a day. This contrasts with the U.S. producing only 15 million barrels of petroleum liquids every day. Most of that water is produced in the Permian Basin and there’s only going to be more of it. Much more. That’s to say nothing of the amount of water needed to fracture the rock during the production process. In a recent Raymond James research report, the authors noted that each well completion uses thirty Olympic swimming pools worth of water. [caption id="attachment_28080" align="alignnone" width="640"]Source: EIA, Drilling Info, Baker Hughes, Raymond James Research [/caption] This water needs to be transported, sometimes long distances, and logistically managed. This function is trending towards consolidation whereby a single entity combines these assets and services. Until the past couple of years there was very little aquatic pipeline infrastructure. Most was handled by trucking, but that is changing as increasing volumes are raising scrutiny on the inefficiency of trucking. Growing demand in West Texas has opened up an estimated $12 billion-dollar market potential in the Permian Basin alone, according to Raymond James. Fees for transporting and disposing produced water typically range from $0.50 to $2.50 per barrel. In addition, there is skimmed oil that can be gathered as well. However, where long distances stand between a production site and disposal infrastructure it can creep up to $4.00 to $6.00 per barrel. In today’s commodity price environment and focus on break-even prices, every dollar per barrel counts. Thus, there is a real incentive to improve infrastructure and push service costs lower. The investment merits of this water infrastructure include the opportunity for more steady business; with long term contracts tied to dedicated acreage, and stable cash flows that can fetch higher valuations than even some of the shale producers themselves in the region. It has been noted that some producers cannot begin drilling in certain areas until the water infrastructure is in place. In addition, there are consolidation opportunities for more fragmented business models between saltwater disposal facilities, equipment rental companies and pipeline companies. More integrated firms that combine these services will function more like traditional midstream operators. The trend has already begun and is being seen in valuations already. Rattler’s $765 million IPO opened at over 18 times EBITDA and recent water driven asset sales have traded between five- and ten-times EBITDA. For example, private equity backed WaterBridge purchased $325 million of Delaware Basin assets (assuming earnouts are paid) from Halcon Resources at an implied 14.5x trailing EBITDA multiple. Firms like NGL Energy Partners and EVX Midstream are also active in the space. Additionally, the opportunity for yield (which energy investors are craving) in the future can be more demonstrable than many upstream opportunities in the oil patch. [caption id="attachment_28081" align="alignnone" width="640"]Source: Company Filings. WaterBridge transaction assumes earnouts. Rattler transaction assumes total units outstanding not just traded ones.[/caption] Amid this activity, landowners are also finding another source of income from royalties stemming from new pipeline and below ground storage rights as well, leading to more local income for ranchers and residents as well as another potential asset base for mineral aggregators and related investors to pursue. Oil and water do appear to mix, and energy bankers will be glad to know they do because it is filling gaps for an otherwise tight capital market space. Originally appeared on Forbes.com.

Selling Your RIA to a Consolidator

Successful Succession for RIAs

As we explained in a recent post, there are many viable exit options for RIA principals when it comes to succession planning. In this post, we will review some of the considerations when partnering with an RIA consolidator.The opportunity for consolidating wealth management firms is well publicized: an industry composed of many small, fragmented firms with aging ownership bases and no clear succession plans is supposedly poised for consolidation. RIA consolidators have emerged to capitalize on this landscape, promising a means for ownership transition, back-office efficiencies, and best practices coaching.Acquisitions by consolidators represent an increasing portion of deal volume in the sector.Consolidators have been gaining traction in the industry. Most well-known RIA consolidators have grown their AUM at double-digit growth rates over the last five years, and acquisitions by consolidators represent an increasing portion of deal volume in the sector.For RIA principals that are looking for an exit plan, selling to a consolidator is one option to consider. A sale to a consolidator typically provides the selling partners with substantial liquidity at close, an ongoing interest in the economics of the firm, and a mechanism to transfer the sellers’ continued interest to next generation management.There are several considerations when considering a sale to an RIA consolidator. Price, of course, is the big one. But after the deal closes, the selling shareholders will typically have to stick around for several years at least (the deal terms will make sure of that). Thus, another important feature to consider is what life will look like after the deal closes. RIA owners who are considering selling to a consolidator should think carefully about which aspects of their business they feel strongly and how those aspects of the business will change after the deal closes.Consolidator Models There are several different consolidator models, and they can vary significantly in terms of the effect they have on the day-to-day operations of the acquired RIA. This is largely a function of the amount of integration that consolidators do for their partner firms.At one extreme, there are consolidators such as Focus Financial that standardize only the minimum level of business processes across their acquired firms, which typically include back-office tasks such as compliance and accounting. This “stay as you are” model has minimal impact on how the firm is run and theoretically maintains the selling partners’ sense of entrepreneurship. Acquired firms can retain their own branding and client-facing processes after the deal closes, and there is usually little or no impact from the perspective of the firm’s clients. This model also mitigates the risk of culture clash since acquired firms aren’t forced into a one-size-fits-all mold.At the other extreme, there are consolidators like United Capital (now part of Goldman Sachs) or Mercer Advisors, which unify the branding of acquired firms and present a homogenous wealth management platform to clients. Under this model, most functions of the acquired RIA—things like marketing, HR, and technology—are moved under the corporate umbrella. Sellers have much less control after the deal closes under this model. Some sellers may see this as gaining freedom from the day-to-day management of their firms, but others may be reluctant to relinquish that much control.Deal PricingThe multiples paid by consolidators will vary depending on the current market environment, but they are generally competitive with other exit strategies. Different consolidator models can have characteristics that more closely resemble either a financial buyer or strategic buyer, and this classification can impact the multiple that the consolidator is able to pay.Different models have characteristics that resemble either a financial buyer or strategic buyer, which impacts the multiple that it is able to pay.Consolidators like Focus Financial, which make minimal changes to the acquired business, are best classified as financial buyers. Financial buyers purchase the business “as is”, with few plans to make changes to the way the business operates beyond moving selected business functions to the corporate office. There may be some plans for expense reductions or revenue enhancement, but financial consolidators are unlikely to pay the buyer for those potential benefits.Other consolidators can be considered strategic buyers. Companies like Mercer Advisors fall into this category. By making major changes to the way the acquired RIA operates, strategic consolidators have more opportunity to realize synergies and initiate growth-oriented strategic objectives. In theory, this gives strategic consolidators the ability to pay a higher multiple, but at a cost to the selling shareholders of giving up more control in how the business is run after the deal closes.Deal StructureConsolidators typically purchase 100% of RIAs, but that doesn’t mean that they purchase 100% of the acquired firm’s economics. RIAs are for the most part owner-operated businesses, so some portion of the acquired firm’s earnings before owner compensation (EBOC) needs to be diverted to the selling shareholders in order to keep them around and align incentives after the close. For RIAs, it can be difficult to disentangle EBOC into returns to equity versus returns to labor. As a practical matter, the normalized or post-closing compensation for selling shareholders is a negotiating point when striking a deal with a consolidator.The selling shareholders are likely to maintain an ongoing interest in the economics through earnouts, employment agreements, or other deal features. For example, Focus Financial structures its deals so that a portion of the acquired EBOC is directed to a newly established management company owned by the selling shareholders. Initially, this structure provides the selling shareholders with compensation that varies with the profitability of the firm. In the longer term, the management company equity can, in theory, be sold to the next generation of management when the selling shareholders retire.Cash vs Stock ConsiderationIt’s also worth noting that consolidators often use their own stock as part of the total consideration. For publicly traded companies like Focus Financial, it’s clear exactly how much that’s worth at any given time. For closely-held aggregators like Hightower and Captrust, their stock price is not readily apparent.Even if the consolidator is publicly traded, you should be wary of any lock-up provisions since stock prices for these companies can be volatile.Facilitating M&AAnother purported benefit of selling to a consolidator is that the acquired firm gains access to the consolidator’s balance sheet to pursue its own acquisitions. The low cost of capital for consolidators can allow the acquired firms to complete their own acquisitions in a way that is still accretive to the selling shareholders.Many partner firms of Focus Financial, for example, have completed their own acquisitions, and presumably, these deals make financial sense for the partner firm’s principals. For firms that are considering inorganic growth, this aspect of a sale to a consolidator may be a key consideration.Other OptionsSelling to a consolidator is just one exit strategy among many, and RIA owners should carefully weigh the pros and cons selling to a consolidator relative to those of other exit strategies. In subsequent posts, we will discuss other viable exit options for RIA principals.

How to Perform a Purchase Price Allocation for an E&P Company

This guest post first appeared on Mercer Capital’s Financial Reporting Blog on January 18, 2016. When performing a purchase price allocation for an Exploration and Production (E&P) company, careful attention must be paid to both the accounting rules and the specialty nuances of the oil and gas industry. E&P companies are unique entities compared to traditional businesses such as manufacturing, wholesale, services or retail. As unique entities, the accounting rules have both universal rules to adhere as well as industry specific. Our senior professionals bring significant experience in performing purchase price allocations in the E&P area where these two principles collide. For the most part, current assets, current liabilities are straight forward. The unique factors of an E&P are found in the fixed assets and intangibles: producing, probable and possible reserves, raw acreage rights, gathering systems, drill rigs, pipe, working interests, royalty interests, contracts, hedges, etc. Different accounting methods like the full cost method or the successful efforts method can create comparability issues between two E&P’s that utilize opposite methods. We will explore the unique factors in future entries. In this blog post, we discuss the guidelines for purchase price allocations that all companies must adhere.Reviewing a purchase price allocation report can be a daunting task if you don’t do it for a living – especially if you aren’t familiar with the rules and standards.Reviewing a purchase price allocation report can be a daunting task if you don’t do it for a living – especially if you aren’t familiar with the rules and standards governing the allocation process and the valuation methods used to determine the fair value of intangible assets. While it can be tempting as a financial manager to leave this job to your auditor and valuation specialist, it is important to stay on top of the allocation process. Too often, managers find themselves struggling to answer eleventh-hour questions from auditors or being surprised by the effect on earnings from intangible asset amortization. This guide is intended to make the report review process easier while helping to avoid these unnecessary hassles.Please note that a review of the valuation methods and fair value accounting standards is beyond the scope of this guide. Grappling with these issues is the responsibility of the valuation specialist, and a purchase price allocation report should explain the valuation issues relevant to your particular acquisition. Instead, this guide focuses on providing an overview of the structure and content of a properly prepared purchase price allocation report.General RulesWhile every acquisition will present different circumstances that will impact the purchase price allocation process, there are a few general rules common to all properly prepared reports. From a qualitative standpoint, a purchase price allocation report should satisfy three conditions:The report should be well-documented. As a general rule, the reviewer of the purchase price allocation should be able to follow the allocation process step-by-step. Supporting documentation used by the valuation specialist in the determination of value should be clearly listed and the report narrative should be sufficiently detailed so that the methods used in the allocation can be understood.The report should demonstrate that the valuation specialist is knowledgeable of all relevant facts and circumstances pertaining to the acquisition. If a valuation specialist is not aware of pertinent facts related to the company or transaction, he or she will be unable to provide a reasonable purchase price allocation. If the report does not demonstrate this knowledge, the reviewer of the report will be unable to rely on the allocation.The report should make sense. A purchase price allocation report will not make sense if it describes an unsound valuation process or if it describes a reasonable valuation process in an abbreviated, ambiguous, or dense manner. Rather, the report should be written in clear language and reflect the economic reality of the acquisition (within the bounds of fair value accounting rules).Assignment DefinitionA purchase price allocation report should include a clear definition of the valuation assignment. For a purchase price allocation, the assignment definition should include:Objective. The definition of the valuation objective should specify the client, the acquired business, and the intangible assets to be valued.Purpose. The purpose explains why the valuation specialist was retained. Typically, a purchase price allocation is completed to comply with GAAP financial reporting rules.Effective Date. The effective date of the purchase price allocation is typically the closing date of the acquisition.Standard of Value. The standard of value specifies the definition of value used in the purchase price allocation. If the valuation is being conducted for financial reporting purposes, the standard of value will generally be fair value as defined in ASC 820.Statement of Scope and Limitations. Most valuation standards of practice require such statements that clearly delineate the information relied upon and specify what the valuation does and does not purport to do.Background InformationThe purchase price allocation report should demonstrate that the valuation specialist has a thorough understanding of the acquired business, the intangible assets to be valued, the company’s historical financial performance, and the transaction giving rise to the purchase price allocation.Company OverviewDiscussion related to the acquired company should demonstrate that the valuation specialist is knowledgeable of the company and has conducted sufficient due diligence for the valuation. The overview should also discuss any characteristics of the company that play a material role in the valuation process. The description should almost always include discussion related to the history and structure of the company, the competitive environment, and key operational considerations.Intangible AssetsThe intangible assets discussion should both provide an overview of all relevant technical guidance related to the particular asset and detail the characteristics of the asset that are significant to the valuation. The overview of guidance demonstrates the specialist is aware of all the relevant standards and acceptable valuation methods for a given asset.After reading this section, the reviewer of the purchase price allocation report should have a clear understanding of how the existence of the various intangible assets contribute to the value of the enterprise (how they impact cash flow, risk, and growth).Historical Financial PerformanceThe historical financial performance of the acquired company provides important context to the story of what the purchasing company plans to do with its new acquisition. While prospective cash flows are most relevant to the actual valuation of intangible assets, the acquired company’s historical performance is a useful tool to substantiate the reasonableness of stated expectations for future financial performance.This does not mean that a company that has never historically made money cannot reasonably be expected to operate profitably in the future. It does mean that management must have a compelling growth or turn-around story (which the specialist would thoroughly explain in the company overview discussion in the report).Transaction OverviewTransaction structures can be complicated and specific deal terms often have a significant impact on value. Purchase agreements may specify various terms for initial purchase consideration, include or exclude specific assets and liabilities, specify various structures of earn-out consideration, contain embedded contractual obligations, or contain other unique terms. The valuation specialist must demonstrate a thorough understanding of the deal terms and discuss the specific terms that carry significant value implications.Fair Value DeterminationThe report should provide adequate description of the valuation approaches and methods relevant to the purchase price allocation. In general, the report should outline the three approaches to valuation (the cost approach, the market approach, and the income approach), regardless of the approaches selected for use in the valuation. This demonstrates that the valuation specialist is aware of and considered each of the approaches in the ultimate selection of valuation methods appropriate for the given circumstances.The report should outline the three approaches to valuation, regardless of the approaches selected for use in the valuation.Depending on the situation, any of a number of valuation methods could be appropriate for a given intangible asset. While selection of the appropriate method is the responsibility of the valuation specialist, the reasoning should be documented in the report in such a way that a report reviewer can assess the valuation specialist’s judgment.At the closing of the discussion related to the valuation process, the report should provide some explanation of the overall reasonableness of the allocation. This discussion should include both a qualitative assessment and quantitative analysis for support. While this support will differ depending on circumstances, the report should adequately present how the valuation “hangs together.”Something to RememberA purchase price allocation is not intended to be a black box that is fed numbers and spits out an allocation. The fair value accounting rules and valuation guidance require that it be a reliable and auditable process so that users of financial statements can have a clear understanding of the actual economics of a particular acquisition. As a result, the allocation process should be sufficiently transparent that you are able to understand it without excessive effort, and the narrative of the report is a necessary component of this transparency.

Community Bank Valuation (Part 2): Key Considerations in Analyzing the Financial Statements of a Bank

The June BankWatch featured the first part of a series describing key considerations in the valuation of banks and bank holding companies. While that installment provided a general overview of key concepts, this month we pivot to the analysis of bank financial statements and performance.1 Unlike many privately held, less regulated companies, banks produce reams of financial reports covering every minutia of their operations. For analytical personality types, it’s a dream.The approach taken to analyze a bank’s performance, though, must recognize depositories’ unique nature, relative to non-financial companies. Differences between banks and non-financial companies include:Close interactions between the balance sheet and income statement. Banking revenues are connected tightly to the balance sheet, unlike for nonfinancial companies. In fact, you often can estimate a bank’s net income or the growth therein solely by reviewing several years of balance sheets. Banks have an “inventory” of assets that earn interest, referred to as “earning assets,” which drive most of their revenues. Earning assets include loans, securities (usually highly-rated bonds like Treasuries or municipal securities), and short-term liquid assets. Changes in the volume of assets and the mix of these assets, such as the relative proportions of lower yielding securities and higher yielding loans, significantly influence revenues.The value of liabilities. For non-financial companies, acquisition motivations seldom revolve around obtaining the target entity’s liabilities. The effective management of working capital and debt certainly influences shareholder value for non-financial companies, but few attempt to stockpile low-cost liabilities absent other business objectives. Banks, though, periodically buy and sell branches and their related deposits. The prices (or “premiums”) paid in these transactions reveal that bank deposits, the predominate funding source for banks, have discrete value. That is, banks actually pay for the right to assume another bank’s liabilities.Why do banks seek to acquire deposits? First, all earning assets must be funded; otherwise, the balance sheet would fail to balance. Ergo, more deposits allow for more earning assets. Second, retail deposits tend to cost less than other alternative sources of funds. Banks have access to wholesale funding sources, such as brokered deposits and Federal Home Loan Bank advances, but these generally have higher interest rates than retail deposits. Third, retail deposits are stable, due to the relationship existing between the bank and customer. This provides assurance to bank managers, investors, and regulators that a disruption to a wholesale funding source will not trigger a liquidity shortfall. Fourth, deposits provide a vehicle to generate noninterest income, such as service charges or interchange. The strength of a bank’s deposit portfolio, such as the proportion of noninterest-bearing deposits, therefore influences its overall profitability and franchise value.Capital Adequacy. In addition to board and shareholder preferences, nonfinancial companies often have debt covenants that constrain leverage. Banks, though, have an entire multi-pronged regulatory structure governing their allowable leverage. Shareholders’ equity and regulatory capital are not the same; however, the computation of regulatory capital begins with shareholders’ equity. Two types of capital metrics exist – leverage metrics and risk-based metrics. The leverage metric simply divides a measure of regulatory capital by the bank’s total assets, while risk-based metrics adjust the bank’s assets for their relative risk. For example, some government agency securities have a risk weight equal to 20% of their balance, while many loans receive a risk weight equal to 100% of their balance.Capital adequacy requirements have several influences on banks. Most importantly, failing to meet minimum capital ratios leads to severe repercussions, such as limitations on dividends and stricter regulatory oversight, and is (as you may imagine) deleterious to shareholder value. More subtly, capital requirements influence asset pricing decisions and balance sheet structure. That is, if two assets have the same interest rate but different risk weights, the value maximizing bank would seek to hold the asset with the lower risk weight. Stated differently, if a bank targets a specific return on equity, then the bank can accept a lower interest rate on an asset with a smaller risk weight and still achieve its overall return on equity objectives.Regulatory structure. In exchange for receiving a bank charter and deposit insurance, all facets of a bank’s operations are tightly regulated to protect the integrity of the banking system and, ultimately, the FDIC’s Deposit Insurance Fund that covers depositors of failed banks. Banks are rated under the CAMELS system, which contains categories for Capital, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to Market Risk. Separately, banks receive ratings on information technology and trust activities. While a bank’s CAMELS score is confidential, these six categories provide a useful analytical framework for both regulators and investors.Understanding the Balance SheetWe now cover several components of a bank’s balance sheet.Short-Term Liquid Assets and SecuritiesBanks are, by their nature, engaged in liquidity transformation, whereby funds that can be withdrawn on demand (deposits) are converted into illiquid assets (loans). Several alternatives exist to mitigate the risk associated with this liquidity transformation, but one universal approach is maintaining a portfolio of on-balance sheet liquid assets. Additionally, banks maintain securities as a source of earning assets, particularly when loan demand is relatively limited.Liquid assets generally consist of highly-rated securities issued by the U.S. Treasury, various governmental agencies, and state and local governments, as well as various types of mortgage-backed securities. Relative to loans, banks trade off some yield for the liquidity and credit quality of securities. Key analytical considerations include:Portfolio Size. While there certainly are exceptions, most high performing banks seek to limit the size of the securities portfolio; that is, they emphasize the liquidity features of the securities portfolio, while generating earnings primarily from the loan portfolio.Portfolio Composition. The portfolio mix affects yield and risk. For example, mortgage-backed securities may provide higher yields than Treasuries, but more uncertainty exists as to the timing of cash flows. Also, the credit risk associated with any non-governmental securities, such as corporate bonds, should be identified.Portfolio “Duration.” Duration measures the impact of different interest rate environments on the value of securities; it may also be viewed as a measure of the life of the securities. One way to enhance yield often is to purchase securities with longer durations; however, this increases exposure to adverse price movements if interest rates increase.LoansA typical bank generates most of its revenue from interest income generated by the loan portfolio; further, the lending function presents significant risk in the event borrowers fail to perform under the contractual loan terms. While loans are more lucrative than securities from a yield standpoint, the cost of originating and servicing a loan portfolio – such as lender compensation – can be significant. Key analytical considerations include:Portfolio Composition. Bank financial statements include several loan portfolio categories, based on the collateral or purpose of each loan. Investors should consider changes in the portfolio over time and compare the portfolio mix to peer averages. Significant growth in a portfolio segment raises risk management questions, and regulatory guidance provides thresholds for certain types of real estate lending. Departures from peer averages may provide a sense of the subject bank’s credit risk, as well as the portfolio’s yield. Analysts may also wish to evaluate whether any concentrations exist, such as to certain industry niches or customer segments.Portfolio Duration. Banks compete with other banks (and non-banks in some cases) on interest rate, loan structure, and underwriting requirements. Most banks will say they do not compete on underwriting requirements, such as offering higher loan/value ratios, which leaves rate and structure. To attract borrowers, banks may offer more favorable loan structures, such as longer-term fixed rate loans. Viewed in isolation, this exposes banks to greater interest rate risk; however, this loan structure may be entirely justified in light of the interest rate risk of the entire balance sheet.Allowance for Loan & Lease Losses (“ALLL”)Banks maintain reserves against loans that have defaulted or may default in the future. While a new regime for determining the ALLL will be implemented beginning for some banks in 2020, the size of the ALLL under current and future accounting standards generally varies between banks based on (a) portfolio size, (b) portfolio composition, as certain loan types inherently possess greater risk of credit loss, (c) the level of problem or impaired loans, and (d) management’s judgment as to an appropriate ALLL level. Calculating the ALLL necessarily includes some qualitative inputs, such as regarding the outlook for the economy and business conditions, and reasonable bankers can disagree about an appropriate ALLL level. Key analytical considerations regarding the ALLL and overall asset quality include:ALLL Metrics. The ALLL – as a percentage of total loans, nonperforming loans, or loan charge-offs – can be benchmarked against the bank’s historical levels and peer averages. One shortcoming of the traditional ALLL methodology, which may or may not be remediated by the new ALLL methodology, is that reserves tend to be procyclical, meaning that reserves tend to decline leading into a recession (thereby enhancing earnings) but must be augmented during periods of economic stress when banks have less financial capacity to bolster reserves.Charge-Off Metrics. The ALLL decreases by charge-offs on defaulted loans, while recoveries on previously defaulted loans serve to increase the ALLL. One of the most important financial ratios compares loan charge-offs, net of recoveries, to total loans. Deviations from the bank’s historical performance should be investigated. For example, are the losses concentrated in one type of lending or widespread across the portfolio? Is the change due to general economic conditions or idiosyncratic factors unique to the bank’s portfolio? Is a new lending product performing as expected?Charge-off ratios also provide insight into the amount of credit risk accepted by a bank, relative to its peer group. However, credit losses should not be viewed in isolation – yields matter as well. It is safe to assume, though, that higher than peer charge-offs, coupled with lower than peer loan yields, is a poor combination. While banks strive to avoid credit losses, a lengthy period marked by virtually nil credit losses could suggest that the bank’s underwriting is too restrictive, sacrificing earnings for pristine credit quality.Loan Loss Provision. The loan loss provision increases the ALLL. A provision generally is necessary to offset periodic loan charge-offs, cover loan portfolio growth, and address risk migration as loans enter and exit impaired or nonperforming status.DepositsAs for loans, bank financial statements distinguish several deposit types, such as demand deposits and CDs. It is useful to decompose deposits further into retail (local customers) and wholesale (institutional) deposits. Key analytical considerations include:Portfolio Size. Deposit market share tends to shift relatively slowly; therefore, quickly raising substantial retail deposits is a difficult proposition. Banks with more rapid loan growth face this challenge acutely. Often these banks rely more significantly on rate sensitive deposits, such as CDs, or more costly wholesale funds. Therefore, analysts should consider the interaction between loan growth objectives and the availability and pricing of incremental deposits.Composition. Investors generally prefer a high ratio of demand deposits, because these accounts usually possess the lowest interest rates, the lowest attrition rates and interest rate sensitivity, and the highest noninterest income. Of course, these accounts also are the most expensive to gather and service, requiring significant investments in branch facilities and personnel. With that said, other successful models exist. Some banks minimize operating costs, but offer higher interest rates to depositors.Rate. Banks generally obtain rate surveys of their local market area, which provide insight into competitive conditions and the bank’s relative position. Also, it is useful to benchmark the bank’s cost of deposits against its peer group. Deposit portfolio composition plays a part in disparities between the subject bank and the peer group, as do regional differences in deposit competition.Shareholders’ Equity and Regulatory CapitalHistorical changes in equity cannot be understood without an equity roll-forward showing changes due to retained earnings, share sales and redemptions, dividends, and other factors. In our opinion, it is crucial to analyze the bank’s current equity position by reference to management’s business plan, as this will reveal amounts available for use proactively to generate shareholder returns (such as dividends, share repurchases, or acquisitions). Alternatively, the analysis may reveal the necessity of either augmenting equity through a stock offering or curtailing growth objectives.The computation of regulatory capital metrics can be obtained from a bank’s regulatory filings. Relative to shareholders’ equity, regulatory capital calculations: (a) exclude most intangible assets and certain deferred tax assets, and (b) include certain types of preferred stock and debt, as well as the ALLL, up to certain limits.Understanding the Income StatementThere are six primary components of the bank’s income statement:Net interest income, or the difference between the income generated by earning assets and the cost of funding.Noninterest income, which includes revenue from other services provided by the bank such as debit cards, trust accounts, or loans intended for sale in the secondary market. The sum of net interest income and noninterest income represents the bank’s total revenues.Noninterest expenses, which principally include employee compensation, occupancy costs, data processing fees, and the like. Income after noninterest expenses commonly is referred to by investors, but not by accountants, as “pre-tax, pre-provision operating income” (or “PPOI”).Loan loss provisionSecurity gains and lossesTaxesNet Interest IncomeThe previous analysis of the balance sheet foreshadowed this net interest income discussion with one important omission – the external interest rate environment. While banks attempt to mitigate the effect on performance of uncontrollable factors like market interest rates, some influence is unavoidable. For example, steeper yield curves generally are more accommodative to net interest income, while banks struggle with flat or inverted yield curves.Another critical financial metric is the net interest margin (“NIM”), measured as the yield on all earning assets minus the cost of funding those assets (or net interest income divided by earning assets). The NIM and net interest income are influenced by the following:The earning asset mix (higher yielding loans, versus lower yielding securities)Asset duration (longer duration earning assets usually receive higher yields)Credit risk (accepting more credit risk should enhance asset yields and NIM)Liability composition (retail versus wholesale deposits, or demand deposits versus CDs)Liability duration (longer duration liabilities usually have higher interest rates)Noninterest IncomeThe sensitivity of net interest income to uncontrollable forces – i.e., market interest rates – makes noninterest income attractive to bankers and investors. Banks generate noninterest income from a panoply of sources, including:Fees on deposit accounts, such as service charges, overdraft income, and debit card interchangeGains on the sale of loans, such as residential mortgage loans or government guaranteed small business loansTrust and wealth management incomeInsurance commissions on policies soldBank owned life insurance where the bank holds policies on employees Some sources of revenue can be even more sensitive to the interest rate environment than net interest income, such as income from residential mortgage originations. Yet other sources have their own linkages to uncontrollable market factors, such as revenues from wealth management activities tied to the market value of account assets. Expanding noninterest income is a holy grail in the banking industry, given limited capital requirements, revenue diversification benefits, and its ability to mitigate interest rate risk while avoiding credit risk. However, many banks’ fee income dreams have foundered on the rocks of reality for several reasons. First, achieving scale is difficult. Second, cross-sales of fee income products to banking customers are challenging. Third, significant cultural differences exist between, say, wealth management and banking operations. A fulsome financial analysis considers the opportunities, challenges, and risks presented by noninterest income.Noninterest ExpensesIn a mature business like banking, expense control always remains a priority.Personnel expenses. Personnel expenses account for 50-60% of total expenses. Significant changes in personnel expenses generally are tied to expansion initiatives, such as adding branches or hiring a lending team from a competitor. Regulatory filings include each bank’s full-time equivalent employees, permitting productivity comparisons between banks.Occupancy expenses. With the shift to digital delivery of banking services, occupancy expenses have remained relatively stable for many community banks, while larger banks have closed branches. Nevertheless, banks often conclude that entering a new market requires a beachhead in the form of a physical branch location.Other expenses. Regulatory filings lump remaining expenses into an “other” category, although audited financial statements usually provide greater detail. More significant contributors to the “other” category include data processing and information technology spending, marketing costs, and regulatory assessments.Loan Loss ProvisionWe covered this income statement component previously with respect to the ALLL.Income TaxesBanks generally report effective tax rates (or actual income tax expense divided by pre-tax income) below their marginal tax rates. This primarily reflects banks’ tax-exempt investments, such as municipal bonds; bank-owned life insurance income; and vehicles that provide for tax credits, like New Market Tax Credits. It is important to note that state tax regimes may differ for banks and non-banks. For example, some states assess taxes on deposits or equity, rather than income, and such taxes are not reported as income tax expense.Return DecompositionAs the preceding discussion suggests, many levers exist to achieve shareholder returns. One bank can operate with lean expenses, but pay higher deposit interest rates (diminishing its NIM) and deemphasize noninterest income. Another bank may pursue a true retail banking model with low cost deposits and higher fee income, offset by the attendant operating costs. There is not necessarily a single correct strategy. Different market niches have divergent needs, and management teams have varying areas of expertise. However, we still can compare the returns on equity (or net income divided by shareholders’ equity) generated by different banks to assess their relative performance.The figure below presents one way to decompose a bank’s return on equity relative to its peer group. This bank generates a higher return on equity than its peer group due to (a) a higher net interest margin, (b) a slightly lower loan loss provision, and (c) higher leverage (shown as the “equity multiplier” in the table).Income Statement MetricsThe figure below cites several common income statement metrics used by investors, as well as their strengths and shortcomings.Sources of InformationBanks file quarterly Call Reports, which are the launching pad for our templated financial analyses. Depending on asset size, bank holding companies file consolidated financial statements with the Federal Reserve. All bank holding companies, small and large, file parent company only financial statements, although the frequency differs. Other potentially relevant sources of information include:Audited financial statements and internal financial dataBoard packets, which often are sufficiently extensive to cover our information requirementsBudgets, projections, and capital plansAsset quality reports, such as criticized loan listings, delinquency reports, concentration analyses, documentation regarding ALLL adequacy, and special asset reports for problem loansInterest rate risk scenario analyses and inventories of the securities portfolioFederal Reserve form FR Y-6 provides the composition of the holding company’s board of directors and significant shareholders’ ownershipConclusionA rigorous examination of the bank’s financial performance, both relative to its history and a relevant peer group and with due consideration of appropriate risk factors, provides a solid foundation for a valuation analysis. As we observed in June’s BankWatch, value is dependent upon a given bank’s growth opportunities and risk factors, both of which can be revealed using the techniques described in this article.1 Given the variety of business models employed by banks, this article is inherently general. Some factors described herein will be more or less relevant (or even not relevant) to a specific bank, while it is quite possible that, for the sake of brevity, we altogether avoided mention of other factors relevant to a specific bank. Readers should therefore conduct their own analysis of a specific bank, taking into account its specific characteristics.Originally published in Bank Watch, August 2019.

Partnering with a Minority Financial Investor

Successful Succession for RIAs

As we explained in a recent post, there are many viable exit options for RIA principals when it comes to succession planning. In this post, we will review some considerations of partnering with a minority financial investor to achieve a successful transition of ownership.What is a minority financial investor?There are two features of a minority financial investor to breakdown: minority and financial.A minority investor does not seek control of your business. Often, a change of control is thought to occur when greater than 50% of the equity changes hands. However, the notion of control can be more complicated with RIAs as an “assignment” of client contracts necessitates client consent. When a “controlling block” of voting shares changes hands, the SEC considers there to have been an assignment of client contracts. While the SEC does not define a “controlling block,” it is typically thought to be the holder of 25% of voting shares or a partner who has the right to receive 25% of the capital upon dissolution.A financial investor is contrasted to a strategic investor. Financial buyers can generally be classified as investors interested in the return they can achieve by buying a business. They are interested in the cash flow generated by a business and the future exit opportunities from the business. Strategic buyers are interested in a company’s fit into their own long-term business plans. Their interest in acquiring a company may be related to expanding into a new market or consolidating administrative tasks to realize efficiencies.Bringing the two together, a minority financial investor is typically interested in acquiring less than 25% of your business to participate in the distribution of cash flow or upside from selling your company in a few years to another investor or strategic acquirer.Is a minority financial investor the best solution for you?As mentioned above, a minority financial investor does not seek control of your business. Therefore, the majority of your company’s management team must agree to stay on after the capital infusion. While the lack of interference in day to day operations is an attractive feature to some management teams (if, for instance, they’re looking to transition out retiring partners, recycle ownership to future generations, and maintain control of day to day operations), a minority financial investor is not the solution for management teams hoping to achieve a clean break.How is a minority financial investment structured?In general, a minority financial investment can be structured as a term investment or a permanent investment. PE firms typically invest for a five to seven-year term with the goal of improving the company’s financial profile in order to sell it at a higher multiple, while permanent capital investors (often single-family offices) are more interested in the business’ long-term cash flow potential.While every agreement with a minority financial investor will have differences in the details, there are generally two ways to structure these deals.1. Revenue Share 2. Preferred EquityRevenue ShareA revenue share is a right to a percentage of revenue instead of a right to distributable cash flow. This structure works exceptionally well for passive minority investments because the minority investor’s distribution is not affected by the operational decisions of management, such as the size of the bonus pool, because their distribution is determined before the removal of expenses. With that, a revenue share generally does not include board representation.There are benefits to a revenue share for businesses that have stable or expanding margins. As shown in the example below, as margins expand and more flows through to the bottom line, the revenue share as a percentage of EBITDA (as a proxy for free cash flow) decreases, and the common equity holders split a larger share of the distributable cash flow. On the flip side, if margins contract, the size of the revenue share as a percent of EBITDA will increase and the revenue shareholder will gain a larger share of distributable cash flow.A revenue share usually includes customary minority protections. For example, consent is typically required for certain matters such as:Bringing on excess debt or changing the company’s capital structure in a way that would adversely affect the revenue share ownerEntering into a JV, related party transactions, or new lines of businessChanging accounting/billing practices or tax election in a way that would adversely affect the revenue share ownerPreferred EquityLike a revenue share, preferred equity holders participate in the distribution of cash flow before common equity holders; however, preferred equity holders distribution is determined by the bottom line, not the top. Because of this, preferred equity holders are more interested in operational decisions such as executive compensation and budgeting because their distribution could be reduced with additional expenses. Preferred equity holders typically ask for board representation and veto rights on certain key items. Such protective rights include:Required distributions of excess cash flowBudget approvalApproval of executive compensationTag along rightsPreemptive rights to protect preferred equity holders from dilution Although preferred equity holder’s rank higher than common equity holders, a preferred equity holder faces more risk than a revenue shareholder. In the example of margin compression explored above, the preferred equity holder would likely face a similar decline in distributions as the common equity holder. Because of the risk profile of each investment, a revenue shareholder may be able to offer more in terms of pricing than a preferred equity investor. A minority financial partner can help you successfully transition ownership from retiring partners but is not the solution for every RIA. In the next few posts, we will continue to discuss other viable exit options for RIA principals when it comes to succession planning.

Key Valuation Considerations for FinTech Purchase Price Allocations

FinTech M&A continues to be top of mind for the sector as larger players seek to grow and expand while founders and early investors look to monetize their investments.This theme was evident in several larger deals already announced in 2019 including Global Payments/Total System Services (TSYS), Fidelity National Information Services, Inc./Worldpay, Inc., and Fiserv, Inc./First Data Corporation.One important aspect of FinTech M&A is the purchase price allocation and the valuation estimates for goodwill and intangible assets as many FinTech companies have minimal physical assets and a high proportion of the purchase price is accounted for via goodwill and intangible assets.The majority of value creation for the acquirer and their shareholders will come from their investment in and future utilization of the intangibles of the FinTech target.To illustrate this point, consider that the median amount of goodwill and intangible assets was ~98% of the transaction price for FinTech transactions announced in 2018.Since such a large proportion of the transaction price paid for FinTech companies typically gets carried in the form of goodwill or intangibles on the acquirer’s balance sheet, the acquirer’s future earnings, tax expenses, and capitalization will often be impacted significantly from the depreciation and amortization expenses.When preparing valuation estimates for a purchase price allocation for a FinTech company, one key step for acquirers is identifying the intangible assets that will need to be valued.In our experience, the identifiable intangible assets for FinTech acquisitions often include the tradename, technology (both developed and in-development), noncompete agreements, and customer relationships.Additionally, there may be a need to consider the value of an earn-out arrangement if a portion of transaction consideration is contingent on future performance as this may need to be recorded as a contingent liability.Since the customer relationship intangible is often one of the more significant intangible assets to be recorded in FinTech acquisitions (both in $ amounts and as a % of the purchase price), we discuss how to value FinTech customer relationships in greater detail in the remainder of the article.Valuing Customer-Related AssetsFirms devote significant human and financial resources in developing, maintaining and upgrading customer relationships. In some instances, customer contracts give rise to identifiable intangible assets. More broadly, however, customer-related intangible assets consist of the information gleaned from repeat transactions, with or without underlying contracts. Firms can and do lease, sell, buy or otherwise trade such information, which are generally organized as customer lists.Since FinTech has some relatively varied niches including payments, digital lending, WealthTech, or InsurTech, the valuation of FinTech customer relationships can vary depending on the type of company and the niche that it operates in.While we do not delve into the key attributes to consider for each FinTech niche, we provide one illustration from the Payments niche.In the Payments industry, one key aspect to understand when evaluating customer relationships is where the company is in the payment loop and whether the company operates in a B2B (business-to-business) or B2C (business-to-consumer) model.This will drive who the customer is and the economics related to valuing the cash flows from the customer relationships.For example, merchant acquirers typically have contracts with the merchants themselves and the valuable customer relationship lies with the merchant and the dollar volume of transactions processed by the merchant over time, whereas the valuable relationship with other payments companies such as a prepaid or gift card company may lie with the end-user or consumer and their spending/card usage habits over time.Valuation ApproachesValuation involves three approaches: 1) the cost approach, 2) the market approach, and 3) the income approach. Customer relationships are typically valued based upon an income approach (i.e., a discounted cash flow method) where the cash flows that the customer relationships are expected to generate in the future are forecast and then discounted to the present at a market rate of return.Cost ApproachValuation under the cost approach requires estimation of the cost to replace the subject asset, as well as opportunity costs in the form of cash flows foregone as the replacement is sought or recreated. The cost approach may not be feasible when replacement or recreation periods are long. Therefore, the cost approach is used infrequently in valuing customer-related assets.Market ApproachUse of the market approach in valuing customer-related assets is generally untenable for FinTech companies because transactional data on sufficiently comparable assets are not likely to be available.Income ApproachUnder the income approach, customer-related assets are valued most commonly using the income approach. One method within the income approach that is often used to value FinTech customer relationships is the Multi-Period Excess Earnings Method (MPEEM).MPEEM involves the estimation of the cash flow stream attributable to a particular asset. The cash flow stream is discounted to the present to obtain an indication of fair value. The most common starting point in estimating future cash flows is the prospective financial information prepared by (or in close consultation with) the management of the subject business.The key valuation inputs are often estimates of the economic benefit of the customer relationship (i.e., the cash flow stream attributable to the relationships), customer attrition rate, and the discount rate.Three key attributes that are important when using these inputs to valuing customer relationships include:Repeat Patronage. The expectation of repeat patronage creates value for customer-related intangible assets. Contractual customer relationships formally codify the expectation of future transactions. Even in the absence of contracts, firms look to build on past interactions with customers to sell products and services in the future. Two aspects of repeat patronage are important in evaluating customer relationships. First, not all customer contact leads to an expectation of repeat patronage. The quality of interaction with walk-up retail customers, for instance, is generally considered inadequate to reliably lead to expectations of recurring business. Second, even in the presence of adequate information, not all expected repeat business may be attributable to customer-related intangible assets. Some firms operate in monopolistic or near-monopolistic industries where repeat patronage is directly attributable to a dearth of acceptable alternatives available to customers. In other cases, it may be more appropriate to attribute recurring business to the strength of the trade names, software platform, or brands.Attrition. Customer-related intangible assets create value over a finite period. Without efforts geared towards continual reinforcement, customer lists dwindle over time due to customer mortality, the ravages of competition, or the emergence of alternate products and services. The mechanics of present value mathematics further erode the economic benefits of sales to current customers in the distant future. Customer relationships are wasting assets whose economic value attrite with the passage of time.Other Assets.Customer-related intangible assets depend on the existence of other assets to provide value to the firm. Most assets, including fixed assets and intellectual property, are essential in creating products or providing services. The act of selling these products and services enable firms to develop relationships and collect information from customers. In turn, the value of these relationships depends on the firms’ ability to sell additional products and services in the future. Consequently, for firms to extract value from customer-related assets, a number of other assets need to be in place.ConclusionMercer Capital has experience providing valuation and advisory services to FinTech companies and their acquirers.We have valued customer-related and other intangible assets to the satisfaction of clients and their auditors within the FinTech industry across a multitude of niches (payments, wealth management, insurance, lending, and software).Most recently, we completed a purchase price allocation for a private equity firm that acquired a FinTech company in the Payments niche.Please contact us to explore how we can help you. Originally published in the Value Focus: FinTech Industry Newsletter, Mid Year 2019.

Posturing for a Successful Succession

This post serves as an introduction to our succession planning series, which is intended to address an overlooked but critical issue facing many RIAs today.A recent Schwab survey asked RIA principals to rank their firm’s top priorities in the coming year. We were disappointed but not surprised to discover that developing a succession plan was dead last. This is unfortunate because 62% of RIAs are still led by their founders with only about a quarter of them sharing equity with other employees to support succession planning. Not much progress has been made, and there doesn’t seem to be much of a push to resolve this issue any time soon. Brent Brodeski, CEO of Savant Capital, describes this predicament more crassly:The average RIA founder is over 60 years old, and many are like ostriches: They stick their heads in the sand, ignore the need for succession planning, ignore that their clients are aging, let organic growth slow to a crawl or even backslide, and have increasingly less fun and a waning interest in their business.Fortunately, it doesn’t have to be this way. There are many viable exit options for RIA principals when it comes to succession planning. We’ll outline these options in this post and expound upon them in more detail later in the series.Sale to a strategic buyer. In all likelihood, the strategic buyer is another RIA, but it could be any other financial institution hoping to realize certain efficiencies after the deal. They will typically pay top dollar for a controlling interest position with some form of earn-out designed to incentivize the selling owners to transition the business smoothly after closing. This scenario often makes the most economic sense, but it does not afford the selling principals much control over what happens to their employees or the company’s name.Sale to a consolidator or roll-up firm. These acquirers typically offer some combination of initial and contingent consideration to join their network of advisory firms. The deals are usually debt-financed and typically structured with cash and stock upfront and an earn-out based on prospective earnings or cash flow. Consolidators and roll-up firms usually don’t acquire or pay as much as strategic buyers, but they often allow the seller more autonomy over future operations. While there are currently only a handful of consolidators, their share of sector deal making has increased dramatically in recent years.Sale to a financial buyer. This scenario typically involves a private equity firm paying all-cash for a controlling interest position. PE firms will usually want the founder to stick around for a couple of years after the deal but expect him or her to exit the business before they flip it to a new owner. Selling principals typically get more upfront from PE firms than consolidators but sacrifice most of their control and ownership at closing.Patient (or permanent) capital infusion. Most permanent capital investors are family offices that make minority investments in RIAs in exchange for their pro-rata share of future dividends. They typically allow the sellers to retain their independence and usually don’t interfere much with future operations. While this option is not as financially lucrative as the ones above, it is often an ideal path for owners seeking short term liquidity and continued involvement in this business.Internal transition to the next generation of firm leadership. Another way to maintain independence is by transitioning ownership internally to key staff members. This process often takes a lot of time and financing as it’s unlikely that the next generation is able or willing to assume 100% ownership in a matter of months. Bank and/or seller financing is often required, and the full transition can take 10-20 years depending on the size of the firm and interest transacted. This option typically requires the most preparation and patience, but allows the founding shareholders to handpick their successors and future leadership.Combo deal. Many sellers choose a combination of these options to achieve their desired level of liquidity and control. Founding shareholders have different needs and capabilities at different stages of their life, so a patient capital infusion, for instance, may make more sense before ultimately selling to a strategic or financial buyer. Proper succession planning needs to be tailored, and all these options should be considered. If you’re a founding partner or selling principal, you have a lot of exit options, and it’s never too soon to start thinking about succession planning. You will have a leg up on your competition that’s probably not prioritizing this. You’ve likely spent your entire career helping clients plan for retirement, so it’s time to practice what you preach. Please stay tuned for future posts on this topic and give us a call if you are ready to start planning for your eventual business transition.

Purchase Accounting Considerations for Banks Acquiring Asset Managers

Due to the historical popularity of this post, we revisit it this week. The purpose of this post is to help you, the reader, understand how the characteristics of the asset management industry, in general, and those attributable to a specific firm, influence the values of the assets acquired in transactions between banks and asset managers. As banks of all sizes seek new ways to differentiate themselves in a competitive market, we see many banks contemplating the acquisition of an existing asset management firm as a way to expand and diversify the range of services they can offer to clients. Following a transaction, the bank is required under accounting standards to allocate the purchase price to the various tangible and intangible assets acquired. As noted in the following figure, the acquired assets are measured at fair value. Transaction structures between banks and asset managers can be complicated, often including deal term nuances and clauses that have significant impact on fair value. Purchase agreements may include balance sheet adjustments, client consent thresholds, earnouts, and specific requirements regarding the treatment of other existing documents like buy-sell agreements. Asset management firms are unique entities with value attributed to a number of different metrics (assets under management, management fee revenue, realized fee margin, etc.). It is important to understand how the characteristics of the asset management industry, in general, and those attributable to a specific firm, influence the values of the assets acquired in these transactions. Common intangible assets acquired in the purchase of a private asset manager include the trade name, existing customer relationships, non-competition agreements with executives, and the assembled workforce. Trade NameThe deal terms we see employ a wide range of possible treatments for the trade name acquired in the transaction. The bank will need to make a decision about whether to continue using the asset manager’s name into perpetuity or only use it during a transition period as the asset manager’s services are brought under the bank’s name. This decision can depend on a number of factors, including the asset manager’s reputation within a specific market, the bank’s desire to bring its services under a single name, and the ease of transitioning the asset manager’s existing client base. However, if the bank plans immediately to take asset management services under its own name and discontinue use of the firm’s name, then the only value allocable to the tradename would be defensive.In general, the value of a trade name can be derived with reference to the royalty costs avoided through ownership of the name. A royalty rate is often estimated through comparison with comparable transactions and an analysis of the characteristics of the individual firm name. The present value of cost savings achieved by owning rather than licensing the name over the future period of use is a measure of the value of the trade name.Customer RelationshipsThe nature of relationships between clients and portfolio managers often gives rise an allocation to the existing customer relationships transferred in a transaction. Generally, the value of existing customer relationships is based on the revenue and profitability expected to be generated by the accounts, factoring in an expectation of annual account attrition. Attrition can be estimated using analysis of historical client data or prospective characteristics of the client base. Many of the agreements we see include a clause that requires a certain percentage of clients to consent to transfer their accounts in order for the deal to close at the stated price. If the asset manager secures less than the required amount of client consents, the purchase price may be adjusted downward or the deal may be terminated entirely. Due to their long-term nature and importance as a driver of revenue in the asset management industry, customer relationships may command a relatively high portion of the allocated value.Non-Competition AgreementsIn many asset management firms, a few top executives or portfolio managers account for a large portion of new client generation and are often being groomed for succession planning. Deals involving such firms will typically include non-competition and non-solicitation agreements that limit the potential damage to the company’s client and employee bases if such individuals were to leave.These agreements often prohibit the individuals from soliciting business from existing clients or recruiting current employees of the company. In certain situations, the agreement may also restrict the individuals from starting or working for a competing firm within the same market. The value attributable to a non-competition agreement is derived from the expected impact competition from the covered individuals would have on the firm’s cash flow and the likelihood of those individuals competing absent the agreement. In the agreements we’ve observed, a restricted period of two to five years is common.Assembled WorkforceIn general, the value of the assembled workforce is a function of the saved hiring and assembly costs associated with finding and training new talent. However, in a relationship-based industry like asset management, getting a new portfolio or investment manager up to speed can include months of networking and building a client base, in addition to learning the operations of the firm. Employees’ ability to establish and maintain these client networks can be a key factor in a firm’s ability to find, retain, and grow its business. An existing employee base with market knowledge, strong client relationships, and an existing network often may command a higher value allocation to the assembled workforce. Unlike the intangible assets previously discussed, the assembled workforce is valued as a component of valuing the other assets. It is not recognized or reported separately, but rather as an element of goodwill.GoodwillGoodwill arises in transactions as the difference between the price paid for a company and the value of its identifiable assets (tangible and intangible). Expectations of synergies, strategic market location, and access to a certain client group are common examples of goodwill value derived from the acquisition of an asset manager. The presence of these non-separable assets and characteristics in a transaction can contribute to the allocation of value to goodwill.EarnoutsIn the purchase price allocations we do for banks and asset managers, we frequently see an earnout structured into the deal as a mechanism for bridging the gap between the price the bank wants to pay and the price the asset manager wants to receive. Earnout payments can be based on asset retention, fee revenue growth, or generation of new revenue from additional product offerings. Structuring a portion of the total purchase consideration as an earnout provides some downside protection for the bank, while rewarding the asset management firm for continuity of performance or growth. Earnout arrangements represent a contingent liability that must be recorded at fair value on the acquisition date.ConclusionThe proper allocation of value to intangible assets and the calculation of asset fair values require both valuation expertise and knowledge of the subject industry. Mercer Capital brings these together in our extensive experience providing fair value and other valuation work for the asset management industry. If your company is involved in or is contemplating a transaction, call one of our professionals to discuss your valuation needs in confidence.

Themes from Q2 2019 Earnings Calls

Will “Capital Efficiency” Prevent Bankruptcy and Maintain Production as E&P’s Reduce CapEx?

While large, rapid commodity price declines are certainly harmful for near-term profits and long-term planning, persistently low prices may be more ominous for industry operators and investors. Prices rebounded from a low of $45/bbl, but crude has been below $60 for nearly 3 months. Natural gas prices have similarly languished, remaining below $2.50/mmbtu in that time. Two Houston-based E&P companies (Halcon & Sanchez) recently filed for Chapter 11 bankruptcy within days of each other, raising questions about the state of the industry. Size and operational efficiency may enable some players to stave off issues, while others may be forced into difficult decisions between preserving capital and investing over budget to produce enough debt-servicing cash flow.Theme 1: Bankruptcies May Return if Prices Remain Low Over the last year, we have taken proactive steps to address the challenging oil and natural gas price environment, including stabilizing our production profile, improving our capital efficiency, and reducing our overall cost structure. Undergoing a financial restructuring through a voluntary process represents the next phase for Sanchez Energy, as we work with our creditors on a plan to right-size our balance sheet, further invest in our assets and generate long-term value for our stakeholders. - Tony Sanchez III, CEO, Sanchez EnergyRagan [incoming CFO] is joining Halcon at a critical time [bankruptcy restructuring] and will help lead our focus on capital discipline, cost control, and strategic plans for developing the Company’s assets to maximize shareholder return. - Rich Little, CEO, Halcon Resources We start with quotes from companies that didn’t actually host earnings calls. Sanchez Energy has been beleaguered for years now, unable to turn a profit since the drop in oil prices. Once the third most active driller in the Eagle Ford, Sanchez filed for Chapter 11 bankruptcy on August 11th. Sanchez’ CEO touches on capital efficiency like many executives in the industry, as we’ll address later. He also harps on generating long-term value for stakeholders, a slight twist on the predictable “providing long-term value to shareholders” due to their debt-laden predicament. Sanchez certainly isn’t alone. Halcon Resources filed for bankruptcy on August 7th. However, the company expects a 60-day turn around, during which it will continue to pay vendors, royalty owners, and others as part of ordinary business through the bankruptcy process, subject to approval from the courts. This is the second time since 2016 that the company has buckled under its debt load. The Sanchez quote came as part of its press release regarding the bankruptcy proceedings, and the Halcon quote addresses the hiring of a new CFO in the wake of its filing. Each CEO outlines a critical issue for industry operators. Large scale, multi-year projects employ debt financing to lower the cost of capital, but too much debt can raise the cost of capital due to the increased risk of making the required payments. Fluctuating commodity prices further hamper the ability of E&P companies to make these payments. When companies are forced to file for Chapter 11 bankruptcy, they are usually able to resume operations, though the shareholders essentially lose all, or a substantial portion, of their investment. Industry operators will hope that these low prices will not persist, or other companies may join Sanchez and Halcon.Theme 2: Size MattersWe have a very large footprint though that allows us to work within certain areas over a vein, within certain areas due to these [Bakken gas processing] constraints. So we are able to work around them. And we have led the industry up there with gas capture we still do. - Harold Hamm, CEO, Continental ResourcesCombining Oxy and Anadarko will create a diverse portfolio of high quality and complementary assets, well suited for our core competencies. As we apply our development approach to the combined portfolio, we expect this to be the low-cost producer in all of the areas we operate. For example, along with the expertise I've already mentioned, we will apply our proprietary drilling process, Oxy drilling dynamics across Anadarko acreage. To date, Oxy drilling dynamics has reduced costs by at least 30% in all of the areas that we've applied it, and we expect to achieve similar results in Anadarko’s onshore and offshore developments. - Vicki Hollub, CEO, Occidental PetroleumOne final point on our pending acquisition of Carrizo and one of the most important aspects of the transaction is the ability to optimize long-term development value of our combined inventory. By merging these two companies we are creating a vehicle that can effectively compete in a lower commodity price environment without the need to high-grade near-term target zones at the expense of other zones that are left behind for less efficient future development after the passage of time. - Joseph Gatto, CEO, Callon Petroleum Size allows companies to achieve scale in their operations, spread expenses over larger amounts of revenue, access capital markets, and even negotiate lower capital costs. Larger E&P companies are typically less at risk of bankruptcy than smaller players in the industry. Chevron began the quarter with its announcement of plans to acquire Anadarko Petroleum, but Occidental stepped up with a larger offer and eventually won the day. While this transaction has stolen the headlines, Callon’s smaller acquisition of Carrizo after quarter-end echoes the trend in the industry. Size allows these companies to achieve synergies, apply techniques to more acreage, and survive in low-price environments.Theme 3: Capital Efficiency to Bridge Gap Between Production Estimates and CapEx BudgetsWe have also achieved the efficiencies throughout the first-half of 2019 that will allow the reduction of drilling rigs from 19 rigs in SCOOP STACK to 12 rigs on early fourth quarter of 2019. […] I am proud that our teams can exceed production estimates with lower rig activity, that is operating and capital efficiency at its best. […] We're very committed to meeting our CapEx and other corporate guidance for the year, and have the flexibility to do so as we're demonstrating. - Harold Hamm, CEO, Continental ResourcesFor two quarters in a row we delivered more oil for less capital. With efficiency gains and new technology, we are achieving strong capital and operating cost reductions, while at the same time delivering excellent well performance. […] Looking ahead to the remainder of 2019, we modestly increased our full year U.S. oil production guidance as a result of better well performance. There is no change to our activity level in 2019. We will remain disciplined and still expect capital expenditures to be within the original range of $6.1 billion and $6.5 billion. - Bill Thomas, Chairman/CEO, EOG ResourcesTowards the end of the quarter, we shifted our focus to the completion of our first Delaware mega pad, which importantly utilized a simultaneous operation of two completion crews to increased efficiency and reduced cash cycle times. As we've emphasized previously, increased use of this model is made possible within a larger entity and is a clear strategic benefit of the Carrizo merger. - Joseph Gatto, CEO, Callon Petroleum Shale oil production has increased output, and U.S. E&P companies have provided much of the supply growth in global production. However, shale’s inherently higher declines rates require more drilling to replace more rapidly declining production, making investors wary to receive their share (dividends) of the returns on these investments. This, in combination with depressed commodity prices at year-end, led to lower capex budgets for 2019. Seeking to keep their promises after blowing through their budgets last year, E&P companies have preached capital efficiency. They tout the operational efficiencies that will allow them to decrease their capital spend to close 2019. These efficiencies are crucial because according to data compiled by Shale Experts (subscription required) in the below table, many E&P companies have already spent over half their budget. There are many factors at play in this number. Capex can and tends to be frontloaded due to seasonal factors. Still, executives will be hoping that their drilling efficiencies are achieved. Some companies may find issues hitting their production targets while decelerating drilling activities. They may be stuck between a rock and a hard place: failing to reach production targets or failing to remain within capex budgets. Theme 4: Parent-Child Problem Continues to Plague OperatorsIn the Delaware Basin, the 23 well Dominator project was designed to test logistical capabilities and well spacing that was approximately 50% tighter than our current resource assessment. While initial rates were solid, current performance data indicates that we developed the Upper Wolfcamp too densely. We're incorporating the data into our development model to adjust spacing on future projects including those projects set to spud in the second half of 2019. -Tim Leach, CEO, Concho ResourcesWe've always been conservative in our spacing assumptions, and we don't really have any plans right now, especially as commodity price continues to decline, to look at any reasons to increase well spacing. This is one of those things where we've been pretty steadfast in our strategic development objectives on spacing. And we would pay attention to other spacing results that go on in the Permian Basin. And we try to learn from those as well too without exposing our shareholders to down spacing risks. -Travis Stice, CEO, Diamondback Energy As we noted earlier, E&P companies are always looking to gain efficiencies. This can come from strategic M&A, contiguous acreage, repeatable drilling methods, and many other sources. However, there are limits. Specifically, well spacing has become increasingly important in the Permian as the parent-child problem continues to plague operators. Stated plainly, the first well drilled in a pad (the “parent”) tends to be the strongest well, getting the most bang for your buck in the reservoir. Subsequent wells drilled in the pad (the “children”) allow for more oil to be harvested quickly but at a decreasing rate per well. Trying to fit more wells onto pads may be more efficient from a drilling standpoint, but geological factors tend to lead to diminishing marginal returns from this approach. As Concho’s CEO admitted at the beginning of the earnings call, their Dominator project was not properly spaced. This news was not well received, as Concho’s stock dropped 22.2% on the day and has slid even further since. It appears Diamondback’s approach to conservative well spacing was well received as its stock increased 2.7% on its announcement and has continued its upward trajectory.ConclusionCommodity price will always be at the forefront of the oil and gas industry. Higher prices allow for more investment, higher profits, and lofty valuations. On the downside, operators must make it through lean times while avoiding bankruptcy. While keeping debtholders happy by making their required payments, they must also seek to please equity investors by achieving production growth on a tight capex budget. Size tends to help both of these as capital becomes cheaper and scale allows for successful drilling techniques from one basin to be applied to operations in other areas.At Mercer Capital, we have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. We can help companies navigating the bankruptcy process, considering M&A in an acquisitive market, or maintaining their operations business as usual. Contact a Mercer Capital professional to discuss your needs in confidence.

How Does Your RIA Measure Up?

Schwab’s 2019 Benchmarking Study Offers Insights Into the RIA Industry

Schwab recently released its 2019 RIA Benchmarking Study. The survey contains responses from over 1,300 RIAs that custody their assets at Schwab to questions about firm operating performance, strategy, and practice management. The survey is a great resource for RIA principals to see how their firm’s performance and direction measure up against the average firm. We’ve highlighted some of the key results from the study below. You can download the full survey here.Firm PrioritiesAs part of the survey, Schwab asked RIA principals to rank the top priorities for their RIA. Not surprisingly, top-line growth is a top-line priority—most RIAs ranked gaining new clients through existing client referrals or business referrals as their primary focus. Just behind new client acquisition was improving productivity through new technology (e.g., taking advantage of CRM efficiencies). Developing or enhancing a succession plan was at the bottom of the list, a result which is generally consistent with our experience working with many different RIA clients. Succession plans are easy to put off because there is no immediate benefit for developing one. But eventually every firm will need one, and developing a succession plan may very well be the lowest hanging fruit to enhance firm value, protect clients, and improve career satisfaction.GrowthThe firms participating in the survey have seen strong five-year growth on average. Between 2014 and 2018, AUM grew at a compound annual growth rate (CAGR) of 7.5%, while revenue and number of clients grew at a respective 9.5% and 5.4% CAGR. The best-performing firms (Schwab defines this as the top 20%) saw positive AUM growth even in 2018 (the worst year for market performance covered by the survey) due to strong net organic growth. Interestingly, the fact that revenue growth has outpaced AUM growth suggests that the effective realized fees for these firms has increased over the last five-years, despite reports of fee pressure across the industry. This could be attributable in part to the fact that the respondent firms reported an increased breadth of services offered between 2014 and 2018. All of the RIA size categories identified in the survey saw similar growth over the last five years, although firms managing less than $2.5 billion in AUM generally experienced higher growth than firms over $2.5 billion in AUM.M&AM&A contributed to growth for many firms over the last five years. 4% of firms acquired new clients by M&A in 2018, and 18% of firms have completed an acquisition in the last five years. Over the past five years, 13% of firms gained new clients by bringing on an advisor with an existing book of business.Succession PlanningSuccession planning is a key concern for the industry, particularly since 62% of firms are still primarily led by their founders. Eventually, of course, all of these founder-led firms will need an exit strategy for the founding partners, whether that is through internal succession or a sale to a third party. A full 92% of respondents indicated that they were considering internal succession, but only 38% of firms have a documented path to partnership. Most firms, however, have added non-founders to the ownership base—only 29% of firms reported not sharing equity with non-founders. 26% of firms reported sharing equity with non-founders to support succession planning, while a further 27% reported sharing equity to retain key talent. These equity purchases are mostly financed either by the employee (self-financing) or by the current shareholders (seller financing), although there are an increasing number of options for third-party financing of equity purchases.ProductivityRespondent firms reported increases in productivity between 2014 and 2018. Over this period, AUM per professional increased from $88 million to $97 million, and the number of clients per professional increased from 46 to 52. Also over this period, hours per client for operations and administration decreased from 19 to 17, while hours per client for client service remained flat at 34, suggesting that these gains in productivity were the result of administrative efficiencies, not a decrease in client service.ProfitabilityThe respondent firms reported strong standardized operating margins across size categories, ranging from 26.4% for the $2.5 billion + AUM category to 30.0% for the $1.0 to $2.5 billion size category. Even the smallest size category, RIAs with $100 to $250 million AUM, reported standardized operating margins of 28.9%.As indicated by the Schwab survey, succession planning is at the bottom of many firms’ to-do lists, but it’s a critical issue that all firms will have to face eventually. For more information on RIA succession planning, keep an eye out for our upcoming whitepaper, Buy-Sell Agreements for Wealth Management Firms (scheduled for release in early September).

An Overview of Saltwater Disposal

Part 2 | Economics of the Industry

In a prior blog post, we provided an overview of the saltwater disposal (SWD) industry, detailing the source of demand for SWD services, the impact of the shale boom, geographic distribution, site selection, construction, and regulation. We now take a look at the economics of the SWD industry and the trends that impact the economics.SWD EconomicsIn the past, SWD wells were typically drilled and operated by producers for the purpose of handling the producers’ own disposal needs. However, the growing inefficiency of individual operators having in-sourced SWD operations has in recent years created an increased demand for specialized outsourced SWD services. The expertise and economies of scale provided by these independent SWD service providers allow for reductions in the saltwater transportation and disposal expense to the producer. As a result, the operation of SWD facilities as a stand-alone business has shown enormous growth in recent years.Revenue StreamsRevenues streams to SWD operators consist primarily of disposal fees – typically in the range of $0.50 to $2.50 per barrel – and skim oil sales. Produced water contains significant amounts of suspended crude oil that the SWD facility “skims-off” (by various methods) and sells to increase revenues. Where disposal services are abundant, the cost is typically in the lower third of the indicated range. Locations with fewer available SWD facilities can see fees in the upper end of the range. Skim oil volumes are typically quite small relative the volume of produced water received for disposal. However, the sale of the skimmed oil can account for 10% to 30% of total SWD revenues. The portion of revenues attributable to skim oil sales depends on the SWD facility’s skimming and impurity removal capabilities, in addition to the presence of a local market for alternative skim oil use.Revenues streams to SWD operators consist primarily of disposal fees – typically in the range of $0.50 to $2.50 per barrel – and skim oil sales.Additional revenues may be generated by providing trucking services for the purpose of transporting the produced water from the well site to the disposal facility. Revenues from such services can vary widely. Transport rates are typically near $1 per barrel per hour of transport time. Where SWD facilities are readily available and the distance from the well site is minimal, the trucking cost may only add $0.50 per barrel. However, the incremental revenue can reach $4 to $6 per barrel where facilities are lacking and the distance is significant.As with the in-sourcing of SWD operations by producers, the provision of trucking services by SWD facility operators is on the decline. As the oilfield waste disposal industry has rapidly grown in recent years, the ability to provide specialized services at significant economies of scale has led to oilfield waste transportation services being provided as a stand-alone business. As detailed below, the growing benefits of transporting produced water to SWDs via pipeline has also contributed to the decline in trucking services among SWD facility operators.Cost StructureThe structure of a SWD facility’s expenses is significantly skewed to fixed costs relative to variable costs. Like other fixed asset-intensive businesses, a large portion of a SWD facility operator’s costs are incurred up-front in the construction of the facility, including the cost of drilling the primary disposal well and any back-up well. While drilling costs can vary markedly based on the site geology, the target zone, and well depth, the total facility cost can easily reach $3 million to $4 million even if the facility offers no produced water transportation via pipeline.Ongoing expenses are fairly limited and are primarily comprised of power and maintenance/repair costs. Incremental costs are typically quite low, often less than $1 per barrel. Labor costs vary little whether disposal volumes are high or low. Ticketing and invoicing processes are typically heavily automated, and therefore, related expenses do not vary significantly with volumes.The one area of expense that is to some degree within the control of the SWD operator is maintenance expenses. The SWD operator is well advised to exercise diligence in the maintenance of the SWD well as any downtime, expected or unexpected, can be costly in terms of lost revenues.Focus on VolumeGiven the fixed-heavy cost structure, the SWD facility operator’s primary lever for improving operating results lies in increasing volumes. However, for the well operator, the primary consideration in choosing a SWD facility is the transportation cost, which is largely a factor of the distance from the well site to the disposal facility. So, once the SWD facility is sited, the primary SWD decision driver – distance – is fixed and can’t be altered. To gain more disposal business, SWD facilities often provide transport services via truck. However, as previously indicated, recent trends have moved SWD facility operators away from trucking services.Trends in Volume AcquisitionHistorically, the transportation of produced water to a commercial disposal facility has been heavily weighted toward trucking. Due to the smaller volumes of water requiring disposal and the typical patchwork of acreage controlled by any single E&P company, the construction and use of pipeline systems for gathering and transporting produced water to a central disposal facility was cost-prohibitive. However, with the vast increase in produced water volumes in recent years, and the recent trend among the E&Ps to aggregate more contiguous acreage, the feasibility of pipeline systems has grown. With trucking costs now more than doubling pipeline transportation costs in many markets, the large up-front cost of constructing a pipeline network is often no longer an economic hindrance.Similarly, several producers have put in place longer-term programs for the systematic development of their large – and more contiguous - acreage holdings. As part of these programs, the producers have found it economically viable to build out pipeline systems for gathering and transporting produced water to local SWD networks. Although the trucking of produced water is still dominant in some areas - the Bakken and the Eagle Ford - SWD operators in the Delaware Basin have indicated that piped volumes are likely exceeding trucked volumes in that pipe-heavy area. Data from NGL Energy shows the progression of piped versus trucked produced water in recent years. While many of the more extensive pipeline systems were originally operated by the E&Ps, much of the current systems are held by businesses that specialize in oilfield waste disposal via E&P asset drop-down and asset sale transactions. Produced Water ContractsAlong with the rise in the prevalence of produced water pipeline gathering and transport systems has come the need for the owners/operators of those systems to ensure the disposal volumes into their systems will be sufficient to service the debt taken on related to the pipeline construction or acquisition. In pursuit of steadily produced water volumes, SWD operators and E&Ps have begun entering into contractual commitments that often include dedicated acreage and/or take-or-pay volumes. These contractual relationships are often multi-year agreements, ensuring a steady stream of produced water. The enhanced economies of scale result in a risk/return profile that is less like that of oilfield service providers and more like midstream companies. This lowers the cost of capital for SWD operators.Produced Water RecyclingOne detrimental economic trend in the SWD industry is produced water recycling.One detrimental economic trend in the SWD industry is produced water recycling. Hydraulic fracturing requires enormous amounts of water and therefore results in enormous amounts of produced water. Traditionally, fracking operations only utilized freshwater. However, in recent years operators have begun experimenting with mixes of fresh and produced water for fracking purposes with largely favorable results. This brings the potential for significant quantities of produced water no longer heading to SWD facilities for disposal but instead being recycled and reused at the well site. While reducing both freshwater supply and produced water disposal expenses would seem to be an obvious benefit to the operator, produced water recycling carries its own cost.Produced water recycling entails a multiple-step process with each step removing a certain part of the produced water mix. Although the recycling process does not have to bring the produced water to a “drinking water” level of freshness, recycling to the level required for use in fracking can entail a significant expense. The recycling economics often hinges on the availability – and therefore cost – of freshwater for fracking use. In areas where freshwater is abundant and inexpensive, recycling economics are less beneficial. In areas where freshwater is scarce and expensive, recycling often makes economic sense. As recycling technology improves and greater efficiencies are realized, it’s likely that a greater percentage of produced water will be reused, rather than removed for disposal. However, research by Raymond James indicates that fracking-related water demand growth falls far short of estimates of produced water disposal demand growth, even with produced water recycling considerations.[caption id="attachment_27673" align="aligncenter" width="940"]Source: EIA, Drilling Info, Baker Huges, Raymond James Research[/caption] As of now, recycling of produced water is still in early development with estimates of disposal to recycle ratios at 20:1. SummaryAs detailed, the outlook of the SWD industry is quite favorable although the economics are, and will continue to be, in a state of flux as the industry grows and matures. Despite some potential detrimental market dynamics along the way, the overall direction points to strong benefits to investors as the business of SWD continues to evolve away from a being cost center for operators, to a cash flow generating third-party service provider to operators.

Public Royalty Interests: Picking the Right Comparable

In previous posts, we have discussed the relationship between public royalty interests and their market pricing implications to royalty owners. Here, we will define our group of royalty interests which can be used to gain valuation insights. Specifically, we will look at mineral aggregators, natural gas focused trusts, and crude oil focused trusts and the statutory differences between them. We also consider how dividend yields and other public data can be used to imply value for private mineral interests while being judicious in our application of such metrics.What is a Royalty Trust?Historically, the most common way mineral interests have been structured for public investment has been in the form of a trust. The trust’s sponsor (frequently though not always the operator) conveys a percentage interest in specified properties, and the trust is prohibited from acquiring more interests. In some cases, the trust has a defined termination date, but this can also be based on a certain threshold of production, or there may be no specified termination at all.The most common way mineral interests have been structured for public investment has been in the form of a trust.Distributions are paid on an established schedule (monthly is the most common), and these distributions are based on commodity prices and the level of production. While the former depends on market forces, the latter tends to decline over time as the resources are drained from the specified properties. Thus, the stock prices of these trusts decline over time, and the return comes almost exclusively from the dividend yield, with minimal opportunity for capital appreciation.Because they are structured as a trust, these investment vehicles are required to distribute a substantial portion of their income. However, trusts can withhold a certain percentage of cash flows to pay trust administrative expenses or create a reserve for future distributions. Because the interests in the specified properties are typically revenue interests, the trust is not required to pay for any expenses related to production, so expenses are relatively minimal.What is a Mineral Aggregator?The more popular investment vehicle for mineral interests recently has been the emerging sector of mineral aggregators. Aside from Dorchester Minerals, LP, which IPO’d back in 2003, the remaining five aggregators have gone public in the past five years, including Falcon Minerals and Brigham Minerals in the past twelve months.1 While aggregators also allow investors to gain exposure to the energy sector without investing directly in E&P companies or commodities, there are differences between aggregators and trusts, beginning with their structure.Dorchester, Viper Energy Partners, Blackstone Minerals, and Kimbell Royalty Partners are all structured as MLPs, while Falcon and Brigham are corporations.2 Eschewing the trust structure provides certain benefits to these entities. Aggregators are not restricted from acquiring more interests, and as their name implies, they seek to reinvest their earnings into the acquisition of new properties. The value of units in a public royalty trust tend to decline with production over time, but aggregators stem the tide of these losses with their reinvestment, and they do not have the statutory termination present in some trusts.They can also issue more common units, take on debt, and incur operating expenses in ways that royalty trusts cannot. While these make aggregators appear to be the better option, trusts by nature have beneficial tax treatment, and their yields tend to be higher and relatively more predictable given their distribution requirement, which mineral aggregators could decide to forego.A table summarizing the primary differences between a royalty trust and a mineral aggregator is included below:Market Data for Trusts and AggregatorsTo gain a better insight into how these factors play out in the public marketplace, we should analyze the data. The following tables gives some critical market data for valuation purposes: [caption id="attachment_27589" align="aligncenter" width="868"]Source: Capital IQ[/caption] While these trusts are predominantly focused on natural gas, many also have oil and NGL reserves. These natural gas trusts have the lowest market caps and relatively high dividend yields. Compared to the crude oil trusts, these exhibit more diversity in product mix including notable amounts of NGLs. [caption id="attachment_27615" align="aligncenter" width="867"]Source: Capital IQ[/caption] [caption id="attachment_27609" align="aligncenter" width="860"]Source: Capital IQ[/caption] Compared to natural gas focused trusts, crude oil trusts tend to have relatively higher market caps with similar yield and pricing multiples, despite being based on a different commodity. The levels of operating expenses are comparable as well. For this post, we have further delineated between perpetual and terminal crude oil trusts. The latter have a specified end date, while the former do not. However, both groups ultimately will receive distributions related to crude oil prices and declining production, regardless, whether there is a statutory termination or not. Going forward, we do not plan to group these separately.Mineral AggregatorsAs noted previously, mineral aggregators have been the apple of certain investors’ eyes lately. They are not bound by distribution requirements, which allows aggregators to gobble up additional acreage. This provides investors an element of growth in what has historically been a declining, yield-only return play. Despite no statutory requirements to distribute, the below aggregators have offered an attractive yield to investors. [caption id="attachment_27591" align="aligncenter" width="859"]Source: Capital IQ[/caption] When compared to the trusts, aggregators are significantly larger in terms of market cap and have notably more operating expenses and product diversity. Also, they tend to trade at higher revenue multiples, with lower yields. While mineral aggregators may present an attractive option for investors, they are less functional as comparables for mineral interest owners. The lower yield, influenced by potential for return from future growth, and higher operating expenses render aggregators less comparable to traditional mineral interests.Other Valuation ConsiderationsNow that we have the data to back up the differences between trusts and aggregators, one must delve deeper into the subject characteristics of the individual trusts to determine how one might use these to value their own private royalty interest. While tempting, drawing valuation conclusions simply by selecting the appropriate commodity mix would be shortsighted. There are plenty of other considerations and judgments that need to be made such as:Timing quirks related to market pricing and dividendsIdiosyncratic issues with the operatorRegion/basin Dividends are a product of production and commodity pricing over the past year, whereas stock prices tend to be based on expected future commodity prices. WTI crude prices are expected to remain below $60/bbl for the rest of 2019, but dividends in the past year include those from back in late 2018, when some floated the possibility of crude oil returning to $100/bbl. Contrast this to a recent declaration that oil could conceivably drop to $30/bbl. With dividends paid out monthly, the numerator of the yield is impacted by stale prices that do not typically inform future expectations. These expectations, however, are a critical driver for the denominator, so bearish sentiment leads to higher yields. Higher yields inform current market sentiment about relative risk factors, however simply taking the prevailing dividend yield is not advisable.One must delve deeper into the subject characteristics of the individual trusts to determine how one might use these to value their own private royalty interest.Case in point(s): San Juan Basin Royalty Trust has not paid a dividend in the past year. That doesn’t mean there is no risk in their cash flows, it means there are no cash flows. On the opposite end of the spectrum, Whiting USA Trust II has a yield north of 77% as its quarterly dividends have nearly matched its prevailing market price. Again, this should not imply to a private mineral owner that their potential future revenue checks will carry this level of risk.Another important consideration for utilizing trusts as comparables is the operator of the subject interests. Take the three SandRidge trusts for example. Trust distributions are a function of both production and price, and SandRidge has struggled to maintain production given its various woes. Comparing the risk of a private mineral interest to one whose operator is hemorrhaging is not prudent.Finally, one must consider the region or basin. Geological factors distinguish the commodities produced in different plays and basins, and regional transportation dynamics also play a role. As a result, investors may pay a premium to be in a basin such as the Permian. SandRidge Permian Trust bears many of the idiosyncratic issues as the SandRidge Mississippian Trusts, but it is in a more desirable location and therefore is expected to command a higher multiple. Again, production and price determine the distributions, and certain basins such as the Eagle Ford may provide the opportunity for premium prices while others like the Permian may be more attractive for other reasons.How These Factors Impact ValuationsTo value a currently producing royalty interest under the income approach, a valuation professional must determine some indication of projected future cash flows and discount these back to the present. Given the declining nature of the production, total return comes almost exclusively from the yield. Thus, we can use yields on public royalty trusts to discount the projected future cash flows of the subject interest back to the present. As noted above, judgment is required in determining the relative risk and return characteristics of the subject interest. As we noted in our last post, the SEC prices reserves based on a present value factor of 10%. While this is less applicable to PUDs and similarly more risky assets, private mineral interests that have been delivering consistent cash flows in the form of monthly royalty payments are more likely to be around this 10% discount rate, even if current yields indicate something higher.ConclusionWhen investing in a public royalty trust or using it as a pricing benchmark for private royalty interests, there are many items to consider that are unique to each royalty trust. The commodity mix, operator/sponsor, region, termination (or lack thereof), and other key aspects make each of these investment vehicles unique. Further analysis is required to verify these provide meaningful valuation indications.We have assisted many clients with various valuation and cash flow questions regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.1 Actual IPO of entity holding Falcon Minerals occurred in 2017, but it discontinued its Special Purpose Acquisition Company (“SPAC”) in 2018.2 Viper and Kimbell have both elected to be taxed as C-corporations.

Bank M&A 2019 Mid-Year Update

Through late July, M&A activity in 2019 is on pace to match the annual deal volume achieved in the last few years. Since 2014, approximately 4%-5% of banks have been absorbed each year via M&A. According to data provided by S&P Global Market Intelligence, there were 136 announced transactions in the year-to-date period, which equates to 2.5% of the 5,406 FDIC-insured institutions that existed as of year-end 2018.In the first seven months of the year, aggregate deal volume reached $41.3 billion, which surpasses the $30.5 billion in announced deals in all of 2018 as shown in Figure 1. The increase primarily reflects the $28 billion BB&T-SunTrust merger that was announced on February 7 and represents the largest deal since the 2007-2009 financial crisis. While deal value is up, multiples are down relative to 2018 with the average P/TBV multiple declining from 174% to 161% and the median P/E multiple declining from 25.3x to 17.1x as shown in Figure 2, although the price/earnings multiples from the 2018 period may be distorted by the effects of tax reform. The tables below provide a more detailed look at deal activity and the change in multiples in 2019 relative to 2018. For banks with assets less than $500 million, P/TBV multiples declined approximately 5%. While deal volume in the $500 million to $1 billion size group somewhat limits the meaningfulness of comparisons, it’s interesting to note that the median P/TBV multiple increased for this group relative to 2018 while the median buyer size increased from $3.1 billion in assets to $6.8 billion. As shown in Figure 3 below, the landscape of buyers has shifted somewhat in favor of bigger banks over the last decade. Deal activity among the smallest group (buyers with assets less than $500 million) peaked in 2015 with 95 announced deals. In 2018, this group announced 56 acquisitions. In contrast, buyers with total assets between $10 billion-$50 billion announced a 10-year high, 28 deals in 2018 and are on pace to reach a similar level in 2019. In May 2018, the SIFI threshold was increased to $250 billion, providing immediate relief to banks with assets between $50 billion and $100 billion. For those with assets between $100 billion and $250 billion, regulatory relief will phase in after 18 months. This change is expected to encourage additional M&A activity among bigger players. The theme of the story hasn’t changed; consolidation of the banking industry continues at a pace on par with the historical average. Target banks with less than $500 million in assets continue to comprise 75%-85% of total deal volume, but the composition of the buyer universe does seem to be shifting. In addition to the move towards larger buyers, another trend that appears to be gaining speed is the acquisition of commercial banks by credit unions. In 2015, three of such transactions were announced. In 2018, nine deals by credit unions were announced, and an additional ten have been announced through late July of this year. As to be expected, pricing trends over the last few years have also further cemented the value of a stable and low-cost customer base. As shown in Figure 4 below, as interest rates increased from the end of 2015 through 2018, pricing diverged in favor of banks with the highest percentage of noninterest-bearing deposits to total deposits. Mercer Capital has been providing transaction advisory and valuation services for over 30 years. To discuss a transaction or valuation issue in confidence, please contact us. Originally published in Bank Watch, July 2019.

Community Bank Valuation (Part 1): Financial Performance, Risk, and Growth

This article begins a series focused on the two issues most central to our work at Mercer Capital: What drives value for a depository institution and how are these drivers distilled into a value for a given depository institution?We leave the more technical valuation discussion for subsequent articles. At its core, though, value is a function of a specified financial metric or metrics, growth, and risk.Financial MetricsMany industries have a valuation benchmark used by industry participants, although this metric does not necessarily cohere with benchmarks used by investors. In the banking industry, “book value” fills this role. In fact, there are several potential measures of book value, including:Stated shareholders’ equity, as indicated in the institution’s financial statementsTangible book value, which deducts purchase accounting intangible assets from stated shareholders’ equityTier 1 common equity, which is a regulatory capital measure that is less commonly used as a valuation metric The most commonly used book value metric is tangible book value (or TBV). Like most industry benchmarks, simplicity and commonality are reasons industry participants embrace TBV as a valuation metric. Strengths of TBV as a valuation metric include:It is reported frequently and comparable from institution to institution.TBV is subject to less pronounced volatility than net income; thus, valuation multiples computed using TBV may be less prone to exaggeration when, for example, earnings are temporarily depressed. TBV can be used to capture the mean reversion tendencies of return on equity (ROE). For example, consider an institution with an ROE exceeding its peer group. Over time, as competitors understand and replicate its business model, these excess returns may diminish. An analyst could use TBV multiples to model potential mean reversion in ROE, which is more difficult to capture using a current period price/earnings multiple. While TBV has its place, investors focus primarily on an institution’s earnings and the growth therein. This earnings orientation occurs because investors are forward looking, and TBV inherently is a backward-looking measure representing the sum of an institution’s common stock issuances, net income, dividends, and share redemptions since its inception. In addition to being forward-looking, investors also appreciate that earnings ultimately are the source of returns to shareholders. With earnings, the institution can do any of (or a combination of) the following:1Reinvest (i.e., retain earnings), with the goal of generating higher future earningsPay dividends to shareholdersRepurchase stock, which supports the per share value by reducing the outstanding sharesAcquire other companies. Because goodwill and intangible assets are deducted when computing regulatory capital, earnings offset the TBV dilution created in these transactions More bluntly, investors like growing earnings and cash returns (dividends or share repurchases), which are difficult to provide without a sustainable base of strong earnings. Investors will tolerate some near-term drag on earnings from expansion or risk mitigation strategies, but their patience is not limitless. In many industries, earnings before interest, taxes, depreciation, and amortization (EBITDA) or a similar metric is the preferred earnings measure. However, banks derive most of their revenues from interest spreads, and EBITDA is an inappropriate metric. Instead, bank investors focus on net income and earnings per share. When credit quality is distressed, investors may consider earnings metrics calculated before the loan loss provision, such as pre-tax, pre-provision operating income (PPOI). While earnings-based analyses generally should have valuation primacy in our opinion, TBV multiples nevertheless serves as an important test of reasonableness for a valuation analysis. It would be foolhardy to develop a valuation for a depository institution without calculating the TBV multiple implied by the concluded value. Analysts should be able to reconcile implied TBV multiples to public market or M&A market benchmarks and explain any significant discrepancies. Occasionally, analysts cite balance sheet-based metrics beyond TBV, some of which have more analytical relevance than others. The most useful is a multiple of “core” deposits, a definition of deposits that excludes larger deposits and deposits obtained from wholesale funding markets. Core deposits are time consuming and costly to gather; thus, a multiple of core deposits aligns a bank’s value with its most attractive funding source. A less useful multiple is value as a percentage of total assets, the use of which would implicitly encourage management to stockpile assets without regard to their incremental profitability.GrowthInvestors like growth and accelerating growth even more. Without demonstrating the mathematics, higher expected growth rates produce higher valuation multiples. Further, price/earnings multiples expand at an increasing rate as growth rates increase, as indicated in the following chart. The opposite is true, too, as slowing growth reduces the price/earnings. Banks report innumerable metrics to directors and investors, but what are the most relevant growth indicia to investors? Usually, investors focus on growth in the following: Balance sheet components like loans and deposits, which ultimately drive revenue growthAsset quality and capital adequacyPre-tax, pre-provision operating income, which smooths earnings fluctuations caused by periodic volatility in provisions for loan lossesNet income per shareDividends per shareTangible book value per share Valuation is inherently forward-looking, and historical growth rates are useful mostly as potential predictors of future growth. Further, most investors understand that there is some tradeoff between earnings today and investing for higher earnings in the future. While some near-term pressure on earnings from an expansion strategy is acceptable, strategic investments should not continually be used to explain below average profitability. After all, a bank’s competitors likely are reinvesting as well for the future. How does growth affect value? As a thought experiment, consider a bank with no expected growth in earnings and a 100% dividend payout ratio. Should this bank’s common equity value increase? In this admittedly extreme scenario, the answer is no. This bank’s common equity resembles a preferred stock investment, with a shareholder’s return generated by dividends. That is, for value to grow, one (or preferably more) of the preceding factors must increase. Should a bank prioritize growth in earnings per share, dividends per share, or another metric? The answer likely depends on the bank’s shareholder base. In public markets, investors tend to be more focused on earnings per share growth. If an investor desires income, he or she can sell shares in the public market. For privately-held banks, though, investors often are keenly aware of dividend payments and emphasize the income potential of the investment. Of course, sustaining higher dividend payments requires earnings growth. Growth creates a virtuous cycle – retained earnings lead to higher future net income, allowing for future higher dividends or additional reinvestment, and so the cycle continues. One important caveat exists, though. This virtuous cycle presumes that the retained earnings from a given year are invested in new opportunities yielding the same return on equity as the existing operations. If reinvestment occurs in lower ROE opportunities – such as liquid assets supported by excess capital beyond the level needed to operate the bank safely – then growth in value may be diminished. This discussion of growth segues into the third key valuation factor, risk.RiskMore than most industries, risk management is an overarching responsibility of management and the board of directors and a crucial element to long-term shareholder returns. Banks encounter the following forms of risk:Credit risk, or the risk that the bank’s investments in loans and other assets may not be repaid in full or on a timely basisLiquidity risk, or the risk that arises from transforming liabilities that are due on demand (deposits) into illiquid assets (loans)Interest rate risk, or the risk attributable to assets and liabilities with mismatched pricing structures or durationsOperational risk, such as from malevolent actors like computer hackers While growth rates are observable from reported financial metrics, the risk assumed to achieve that growth often is more difficult to discern – at least in the near-term. Risk can accumulate, layer upon layer, for years until a triggering event happens, such as an economic downturn. Risk also is asymmetric in the sense that a strategy creating incremental risk, such as a new lending product, can be implemented quickly, but exiting the problems resulting from that strategy may take years. From a valuation standpoint, investors seek the highest return for the least risk. Given two banks with identical growth prospects, investors would assign a higher price/earnings multiple to the bank with the lower risk profile. Indicia of risk include:The launch of new products or business lines » Expansion into new geographic marketsHigher than average loan yields coupled with lower than average loan losses None of the preceding factors necessarily imply higher risk vis-à-vis other banks; the key is risk management, not risk avoidance. However, if an investor believes risk is rising for any reason, then that expectation can manifest in our three pronged valuation framework as follows:Financial Metric. The investor may view a bank’s current earnings as unsustainable once the risk associated with a business strategy becomes evident, leading to reduced expectations of future profitability.Growth. An investor may assess that a bank’s growth rates are exaggerated by accepting too much risk in pursuing growth. In this event, earnings growth expectations would be tempered as the bank realigns its growth, risk, and return objectives.Risk. Valuation multiples are inversely related to risk. By increasing the investor’s required return, the investor increases his or her margin of safety in the event of unfavorable financial developments. An old adage is that risk can be quantified and uncertainty cannot. This observation explains why stock prices and pricing multiples can be particularly volatile for banks in periods of economic uncertainty or distress. If investors cannot quantify a bank’s downside exposure, which often is more attributable to general economic anxieties than the quality of the bank’s financial disclosures, then they tend to react by taking a pessimistic stance. As a result, risk premiums can widen dramatically, leading to lower multiples.ConclusionThis article provides an overview of the three key factors underlying bank stock valuations – financial performance, risk, and growth. While these three factors are universal to valuations, we caution that the examples, guidance, and observations in this article may not apply to every depository institution.At Mercer Capital, valuations of clients’ securities are more than a mere quantitative exercise. Integrating a bank’s growth prospects and risk characteristics into a valuation analysis requires understanding the bank’s history, business plans, market opportunities, response to emerging technological issues, staff experience, and the like. These important influences on a valuation analysis cannot be gleaned solely from reviewing a bank’s Call Report. Future editions of this series will describe both the quantitative and qualitative considerations we use to arrive at sound, well-reasoned, and well-supported valuations.1 In theory, a bank could accomplish the preceding without earnings, but eventually that well (i.e., the bank’s TBV) will run dryOriginally published in Bank Watch, June 2019.

Is 16x Pro Forma EBITDA a Realistic Valuation for Mercer Advisors?

Pre-season Soccer and the Mercer Price Tag are Likely More About Form Than Substance

I was initially intrigued by this match-up. Two of Europe’s greatest soccer clubs and intra-city competitors squaring off in front of a packed crowd on American soil for the first time in their storied history. Fittingly, the game was played in a football stadium because it was that kind of score. The New York Giants and Jets fans that typically frequent the grounds probably appreciated all the action, but Real Madrid supporters and other soccer enthusiasts had a different impression. Despite all the hype leading up to the game, only one team had any interest in being there, and the match itself has been widely panned by most (non-Atleti) observers.The Real/Atleti debacle is perhaps a microcosm for the broader International Champions Cup (“ICC”) in which it is played. The pre-season tournament has been criticized for the lack of quality competition and blatant apathy of the players despite broad participation by most of Europe’s top clubs. Blame the heat, injury aversion, or American nightlife, but it hasn’t been pretty. Like most pre-season affairs, there’s even talk of cancelling it all together, but that probably doesn’t make sense from an economic perspective. The real culprit is the lack of meaning to the games since they have no implications for the teams’ league status and no (direct) impact on the players’ compensation levels. There have been discussions of playing regular season European matches in America (much like the NFL and MLB are doing in London) to remedy this issue, but no definitive decisions have been made yet.I was similarly intrigued (and skeptical) of the recent reports that RIA aggregator Mercer Advisors was looking to fetch a $700 million-plus price tag in a prospective sale by its PE backers at Genstar Capital. A 15-16x multiple on an estimated pro-forma, run-rate EBITDA of approximately $50 million results in a $750 million to $800 million enterprise value for the business, which certainly got my attention. Still, this figure could be as meaningless as the ICC if it’s an unlikely appraisal of Mercer Advisor’s current market value. We’ll address our opinion from a fair market value and strategic value perspective in this week’s blog.The Fair Market Value of Mercer AdvisorsDespite the similar name, we have no relation to Mercer Advisors. On the one hand, this means that our opinion is not conflicted, but it also means that we are not privy to its financial situation, so we’ll have to opine in general terms. The 15-16x multiple feels a bit rich (we’ll address this later) but may not be nearly as big of a stretch as the “pro forma, run-rate EBITDA estimate” to which it is applied. We don’t know what adjustments were made to get from reported EBITDA to pro forma, run-rate EBITDA, but in our experience, they can be substantial and unsubstantiated.Historically, most publicly traded RIAs with under $100 billion in AUM have traded in the 8-11x range.The context of fair market value, according to most definitions, is a transaction between a hypothetical willing buyer and a hypothetical willing seller, both having reasonable knowledge of the facts and circumstances. The word hypothetical precludes any consideration for what an actual, specific buyer would pay for the business. This means that certain synergies that could be realized by a strategic buyer are typically not considered in a fair market value appraisal. Since the pro forma adjustments likely include such synergies, they are probably not relevant from a fair market value perspective.The 15-16x EBITDA multiple is probably also a stretch. Historically, most publicly traded RIAs with under $100 billion in AUM have traded in the 8-11x range, and this has actually ticked lower over the last few years. Even though Mercer Advisors isn’t really an RIA, it is in a similar line of business, so we can’t totally ignore the market’s current pricing of these companies. On balance, an inflated multiple on a stretched earnings estimate is likely outside a reasonable fair market value range for this business as a stand-alone entity. Especially since RIA aggregators market prices have declined over 30% over the last twelve months leading multiples to fall.The Strategic Value of Mercer AdvisorsSince many believe Mercer’s ultimate acquirer will have synergistic intentions, strategic value may be more applicable in determining the likely purchase price.Unlike fair market value, strategic value considers the particular motivations of a specific buyer and the synergies that could arise in a contemplated transaction. Since many believe Mercer’s ultimate acquirer will have synergistic intentions, strategic value may be more applicable in determining the likely purchase price. In this context, pro forma EBITDA estimates become more relevant, and we can look to recent transaction evidence for perspective on what strategic buyers are paying for these businesses. The most recent transaction in the space involved Goldman Sachs’ purchase of RIA aggregator United Capital for $750 million or an estimated 18x EBITDA. This price tag may be a bit rich for Mercer Advisors, which, at $16 billion in AUM, is quite a bit smaller than United’s $25 billion in client assets. Mercer’s pro forma EBITDA estimate may also be more heavily adjusted, so $750 million and/or 18x is probably a bit optimistic.The Focus Financial IPO last Summer offers additional guidance. The IPO price implied a total enterprise value of $2.8 billion or 16x (heavily) adjusted EBITDA. While Focus is much larger than Mercer and United, the 16x multiple may be more applicable here since it is on top of an adjusted EBITDA figure and is reasonably in line with current pricing. Overall, there does appear to be some support for a 16x multiple from a strategic buyer perspective, but we’d like to know more about the pro forma adjustments before validating the $800 million offering price.Where Do We Think this Deal Will Land?Providing a reasonable range of value for this business is nearly impossible without knowing the acquirer or anything about Mercer’s financial situation, but we’ll take a stab at it. If we back off the multiple a bit and revise our pro forma earnings estimate, we get something closer to a $450 million to $650 million transaction value. This estimate is purely speculative, and if $50 million in incremental EBITDA is truly achievable from a buyer’s perspective, then the $700 million-plus price tag looks very achievable especially since Mercer is one of the few independent RIA aggregators of this size left. Overall, we think the $700 million-plus headline value is a bit rich but certainly more meaningful than an ICC trophy.

Comstock’s Acquisition of Covey Park

A Valuation Analysis of the Multibillion-Dollar Haynesville Deal

On July 16, 2019, Comstock Resources, Inc (NYSE: CRK) finalized its acquisition of Haynesville operator Covey Park Energy LLC. Announced on June 10, 2019, the companies entered into an agreement under which Comstock would acquire Covey Park in a cash and stock transaction valued at approximately $2.2 billion, including assumption of Covey Park’s outstanding debt and retirement of Covey Park’s existing preferred units (totaling approximately $1.1 billion). Covey Park is a natural gas operator with core operations located in the Haynesville Shale Basin and is backed by private equity firm Denham Capital. This acquisition is the latest addition to the continuing resurgence of the Haynesville Shale Basin.For the purposes of this post, we will be examining this deal from a few different vantage points and reviewing the fair value of the various components that make up total deal value. We’ll also look at how this transaction compares to industry valuation metrics and what kind of strategic advantages Comstock may have a result of the deal.Deal OverviewThe transaction is structured in multiple layers, including a substantial investment from Dallas Cowboys owner and Comstock majority stockholder, Jerry Jones. Details behind the total deal consideration are outlined below: As a result of the finalized deal, Comstock’s holdings in North Louisiana and East Texas comes out to a total of 374,000 net acres with over 1.1 bcfe/d of net production. The company also holds assets in North Dakota. The chart below maps the acreage of Comstock and Covey Park prior to the merger and where it fits into the Haynesville Shale: As the various components of the deal are considered, we then begin to analyze the assets actually purchased by Comstock. Analysts, accountants, and investors alike look at fair value of the parts that make up the total purchase, and allocating fair value among the components begins to paint a clearer picture of how we get to deal value. Allocation of Assets and Liabilities to Fair ValueThe table below outlines the allocation for both the assets acquired and the liabilities assumed. The calculation is management’s estimate from the Definitive Proxy Statement that Comstock had filed with the SEC on June 24, 2019. For an E&P company, most of its asset fair value naturally derives from its property and equipment. It’s no surprise that of the assets acquired an estimate of nearly $2.2 billion is in the property and equipment camp. We can then take a step further into understanding the value of these assets by diving into the proven resource reserves that are contained within these properties. The SEC has clear rules and regulations regarding oil and gas reserve reporting (more commonly known as PV-10), and while these summaries of reserves under SEC pricing may not be accurate for determining fair market value, they do provide a general ballpark figure. Below is the summary of proved reserves for Covey Park from the Definitive Proxy Statement: Under the standardized measure, the total value of the proved reserves (both developed and undeveloped), totals around $2.3 billion. What is interesting is this amount is north of the purchase price by Comstock and may have some investors wondering if this falls into the territory of a bargain purchase. As we mentioned above, SEC pricing may not be the best indicator of fair value. It’s not unusual for fair value to vary 10-20% from PV-10 value, and most of that generally comes from the developed and undeveloped (PUD) reserve mix. The valuation of PUDs can be tricky at times, and they generally have a fair value that trades at a haircut. Given the mix of the total proved reserves is fairly PUD heavy, it makes sense as to why the management estimated value of properties comes in under the SEC PV-10 amount. Other assets of note that typically are glossed over are the derivative financial instruments. E&P companies often hold futures and other derivative contracts for hedging purposes, and these contracts are marked to fair value for the purposes of the allocation. These are relatively less important given the magnitude of the other assets, but they certainly merit consideration, particularly for companies that may have significant hedging practices. How Do Reported Valuation Multiples Compare to the Industry?Below is a list of comparable companies that Comstock identifies in their latest 10-K as competitors, excluding non-gas players, and common valuation multiples (such as EV to Production) used for relative industry analysis. In comparison to other operators, the acquired assets come in slightly above the median values for EBITDA multiples but are generally close to direct competitors such as Cabot and Antero. The lower acreage multiple observed in the deal compared to the industry group makes sense given our analysis above of the sizable amount of PUDs in the proved reserves. After analyzing the structure of the deal and how it compares to other valuation metrics, we will take a look at some of the competitive advantages available to Comstock as a result of the deal. Large Footprint, Established Infrastructure, and Low Gathering CostsWhile the company already owns over 500 miles of gas gathering infrastructure, it also enjoys many locational benefits: limited basis risk due to proximity to Henry Hub, lowest in-basin gathering, treating, and transport costs (approx. 26¢ per Mcfe), and even twelve approved LNG export terminals located in the Gulf Coast.The Houston Ship Channel and other gathering and transportation pipeline infrastructure already present in the Louisiana and East Texas regions mitigate the risks of capacity constraints and bottlenecking unlike those that historically, up until recently, plagued Northeast gas production in the Marcellus/Utica Shale.The Competitive Edge: Capital AdvantageBeing the largest operator in the Haynesville Shale provides Comstock with a strategic advantage due to sheer size of acreage owned. Just as importantly though, Comstock has another major advantage that competitors have been struggling with for some time: access to capital.E&P companies have been facing headwinds in the public markets for some time. The major uptick in U.S. production over the past several years has triggered the need for upstream companies to increase capital expenditures to keep up with demand. However, investors have been unwilling to participate in the upstream sector because free cash flow has been directed to these capital expenditures and additional acreage as opposed to returns in the form of payouts. Consequently, investors have shifted into the realm of mineral rights aggregators because of the immediate returns in the form of dividends and returns on capital. As a result, access to capital markets (both equity and debt) has proved difficult for E&P companies in general.Comstock, however, appears to have bypassed this hurdle before having to cross it. Jerry Jones’ large stake (75% ownership) and his deep pockets can facilitate large capital raises should the need arise. However, Mr. Jones isn’t Comstock’s sole non-public capital raising option. The aforementioned Denham Capital owns 16% ownership interest, and Comstock just renewed its bank credit facility to $2.5 billion concurrent with the transaction. This gives the company the ability to raise any needed funds before having to jump into the public markets.ConclusionAs a result of the transaction, Comstock is now the largest operator in the Haynesville Shale. While it may seem that Comstock managed to acquire Covey Park’s large amount of acreage at a bargain, the examination of the components of the fair value allocation show that the heavy mix of PUDs in the reserves account for much of the estimated fair value by management, even though it came out lower than the calculated PV-10 valuation. This seemed to be confirmed in our comparisons to industry multiples. However, given the advantages Comstock now has as a result of the deal, the company has positioned itself to be a strong player in the Haynesville Shale Basin.Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

One Year Later: The Focus IPO Reshaped the RIA Industry

Attention Drives Activity

Whether or not the road tests and sales figures confirm it, the new Corvette is already a success. It’s only been two weeks since the car debuted, and I can’t remember another new model launch that generated as much conversation. Last Thursday I had complete strangers asking me what I thought about it on the elevator ride up to the office in the morning and down that afternoon. One told me he had already put down a deposit.Unlike previous iterations, the eighth generation Corvette sports a mid-engine configuration, and if you squint it looks like a Ferrari 488. The Stingray is no Prancing Horse, however. With a 6.2 liter normally-aspirated (no turbo) V-8 generating 495 hp, GM is eschewing the high compression engines favored by European manufacturers (the Ferrari produces more than twice as many horsepower per liter). Corvette faithful will appreciate the old-school iron under the hood, if they can accept the “hood” being behind them, an automatic transmission, and a dizzying number of character lines in the bodywork.Focus Got People Talking, and MovingIt’s been a year since the Focus Financial IPO generated a similar level of conversation in the RIA community – and the transaction dominos have been falling ever since. In that same year, Victory Capital pulled off a major acquisition, Affiliated Managers Group got back into the acquisition game following a two-year hiatus, United Capital was acquired by Goldman Sachs, and Mercer Advisors is soliciting bids.I was thinking about all of this on a road trip across the southeast last week, in-between blasting Tom Petty on satellite radio and dropping in on a few clients. At one of my first stops, a client asked if I saw a lot of M&A activity in the RIA space. Yes, I replied, but I see even more headlines about it. Plenty has changed in the RIA community in the last twelve months, but even more has not.The Focus IPO was a Watershed MomentThe Focus management team is to be congratulated for surviving their first year as a listed company. Serving private equity masters is no walk in the park, but public company life means enduring the unexplained ups and downs of daily trading activity, the tedium of analyst calls, and half-informed commentary from armchair quarterbacks such as myself. It must weigh on Rudy Adolf and his colleagues, but they made it this far. Their share price has been volatile but mostly resilient, and the analyst calls are becoming routine. The question is: now what?The Voting Machine and the Weighing MachineBenjamin Graham developed the metaphor for the stock market acting, in the short run, like a voting machine (a popularity contest) and in the long run, like a weighing machine (based on sustainable profitability). It’s a useful way to look at Focus, as well as the overall RIA consolidation movement. Headline activity attracts capital and acquisition opportunities, and headlines begat headlines as others rush to join a crowded trade. At least for now. Eventually, all of these consolidators will have to demonstrate they can do something productive with their acquired businesses, and that’s when the robustness, or lack thereof, of the different rollup models will show.Benjamin Graham developed the metaphor for the stock market acting, in the short run, like a voting machine and in the long run, like a weighing machine.The IPO gave Focus an edge in vying for attention among RIA sellers. As a quick reminder, Focus Financial is not an RIA. It is a leveraged investment enterprise that accumulates preferred stakes in RIAs, encouraging their growth with best-practices coaching and sub-acquisition financing. It is not unlike the European Union: financial bonds without much consolidated governance. Nevertheless, Focus is viewed as a bellwether for acquisition behavior in the RIA community, and rightfully so.United Capital and Mercer Advisors are more typical consolidation models: national platforms with cohesive branding, marketing, management structure, compliance, and investment products. Focus’s de-consolidated model probably guarantees independence. Goldman Sachs, which recently acquired United Capital, could never have fit Focus into their framework.Now that Mercer Advisors has put a for-sale sign in the yard, it will be interesting to see who wants their franchise. One would expect Goldman to consider the possibility of rolling Mercer into their United Capital unit, which could be awkward because Goldman is running the book, but it could happen anyway. Goldman also led the Focus IPO, and anyone who doubts David Solomon’s commitment to building an investment management franchise hasn’t been paying attention. My contacts within the Goldman partner network say 1) Solomon is committed to transforming Goldman Sachs and 2) they are impressed with what he’s doing - a powerful endorsement from a tough audience.For Now, It’s a Land GrabIn the near term, Focus will be judged as an acquisition model, which is much more difficult than it sounds. Acquisition activity is difficult to sustain. Focus announced eight transactions in the second quarter. Skimming the ADVs of the acquired entities, these eight firms came with just under $10 billion in AUM and 83 employees. That’s not insubstantial, although nearly half of that workforce and 70% of that AUM came from one deal. The other seven transactions averaged about $400 million in AUM and six employees.When you’re the size of Focus Financial ($100+ billion in partner firm AUM and thousands of partner firm employees), it’s tough to move the needle with small deals. Focus claims thousands of potential acquisition targets, but a realistic assessment is far fewer. Their model won’t appeal to every would-be seller, and firms that work much outside of the advice and planning space won’t suit Focus.As Focus grows, the pressure will build to do larger transactions. The rise of competing acquisition platforms will drive up the competition and the multiples, and limit the opportunities for arbitraging the cost of capital. Deals will still be accretive in the future, but less so than in the past. All of the consolidators will face this.How Will Things Look in Ten Years?In the longer term, Focus will be judged as an operating model. Since Focus allows their partner firms to run independently, they have limited opportunities to widen margins with scale. Monitoring marketing and compliance activities may become more labor-intensive. Seeing hundreds of firms through succession issues could prove daunting. Ultimately, the parent organization will have to justify its considerable overhead by helping partner firms grow faster (organically) or become more profitable (than they would be independently) – otherwise the whole will be worth less than the sum of its parts.As for the more integrated consolidation models, the future of Goldman Sachs’s mass-affluent wealth management practice would be easier to forecast if Joe Duran’s acquisition chief, Matt Brinker, had stayed. Brinker left on the eve of the Goldman deal closing, perhaps to avoid a non-compete. While he hasn’t said so, it’s hard not to imagine Brinker resurfacing in a similar role elsewhere. With Brinker out, will Goldman try to grow this platform organically, or draw on other internal resources to hunt for acquisitions? We’ll know more when Mercer Advisors announces their acquirer. If Mercer flips to another PE firm, we’ll see more of the same from them. Word is strategic acquirers are looking at the deal. In any event, RIA sellers will have several acquisition models from which to choose.Who’s Paying for All of This?The equity multiples being bandied about for RIA consolidators are dizzying. We know Focus went public at a high-teens multiple of adjusted EBITDA. Similar multiples were rumored (and remain unconfirmed) for the Goldman/United transaction, and many have suggested the ask for Mercer Advisors is just as high. RIAs cannot sustain those valuations, so either the pricing is overstated, the pro forma adjustments are substantial, the expected growth is steep, or these really are the end times.One of the earliest lessons I learned in finance was that labor-intensive businesses don’t handle debt well because all they can really mortgage is future compensation.We can only speculate about much of this. However, much of this activity is financed with borrowed capital rather than equity, and because leverage is more formulaic, the behavior surrounding it is more transparent. To that end, we’re puzzled about Focus’s debt burden. In their Q1 2019 filings, Focus reported term debt of almost $800 million and another $290 million on their revolver. Management reported that this represented a bit less than 4.0x a defined measure of cash flow. Focus recently announced consolidating $300 million of revolver debt under the term loan, and then quietly filed an 8-K on Friday that upped that amount to $350 million.Term debt is generally more expensive, but freeing up the acquisition line offers flexibility. With a $650 million revolver in place, Focus could expand their indebtedness considerably – in sharp contrast to what we’re accustomed to seeing.Most RIAs have unremarkable balance sheets. One of the earliest lessons I learned in finance was that labor-intensive businesses (such as professional service firms) don’t handle debt well because all they can really mortgage is future compensation. When leverage ratios get stretched and operating conditions dim, the analyst community becomes agitated. Until then, with a sympathetic Federal Reserve on tap and a land-grab strategy to execute, it’s going to be tempting for Focus management to lever up. We expect to hear more about this during the earnings call next week.As For Everyone ElseAt one-quarter the price of a new Ferrari, the new Corvette will attract a lot of buyers for Chevrolet. GM would probably be satisfied with a lot of lookers. The Corvette is what is known as a “halo-car," designed to showcase what the automaker can do and get people into the showrooms to look at all of their models (less than 5% of Chevy sales in 2018 were Corvettes). Attention drives activity.I haven’t touched on Hightower or Victory or Captrust or Fiduciary Network or any of the other consolidation platforms. And I haven’t talked about the PE platforms like Kudu Investment Management that are making headway in the RIA space. It’s been an active year since the Focus IPO, and the domino effect that comes from transactions completed at seller-friendly pricing and terms sends ripples throughout the industry. Whether you plan to jump into the fray in the foreseeable future or not, the marketplace around your firm is caught up in it, and it affects you.

Challenges in Appraising Refinery Businesses

The appraisal of businesses involved in the refining of crude oil entails a number of challenges. Some are unique to the industry, and others are more common. The challenges arise primarily in two areas – assessing the level of uncertainty inherent in the entity’s future cash flows and forecasting the entity’s future operating results.The greater the range of future cash flows, the greater the rate of return an investor will require to invest in the business.Assessing the level of uncertainty for a particular business’ future cash flows is a key part of any business valuation. Basic economics tells us that the present value of an expected future cash flow is greater if the possible range of the cash flow is +/-10% from the expected level, compared to the possible range of the cash flow being +/-30% from the expected level. Investors aren’t willing to pay as much for an expected future cash flow with a potentially high divergence from expectations than for an expected future cash flow with a potentially low divergence from expectations. The greater the range of future cash flows (the degree of uncertainty of the future cash flows), the greater the rate of return an investor will require to invest in the business.In addition to the challenges posed in the risk (uncertainty) assessment, the appraisal of an oil refinery business also carries particular challenges in forecasting future operating results. Oil refining entails not only a commodity input (feedstock), but also commodity products - gasoline, diesel, liquefied petroleum gases, jet fuel, residual fuel oils, still gases, lubricants, and waxes. Complexity increases in these product markets since they are significantly influenced by international, domestic and local supply and demand, heavy regulation, domestic politics and international politics. Add to those enormous capital requirements and high barriers to entry and you have an industry rife with forecasting complexity.Assessing UncertaintyAssessing the level of cash flow uncertainty for a particular crude oil refining business requires a thorough analysis of the subject company’s internal operations. This analysis includes its facilities, suppliers, customers, level of integration, and use of hedging. Additionally, external factors, such as infrastructure availability and limitations, feedstock and product supply and demand, government and environmental policies, geopolitical matters, and currency exchange rates must be considered. Some potentially key uncertainty assessment considerations are addressed as follows:ConfigurationConfiguration refers to a facility’s ability to accept a range of crude oils (light-sweet crude, or heavy crude) as feedstock. Refineries with limited feedstock abilities lack the flexibility of shifting from one type feedstock oil to another, thereby exposing the business to uncertainties regarding particular feedstock supply and demand. For example, refineries that were specifically designed (configured) to process heavy crude would be exposed to the negative economics of an unexpected decrease in heavy crude availability. On the contrary, refineries configured for greater feedstock flexibility would potentially avoid the negative impact of a reduced supply of heavy crude by shifting to a light crude feedstock.Secondary Processing SystemsSecondary processing capabilities refers to the ability to engage in processing crude oil beyond initial distillation to processes involving catalytic cracking and reforming. These secondary processes allow a refinery to shift between maximizing distillate production in the winter months when heating oil is in higher demand and gasoline production during the summer months when automotive fuel is in demand. Without secondary processing systems, a refinery is more vulnerable to the negative economics of seasonal product supply and demand shifts.Feedstock Source ConstraintsFeedstock source constraints refer to the refinery’s ability to economically choose between feedstock sources. Facilities that are located along the U.S. coastline have the option of using either the WTI (inland U.S. produced) or the Brent (North Sea produced) varieties of crude oil. As such, they have the ability to favorably respond to shifts in WTI versus Brent pricing (the Brent-WTI spread). Refineries located in the U.S. interior have a much lower economic ability to utilize Brent and are therefore subject to the impacts (positive or negative) of pricing variations between the two varieties.Inventory ExposureRefineries typically hold significant levels of inventory (feedstock and product inventory) with these inventories comprising 13% to 17% of total assets. Due to the potential for material swings in the market price for the feedstock inventories (crude oil) and end products, refiners face a significant level of uncertainty regarding their profits. Market-driven increases/decreases in crude prices can raise/reduce the value of feedstock holdings, while market-driven increases/decreases in end product prices can raise/lower revenues and profit margins. While protection against the negative impacts of such market changes is available through commodity price hedging, refining businesses vary in the degree to which they utilize hedging strategies. In appraising a particular oil refining business, the appraiser must gain a clear understanding as to the commodity price risks that are hedged and those that remain unhedged.Ability to Pass-on CostsThe ability to pass-on the higher feedstock costs is often dependent on the current conditions in the local and international end product markets.When crude oil prices are rising, oil refinery businesses may be able to pass those higher feedstock prices on to customers in the form of higher-end product prices and thereby maintain margins. The ability to pass-on the higher feedstock costs is often dependent on the current conditions in the local and international end product markets. If the petroleum product market is experiencing particularly high supply, or low demand, the refiner’s ability to pass-on higher crude oil prices may be significantly limited. However, in situations of lower supply, or higher demand, higher crude prices may more readily be passed through to customers. As such, an appraiser must not only be aware of near-term expectations for crude prices, but also near-term expectations for the various end products of the particular refining business in order to correctly assess the level of uncertainty that should be factored into the appraisal analysis. In performing this part of the analysis, the appraiser must take into consideration the degree to which the uncertainty would be expected to be avoided by the subject company’s use of hedging.IntegrationSome oil refiners are integrated in that they are also involved in the ownership/control of crude oil reserves, or as with many larger refineries, they also own the petrochemical plant customer of the refiner. Such integrated refineries can allow for the shifting commodity price risks between the refinery and the entity that owns the crude reserves or the petrochemical producer. As such, an important part of the refinery appraisal involves a careful assessment of how the commodity price risk is being handled between the entities involved, and how such handling of the risk should be incorporated into the appraiser’s assessment of future cash flow uncertainty.Infrastructure ChangesInfrastructure changes can have a significant impact on a refinery’s profitability. Changes in the availability of the necessary infrastructure for bringing crude oil “to market” (to local refineries, more distant refineries, or to a port for export) can have a significant impact on the refinery’s profitability. For example, for years various market forces (high international demand for Brent, high WTI supply and interior U.S. pipeline capacity deficiencies) maintained a Brent-WTI spread that was advantageous to U.S. refineries. However, more recently shifts in market forces, including improvement of U.S. pipeline capacity, has contributed to a significant narrowing of the Brent-WTI spread. These shifts have resulted in the loss of a considerable portion of the crude supply cost advantage for U.S. refineries. A particular refinery’s exposure to potential changes in crude transportation infrastructure must be considered by an appraiser as part of the analysis in determining the relative uncertainty of the refinery’s cash flows.Facility EfficiencyThe efficiency of a particular refinery can be a material contributor to cash flow uncertainty. The oil refining industry is subject to a large number of market forces that can have a material impact on profitability. In considering the refinery’s ability to successfully adjust to changes in those many market forces, one must consider the facility’s efficiency. In an environment where the number of facilities is expected to downsize and consolidate in the short-term, facilities with lower levels of efficiency are more subject to having their utilization trimmed back, or even being shut-down.Government RegulationThe oil refining industry is subject to an extensive array of both federal and state regulations, which can be changed, delayed, or accelerated, depending on the political climate. While some of these regulations are static, others have restrictions that are implemented over time. For example, MarPol 2020 represents a significant, albeit long foreseen, change beginning January 1, 2020 where the allowable sulfur for fuel used in ocean-bound vessels is reduced from 3.5% to just 0.5%. U.S. refiners with the ability to produce a higher proportion of lighter, low-sulfur fuels from each barrel of oil will stand to profit from the change in legislation, particularly if supply is low in the short term following the change.One must be aware of potential regulatory changes and the facility’s ability to conform.In the appraisal of a refining business, one must be aware of potential future regulatory changes and the particular facility’s ability to conform to such regulations. In some cases, this flexibility may be tied to the configuration of the plant, and in others may be tied to technology-related efficiency. Any factors that create a question as to the ability or willingness from a financial perspective to comply with potential regulatory changes must be considered in assessing the uncertainty of future cash flows.Forecasting Operating ResultsForecasting future operating results can present a challenge for many industries. With the number of market forces in play, several considerations in the forecasting process deserve special attention when appraising a business in the oil refining industry. Some of the areas for particular attention include commodity pricing considerations on volumes and margins, and capital intensity considerations.Commodity Pricing ConsiderationsThe commodity nature of refinery feedstock (crude oil) makes the forecasting of future revenues worthy of particular attention. International, domestic and local supply and demand, heavy regulation, domestic politics and international politics all come into play in the oil refining industry and the uncertainty as to the impact of these various factors is why hedging plays such a significant role within the industry. While careful analysis can identify pertinent short-term and long-term trends, the future direction of feedstock prices always remains uncertain to some degree. As such, the appraiser of a refinery business must be familiar with the mix of factors that can impact future feedstock prices and accurately factor the “knowns” and “unknowns” into projections of future revenue levels.The factors that come into play in forecasting future refinery revenues can also impact future operating margins, but not necessarily. As previously mentioned, the ability to pass-on changes in feedstock prices can vary over time based on supply and demand dynamics regarding the refinery’s products. Similar to the refinery’s crude oil feedstock, the end products are also commodities and are therefore subject to pricing changes that are well beyond the control of the refinery operator. In some cases, those dynamics may allow for changes in crude oil prices to be passed on to the refinery’s customers, thereby maintaining operating margins. However, end product market dynamics may create an environment where increases in crude oil prices can’t be passed-on such that future operating margins would be expected to be trimmed.Capital IntensityCapital expenditures in the oil refining business can be much more significant and much less steady in magnitude than in other industries.Petroleum refining is a capital intensive process requiring large investments in property, plant, and equipment (PP&E). While machinery and equipment maintenance expenses are often somewhat steady over time, certain aspects of such expenses can be much more irregular. In contrast, capital expenditures in the oil refining business can be much more significant and much less steady in magnitude than in other industries. Short-term capital expenditures expectations can vary widely depending on past maintenance expenditures and the facility’s past acceleration, or delaying, of major expenditures. Longer-term capital expenditures, or periodic expenditures, are typically significant and quite large. A detailed discussion with facility management is often necessary in order to gain a clear understanding as to both timing and cost expectations for such expenditures. With the high level of industry regulation, often environmentally focused, the timing and magnitude of some capital expenditures may well be outside of facility management control.In addition to the more direct impact of oil refinery capital intensity on maintenance and capital expenditures is the impact on tax expenditures from the depreciation of the machinery and equipment. With PP&E assets totaling hundreds of millions, or even billions of dollars, tax depreciation of those assets can have a significant impact on expected cash flows. The difference of results between a simplified straight-line depreciation modeling and a more detailed accelerated (MACRS) tax depreciation modeling can be significant even before incorporating potential bonus depreciation and Section 179 immediate expensing of qualifying property.While appraisers may be provided with detailed tax depreciation schedules for existing machinery and equipment, it may be within the appraiser’s scope of service to develop the expected tax depreciation scheduling for machinery and equipment that will be put in place during the forecast period. The detailed tax depreciation forecasting may not be particularly pertinent in less asset-intensive industries, but it can have a material impact in the appraisal of more asset-intensive businesses such as oil refining.Mercer Capital has a breadth and depth of experience in the appraisal of businesses in the oil and gas industry that is rare among independent business appraisal firms. Our Energy Team is led by professionals with 20 to 30+ years of experience involving upstream businesses (E&Ps, oilfield product manufacturers and oilfield service providers), midstream (gathering systems, pipeline MLPs, pipeline processing facilities), and downstream (refining, processing, and distribution). Feel free to contact us to discuss your valuation needs in confidence.

Q2 2019 Asset Manager M&A Trends

Asset and Wealth Manager M&A Keeping Pace with 2018’s Record Levels

Through the first half of 2019, asset and wealth manager M&A has kept pace with 2018, which was the busiest year for sector M&A over the last decade. M&A activity in the back half of 2019 is poised to continue at a rapid pace as business fundamentals and consolidation pressures continue to drive deal activity. Several trends, which have driven the uptick in sector M&A in recent years, have continued into 2019, including increasing activity by RIA aggregators and rising cost pressures.Total deal count during the first half of the year is on pace to slightly exceed 2018’s record levels. Reported deal value during the first half of 2019 was down significantly, although the quarterly data tends to be lumpy and many deals have undisclosed pricing. Acquisitions by (and of) RIA consolidators continue to be a theme for the sector. The largest deal of the second quarter was Goldman Sachs’s $750 million acquisition of RIA consolidator, United Capital Partners. The deal is a notable bid to enter the mass-affluent wealth management market for Goldman Sachs. For the rest of the industry, Goldman’s entrance into the RIA consolidator space is yet another headline that illustrates the broad investor interest in the consolidator model. If there was any doubt of that fact, just a few weeks ago it was reported that Mercer Advisors (no relation), an RIA consolidator managing $16 billion, is up for sale by its PE backer, Genstar Capital. Mercer could fetch an estimated $700 million price tag, putting it in a similar size bracket as the United Capital acquisition. These RIA aggregators have been active acquirers in the space themselves, with Mercer Advisors and United Capital Advisors each acquiring multiple RIAs during 2018 and the first half of 2019. The wealth management consolidator Focus Financial Partners (FOCS) has also been active since its July 2018 IPO, although acquisitions slowed during the second quarter of 2019. Focus announced a total of eight transactions during the second quarter, most of which were smaller sub-acquisitions by partner firms, except for the acquisition of William, Jones & Associates, a New York-based RIA managing $7 billion. The prospect of using buyer resources to facilitate their own M&A may be a key motivation.Sub-acquisitions by Focus Financial’s partner firms and other firms owned by RIA consolidators are a growing M&A driver for the industry. These acquisitions are typically much smaller and are facilitated by the balance sheet and M&A experience of the consolidators. For some RIAs acquired by consolidators, the prospect of using buyer resources to facilitate their own M&A may be a key motivation for joining the consolidator in the first place. For the consolidators themselves, these deals offer a way to drive growth and extend their reach into the smaller RIA market in a way that is scalable and doesn’t involve going there directly.Consolidation RationalesThe underpinnings of the M&A trend we’ve seen in the sector include the lack of internal succession planning at many RIAs and the increasing importance of scale against a backdrop of rising costs and declining fees. While these factors are nothing new, sector M&A has historically been less than we might expect given the consolidation pressures the industry faces.Consolidating RIAs, which are typically something close to “owner-operated” businesses, is no easy task. The risks include cultural incompatibility, lack of management incentive, and a size-impeding alpha generation. Many RIA consolidators structure deals to mitigate these problems by providing management with a continued interest in the economics of the acquired firm, while allowing it to retain its own branding and culture. Other acquires take a more involved approach, unifying branding and presenting a homogeneous front to clients in an approach that may offer more synergies, but may carry more risks as well.Market ImpactIn 2019, equity markets have largely recovered and trended upwards.Deal activity in 2018 was strong despite the volatile market conditions that emerged in the back half of the year. So far in 2019, equity markets have largely recovered and trended upwards. Publicly traded asset managers have lagged the broader market so far in 2019, suggesting that investor sentiment for the sector has waned after the volatility seen at year-end 2018.M&A OutlookConsolidation pressures in the industry are largely the result of secular trends. On the revenue side, realized fees continue to decrease as funds flow from active to passive. On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs. The continuation of these trends will pressure RIAs to seek scale, which will in turn drive further M&A activity.With over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies. Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth and margin compression. An aging ownership base is another impetus. The recent market volatility will also be a key consideration for both sellers and buyers in 2019.

Are Trust Companies Changing for the Better?

Trust Company Sector Update

Trust law dates back to the 12th century when landowners who left England to fight in the Crusades retitled their property to another trusted individual to manage the property until the crusader returned home. Upon returning home, however, the land title holder (the “trustee”) often refused to return the property to the crusaders (the “beneficiary”). The Lord Chancellor typically ruled in favor of the returning crusader, requiring the title holder to return ownership of the land to the original holder. Hence, the foundation for modern trust law was formed.Trust companies are changing to meet clients’ evolving needs.Trust law has evolved over time, most recently with modern trust laws in the 1980s and 90s established by certain states such as Delaware, Nevada, and South Dakota. Other states, such as Tennessee, have developed compelling trust statutes in more recent years. Just as trust law has changed with the regulatory environment, trust companies are changing to meet clients’ evolving needs.As demand for trust company services increases with the generational transfer of wealth from baby boomers to their successors, trust companies are competing for new business by changing their model to better serve their clients and altering their marketing strategies to attract new assets.A Fiduciary Minded ModelAs depicted in the illustration below published by Wealth Advisors Trust Company, trust companies have traditionally managed the distribution, administration, and investment of trust assets. However, more trust companies are shifting to a directed trustee model, which allows an investment advisor to be named on the account so that investment decisions are made by the appointed advisor rather than the trust company. This allows the trust company to focus on fiduciary issues related to trust and estate administration rather than investment management. The directed trustee model leads to a mutually beneficial relationship between the trust company, the investment advisor, and the client. The trust company avoids competition with investment advisors, who are often their best referral sources. The investment advisor’s relationship with their client is often written into the trust document. And most importantly, this model should result in better outcomes for the client because its team of advisors is ultimately doing what each does best—its trust company acts as a fiduciary, and its investment advisor is responsible for investment decisions. Increased Marketing EffortsTrust companies have historically relied heavily on referrals for new clients. While the directed trustee model protects these referral relationships, many referral sources have been lost to industry consolidation. This has led trust companies to increase their online marketing efforts. Many of our clients have seen a reduction in referrals from their traditional referral sources and have responded by increasing spending on website upgrades and digital marketing.Not only do marketing efforts generate new clients, but those clients tend to stick around.According to Forbes, 80% of trust company clients keep the same trustee for the life of the trust. This makes effective marketing essential for trust companies, because trust clients are sticky, and once with another provider, a potential client has likely been lost for good.Industry Tailwinds Demand for trust company services has increased over the first half of 2019 as “high-net-worth families re-evaluate[d] their personal exposure to the market and follow[ed] through on any big moves they’ve been putting off.” This momentum in the industry is driving increased awareness of trusts as an important component of the financial planning process.Additionally, industry participants generally believe that a large portion of the impending wealth transfer from baby boomers to gen X-ers and millennials will be left through real estate holdings, individual retirement accounts, and trusts; thereby providing a tailwind for the trust company industry.Market MultiplesThe market for asset and wealth management firms can offer some insight.While there are no pure-play publicly traded trust companies, analysis of the public markets can lead to a better grasp of trust company valuations. Even though trust companies are increasingly outsourcing investment management, there are still a number of underlying similarities between the business models of trust companies and asset and wealth managers—the most notable being that revenue for all of these businesses is a function of assets under management. Because of the similarities, the market for asset and wealth management firms can offer some insight into valuation trends affecting trust companies.Investment manager valuations have started to recover after stumbling in the first quarter following a rocky Q4 across the entire market. P/E multiples averaged approximately 15.3x LTM earnings as of the end of 2Q 2019, up from 14.1x at the end of the 1Q 2019. The positive movement in asset and wealth manager multiples is likely to translate, to some extent, to trust companies as well, given the similarities between revenue models.Mercer Capital assists RIA clients with valuation and related consulting services for a variety of purposes. In addition to our corporate valuation services, Mercer Capital provides transaction advisory and litigation support services to the investment management industry. We have relevant experience working with independent trust companies, wealth management firms, traditional and alternative asset managers, and broker-dealers to provide timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Natural Gas Takeaway Constraints

A Tale of Two Basins

Appalachia and the Permian are responsible for much of the United States’ surging natural gas production, resulting in relatively low benchmark prices. However, difficulties capturing, storing, and transporting natural gas mean that large regional price differentials can occur. While Appalachia price differentials have narrowed significantly, Permian pricing differentials have widened, often resulting in $0 or sometimes negative realized prices.[1] Going forward, futures prices imply a modest widening of the Appalachia basis over time, while the Permian basis will not stabilize until 2021. Appalachia Takeaway Constraints Easing – Northeast Supply Constraints, Not so MuchAppalachia natural gas takeaway capacity constraints have eased significantly over the past several years as new pipelines have come into service. RBN Energy estimates the total excess takeaway capacity out of Appalachia at approximately 4 bcf/d. However, the new pipelines are largely moving volumes to the Gulf Coast and Midwest rather than nearby population centers in the Northeast. Proposed pipelines that would connect the gas-rich Marcellus and Utica plays to East Coast cities have faced intense pushback. The PennEast Pipeline would transport natural gas from northeast Pennsylvania to New Jersey, but has been targeted by multiple environmental and community groups and still awaits approval from various regulatory bodies, including the New Jersey Department of Environmental Protection. A federal appeals court vacated permits issued by the U.S. Forest Service for the Atlantic Coast Pipeline, slated to cross two national forests and the Appalachian Trail in order to transport up to 1.5 bcf/d of natural gas from West Virginia to Virginia and North Carolina. The pipeline’s primary backer, Dominion Energy, has appealed the ruling to the Supreme Court. And The Williams Cos. has battled with the state government of New York for years over water quality certifications needed to move forward with the 125-mile Constitution Pipeline, which would transport gas from northern Pennsylvania. These various hurdles mean that cities are struggling with supply during winter and some natural gas utilities are not accepting new customers, as recently reported by the Wall Street Journal. Without the ability to hook into natural gas lines, certain new real estate developments are on hold or being shelved. And those customers with access to natural gas sometimes pay dearly, with Transco Zone 6 (servicing New York and New Jersey) prices exceeding $140/mmbtu in January 2018. The recent infrastructure build-out has helped Appalachian E&Ps, but Northeast end-users will likely continue to be subject to significant seasonal spikes until connectivity to Marcellus and Utica production is improved. Permian Natural Gas Takeaway Capacity to Remain Constrained in the Near TermWhile Appalachia takeaway constraints have largely been alleviated, the same cannot be said for the Permian. Much of the infrastructure build-out designed to service surging hydrocarbon production in the Permian Basin was focused on higher-value crude, with a significant amount of associated natural gas production simply flared. However, with increasing scrutiny on flaring and Waha natural gas prices falling as low as negative $8.50/mmbtu, midstream companies are finally starting to build meaningful takeaway capacity out of the basin. And while the political and regulatory environment in Texas is much more amenable to pipeline construction, new pipelines have not been unchallenged. A group of landowners sued Kinder Morgan over the route of the company’s Permian Highway Pipeline. However, the lawsuit, filed in April 2019, was thrown out by a Texas court only two months later. The new takeaway capacity should help with pricing, as indicated by Waha basis futures, but differentials will remain elevated until 2021. ConclusionAppalachian takeaway constraints have largely been alleviated, though incremental capacity largely takes volumes to the Gulf Coast and Midwest. As such, Northeast cities will likely still face supply issues despite being located just a few hundred miles from prolific natural gas production. Permian natural gas takeaway constraints remain, and will likely continue until 2021.We have assisted many clients with various valuation needs in the upstream oil and gas space in both conventional and unconventional plays in North America and around the world. Contact a Mercer Capital professional to discuss your needs.[1] Appalachia basis reflects Dominion South pricing. Permian basis reflects Waha pricing.

Valuations In The Permian

Gearing Up For The Long Haul Or Running In Place?

When it comes to the oil patch, the word “growth” can be a vague term. It’s a word that can be masqueraded around to suit the perspective of whomever utters it. What does it mean in an industry whose principle resources are constantly in a state of decline? When it comes to the Permian Basin these days, growth applies to resources, drilling locations and production. Unfortunately, the same can’t be said for profits, free cash flow or new IPOs. Don’t misunderstand, the Permian is the king of U.S. oil plays and by some measures could be taking the crown as the biggest oil field in the world. However, various economic forces are keeping profits and valuations in check.Permian Reserves: A Behemoth and Getting BiggerFrom a macro perspective, the Permian Basin is, and will continue to be, a record setting engine of hydrocarbon extraction. The Permian has been and will continue to make new production records in the U.S. and globally. In 2018, the U.S. accounted for 98% of global production growth (there’s that word again). Despite alternative energy sources and climate change policies being in vogue, global oil demand has increased for nine straight years, and the Permian has led the way to fill this demand gap. In May 2019, with a mix of productivity gains and drilled but uncompleted (DUC) well drawdowns, Texas’ crude oil production topped 5 million barrels per day for the first time. Shale output, the leading force for this production continues to rise. This will not stop for decades to come. In fact, a USGS survey covering the Wolfcamp and Bone Spring formations estimates an additional 46 billion barrels of oil (enough to supply the world for half a year) and 280 trillion cubic feet of gas (enough to supply the world for two years) are technically recoverable. For context, total U.S. proved oil reserves (which must be technically and economically recoverable) totaled 39.2 billion barrels at year-end 2017, according to the EIA. It’s an amazing growth story.Pipeline Capacity (Finally) ArrivingOne of the biggest constraints for the Permian over the past 15 months has been a lack of pipeline capacity. For months on end, local prices in the Permian suffered huge differentials to NYMEX prices due to the bottleneck issues that plagued the area. Transportation came at a premium and so did costs; however, that's in the process of changing. According to the American Petroleum Institute, the Permian Basin is expected to get 1.5 million barrels a day of new crude capacity. This includes expansions of the Grey Oak, Cactus II and Seminole Red pipelines, taking crude to the Gulf of Mexico for refining or export. Natural gas, which has been flared in many cases, is also getting a reprieve. Almost 5.0 bcf per day of new gas capacity additions are expected to go live by the end of 2019. See the map below made by RBN Energy.[caption id="attachment_27170" align="aligncenter" width="468"]Source: RBN Energy[/caption] These capacity additions should cut transportation costs for many producers, and none too soon because every dollar and penny count when it comes to profitability in the Permian these days. Tight Breakeven Spreads and Negative Cash FlowAmid these positive big picture developments in the Permian, most shale producers are struggling to keep up cash balances. According to one analysis for Q1 2019, only 10% of shale companies had a positive cash flow from operating activities, and other studies have shown similar results. Shale producers are spending more than they are making. How can this be with such a plethora of resources and the means to transport it? The answer lies in two conundrums: (i) expensive fracking and completion costs; and (ii) steep production decline curves. Getting to the oil is expensive, and once a producer finds it, the tight well formations drain quickly. The only way to get more production and associated revenues is to drill more. Investing skeptics describe this as a treadmill effect.This wouldn’t be too much of a problem in a $65 or $70 oil environment, but when oil is in the mid $50s, there’s not much profitability cushion and it shows. The April issue of Oil & Gas Investor includes a table showing median breakeven prices in the Permian. In the Delaware Basin median breakevens range between $42.50 and $45. In the Midland Basin median breakevens range between $44.30 and $53.00. Keep in mind – these are medians. Half of producers can produce it cheaper, but half are more expensive too.[caption id="attachment_27171" align="aligncenter" width="600"]Source: Oil & Gas Investor[/caption] This kind of narrow profit cushion has soured many investors and made financing new drilling more expensive for producers. Investors have demanded austerity and are either charging bigger financing premiums or are cutting off financing altogether. IPOs for producers have been anemic in the past several quarters. Cost control and economies of scale are becoming increasingly important, and thus, the answer has been in the form of consolidation. Valuation Winners: Low Cost Producers & Royalty HoldersM&A in the Permian has been consistently healthy amid the aforementioned challenges. Values from an acreage and production perspective are generally the highest of any major U.S. basin. With Oxy’s acquisition of Anadarko as the most recent flagship example, producers are scrambling to amass contiguous acreage and drilling synergies, coupled with reduced overhead to create more consistent profitability. This kind of rationale is driving mergers, acquisitions and dispositions. It is also attracting the majors such as Exxon and Chevron to the region. See the table below.[caption id="attachment_27172" align="aligncenter" width="800"]Source: Shale Experts[/caption] However, this is easier said than done, and not everyone is a believer. Carl Icahn isn’t as he recently opened a shareholder lawsuit in relation to Oxy’s acquisition. Oxy’s price has slid since the announcement. Perhaps the best investment strategy is not to take operating cost risks at all. Enter the mineral and royalty sub-sector, which has been among the most successful areas of energy in the past several years. While producers can’t get access to public equity, royalty companies have had numerous IPOs in the past couple of years. Getting access to the production boom, without exposure to fracking costs, has been the attraction and it appears to be gaining momentum. Lower costs are the key to creating value in the Permian. Whoever can master this kind of fiscal discipline will move to the top of the heap and finally growth in profits will follow. Originally appeared on Forbes.com.

Unsolicited Offers for Your RIA

Is the First Bid the Best?

When clients call us seeking advice after receiving an unsolicited offer for their RIA, the first questions they ask generally revolve around two issues:Is the price reasonable? andDo we think the buyer will be willing to improve the offer? “Price” is a sticky wicket that we’ve covered in many posts, but whether or not the first offer is going to change in the negotiation and due diligence process is a certainty: yes. The only question is which direction (higher or lower) the offer will move before the transaction closes.Universal Truths on Unsolicited OffersIf you receive an unsolicited offer for your investment management firm, you’ll find it is usually difficult to immediately assess the sincerity of the offer. And while making generalizations about the M&A process can be more misleading than helpful, we will assert the following:An unsolicited offer is made based on limited information. Often the initial overture is based on information beyond what is publicly available on the seller’s website and in regulatory filings. Even with financial statements in hand, prospective buyers making their offer know very little about the seller. The due diligence process involves the review of hundreds of pieces of documentation that can and will shape the purchase agreement.An unsolicited offer may be a competitive bid, but it is not a bid made in a competitive market. Not every sale is best conducted in an auction process, but the prospective buyer making an unsolicited offer knows that it is, at least for the moment, the only bidder. The object of an unsolicited offer is to get the seller’s attention and cause them to enter into negotiations, often giving the bidder an exclusive right to negotiate for a fixed amount of time.Whether the offer is made at the high end or the low end of a reasonable range depends on the bidder’s perception of the seller. If a buyer thinks a seller is desperate, the initial offer may be at the low end of a reasonable range, in which the selling process should evolve to move pricing and terms more favorable to the seller. In many cases, though, the initial offer is above what the buyer ultimately wants to pay (“bid it to get it”) and will use the due diligence process to beat the price down or insert terms that shift the burden of risk to the seller. If the initial offer seems too good to be true, consider the latter a distinct possibility.An LOI is NOT a purchase agreement. Many sellers think the deal is done if they receive an unsolicited offer with a strong price and favorable terms. We don’t want to suggest that buyers never put their best foot forward on the first round, but an unsolicited offer should be viewed more as an overture than a commitment.Once the offer is accepted, the real work begins. Stop and think for a moment about what you would like your employment arrangement to be post-transaction. Do you want a substantial base, incentive compensation, a multi-year arrangement, roll-over ownership, administrative responsibilities or just client-facing work, protections in the event of termination without cause, an internal or external reporting requirement, and/or other arrangements? Imagine your situation as viewed by the buyer and what they would want. This is just one item which is rarely delineated in detail on the first offer. A legion of issues must be resolved in the process of negotiating a final purchase agreement, which is why “deal fatigue” is a prevalent cause of abandoned transactions.ConclusionThe offer gets the process started, but it’s the process that creates the deal. Transacting an investment management firm is complicated. Advisors to buyers and sellers have the delicate task of aggressively representing their clients and covering every bit of ground in the due diligence process without killing the deal by exhausting the buyer and seller and making them wonder why they ever started negotiations in the first place. The primary danger of an unsolicited offer is that it lures potential sellers into thinking the deal is done and the process will be easy. As with most things in life, if something looks too good to be true, it usually is.

Q2 2019 RIA Market Update

Asset Management Stocks Find Some Relief After Year-End Rout

Broad market indices generally increased over the last quarter, and publicly traded asset and wealth manager stocks followed suit.Publicly traded traditional asset and wealth managers ended the quarter up 6.2%, beating out the S&P 500, which rose 2.6%. Alt managers were the bright spot in the sector, up nearly 18%. Aggregators and multi-boutique model firms did not fare well, despite all the hype about consolidation pressures in the industry and the high-profile deals in the aggregator space. These businesses ended the quarter down more than 14%. Ordinarily, we’d expect investment manager stocks to outperform the S&P in a stock market rally, for the simple reason that higher AUM leads to higher revenue and an even greater increase in profitability with the help of operating leverage. This was the case during the second quarter when multiples continued to recover from December lows, and profitability remained steady to improving. As a result, asset and wealth management stocks saw positive performance relative to the S&P 500 during the second quarter, as shown in the chart above. Expand the chart over the last year, however, and the story for traditional asset and wealth managers looks less upbeat. Over the last year, traditional asset and wealth managers have trailed the market significantly. While the S&P 500 is up 8% over the last year, asset and wealth manager stocks are down 5%. While the S&P 500 is up 8% over the last year, asset and wealth manager stocks are down 5%.The asset and wealth management industry is facing numerous headwinds, chief among them being ongoing pressure for lower fees. Traditional asset and wealth managers feel this pressure acutely, which has likely contributed to their relative underperformance over the last year. Alt managers, which have been the sector’s sole bright spot during this time, are more insulated from fee pressure due to the lack of passive alternatives to drive fees down.The aggregator and multi-boutique index has declined over 30% during the last twelve months. Several firms in this category have contributed to this decline, but the largest driver has been Focus Financial’s major pullback from its lofty IPO price.The performance of asset and wealth management stocks over the quarter was supported by an improving price to earnings multiple. Multiples for publicly traded asset managers fell considerably near the end of 2018 as the broader equity markets pulled back. While there has been some rebound so far in 2019, multiples remain below the typical historical range.[caption id="attachment_27075" align="aligncenter" width="394"]Source: SNL Financial[/caption] Implications for Your RIAThe multiple expansion in the public markets combined with the expectation for stable-to-improving earnings, given the movement in broad market indices, suggests an improving outlook for privately held RIAs. If the public markets have relaxed a bit in pricing the industry headwinds, resulting in a higher multiple, then it is reasonable to assume that the same trend will have some impact on the pricing of privately held RIAs as well.But the public markets are just one reference point that informs the valuation of privately held RIAs, and developments in the public markets may not directly translate to privately held RIAs. Depending on the growth and risk prospects of a particular closely held RIA relative to publicly traded asset and wealth managers, the privately held RIA can warrant a much higher, or much lower, multiple.These factors all contribute to the less-than-perfect comparability between publicly traded companies and most privately held RIAs.In our experience, the issues of comparability between small, privately held businesses and publicly traded companies are frequently driven by key person risk/lack of management depth, smaller scale, and less product and client diversification. These factors all contribute to the less-than-perfect comparability between publicly traded companies and most privately held RIAs. Still, publicly traded companies provide a useful indication of investor sentiment for the asset class, and thus, should be given at least some consideration.Improving OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market. Their product is, after all, the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth managers and traditional asset managers are vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations.On balance, the outlook for RIAs appears to have improved since the end of 2018. The market has recovered following the Q4 correction, and multiples have trended upwards, although they remain below historical norms.More attractive valuations could entice more M&A, coming off the heels of a record year in asset manager deal making. We’ll keep an eye on all of it during what will likely be a very interesting year for RIA valuations.

Third Quarter 2019 | Segment Focus: Roads, Bridges, and Highways

State and local governments have increased spending on much-needed infrastructure projects but are beginning to face budgetary constraints and the expiration of FAST Act funding.

E&P Third Quarter 2019

Region Focus: Bakken

Region Focus: Bakken // WTI crude prices edged above $60 per barrel to begin the quarter but only crossed that threshold once more in the first trading day after the attack on Saudi Aramco oil processing facilities.

Transportation & Logistics Newsletter

Third Quarter 2019

Q2 2019 Macro Overview

Uncertainties Engulf Global Oil Amid Political Tensions

Brent crude prices began the quarter around $69 per barrel and peaked at nearly $75 in late-April before declining to just below $60 on June 12, 2019. Prices have since increased to $65, with WTI continuing to trail by about $8 per barrel. In this post, we will assess global supply and demand factors that have caused these price fluctuations.Global SupplyOriginally founded by Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela in 1960, OPEC now stands at 14 members, after Qatar terminated its membership at the beginning of the year. OPEC is still a significant organization when assessing global supply, but it has undergone considerable changes. While OPEC only has 14 statutory members, an alliance known as OPEC+ has added 10 non-OPEC member countries headlined by Russia and including Mexico and Kazakhstan. This group agreed in December 2018 to a production decline with the goal of balancing global inventories and stabilizing the oil market (read: raising prices). With churn in its members and inclusion of allies in its production cuts, people may not know exactly who OPEC+ is, but the oil cartel’s mission remains clear (even if oil and cartel are not the O or C in the group’s amorphous acronym).OPEC+ has thus far been successful in reducing output, though for countries like Iran and Venezuela, decreased output hasn’t necessarily been intentional. In May, OPEC members produced 29.9 million barrels per day (b/d), the lowest for any month since July 2014. It remains to be seen if these production cuts set to expire this month will remain intact, and if so, for how long. Saudi Arabia’s energy minister Khalid al-Falih expressed absolute confidence that an agreement would be reached to extend the oil production cuts after “very constructive discussions” with Russian energy minister Alexander Novak. Falih also said,Our intent is to make sure that we continue to work together closely, not just bilaterally, but with all other members of the OPEC+ coalition – and that the good work we have done over the last two and a half years continues to the second half of 2019, maintaining supply constraints to bring balance to the global inventories of oil.The bilateral comment is telling. In April, the planned meeting was cancelled to reportedly have more time to analyze market data. However, the second delay, though only for a week, has shown heightened tensions, as decisions have increasingly been driven by Saudi Arabia and Russia, who combine for over 40% of OPEC+ oil production. Falih said all but one OPEC member nation has agreed to delay the group’s meeting until after the G20 summit, and the holdup figures to be Iran, who has been increasingly perturbed by its diminishing influence. Production cuts rely on all members to stick to their word, as each individual country would be economically incentivized to increase production to reap the benefits sown by those who withhold production.IranAlongside voluntary declines from Saudi Arabia and Russia, Iran has been one of the key reasons for lower production recently. In April, the U.S. reinstated its sanctions on importers of Iranian oil. The sanctions were initially implemented to ramp up “maximum pressure” on Iran as oil is a significant revenue source for the Iranian government. The U.S. is pressuring Iran to curtail its nuclear program and return to the negotiating table on a nuclear deal.Waivers were granted last November to allow countries time to find other sources of supply and three of these countries (Greece, Italy, and Taiwan) have done so as they no longer import any oil from Iran. China and India are the largest importers of Iranian oil whose waivers have been rescinded, which should ramp up pressure on Iran and could have spill-over effects on trade discussions as China expressed displeasure with the U.S.’s decision to reinstate sanctions.Alongside voluntary declines from Saudi Arabia and Russia, Iran has been one of the key reasons for lower production recently.These sanctions are not the only concerns related to Iran. The recent crude price rebound following its 5-month low is due in part to Iran shooting down a U.S. drone, raising already heightened tensions. This comes after attacks in May on two tankers near the Strait of Hormuz, which the U.S. blames on Iran. The Strait of Hormuz, described by the EIA as the world’s most important oil choke point, separates UAE, Oman, and Iran and a significant amount of world oil supply passes through this relatively narrow shipping route.The White House has put out two statements in the past few days, seeking to set the record straight and with Saudi Arabia, UAE, and the UK jointly condemn these attacks. The situation remains fluid and volatile and continues to threaten the flow of oil, as President Trump began the week by announcing new sanctions on Iran.Rising U.S. ProductionProduction cuts from OPEC+ (intentional or not) have been able to raise prices since the lows seen at the end of 2018, and the U.S. has been one of the prime benefactors. The U.S. has been able to increase its global market share, increasing production to fill the void left by OPEC+ production. Additionally, any elevated prices caused by these production cuts have also increased top line revenues for American producers, a fact not lost on OPEC.According to the EIA’s latest Short Term Energy Outlook (“STEO”), U.S crude oil production increased 17% in 2018, peaking at an all-time rate of 10.96 million b/d. This was capped by a December that saw 11.96 million b/d, the highest monthly level on record, despite crude prices sliding considerably in the fourth quarter. The EIA expects this growth to continue with production reaching 13.3 million b/d on average by 2020.Slowing Global DemandAccording to the STEO, the EIA is projecting lower crude prices for 2019 due to uncertainty about global oil demand growth. In late May, President Trump announced the potential for tariffs on Mexico, which would have particularly negative impacts on the energy industry as the U.S. exports more fuels to Mexico than any other country. Easing continental trade concerns, Mexico became the first country to ratify the USMCA (new NAFTA), though approval has yet to come from Canada or the U.S., and there is no timetable for its passage.Concerns about the U.S.-China trade relations picked up in the second quarter as increased tariffs have been threatened by both sides.Concerns about the U.S.-China trade relations have also picked up in the second quarter as increased tariffs have been threatened by both sides. Expected industrial activity, as measured by the manufacturing Purchasing Managers’ Index (PMI) declined across several countries in May, and the U.S. PMI fell to its lowest level since 2009. These contribute to concerns that future economic growth could be lower than expected, which would, in turn, curb oil demand. However, there was optimism on June 20, related in part to hopes that U.S.-Chinese relations would improve when President Trump meets with President Xi at the G20 Summit.Interest RatesOptimism on June 20 wasn’t restricted to trade with China as the Federal Reserve also met the prior day. The Fed Funds rate has been increased 9 times since December 2015 to a target range of 2.25%-2.50%. However, it has become increasingly clear that the next change is more likely to be up than down. For the first time in Jerome Powell’s tenure as Fed Chairman, a dissent was cast, which advocated for a rate cut. James Bullard, President of the Federal Reserve Bank of St. Louis, said cutting rates now “would provide insurance against further declines in expected inflation and a slowing economy subject to elevated downside risks. Even if a sharper-than-expected slowdown does not materialize, a rate cut would help promote a more rapid return of inflation and inflation expectations to target."In theory, interest rate hikes tend to be negative for risk assets such as equities and commodities such as energy. Conversely, a rate decrease should make holding these products more attractive and raise the price. More important, however, is the overall message it sends to the economy. If the Fed were to cut rates, even if it cited its inflation target as the reason (and not a global economic slowdown), this would be viewed by the market as a bearish signal, likely sending equities and crude oil prices downward.ConclusionWith the G20 Summit occurring June 28 and 29, we’ll close the quarter with a more informed outlook on global demand going forward. OPEC and OPEC+ meetings are expected to occur July 1 and 2, so we’ll have to wait until the beginning of the third quarter for a decision on increased, steady, or reduced production cuts on the supply side. Even with an announcement at the beginning of the quarter, it will take more time to determine how this production will be further impacted by individual country circumstances, particularly from Iran. In the meantime, the U.S. will likely continue its production to capitalize on the shortfall, even if global demand slows or is already slowing. While interest rate hikes or cuts will likely continue to play a role in market sentiment, it is unlikely we see a change on this front in the near-term.At Mercer Capital, we stay current with our analysis of the energy industry both on a region-by-region basis within the U.S. as well as around the globe. This is crucial in a global commodity environment where supply, demand, and geopolitical factors have various impacts on prices. We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and internationally. Contact a Mercer Capital professional to discuss your needs in confidence.

Fidelity’s Latest Move to Stay on Top of RIA Trends

Fidelity’s Partnership with Merchant Investment Management

On June 10th, Fidelity Clearing & Custody Solutions and Merchant Investment Management announced a new partnership to increase wealth managers’ access to capital for acquisitions and growth initiates.With the average transaction size in wealth management M&A increasing 30% in the past year, Fidelity Clearing & Custody Solutions will work with Merchant Investment Management to help firms drive growth and scale in an increasingly concentrated market.Overview of Strategic AllianceFidelity Investment Management, one of the largest discount brokers in the U.S., began offering more customized products and solutions to wealth managers over the last few years through Fidelity Clearing & Custody Solutions, which provides a comprehensive clearing and custody platform to RIAs. While it is typical for custodians to maintain loose affiliations with specialty lenders in order to address the capital needs of RIAs, Fidelity has taken this to the next level by formalizing a strategic relationship with Merchant Investment Management.The deal opens up a sizable new sales channel for Merchant, and in return, Fidelity’s behemoth platform tacks on additional selling points to entice M&A-minded RIAs.Merchant provides growth capital to wealth and asset managers looking to grow or take advantage of strategic opportunities. The company provides capital in the form of minority, non-controlling equity investments and credit solutions. Additionally, Merchant offers management resources, such as regulatory and compliance assistance, as well as outsourced CIO services. As part of the partnership, Merchant will offer Fidelity’s custody clientsdiscounted loan origination fees, as well as discounted rates to some of Merchant’s products, such as Advisor Assist, which offers a suite of compliance solutions, and Compass, which provides outsourced CFO and accounting services for advisory firms. The deal opens up a sizable new sales channel for Merchant, and in return, Fidelity’s behemoth platform tacks on a few additional selling points to entice M&A-minded RIAs.Fidelity’s MotivationThe last 18 months have been busy for investment manager M&A. Several trends are driving the uptick in sector M&A, including rising fee pressures, increasing compliance and technology costs, and organic growth strains. Wealth management consolidators such as Focus Financial, Hightower, and now, Goldman Sachs have capitalized on these trends, and Fidelity seems to be throwing its hat in the ring as well.David Canter, head of the RIA segment at Fidelity Clearing & Custody Solutions, explained Fidelity’s interest in this partnership:Today’s most competitive and future-ready firms are achieving scale through M&A. By our count, there are over 700 RIAs that manage over $1B, and they’re often doing so with national footprints. But it takes capital to create scale—and with the average deal size increasing three-fold in the past five years, access to that capital can sometimes be a roadblock. Lending solutions like this one are a game-changer for firms looking to make strategic acquisitions to create long-term, sustainable value.Chasing TrendsAs one of the largest RIA custody platforms, it certainly makes sense for Fidelity to keep its finger on the pulse of the RIA industry. Fidelity has strived to keep up with RIA trends over the last decade, and the partnership with Merchant appears to be the latest in a series of moves aimed at staying on top of the industry.As part of its efforts to keep pace, Fidelity launched a Robo-advisor platform in 2016. Just a few years later, Fidelity Go was named theTop Robo Advisor in the 2019 winter edition of The Robo Ranking Report from Backend Benchmarking.As passive products have proliferated, Fidelity has backed away from its former strategy ofavoiding low-margin products. In 2018, Fidelity gathered $64 billion in passive products, compared to active product outflows of $17 billion, according to Morningstar estimates. Fidelity was the first discount broker to offer a no-fee index fund.In August of last year, Fidelity “fired major shots in war over fees” when it launched two zero-fee mutual funds and reduced fees for 21 of the firm’s indexed mutual funds. Fidelity was the first discount broker to offer a no-fee index fund—beating out the likes of Vanguard, Schwab, and iShares. And now, with the Merchant partnership, Fidelity appears to be positioning for further consolidation and M&A activity in the industry. Assuming recent M&A trends continue, the Merchant partnership may provide a meaningful incentive for RIAs to use the Fidelity platform.Outlook for Strategic PartnershipsWe expect RIAs to continue to seek bolt-on acquisitions that offer scale and known cost savings from increased operating leverage. Firms struggling with organic growth and margin compression will likely continue using acquisitions to expand distribution footprints and product offerings. Against this backdrop, we expect to see more strategic partnerships involving RIA capital providers going forward.

Measuring Up: Sorting Through the Puzzle of Dealership Metrics and Performance Statistics

This article explains dealership metrics and performance statistics–what they mean, how to evaluate them, and where a particular store stacks up. As always, performance measures are relative.

M&A in the Permian

Big Deals and Bigger Opportunities

The Permian Basin is one of most prolific oil basins in the world and is the engine driving the resurgence of U.S. energy output. According to the latest EIA Drilling Productivity Report, anticipated oil production for June 2019 in the U.S. is almost 8.5 million barrels per day with the Permian alone accounting for nearly 4.2 million. The importance and impact of this basin to U.S. energy cannot be overstated.Operators in the play have had to pay a premium to access the black gold mine, and companies are still lining up for a chance to get in on the action. While the industry as a whole has been moving into a period of rapid consolidation, a substantial portion of this acquisitive activity has been in the Permian, far more than any of the other major basins.Targets with highly contiguous holdings and acreage have been of particular note to acquirers in the Permian. While acreage continuity has not always been the most important aspect of a potential deal, it has certainly become more of a focal point recently.Recent Transactions in the Permian BasinDetails of recent transactions in the Permian Basin, including some comparative valuation metrics are shown below.Oxy to Acquire Anadarko in $38 Billion DealOn May 10, 2019, Anadarko Petroleum signed a deal to be acquired by Occidental Petroleum (“Oxy”) in a cash/stock deal worth $38 billion. This deal was by far the largest and most newsworthy to come out of the Permian Basin, or any other region, for the year.The transaction creates a $100+ billion “global energy leader” with 1.3 million barrels of oil equivalent per day of production.The agreement concludes one of the most closely-watched bidding wars in recent history with Oxy battling with Chevron to acquire the Permian assets of Anadarko. A month earlier, Chevron announced an agreement to purchase Anadarko for $33 billion in a cash/stock deal. Oxy soon joined the fray with a deal that was more accretive to Anadarko shareholders. The price ultimately became too much for Chevron, who received a $1 billion termination fee as part of the initial deal struck with Anadarko. Some lauded Chevron for not raising their offer and potentially overpay for the assets, but as it stands, Oxy is the big winner of the prized Permian assets which present plenty of synergies with its existing acreage portfolio.According to Occidental, the transaction creates a $100+ billion “global energy leader” with 1.3 million barrels of oil equivalent per day of production. The company also said the deal provides “compelling strategic and financial rationale for all stakeholders.”Oxy is expected to fund the cash portion of the consideration through a combination of cash and fully committed debt and equity financing, which also includes a $10 billion equity investment by Berkshire Hathaway, Inc in the form of 100,000 shares of cumulative perpetual preferred stock at $100,000 per share. The investment from Berkshire comes at a steep cost though with a warrant to purchase up to 80 million common shares at $62.50 per share as well as a preferred stock dividend of 8% annually.Potential for TakeoverAlthough the Permian is far and away the most covered oil patch in the U.S. by analysts and journalists alike, the Occidental and Anadarko deal has brought some increased scrutiny to the basin particularly in assessing what other potential big deals could be out there. And the analysis seems to point to quite a few.DrillingInfo produced the map below (as of April 30, 2019) of acreage by major operators within the Permian. An interesting observation here is that several of these operators have assets and land that is largely connected. Concentrated assets and contiguous acreage make several of these companies very attractive targets for takeover. Pioneer Natural Resources, for example, has been hard at work becoming a pure-play Permian Basin operator. With the April 26 announcement that it is to sell off the remaining assets in the Eagle Ford, the company has made itself a more attractive takeover target because of its concentrated asset base in the Delaware Basin within the Permian. Contiguous acreage allows operators to drill longer lateral lengths, which are more productive and cost-effective given recent advancements in drilling technology.There are several benefits in owning such contiguous acreage. First, operators can take advantage of economies of scale, as contiguous acreage provides access to subsurface minerals with fewer well pads required, reducing costs. Logistically, mineral rights considerations are also simplified by consolidation. Contiguous acreage also potentially allows operators to drill longer lateral lengths, which are more productive and cost-effective given recent advancements in drilling technology.Costs are further streamlined as the oilfields are less encumbered by multiple operators each bringing in their own drilling crews. Additionally, armies of tanker trucks for hauling away wastewater for various operators in a crowded field are replaced with efficient networks of surface pipes for wastewater disposal. Companies such as those with adjoining acreage to Pioneer could consider the advantages and synergies of such networks and efficiencies, especially if the infrastructure is already in place.EOG Resources, one of the largest independent operators, owns acreage that borders against Chevron and Occidental in multiple areas. Given the recent loss in the bidding war with Occidental for Anadarko’s assets, Chevron has additional cash (set aside for the prior merger attempt as well as the break-up fee) that could be used for another takeover attempt, and EOG would be an attractive target for the reasons described above.Other pure-play companies such as Diamondback or Concho Resources also have highly contiguous acreage adjacent to large companies who could take advantage of these economies of scale and efficiencies. These companies have been active consolidators in the basin, with Diamondback’s 2018 acquisition of Energen and Concho’s takeover of RSP Permian earlier in that year.ConclusionThe trends for the Permian are apparent. Companies have been working to establish firm footholds in this basin and are willing to pay premiums to get in and stay in. The basin is also in an interesting position that due to the layout of operator acreage and assets, large takeovers of neighboring operators with contiguous acreage and established efficiencies create the opportunity for higher return on investment.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Are Value Managers Undervalued?

Growth Investing Has Outperformed Value for Quite Some Time Now, and the Market’s Taking Notice

Looking BackIf you’re an asset manager, then you’re probably aware of growth investors’ dominance over their value counterparts for the last ten or fifteen years. Since the Financial Crisis, it’s been all growth, which tends to outperform during sustained bull market runs and periods of monetary easing.As most value and growth managers’ clients are primarily (performance chasing) institutional investors, this recent disparity has been particularly challenging for value investment firms looking to grow (or even maintain) their AUM balances. The market has clearly picked up on these issues, especially over the last couple of years – two out of the three public (and predominantly) value-oriented investment firms (Gabelli and Diamond Hill) are in bear market territory while the S&P is up nearly 20% since the Summer of 2017: The economics behind the sector’s fall-out are relatively straightforward. Underperformance leads to outflows and contractions in AUM with corresponding declines in management fees and earnings. Even if the multiple doesn’t slip, the drop in profitability is enough to weigh on share prices. Unfortunately, the multiple did slip, and Gabelli and Diamond Hill have lost a third of their market cap during relatively favorable market conditions. As we’ve noted before, this multiple is a function of risk and growth, so the market either believes their growth prospects have diminished or their risk profile has elevated. In all likelihood, it’s a little bit of both, as growth will likely be adversely affected by lower demand for value products, while the risk of continued outflows remains high. Looking at the MultiplesAgainst this backdrop, we address this post's original question as to whether or not value managers are indeed undervalued at the moment. A quick glance at the P/E graph below reveals that two of these businesses are priced at less than 10x trailing twelve month (after-tax) earnings, while their RIA peers trade at 15.7x (on average) and the broader market is closer to 20x. This is definitely at the lower end of a reasonable range, and is, once again, likely attributable to a particularly high-risk profile and lower growth prospects. The ten-plus year slough of relative underperformance versus growth investing and expectations for continued outflows are the likely culprits. Still, some might contend that this is overblown, or at least short-sighted, if you believe in mean reversion or question the sustainability of the current trend. The last time growth dominated value by this margin was during the tech bubble when the Russell 2000 Growth Index outperformed its value counterpart by 68% (annualized) from October 1, 1998 to March 1, 2000 before giving it all back (and then some) over the next couple of years. The problem for value managers is most of their institutional clients emphasize relative performance over the prospect for mean reversion, so they’re going to have to improve their track records to recover lost AUM. That’s not always a given. Even the world's greatest value investor is struggling.Even the world’s greatest value investor (and perhaps the greatest investor of all time) is struggling to keep pace with the market. Warren Buffet’s Berkshire Hathaway is up just 2% so far this year compared to just over 15% for the S&P 500 and 25% (on average) for the FANG stocks. Fortunately, this hasn’t curtailed Buffet’s ability to raise money for a good cause, as the current bid for his annual charity lunch currently resides at $4.6 million. Buffet’s current predicament is not nearly as dire as 1999 during the Dot Com Crash when the S&P and NASDAQ appreciated 20% and 87%, respectively, while Berkshire lost 22%. Worth noting, however, is BRK-A gaining 32% the following year when the S&P and NASDAQ shed a respective 9% and 45%. We’re not forecasting that level of mean reversion but do want to emphasize how quickly relative outperformance can swing the other way. Looking ForwardThere are very good reasons why value managers’ stocks have performed so poorly over the last few years.The bottom line is that there are very good reasons why value managers’ stocks have performed so poorly over the last few years. Significant underperformance relative to both the market and growth alternatives has led to continued outflows from institutional investors, which in turn has hampered AUM, revenue, and earnings growth despite relatively favorable market conditions. Since the multiple has also slid for these businesses, it appears that the market is anticipating more of the same. That’s probably true since their one, three, five, and ten year track records are lagging, which is what most institutional investors base their hiring and firing decisions on.Regardless, we’re skeptical that this growth-over-value outperformance will persist much longer, given the cyclical nature of investment performance. It’s probably only a matter of time, and if it’s any time soon, that would make value managers (and Berkshire stock) very attractive investments. Otherwise, current valuation levels are justified, and it could be a very long time before the sector regains investor confidence.

The Ultimate Investment Vehicle

Is the Value of your RIA More a Function of Risk or Growth?

On Mother’s Day several years ago I gave my wife a pale blue t-shirt that read “I used to be cool” on the front; on the back it said “Now I drive a minivan.” Such was her lament until an absent-minded motorist in a Tahoe shortened the rear end of her Honda Odyssey by a couple of feet, and we replaced it with a BMW. Unsurprisingly, the manufacturer of the Ultimate Driving Machine doesn’t offer a minivan.Automakers have been trying to square the circle of fun with function, and vice-versa, since they started inviting their marketing departments to engineering meetings. Sometimes this quest has produced absurd results. In the 1990s, the folks at “boxy but good” Volvo put an intercooled, turbocharged motor in their mainline station wagon and created a rocket with room for seven. Kind of a cool idea, but hard to answer the “why?” question.The Ultimate Investment VehicleThe analogous tradeoff between fun and function in the valuation world is risk and growth. Unlike fun and function, risk and growth aren’t so much a dichotomy as they are co-present, and often in direct proportion to each other. Treasuries pay a modest but reliable coupon – they are essentially a no-risk, no-growth investment vehicle. On the other end of the spectrum, seed stage venture capital investing offers supernormal growth rates, and high expected returns to match. The ultimate investment vehicle is the profitable, high-growth, low-risk security: the Registered Investment Advisor.Valuation orthodoxy holds that value equates to cash flow priced for risk (downside exposure) and opportunity (growth or otherwise upside exposure). All else equal, the greater the cash flow, the lower the perceived risks associated with that cash flow, and the greater the likelihood of growth or other upside associated with that cash flow, the higher the value. The reverse is also true.On paper, the RIA model is a value generating machine: a reliable stream of distributable cash flow resulting from sticky, recurring revenues and growing effortlessly with the investment returns available in a diversifiable variety of financial markets. The reality, of course, is more nuanced.Cash is (Still) KingAt a core level, the most attractive feature of the RIA business model is a steady stream of distributable cash flow. This would be true in any market environment; given the low rate circumstance of the past decade-plus, it’s even more so. Unlike many businesses, investment management is not capital intensive, so EBITDA is more or less equivalent to distributable cash flow if an RIA is structured as a tax pass-through entity. RIAs offer the potential for double-digit yields and future growth. There are no fixed income instruments that look anything like that. And it’s for this reason that every week we read a new announcement about capital chasing the RIA space.You can’t value a revenue stream based on unrealistically high fees.The catch is that an RIA’s margin needs to be a real margin. By that I mean that you can’t value a revenue stream based on unrealistically high fees, nor is a profit margin reliable when owner compensation is so low that distributions are really being used as a substitute for wages. Segmenting returns to labor (compensation) and returns to capital (profits) can be difficult, but the value of an RIA is necessarily based on cash flows to the capital providers, as if they were not also part of the firm’s leadership.De-Risking Your FirmBusiness risk is inevitable, even for the best RIAs. Markets tumble. Clients die, and their heirs choose different advisors. Investment committees punish outperformance by rebalancing.Many risks seem avoidable, though. Just look at the headlines. Last week’s announcement that First Republic lost a team responsible for $17 billion in client assets is a potent reminder that revenue producers who see more upside on their own won’t stick around forever, especially if they have a track record of chasing opportunity. And Creative Planning’s breakup with Tony Robbins is a keen reminder of the sort of personality risk that can come with celebrity endorsements, or – thinking back a bit – with founders who want to be celebrities. A lot of times, it seems the big risks that come to bite firms are born out of a growth strategy that soured.Put another way, when evaluating the various “opportunities” available to RIA owners to increase value, it’s worth remembering that opportunity is a two-way street.When evaluating the various “opportunities” available to RIA owners to increase value, it’s worth remembering that opportunity is a two-way street.But it’s not just the usual business risks that bear consideration (client concentration, key manager risk, etc.). These days, I’m thinking more about how prominent the business communities in which RIAs operate have become: consolidators, IBDs, partnerships, and custodians. In a sense, whether you’re talking about Focus Financial, LPL, Fidelity, Raymond James, Goldman Sachs, Charles Schwab, or others, all of these communities act as eco-systems that present support and guardrails to RIAs. Some of these communities will be a better environment for your RIA than others. The biggest risk you face may be the opportunity cost of choosing the wrong one.Growth as an Offset to RiskMathematically, a given increment of growth can mitigate certain business risks. Many years ago we cautioned a buy-side client that they were overpaying for an RIA to tuck into its bank trust department. They wanted the acquisition and did the deal anyway. We weren’t wrong, but the bull market that followed made most of our concerns about the target irrelevant as the growth in the acquired firm gave the bank a handsome return on their investment.You can’t count on bull markets to bail out bad investments, but (even in a cash flowing business) growth matters because it provides part of the expected return on investment. If a given RIA is valued with a discount rate in the mid-teens, say 15%, and the growth expectation associated with the firm’s model is only a modest premium to inflation, say 3%, then the capitalization rate (also known as earnings yield) is 12% (cost of capital of 15% minus the growth rate of 3%). The earnings multiple is the inverse of the earnings yield, or 1/12%, or 8.5x. That’s an after-tax multiple, and the pre-tax equivalent is roughly equal to an EBITDA multiple, or about 6x. At a 5% growth rate, the earnings yield of 10% converts to an after-tax earnings multiple of 10x, or an EBITDA multiple of roughly 7.5x.You can’t count on bull markets to bail out bad investments.That march through the math of cap rates is admittedly dry, but if you’d like to think about how the market values growth, just look at how Focus Financial, an aggregator of mostly wealth management firms, stacks up against Affiliated Managers Group, an aggregator of mostly asset management firms. Since their IPO almost a year ago, Focus has been one of the most, if not the most, acquisitive of the consolidators, and is currently trading at a mid-teens multiple of EBITDA. AMG just announced their first acquisition in two years and has had a tough time growing earnings in these choppy markets. AMG trades for a little less than 10x reported EBITDA, a big discount to Focus.Just Because You Can, Doesn’t Mean You ShouldWe get asked, regularly, what we think the best value-maximizing model is for an RIA. We can tell you that there are approximately 20 thousand RIAs, hybrid IBDs, independent trust companies, and unregistered investment management firms in the United States. Any one of them can be very successful, and we’ve had the pleasure of working with many that do very well. There is no one size fits all model or strategy. We can tell you that value is directly proportionate to cash flow and growth, and inversely proportionate to risk. Any strategy or model can be evaluated in terms of these three levers, and all are available as a way to increase the value of your RIA.Just be careful before you mix and match strategies. Checking the lap time of a carpool carrier is a little like measuring the towing capacity of a Lamborghini. Ridiculous, but some have tried:One of a series of similar advertisements for Volvo

Forecasting Future Operating Results for an Oilfield Services Company

In our prior two Energy Valuation Insights blog posts, we detailed the specifics of “what is” and “what are the characteristics of” an oilfield equipment/services company (“OFS”), and detailed the typical approaches and methodologies utilized in valuing OFS companies. This week, we’ll address some of the special considerations that must be given attention in the appraisal of OFS companies. Specifically, the challenges in forecasting the future operating results for an OFS company.In the appraisal of an OFS company, the application of the income approach often includes the application of a discount cash flow (“DCF”) methodology. Actually, one might make the argument that the application of the income approach in appraising an OFS company should nearly always include the application of a DCF methodology, as opposed to relying solely on a capitalization of earnings methodology (“capitalization method”). While application of a capitalization method can provide a reasonable indication of value for companies in many industries, doing so for an OFS company can be problematic due to the inherent cyclicality of the OFS industry. One can attempt adjustments to a capitalization method indication of value to account for future deviations in cash flow growth rates (such as those caused by OFS industry cyclicality), but doing so can involve unnecessary subjectivity, resulting in an indication of value that may lack reliability. Typically, the better, and often more reliable, option is to utilize a DCF method using a forecast of future operating results rather than a capitalization method with imprecise adjustments.Understanding Industry Cyclicality is an Important Factor in Valuing an OFS CompanyIn applying the DCF method, the starting point is, of course, the development of a forecast of future cash flow for the subject company, which typically begins with a forecast of future revenues. Here we run into the first of several challenges in the appraisal of OFS companies. The OFS industry is of the most cyclical of industries that analysts can cover. Not just cyclical with the general economy of the region, nation or world, but cyclical in a way that is much more difficult to predict fluctuations in the price of oil (or natural gas) tied to a whole host of factors including technological, political, and even geopolitical factors can make forecasting complicated very quickly.Several varying forces can make predicting the future demand for oil from a particular region, and therefore, the demand for OFS products/services, quite difficult.Demand for oil and gas, and therefore demand for OFS products/services, can be as simple as the fact that in a robust economy more goods are being bought by end users and consumers. More purchases of goods, means more goods have to be transported to the end user/consumer, which requires more fuel to facilitate that transportation. Technology can impact the supply side of the equation as oilfield technology advances can lower the cost of oil production, thereby encouraging greater production even when oil prices are stable, or possibly even in decline, all else being equal. Local and national politics can impact demand as well. In the U.S., recent differences in positions on the use of coal as a power source have inserted a new dynamic into the economic demand for oil. In the geopolitical realm, bans on the importation of oil from certain countries (Iran or Venezuela, for example) have created shifts in demand for oil from other oil-producing countries.These varying forces can make predicting the future demand for oil from a particular region, and therefore, the demand for OFS products/services in that region, quite difficult. As indicated in the chart below, the timing and magnitude of cycles in the OFS industry can vary significantly.[caption id="attachment_26698" align="alignnone" width="812"]Note: Median year-over-year revenue change among the smaller publicly-traded OFS industry participants.[/caption] Forecasting OFS Company RevenuesIn forecasting OFS company revenues, one must distinguish between the short-term forecast and the long-term forecast. The short-term forecast will be primarily focused on the current direction of industry revenues, the typical length of industry cycles in estimating the timing of a current down-cycle bottom (or current up-cycle peak), and expectations for the subject company’s revenue cycle relative to that of the OFS industry as a whole (lagging or leading). The long-term forecast for the subject company will be more focused on the expected timing of a return to the mid-cycle level of revenues and the subject company’s particular expected mid-cycle level of revenue, with a potential adjustment for possible changes in the subject company’s market share.In performing the company level analysis, it’s always important to be aware of past transaction activity, changes in product/service, mix, or changes in markets served.In support of both the short-term and long-term forecasting considerations, an analysis of past OFS industry cycles and of the subject company’s past revenue cycles is warranted. With access to certain specialized databases, a detailed analysis of industry cycles (or industry participant cycles) can be readily performed. The same cycle analysis regarding the subject company is possible if the company has a long-enough operating history. In performing the company level analysis, it’s always important to be aware of past transaction activity (acquisitions, or divestitures), changes in product/service, mix, or changes in markets served, that might influence the results.Based on these analyses, the appraiser must determine reasonable estimates for the following:The time until the then current up-cycle will peak, or current down-cycle will bottomThe revenue level at the current up-cycle peak, or current down-cycle bottomThe time to reaching the next mid-cycle point, or mid-cycle level of revenue Estimates based on a sound analysis of historical industry and subject company data will result in a reasonable revenue forecast.Forecasting ConsiderationsBeyond the industry-wide considerations necessary in developing the OFS company forecast, one must also consider a number of more specific, non-industry-wide factors. These may include the target market (geographic), the subject company’s specific product/service offerings, the mix of product/service offerings, and the subject company’s ability to weather a current industry down-cycle.Geographic Target MarketUnlike participants in many other industries, OFS industry participants expect that future operating results can be significantly impacted by the geography of their target market, or, more specifically, the geology of their target market. The cost of extracting oil/gas can vary significantly depending on the basin being served. Similarly, the cost of processing (refining) oil from different basins can vary significantly, based on the quality of the oil being produced. For example, according to a 2016 EIA study, lower production costs were more prevalent in the Delaware Basin and Appalachian Basins while higher production costs were more standard in the Eagle Ford and Midland Basins1.The differences in production costs were partially a factor of the geology of the basins, which impacts the specific processes necessary in order to extract the reserves. In the Marcellus Basin, shallow formations and pad drilling techniques allow for lower cost production, while in the Eagle Ford Basin, deeper and more technically challenging formations tended to result in higher production costs. This changes over time with experience and technology accelerators, as the Eagle Ford’s costs have come down for several producers in the past year.Cost differentials can result in potentially significant differentials in drilling and production activities across the various basins, depending on prevailing oil prices.These cost differentials can result in potentially significant differentials in drilling and production activities across the various basins, depending on prevailing oil prices. Proximity to refiners also plays a role as transportation costs can add up. Prices at $60/bbl, for example, may spur activity in one basin while another basin remains at markedly lower activity levels, often captured in “break-even” prices. As such, in estimating future operating activity levels of an OFS company, one must be aware of the expected oil prices and the level of activity that would be expected in conjunction with those prices in the basins served by the subject company.OFS companies can mitigate some of the cyclicality by diversifying across basins. Operating in multiple markets can spread costs over more operations as well. OFS companies concentrated in one particular basin, on the other hand, would likely experience more volatile swings, particularly if they operate in a high-cost basin.Specific Product/Service OfferingsThe specific products and services offered by the subject OFS company must also be considered, as some services will only experience increased demand at higher oil price points, that justify the operator incurring the additional expense. For example, even in a period of rising production, a provider of services related to more expense stimulation techniques may not see a significant increase in the demand for its services until a certain price point is achieved. On the other hand, providers of services that are necessary for more general production activities would be expected to experience cyclical demand for its services more in-line with the general OFS industry. Some may even be insulated from price declines as E&P companies will continue to demand certain services regardless of price.Mix of Product/Service OfferingsSimilar to the impact of diversification of basins served, diversification across products and services offered can potentially contribute to reduced cycle extremes. An OFS company might see greater cycle extremes for certain exploration and production services. However, offering multiple services not tied to those same exploration and production activities can provide needed diversification which may mute cycle highs and lows.Financial Condition of the Subject CompanyThe subject company’s financial condition is often given inadequate consideration in forecasting future operating results; however, it can be critical when appraising companies in industries that commonly experience more significant cycle highs and lows, such as the OFS industry. This is particularly important when the subject industry is facing a material downturn in activity in the early portion of the forecast period.Consideration of a company's financial condition can be critical when appraising companies in industries that experience significant cycle highs and lows, such as the OFS industry.During an industry downturn, certain expenses can’t be avoided, and the subject company may generate negative cash flows until demand returns. As such, an analysis of the company’s financial condition is important in determining its ability to weather the downturn and participate in the expected improved conditions as the industry cycle swings back to more favorable conditions.Companies that have ample cash reserves, low levels of debt, or a significant ability to reduce fixed costs will be more likely to overcome the impact of the down cycle. Companies that have little cash reserves, substantial leverage, or are less able to cut costs may have to take more significant actions to weather the downturn. Such actions may impact the degree to which they’re able to participate in the industry’s next upswing in demand. In forecasting future operating results, one must include an analysis of the subject company’s financial condition and consider what actions may be necessary in order for the company to deal with the short-term cash outflows. Those actions may, if more extreme, result in the subject company participating to a lesser degree in the eventual industry recovery.Forecasting OFS Company Cash FlowNext, is the task of deriving a cash flow forecast from the revenue forecast, through the forecasting of cost of sales and operating expenses. In both cases, a greater level of analysis is warranted for OFS industry participants than for participants in industries less subject to large cycles. The reason being that depending on the relative level of fixed and variable expenses in cost of sales and operating expenses, those expenses, as a percentage of revenues may fluctuate significantly over the course of the industry’s cycle. As demand for labor, materials, and products will be high near the peak of the industry cycle, their cost will potentially increase relative to revenues, resulting in higher cost of sales relative to revenue and lower gross margins. The opposite would be expected for time periods near the bottom of the cycle, with demand at a low point and cost of sales lower relative to revenues, resulting in higher gross margins. Operating expenses can be tied to these peaks and valleys in the industry cycle as well, but the impact may not be as severe, since they have a larger ratio of fixed versus variable components relative to the cost of sales expense.Unlike companies participating in less cyclical industries where it may be reasonable to forecast cost of sales and/or operating expenses as a static, or near static, percentage of revenues, forecasting OFS company expenses (cost of sales and operating) typically requires an analysis of past operating results in order to identify cycles and ranges of company expenses relative to revenue. The question to be addressed is essentially, what will my cost of sales percentage (of revenues) be at the level of revenue forecasted for each discreet period in the forecast and what will my operating expense percentage be at the level of revenue forecasted for each period in the forecast? Note that due to the likely presence of a greater fixed/variable expense ratio in operating expenses (than cost of sales), the change in operating expenses as a percentage of revenues over the forecast period will likely be more pronounced than for cost of sales.Extreme Industry Condition ImplicationsRare indeed is the industry that is subject to the potential cyclical extremes of the OFS industry. As indicated in the chart below, in 2008 oil prices surged to unprecedented levels for several months (that haven’t been seen since) resulting in a significant spike in OFS product/service demand. Shortly thereafter, in 2009, oil prices dropped sharply to levels that hadn’t been seen since 2003, only to be followed by a sharp increase to a level generally in-line with the price trend that had been established during the 2004 to 2007 period.[caption id="attachment_26700" align="alignnone" width="740"]Source: EIA[/caption] Due to these fluctuations in commodity prices, and therefore OFS activity levels, one must be cautious in applying the DCF method. While typical cycle highs and lows can be dealt with through an analysis of historical industry cycles, periods of extreme highs, or extreme lows, create unusual challenges for OFS forecasting. No matter the level of industry experience, extreme industry activity (high or low), can easily lead to forecasts that result in unreliable indications of value. In such instances, while application of an income approach DCF methodology may be warranted and appropriate, it may be the case that reliance on the indication of value derived from this methodology should be afforded less weight relative to the weight afforded indications of value from other valuation methods - likely a market approach guideline company methodology. ConclusionAs indicated, the unpredictable cyclicality of the OFS industry requires careful consideration of many industry-wide and company-specific factors in developing a reasonable forecast of future operating results. While consideration of such factors should be part of the analysis in the appraisal of businesses in all industries, the impact of these considerations is magnified in highly cyclical industries such as that served by OFS businesses.Mercer Capital has a breadth and depth of experience in the appraisal of businesses in the oil and gas industry that is rare among independent business appraisal firms. Our Energy Team is led by professionals with 20 to 30+ years of experience involving upstream businesses (E&Ps, oilfield product manufacturers and oilfield service providers), midstream (gathering systems, pipeline MLPs, pipeline processing facilities), and downstream (refining, processing, and distribution). Feel free to contact us to discuss your valuation needs in confidence. 1 EIA: Trends in U.S. Oil and Natural Gas Upstream Costs – March 2016

Net Interest Margin Trends and Expectations

Since Bank Watch’s last review of net interest margin (“NIM”) trends in July 2016, the Federal Open Market Committee has raised the federal funds rate eight times after what was then the first rate hike (December 2015) since mid2006. With the past two years of rate hikes and current pause in Fed actions, it’s a good vantage point to look at the effect of interest rate movements on the NIM of small and large community banks (defined as banks with $100 million to $1 billion of assets and $1 billion to $10 billion of assets). As shown in Figure 1, NIMs crashed in the immediate aftermath of the financial crisis, primarily because asset yields fell much quicker than banks could reprice term deposits. NIMs subsequently rebounded as the asset refinancing wave subsided while banks were able to lower deposit rates. A several year period then occurred in which asset yields grinded lower at a time when deposit rates could not be reduced. This period was particularly tough for commercial banks with a high level of non-interest bearing deposits. Since rate hikes started, the NIM for both small and large community banks have increased about 20bps through year-end 2018 before experiencing some pressure in early 2019. The nine hikes by the Fed to a target funds rate of 2.25% to 2.50% amounts to a 225bps increase. At first pass, the expansion in the NIMs is less than might be expected; however, there are always a number of factors in bank balance sheets that will impact the NIM, including: Loan Floors. Many Libor- and prime-based commercial loans had floors that required 100-150bps of hikes before the floors were “out-of-the-money.”Competition. Intense competition for loans in an environment in which bonds yielded very little resulted in pressure in the margin over a base rate as bank and non-bank lenders accepted lower margins in order to make loans.Asset Mix. Community banks located in rural and semi-rural areas tend to have low loan-to-deposit ratios and, therefore, have not benefited as much as peers located in and around MSAs that are “loaned-up.” Nonetheless, net loans as a percentage of assets among community banks increased by an average of 15bps each quarter since year-end 2016 while bond portfolios declined.Loan Mix. Community banks tend to have somewhat more of their loan portfolios allocated to residential mortgages and CRE than regional banks. As a result, it will take much longer for these mostly fixed-rate assets to reprice than Libor-based C&I portfolios.Deposit COF. In recent quarters the marginal cost of funds (“COF”) has become expensive as depositors who came to accept being paid essentially nothing for their money began to demand more competitive rates once the Fed Funds rate approached 2%.Deposit Mix. In addition to depositors demanding higher rates, a mix shift from non-interest bearing and very low-yielding transaction accounts into higher paying money markets and time deposits has pushed the COF higher, too, in recent quarters.Fed to Cut Rates?Recent incremental pressure on NIMs notwithstanding, community banks’ balance sheets were poised to take advantage of rising rates the past several years. The outperformance of bank stocks beginning in November 2016 reflected several factors, including an economic and regulatory backdrop that would allow the Fed to raise rates further and faster, and thereby support NIM expansion.The underperformance of bank stocks since last fall reflects investor concern that this tailwind is ending in addition to more general concerns about what a possible economic slowdown implies for credit costs. Telltale signs include the inversion of the Treasury yield curve and yields on the two-year and five-year Treasuries that, as of the date of the drafting of this article, are below the low-end of the Fed Funds target range. Also, the spot and forward curves for 30-day Libor imply the Fed will cut the Funds target rate and other short-term policy rates one or two times by early 2020 (or stated differently, the December rate hike was a mistake). The Federal Funds rate, the predominant influence on short-term interest rates, has remained unchanged since year-end 2018 at a target range of 2.25%–2.50% due to concerns about lower inflation figures and what they may forewarn about future economic growth as reflected in falling U.S. Treasury yields. The FOMC reiterated its wait-and-see approach on May 1. However, the sand appears to be shifting beneath the Fed’s feet. The Wall Street Journal’s most recent Economic Forecasting Survey revealed an increasing belief that the Fed’s next move will be to cut rates. 51% of respondents said that a rate cut would be the next move, up from 44% in April. 25.5% replied that the next rate raise would occur in 2020 or later. Fed officials have maintained their stance that a rate move in either direction will not occur soon. The Importance of Deposits and Next StepsAs deposit costs initially lagged, but more recently moved with short-term interest rate hikes, the composition of a bank’s deposit base and funding structure has become increasingly important. As shown in Figure 4, the percentage of banks experiencing a rising cost of interest bearing deposits has steadily increased. Total funding costs have nearly doubled since year-end 2016 as depositors have reoriented funds toward accounts offering higher rates. Banks searching for funding either must engage in intense deposit competition or tap into higher-cost sources such as wholesale funding. Going forward community banks may face a modest reduction in NIMs because the yield curve is flat and the cost of incremental funding is expensive. Some community banks will choose to slow loan growth in order to protect margins; others will accept a lower margin. The predicament demonstrates yet again why deposit franchises are a key consideration for acquirers as banks with low cost deposit franchises and excess liquidity are particularly attractive in the current market. Originally published in Bank Watch, May 2019.

Why Has the Public Market Soured on RIA Consolidators?

Recent Capitulations for AMG and Focus Suggest Investors are Starting to Question Their Business Model

While it’s no secret that the last year has been especially challenging for the RIA industry, Affiliated Managers Group (AMG) and Focus Financial (FOCS) have underperformed most of their peers by a fairly significant margin in the last few months. AMG is down nearly 50% over the last year, and Focus has lost over 50% of its value since peaking last September. For this post, we’ll offer our take on the driving forces behind this decline.1) AMG and Focus’ Underlying Investments Have Likely Depreciated with the Industry, and These Losses Have Been Amplified by LeverageIf the RIA sector has underperformed the broader market by 10-15% in the last year (per above), it stands to reason that businesses that invest in this industry would experience a similar decline. Then you have to factor in leverage. Both AMG and Focus employ debt financing to make acquisitions, which magnifies losses when things go bad. Even though the balance sheet isn’t a focal point for most RIAs, AMG and Focus both have growing debt obligations and deficit tangible equity. Their income statements aren’t much better as Focus remains unprofitable (on a reported basis), and AMG is battling margin compression.Asset managers, in particular, have struggled over the last year, which may explain AMG’s underperformance relative to Focus during this time. Fee compression, poor investment performance, and continuous asset flows from active to passive products are largely to blame for the sector’s recent woes.2) Market Declines Can be Particularly Damaging to High Beta Securities like AMG and FOCSA quick perusal of the graph above shows how sensitive these businesses are to market gains and losses. The fourth quarter and recent weeks show significant declines as the market pulls back. Volatility has likely compounded this issue as nervous investors shun active managers and look to products designed to mitigate losses. While Focus Financial CEO Rudy Adolf contends that Focus is relatively well insulated from market downturns, the reality is that this business (and AMG) levers up to buy companies that invest primarily in stocks or equity funds. This dynamic creates an inherently volatile and market sensitive security that will almost certainly underperform the market in a downturn or correction. The opposite is also typically the case, but not always.3) Goldman Sachs’ Recent Entry in the RIA Consolidation Space Means More Competition for Buyers and Possibly Lower ReturnsGoldman’s acquisition of RIA consolidator United Capital could be a game changer for M&A in the wealth management space. A buyer of Goldman’s scale and resources is great for RIAs looking to sell, but not so great for other aggregators competing for deals. Hightower also intends to ramp up RIA acquisitions in an already crowded space. AMG and FOCS’s correction over the last couple of weeks may be attributable to these developments.A buyer of Goldman’s scale and resources is great for RIAs looking to sell, but not so great for other aggregators competing for deals.The public market seems concerned about AMG and Focus’ ability to find deals at attractive valuations (and returns). While Focus has strung together over 20 acquisitions so far this year, keeping up that pace may be a tall order—especially if competition for deals increases. AMG, on the other hand, has had a two-year acquisition dry spell that recently ended with the acquisition of Garda Partners.For aggregators like AMG and Focus, acquisitions are a key part of the growth strategy. While these firms try to foster organic growth as well, acquisitions are still the fastest path to scale. If the public market’s reaction to AMG and Focus is any indication, the outlook for this strategy appears to be facing some challenges.Don’t Read Too Much Into This…Focus and AMG are often regarded as bellwethers for financial advisory firms and asset managers, respectively. We disagree. They’re both in fundamentally different lines of business.AMG and Focus use debt financing to buy RIAs of one kind of another. They’re not managing assets on behalf of clients (at least not directly). They have huge balance sheets and debt obligations, unlike most investment managers. They’re monitoring their own investments, not their clients’. As publicly traded firms, they’re probably more concerned with the beating the Street and appeasing a much broader ownership base.Sure, the fortunes of AMG and Focus are tied to the fortunes of the firms they invest in over the long run. But the business of acquiring RIAs is not the same as the RIA business. So, while AMG and Focus may have lost half of their value in recent months, your business probably hasn’t.…But You Should Still Pay AttentionWe don’t think you should panic because publicly traded consolidators have struggled in recent months. We do think it’s important to recognize the challenges they’re facing, especially if you’re starting to think about an exit strategy. The RIA acquisition model isn’t dying, but investors seem to be anticipating a market share shift away from AMG and Focus.We don’t think you should panic over publicly traded consolidators' recent struggles, but we do think it’s important to recognize the challenges they’re facing.It’s also worth noting that these acquirers often use their own stock as part of the total consideration. For AMG and Focus, you know exactly how much that’s worth. For closely held aggregators like Hightower and Captrust, their stock price is not readily apparent. Given what’s happened to AMG and FOCS over the last year, it’s probably reasonable to assume that other consolidators are not worth as much as they once were. Even if they are publicly traded, you should be wary of any lock-up provisions since their stock prices are so volatile.In all likelihood, these businesses and other consolidators will continue to drive industry M&A. RIA aggregators like AMG and Focus are just one of many exit options for RIA owners, but we’ll likely see their share of overall transaction volume increase with Goldman backing United Capital, and Hightower changing course to compete with Focus et al. As the industry ages, these businesses are poised to play an increasingly important role in resolving the succession dilemma. A few years ago, many of our clients had never heard of AMG or Focus. That has definitely changed.

How to Value an Oilfield Services Company

When valuing a business, it is critical to understand the subject company’s position in the market, its operations, and its financial condition. A thorough understanding of the oil and gas industry and the role of oilfield service (“OFS”) companies is important in establishing a credible value for a business operating in the space. Our blog strives to strike a balance between current happenings in the oil and gas industry and the valuation impacts these events have on companies operating in the industry. After setting the scene for what an OFS company does and their role in the energy sector, this post gives a peek under the hood at considerations used in valuing an OFS company.Oil and Gas Supply ChainThe oil and gas industry is divided into three main sectors:Upstream (Exploration and Production)Midstream (Pipelines and Other Transportation)Downstream (Refineries) [caption id="attachment_26635" align="alignnone" width="790"]Source: Energy Education[/caption] Exploration and production (E&P) companies search for reserves of hydrocarbons where they can drill wells in order to retrieve crude oil, natural gas, and natural gas liquids. To do this, E&P companies utilize oilfield service (OFS) companies to help with various aspects of the process including pumping and fracking, land contract drilling, and equipment manufacturers. E&P companies then sell the commodities to midstream companies who use gathering pipelines to transport the oil and gas to refineries. Finally, refiners convert raw crude and natural gas into products of value. Oilfield Services OperationsE&P companies may own the rights to the hydrocarbons below the surface, but they can’t move them down the supply chain without the help from OFS companies in the extraction process. We can think of various OFS companies being subcontractors in the upstream process much like a general home builder might bring in people specially trained to set the foundation or wire electrical or plumbing. Because the services provided often require sophisticated technology or extensive technical experience, it stands to reason OFS companies would be able to charge a premium price. Thus, OFS would appear to be insulated from the commodity pricing that is inherent in the industry. However, E&P companies are the ones contracting these companies, and if oil prices decline enough, they are pressured to decrease production (and capex budgets), reigning in activity for OFS companies. This is where the specific service provided matters.Regardless of service provided, or industry for that matter, there are certain aspects of a business that should always be considered.As we discussed last week, there are a variety of different services provided by OFS companies. Companies that fall into the category of OFS can be very different from one another as the industry is fragmented with many niche operators. For example, companies servicing existing production are less impacted by changes in commodity prices than OFS companies that service drilling, as these activities are the first to decrease. Regardless of service provided, or industry for that matter, there are certain aspects of a business that should always be considered.Oilfield Equipment and Service Financial AnalysisA financial analyst has certain diagnostic markers that tell much about the condition of a business both at a given point of time (balance sheet) and periodically (income statement).Balance Sheet. The balance sheet of an OFS company is considerably different from others in the energy sector. E&P companies have substantial assets attributed to their reserves. Refiners predominantly have high inventory and fixed assets. OFS companies will depend on the type of product or service, but generally, they tend to have a working capital balance that consists more of accounts receivable than inventory, like other service-oriented businesses. According to RMA’s annual statement studies, A/R made up 22.3% of assets while inventory was 9.3% for Drilling Oil and Gas Wells (NAICS #213111).[1] These figures were 26.6% and 10.8%, respectively for Support Activities for O&G Operations (#213112). Notably, drilling operations had a higher concentration of fixed assets (46.8%) compared to other support services which comprised 35.7% of assets. Broadly speaking, this illustrates the different considerations within the OFS sector as far as the asset mix is concerned.Income Statement. The development of ongoing earning power is one of the most critical steps in the valuation process, especially for businesses operating in a volatile industry environment. Cost of goods sold is a significant consideration for other subsectors in the energy space, particularly as the product moves down the supply chain towards the consumer. This is not the case for OFS companies. RMA does not even break out a figure for gross profit, but instead combines everything under operating expenses. Still, OFS companies deal with significant operating leverage. If expenses are less tied to commodity prices that means costs may be more fixed in nature. That means when activity decreases and revenues decline, expenses don’t decline in lock-step resulting in margin compression and profitability concerns. While the balance sheet does not directly look at income, it can help determine sources of return. Fixed-asset heavy companies like drillers tend to be more concerned with utilization rates as the more their assets are deployed, the more money they will earn. On the other hand, predominantly service-based companies that rely on their technology and expertise tend to be more concerned with the market-determined prices they are able to charge and terms they are able to negotiate. Additionally, OFS companies may have significant intangible value that may not be reflected on the balance sheet. Intangible assets developed internally are accounted for differently than those that are acquired, and a diligent analyst should be cognizant of assets recorded or not recorded in developing an indication of value.How to Value OFS?There are fundamentally three commonly accepted approaches to value: asset-based, market, and income. Each approach incorporates procedures that may enhance awareness about specific business attributes that may be relevant to determining an indication of value. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value.The Asset-Based ApproachThe asset-based approach generally represents the market value of a company’s assets minus the market value of its liabilities.The asset-based approach can be applied in different ways, but in general, it represents the market value of a company’s assets minus the market value of its liabilities. Investors make investments based on perceived required rates of return, so the asset-based approach is not instructive for all businesses. However, the capital intensive nature of certain OFS companies does lend some credence to this method, generally setting a floor on value. If companies have paid off significant portions of their debt load incurred financing its equipment, the valuation equation (assets = liabilities + equity) tilts towards more equity and higher asset approach indications of value. Crucially, as time goes on and debt is serviced, the holding value of the assets must be reassessed. Price paid, net of accumulated depreciation may appear on the balance sheet, but if the equipment or technology begins to suffer from obsolescence, it will have less value in the marketplace. For example, due to the shale revolution in the United States and the increased demand for horizontal drilling, equipment and services that facilitate vertical drilling have less market value than it did less than a decade ago. Ultimately, the asset-based approach is typically not the sole (or even primary) indicator of value, but it is certainly informative.The Income ApproachThe income approach can be applied in several different ways. Generally, analysts develop a measure of ongoing earnings or cash flow, then apply a multiple to those earnings based on market risk and returns. An estimate of ongoing earnings can be capitalized in order to calculate the net present value of an enterprise. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market through the use of a capitalization rate. Stated plainly, there are three factors that impact value in this method: cash flows, growth, and risk. Increasing the first two are accretive to value, while higher risk lowers a company’s value.The income approach allows for the consideration of characteristics specific to the subject business.To determine an ongoing level of earnings, scrutiny must be applied to historical earnings. First, analysts must consider the concentration of revenues by customers. A widely diversified customer base is typically worth more than a concentrated one. Additionally, an analyst should adjust for non-recurring and non-normal income and expenses which will not affect future earnings. For example, disposing of assets utilized in the business is not considered an ongoing source of return and should be removed from the company’s reported income for the period when the disposition occurred. The time period must also be considered. Assuming cash flows from last year will continue into the future may be short-sighted in the energy sector. Instead of using a single period, a multi-period approach is preferable due to the industry’s inherent volatility, both in observing historical performance and projecting into the future. Discounted cash flow (DCF) analyses are an important tool, but factors such as seasonality, cyclicality, and volatility all call for a longer projection period.After developing the earnings to be capitalized, attention is given to the multiple to be applied. The multiple is derived in consideration of both risk and growth, which varies across different companies, industries, and investors. When valuing an OFS company, customer concentration is of particular concern to both risk and growth. Developing a discount rate entails more than applying an industry beta and attaching some generic company risk premium. Analysts must look deeper into the financial metrics addressed earlier and consider their market position. Are they financially stable or over-levered by either fixed costs or debt? Are they a sole provider or one of many? If more players are entering the market, prices charged may be lower than those historically observed. If a company stops investing in its equipment and technology, demand for the company’s products and services declines. Again, metrics such as utilization and day rates are important to analyze when developing a discount rate.Income is the main driver of value of a business as the goal is to generate a reasonable return (income) on its assets. People don’t hang a sign above their door and go into business if they don’t think they will eventually turn a profit. Still, differences of opinion on risk and growth can occur, and analysts can employ a market approach as another way to consider value.The Market ApproachAs the name implies, the market approach utilizes market data from comparable public companies or transactions of similar companies in developing an indication of value. In many ways, this approach goes straight to the heart of value: a company is worth what someone is willing to pay for it. The OFS subsector is a fragmented industry with many niche, specialty operators. This type of market lends itself to significant acquisition activity.However, transactions must be considered with caution. First, motivation plays a role, where a financially weak company may not be able to command a high price, but one that provides synergies to an acquirer might sell for a premium. Transactions must also be made with comparable companies. With many different types of companies falling under the OFS umbrella, analysts must be wary of comparing apples to oranges. While they work in the same subsector, there are clearly important differences between equipment manufacturers and pumpers and frackers. Untangling the underlying earnings sources of these businesses is important when looking at guideline transactions as well as directly comparing to guideline companies.In many ways, the market approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.Larger diversified players, such as Schlumberger and Halliburton, are more likely to provide similar services to companies an analyst might value, but their size, sophistication, and diversification of services likely renders them incomparable to smaller players. Given the relative considerations and nuances, taking their multiples and applying a large fundamental adjustment on it is crude at best and may miss the mark when determining a proper conclusion of value.Analysts using a market-based approach should also be judicious in utilizing the appropriate multiple and ensuring it can be properly applied. Industries focus on different metrics and it is important to consider the underlying business model. For E&P companies, EV/EBITDAX may be more insightful as capital expenditure costs are significant and can be throttled down in times of declining crude prices. For OFS companies, potentially relevant multiples include EV/Revenue and EV/Book Value of Invested Capital, but there is no magic number, and these useful metrics cannot be used in isolation. Ultimately, analysts must evaluate the level of risk and growth that is implied by these multiples, which tends to be more important than the multiples used.The market approach must also consider trajectory and location. There’s a difference between servicing vertical wells that have been producing for decades as opposed to the hydraulic fracturing and long horizontal wells in the Delaware Basin. Distinctions must also be drawn between onshore and offshore as breakeven economics are similar (don’t produce if you can’t earn a profit), but costs related to production vary significantly.Ultimately, the market-based approach is not a perfect method by any means, but it is certainly insightful. Clearly, the more comparable the companies and the transactions are, the more meaningful the indication of value will be. When comparable companies are available, the market approach should be considered in determining the value of an OFS company.Synthesis of Valuation ApproachesA proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations. This is why industry “rules of thumb” or back of the napkin calculations are dangerous to rely on in any meaningful transaction. Such calculation shortcuts fail to consider the specific characteristics of the business and, as such, often fail to deliver insightful indications of value.A thorough approach utilizing the valuation approaches described above can provide significant benefits. The framework provided here can facilitate a meaningful indication of value that can be further refined after taking into account special considerations of the OFS industry that make it unique from other subsectors of the oil and gas industry. In our next post, we plan to delve deeper into these special valuation considerations beyond the framework established in this post. Stay tuned…[1] 2018-2019 RMA Statement Studies. NAICS #213111 and 213112. Companies with greater than $25 million in sales.

Issue No. 4 | Data as of Mid-Year 2019

Feature Article: Valuation Issues in Auto Dealer Litigation

What is an Oilfield Service Company?

The oilfield equipment and services (or OFS) industry refers to all products and services associated with the oil and gas exploration and production process, i.e. the upstream sector of the energy industry. In general these companies are engaged in the manufacturing, repair, and maintenance of equipment used in oil extraction and transportation.Products such as seismic testing, transport services, and directional services for horizontal drillers in addition to well construction, and production and completion services are generally what most would typically think when an oilfield services company comes to mind.However, the range of products and services under the OFS umbrella is wide and include many technology-based services that are vital for successful field operations. Such services include locating energy sources, energy data management, drilling and formation evaluation, geological sciences, and many others. Technological innovation over time has led to increased efficiencies in resource extraction and management, and larger OFS companies such as Schlumberger and Halliburton have capitalized on technology-based services to meet the increasing demand in this subsector. Other OFS companies such as Helmerich & Payne continue to specialize in legacy services, including rigs and equipment manufacturing, drilling services, and products. How Do Oilfield Services Companies Fit in the Industry?OFS providers in their modern form arose through a combination of factors dating back to the oil price slump in the late nineties and the mega-mergers of BP-Amoco in 1998 and Exxon-Mobil in 1999. Mergers of this size allowed for synergies of logistics and allowed for restructuring and optimization of assets.While the advantages of these mergers were clear in the downstream segment, the impact for upstream was not so apparent. In fact, the in-house ownership of these various types of services created inefficiencies and redundant cost centers that made it expensive to provide necessary upstream services without impacting the bottom line.These factors and segment trimmings enabled the development of a specialized oilfield service industry, which today provides the majority of the technology (primarily assets and people) and innovation essential across the life cycle of an oil and gas development.The rationale for the outsourcing of service capability can be summarized in three key points:Economies of scale – Specialization of companies in the service chain allows for intense competition among suppliers while also facilitating technical innovation. In-house ownership of services might not have provided the rapid rise of such competition and technology advances that the industry has seen over the last couple of decades.Capital efficiency – A service company able to supply a wide range of clients (large/small public, government-owned, independents, etc.) would expect to be able to achieve higher rates of utilization for their assets and therefore better return on capital employed than could an E&P company limited by their own inventory.Accountability – Third-party service providers arguably allow for increased accountability and efficient creation of reward structures between operator/contractor. However outsourcing may lead to greater operator risk, execution delays, and even contract mispricing.Key Drivers and Indicators of the Oilfield Services IndustryAt its core, the revenue of the OFS companies is a function of the capital and operating expenditure of the E&P companies, which is in turn governed by current and future expectations of the price of oil & natural gas.There are of course several other factors that come into play (advances in technology, climate, seasonality of spending, availability of financing, political factors, etc.), but ultimately it is the supply and demand balance and market fundamentals which determine incentives for investment by these companies. Below is a non-exclusive list of leading indicators that are used to gauge the outlook and demand across the OFS sector:E&P Capital Expenditure Budgets – Size of capex budgets will ultimately determine how the OFS industry will perform as whole. E&P companies will typically begin drafting capex budgets for the next year in the final quarter of the current year. Many will then announce their forward spending plans, strategy, and quarterly/annual results to the market through quarterly earnings calls and press releases. These calls and news releases tend to be closely watched as a leading indicator of future demand. However, historical trends before the oil collapse in 2014 showed that large companies tended to overspend whereas companies at year end 2018 have been tight on capex budgets, even in rising oil price environments. Lean budgets will push the use of third party services down the priority list resulting in hard hits to an OFS company’s revenue stream.Rig and Well Counts – Historically, one of the most closely followed measures of the level of demand for the OFS industry is the active rotary rig count. Baker Hughes began publishing the North American active rig count on a weekly basis since 1944 and initiated the monthly international rig count in 1975. Rig counts have historically been treated as a business barometer for the drilling industry and its suppliers. The thought is when drilling rigs are active, they consume products & services produced by the OFS industry; however, well counts have been trending towards being the primary leading indicator of profits. The reason is in part due to “pad drilling”, in which multiple wells are drilled from one site. Combined with technological advances and logistical efficiencies, having multiple wells per pad in a shale play has a greater effect on performance in a given area. In essence, fluctuating well counts on a seemingly stagnant overall rig count provide a different picture of the health of the sector. Therefore tracking well counts in the last decade has improved predictive power than indications provided solely by rig counts.Day-rates - Day rate refers to all in daily costs of renting a drilling rig, and roughly makes up half of the cost of an oil well. The operator of a drilling project pays a day rate to the drilling contractor who provides the rig, the drilling personnel and other incidentals. The oil companies and the drilling contractors usually agree on a flat fee per contract, so the day rate is determined by dividing the total value of the contract by the number of days in the contract. Although less easily observable, it is also possible to track trends through day rate announcements for other less ‘liquid’ marine sectors, such as seismic vessels, supply boats, support vessels and installation/heavy-lift vessels. Analyzing day rates in combination with metrics like rig utilization allows investors to gain insight into the overall supply and demand picture of the OFS industry at large. When day rates increase, this implies decreased supply of OFS providers or increased demand for their services.Equipment orders – A steady stream of new orders is critical of any manufacturing company, and it is no different with OFS sector. It is customary for OFS companies to announce major equipment orders, i.e. rig orders, floating production storage and offloading (FPSO) orders, underwater equipment orders, drilling packages, etc. and these announcements provide useful insights as to the level of demand across various parts of the service lifecycle.Backlogs – Similar to engineering and construction companies, many OFS companies announce backlogs as a snapshot of the health of their businesses. Since backlog is not an audited measure and its definition can vary from company to company, it is not a hard and fast figure that should be taken at face value. While a sufficient backlog typically means the company is busy, there is give and take for backlogs that extend too far out. Unless specified by management, the timing of backlogged projects can be fairly unpredictable with durations as short as a few months to as long as a few years. But the general thought in analyzing company backlog is to provide an indication of value of revenue not yet recognized and demand for services to be rendered in the future. In our next post, we'll explore valuation issues relevant to oilfield service companies. Stay tuned.

Will Goldman Sachs Pay 18x EBITDA for Your RIA?

No. But Goldman’s United Capital Buy Suggests the Consolidation Winds are Shifting

Brand value is difficult to create, hard to measure, and easy to ruin.In the late 1960s, Porsche and Volkswagen found themselves trying to develop similar cars. Porsche needed a replacement for the 912, a Carrera look-alike with a smaller engine and a cheaper price, and VW needed an updated version of its top-of-the-range (for Volkswagen) Karmann Ghia coupe. The two automakers combined forces to joint-venture what became the 914 model for Porsche and the new Karmann Ghia for VW. Since the bodies and powertrains of the two cars were going to be very similar, Porsche faced the balancing act of preserving its exclusive image while taking advantage of the economy of working with the maker of “the people’s car.” The automakers resolved this conundrum by deciding that only the Porsche would be sold in North America. This marketing alchemy worked, and while the 914 is not regarded as the best performing or most beautiful Porsche ever developed, it did become their best-selling product, by far, during its seven-year run.Subsequent “down-market” Porsches like the 924 through today’s 918 series have produced the sales volume necessary for Porsche to be efficient while maintaining the pricing power conferred by a premium marque. This combination has delivered higher margins for Porsche than other German automakers with a more consistent top line than the more upmarket strategies followed by rivals from Italy. If you do it right, extending your reach can support your brand, not dilute it.Goldman Sachs Extends Brand to Wealth ManagementSome may wonder whether Goldman Sachs is putting its treasured name at risk by making a bid for the mass-affluent wealth management market in buying United Capital. We don’t think so.Some may wonder whether Goldman Sachs is putting its treasured name at risk by making a bid for the mass-affluent wealth management market in buying United Capital. We don’t think so.The announcement last week that Goldman was buying United Capital for $750 million caught many people by surprise, but the more I think about it, the more it makes sense. The opportunity of consolidating the wealth management industry is well publicized: a highly fragmented and inefficient community of small firms in need of effective ownership transition strategies. Several different approaches to this consolidation have emerged, not all of which would have suited Goldman. Some industry consolidators leave acquired firms with their own brands and SEC registrations, which theoretically maintains their sense of entrepreneurship - but also makes national marketing impossible, regulatory compliance more expensive, and may not ultimately govern the ownership transition process reliably. Joe Duran’s approach was different: bring everyone under the United Capital brand and sell it, coast to coast, as a homogenous wealth management platform with a local presence in nearly 100 markets.If there is one consistent story in these RIA rollups, it’s that building them takes longer than anybody expects. Duran worked on building United Capital for nearly 15 years. Some things require scale that cannot be acquired in one lifetime, however, and that’s where the CEO of Goldman Sachs, David Solomon, saw an opportunity.This Really Starts with David Solomon, not Joe DuranImagine you’re David Solomon. You’ve got a really good job heading a global organization known for producing innovative financial products, outsized profits, and Treasury secretaries. Your predecessor, Lloyd Blankfein, became a public figure by building Goldman in the wake of a crisis that took down several major competitors. But the financial universe never stops changing, and despite their high-brow successes, one thing Goldman Sachs doesn’t have is much reach beyond the very wealthy.Solomon inherited a business that did well on large and risky trades but needed to transition into an era that is more staid and regulated. In this environment, he’s looking to bring Wall Street to Main Street. The opportunities Solomon sees are not upmarket, they’re mass-market. Even as it celebrates 150 years of success as a powerhouse that profitably caters to the well-heeled, Goldman Sachs has plunged headlong into commercial banking, corporate cash management, and even a branded credit card, so it makes sense to prepare to court the mass-affluent through a wealth management advisory practice. Goldman could have started from scratch, but buying United gives Goldman an established platform for outreach to the RIA community to seek other acquisitions, which it will undoubtedly begin to do.Will Goldman Sachs Pay 18x EBITDA for Your RIA?So, what does all this mean to you?It has been suggested that the $750 million Goldman paid for United represents something on the order of 18x EBITDA. The actual multiple isn’t public, but given United Capital’s AUM of $25 billion, total revenue including management fees should be between $200 million and $250 million on an ongoing basis. A multiple of 18x EBITDA suggests an EBITDA margin in the mid-teens to just over 20%. That’s a bit thin, so perhaps Goldman Sachs sees opportunities for margin enhancement that buy-down the multiple. At a 30% margin and midpoint revenue estimate of $225 million, Goldman would have only paid 11x EBITDA. On a pro forma basis, at least, that makes more sense.United Capital is Duran’s accomplishment, but Duran’s accomplishment is now Goldman Sachs’s missionary effort.In any event, David Solomon probably didn’t reach his bid on a spreadsheet – at least not looking at United Capital on a standalone basis. The opportunity is to get a substantial but manageable RIA with consistent branding and systems across a national footprint that puts Goldman Sachs in a position to test the platform and grow it accordingly. Plus, the deal comes with Joe Duran. United Capital is Duran’s accomplishment, but Duran’s accomplishment is now Goldman Sachs’s missionary effort. Goldman will need a front-man to pitch their narrative to skeptics and prospects in the RIA community. Duran will have more credibility than someone who didn’t grow up in the independent channel.This is Not Wirehouse 2.0Some of the early backwash I’ve heard on the deal is that Wall Street money is sucking another example of entrepreneurship into the machine. I think that’s flat wrong. If Goldman just wanted to build a new mass-market wirehouse to push investment products, they could have paid much less for many, many broker-dealers with far more FAs than United Capital. All signs suggest that Goldman is looking for distribution for existing GSAM products (no doubt to upper end clients of United) and also to develop new ones for the more typical mass-affluent client. But this is not simply a distribution play. The decision to do this through a fiduciary practice suggests that this isn’t about Wall Street infecting the RIA community, but that RIA culture has finally come home to infect Wall Street. If Goldman puts its might behind the effort and builds a national brand investment advisory practice, it will be a game changer.Focus + High Tower + Cap Trust + AMG + … + Goldman Sachs = More options for RIAsAlmost lost in the Goldman/United deal was that AMG recently announced their first acquisition (Garda Partners) in a couple of years. And it was just earlier this month that a rebooted Hightower announced a plan to grow through investments in new RIAs. With AMG back in the game, and Hightower muscling in on Focus Financial’s territory, the Goldman Sachs deal suggests that buyer competition is going to be heating up in the money management space – much to the benefit of sellers. It further suggests that RIAs seeking an exit through a consolidation strategy are going to have a number of options depending on their perspective and needs.Even if you’d rather stay independent, stay tuned. As we all know, an option has value, even if you don’t exercise it.

What We’re Reading on the RIA Industry

M&A and Practice Management

Much of the sector’s recent press has focused on the current M&A environment as well as practice management issues for RIA firms, so we’ve highlighted some of the more salient pieces on these topics and a few others that are making news in the investment management industry.Goldman Sachs Readies Splashy RIA Retail Debut as it (Likely) Adds $24-Billion United Capital to $35-Billion AUM Ayco for $59-Billion 82 Office Behemoth; Months After Buying RIA Lure From S&PBy Oisin Breen, RIABiz Goldman Sachs recently completed its acquisition of United Capital for $750 million, marking a major expansion into the RIA space for Goldman and a significant endorsement of the RIA aggregator model. The deal value represents approximately 3% of United Capital’s $24 billion AUM and a little over 3x revenue of $230 million.M&A Gains Drive Focus’ 33% Revenue GrowthBy Jessica Mathews, FinancialPlanning RIA aggregator Focus Financial reported 33% year-over-year revenue growth in the first quarter. The growth comes primarily from new partner firms acquired over the last year. In its IPO filings last year, Focus management outlined a growth strategy based on continued M&A and organic growth at Focus’s partner firms. While organic growth has faltered somewhat (partly due to market conditions), Focus has clearly executed on the M&A component of its growth strategy. So far this year, Focus has acquired 21 firms, with 12 of those acquisitions taking place in the first quarter.Bye-bye Broker Protocol: HighTower Exits in Identity MakeoverBy Charles Paikert, FinancialPlanning HighTower Advisors has exited the broker protocol, the industry agreement which allows advisors switching employers to take basic client contact information with them. Exiting the protocol reflects the evolution of HighTower’s business model from recruiting wirehouse teams to focusing on RIA acquisition activity. For some, the decision to exit the protocol is seen as a way to increase retention — perhaps in preparation for a future liquidity event. With recent liquidity events from the other two major roll-up firms, Focus Financial and United Capital, now may be a good time to exit for PE-backed HighTower.U.S. Wealth Management Becomes Hotbed of M&A By Chris Flood, Financial Times Private equity interest in wealth management has continued to increase, given the industry’s growth opportunities and stable cash flows. The wealth management industry remains highly fragmented but is poised to consolidate.Merger Mania: Why Consolidation in the RIA Space is About to ExplodeBy Jeff Benjamin, InvestmentNews Some industry players see the pace of consolidation picking up. Ron Carson, CEO of Carson Group, predicts that in seven years there will be a third less firms than there are today. Historically, there has been less consolidation than we would expect given the size and fragmentation of the industry. However, given the current dynamics of aging ownership, PE interest in the space, and consolidators offering scale and back office efficiencies, the pace of M&A may accelerate significantly.Kitces: The Ratios That Determine Advisory Firm SuccessBy Michael Kitces, FinancialPlanning Tracking productivity, identifying its drivers, and understanding how to improve are important aspects of managing a successful advisory firm. Michael Kitces offers his take on some of the key performance metrics for advisory firms. In summary, consolidation and M&A continue to be major trends in the investment management industry. RIAs continue to receive interest from PE investors due to the recurring revenue and growth potential that wealth management firms offer. Aging ownership bases have also contributed to the consolidation tailwind. The RIA aggregator model has now been endorsed by Goldman Sachs with its acquisition of United Capital, as well as the public markets with Focus Financial’s IPO last year. Whether HighTower’s PE backers will seek an exit in the near term remains to be seen, but given the interest in the Focus IPO and the attractive multiple offered by Goldman for United Capital, it is clear that market interest in the aggregator model is strong.

Royalty and Mineral Value Proposition Highlights Otherwise Underperforming Energy Sector

The burgeoning mineral market is leading the way for an energy sector that has lagged in returns for several years now. This was one of the themes from the DUG Permian Basin Conference in Fort Worth last month. Among the discussion, presenters including Scott Noble, CEO of Noble Royalties and Rusty Shepherd of RBC Capital Markets highlighted the ascension of the estimated $400 to $600 billion onshore mineral market in the U.S., depending on who’s doing the estimating.The interest in the segment has been undergirded by the attractive cash returns coupled with fewer risks and burdens.The interest in the segment has been undergirded by the attractive cash returns coupled with fewer liability risks, operating risks, and expense burdens. In addition, royalty owners retain ownership rights to perpetuity. These characteristics of royalty and mineral plays have drawn investors in as compared to the market’s negative response to upstream management teams merely seeking to beef up the size of their reserve reports.Overall, the energy market’s returns have been subpar. As a sector, energy has lagged all other major sectors over the past several years. In 2018, the returns were again at the bottom of the heap. [caption id="attachment_26449" align="aligncenter" width="940"]Source: Company filings and FactSet[/caption] However, there is an energy sub-sector that has been an emerging bright spot: public mineral aggregators. Brigham Minerals (MNRL) is the latest mineral acquisition company to go public following a trend of other large mineral rights and royalty companies to IPO in recent years. Brigham began trading on April 18 at $18.00 per share on the New York Stock Exchange. Brigham became the fifth mineral company to go public since 2014, far outpacing the energy sector in general. [caption id="attachment_26456" align="aligncenter" width="885"]Source: Company filings and Brigham S-1[/caption] The attraction and growing appetite for mineral aggregators lies in its asset level economics. Several presenters at the conference touched on various factors that are driving returns and valuations. While current producing wells bring in monthly cash flow, they also demand the lowest returns. According to B.J. Brandenberger of Ten Oaks Energy Advisors, producing minerals are commonly purchased on expected returns of 8% to 10%, whereby DUC wells and permitted wells currently have expected returns around 12% and 15%. Undeveloped properties are often valued at over 20% expected return profiles depending on various factors such as the hydrocarbon producing layers in the ground (or “benches” as the industry sometimes calls them). Most of the uncertainty and intrigue has to do with undeveloped properties. The reasons that expected returns are so much higher than producing properties lies in unknowns such as drilling timing, operator quality and expertise, production assumptions, and pricing differentials to name a few.The mineral segment is representing an economic bright spot in a sector that, while improving, has resided in the dark from a stock return perspective.This kind of uncertainty comes with the opportunity for outsized returns resulting in market attraction. According to Oil and Gas Investor’s reckoning, there were 12 companies listed in their mineral company directory in 2015. In 2019, this has ballooned to 140.Public momentum has grown as demand for these investment vehicles is high. Given most new entrants in the market are private equity funded with exit expectations in upcoming years, the chances are high that we see an increase in the number of IPOs from mineral aggregators in the future compared to upstream and E&P companies. Time will tell. In the meantime, the mineral segment is representing an economic bright spot in a sector that, while improving, has resided in the dark from a stock return perspective.

The Last Mile

Most marathon runners will tell you that the last leg of the race is the hardest. In the same vein, the final leg of freight delivery is often the most complicated. This final leg – the delivery of a package from the warehouse or fulfillment center to the customer’s address – is known as the “last mile,” though the actual distance can vary.

Q1 2019 Call Reports

RIAs Respond to the Changing Industry Landscape with Varied Measures

During Q1 2019, most classes of RIA stocks underperformed the market despite its relatively sharp increase through the first three months. Investors still seemed concerned about the RIA industry’s prospects in the face of fee compression and continued asset outflows. RIAs are responding to this pressure in different ways. Some are actively expanding product offerings to meet clients’ changing demands; others are staying true to the traditional RIA model and responding to revenue pressure by developing cost efficiencies.As we do every quarter, we take a look at some of the earnings commentary of investment management pacesetters to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Industry consolidation has been spurred by a challenging revenue environment for RIAs, but firms are going about this in different ways.Consolidation is driven by a need for succession planning.RIAs are also increasingly seeking options to address succession planning, which is another catalyst of M&A. Industry research indicates that over one-third of all RIAs will transition within the next 10 years, putting $2 trillion of client assets in motion. In our expertise in continuity planning, Focus is well positioned to lead the industry in this area, which will be another important driver of our growth. – Ruediger Adolf, Founder, Chief Executive Officer, and Chairman, Focus FinancialConsolidation is driven by cost savings.We expect to recognize roughly 50% to 55% of the cost synergies by the end of the third quarter. Additionally, by the end of 2019, we'll anticipate capturing approximately 85% of the synergies or more than $400 million in the run rate savings. – Loren Starr, Chief Financial Officer, Invesco (on Invesco’s acquisition of Oppenheimer)Consolidation is driven by the expansion of product offerings to include advanced tech platforms and alternative investments.Last month, we announced the binding offer and exclusive agreement to acquire eFront, the world's leading end-to-end alternative investment management software and solutions provider. As clients increasingly add to their alternatives allocations, the ability to seamlessly manage portfolios and risk across public and private asset classes on the single platform will be critical. The combination of eFront with Aladdin will set a new standard in investment and risk management technology and reinforce Aladdin's value proposition as the most comprehensive investment operating system in the world. – Gary S. Shedlin, Chief Financial Officer, Black RockTheme 2: RIAs see flows back to fixed income after a volatile 2018.We saw strong re-risking for those who were in cash that allocated back into fixed income. We saw that predominantly a lot of investors were believing that interest rates are going to go higher, central banks really continue to tighten and, obviously the change in central bank forward forecast and their behaviors many investors were underinvested and put duration to work across the board. – Laurence D. Fink, Chairman and Chief Executive Officer, Black RockIn general, investors continue to pursue more defensive strategies, such as fixed income at the expense of international and higher beta domestic equity strategies. Outflows for our international core equity and science and technology strategies, remain somewhat elevated during the quarter. While our emerging market equity and high income strategies, also continued to experience outflows, it was at a significantly reduced rate from the previous quarter. – Ben Clouse, Chief Financial Officer, Waddell & ReedOn fixed income, generally, I would say that […] I think we're interested in fixed income. We like the differentiated strategies within fixed income, the kind of core kind of bond U.S. and global. [….]. We've seen substantial appetite from institutions for fixed income relative value. – Jay C. Horgen, President and Chief Financial Officer, AMGTheme 3: RIAs continue to respond to the demand for responsible investing.Clients are increasingly attracted to our Responsible and Impact investing portfolio offerings. Assets in a diverse array of responsible equity and fixed income services totaled $1.9 billion at quarter-end, a 23% increase since year-end. – Seth Perry Bernstein, Alliance BernsteinLast week, we launched a Liquid Environmentally Aware Fund or LEAF, as a prime money market fund with an environmentally focused investment strategy. The fund will use 5% of its net revenues to purchase and retire carbon offsets and direct a portion of the proceeds to OUR conservation efforts. Increasingly, clients want sustainable strategies that provide financial returns and target a measurable social or economic impact. BlackRock's goal is to make those strategies more accessible to more people. Beyond dedicated sustainable investment funds, we're also integrating environmental, social, and government risk factors across all our investment processes. – Laurence D. Fink, Chairman and Chief Executive Officer, BlackRock Asset managers saw some improvement in performance in Q1 2019, but performance fees remained depressed as products worked back up to their previous watermark. RIAs are still experiencing headwinds and are responding in various ways. Under the assumption that fee pressure is the new norm, we are still seeing increased spending on technology in order to lower costs. Others are expending into higher margin products such as illiquid alternative investments. Overall, RIAs are well positioned to have a stronger second quarter. We will continue to follow the key drivers of consolidation in the industry, as well as changes in fees and asset mixes during the rest of 2019.

Ignoring the Obvious: What the Market isn’t Telling us About RIA Valuations

Classic car collecting has probably reached its apex, with stories touting old iron as an alt-investment and giving tips for beginners to the space. Have muscle cars finished their run? Are 90s cars next to rise? Are Ferraris and Porsches on the downslope? And so forth. The chatter is interesting but mostly misses the point. Collecting old cars is about nostalgia and stories and traveling to auctions in beautiful locations and very occasionally about making money. About the only thing you can guarantee by investing in classic cars is that it is cheaper than owning horses.Private Markets for RIAs Have Diverged from the Public MarketsOver the weekend, the Financial Times published an article touting the rising merger and acquisition activity in the U.S. wealth management industry. The piece echoed much of the typical commentary on the RIA industry’s prospects for deal activity: a large, profitable, but fragmented community of firms needing scale to develop the necessary technology infrastructure and serve sophisticated client needs. The article talked to leaders in several PE-backed consolidators and some M&A specialists in the space, all of whom talked their book in general agreement that valuations were strong and consolidation was on. What the article didn’t address is that while private equity has indeed been actively pursuing the investment management industry, the public markets seem to have lost interest.What Goes Down, Can Go Down FurtherIt’s not rocket science: strong fundamentals plus weak pricing equals a buying opportunity.Last July, Barron’s ran an article talking up the investment management industry that looked at six firms with depressed valuations and strongly suggested there was a lot of upside there for the taking. I’ll admit that I nodded my head in agreement, because many publicly traded investment management firms had double-digit losses, and we knew from talking to our clients that business was actually pretty good. It’s not rocket science: strong fundamentals plus weak pricing equals a buying opportunity.Fortunately, I didn’t execute on the idea. In the nine months since the article came out, valuations for this group have generally declined further, with four of the six names covered in the Barron’s piece down even more (Legg Mason and Franklin Resources are up, barely).Public RIA Multiples are Following the Trend LowerOne of my colleagues at Mercer Capital, Zach Milam, has been keeping an eye on EBITDA multiples for smaller money managers. He updated the chart below through the end of April.The chart mimics what we’re seeing in the pricing of public investment management houses. Most of the time over the past ten years, money managers traded at high single-digit or low double-digit multiples of EBITDA – a metric that should not surprise anyone. But last year the group took a nosedive toward the mid-single digits. Valuations bounced back a bit in the first part of 2019, but it’s hard to say they’ve truly recovered, despite record highs being set by many major equity indices and bond prices firming. Given the improvement in pre-tax returns yielded by the late 2017 Tax Cuts and Jobs Act, this down leg in EBITDA multiples is alarming.When the Trend is NOT Your FriendEven Warren Buffett is not having much luck with investors, having spent this last weekend facing down questions about the pace of Berkshire Hathaway’s succession planning and why the company has underperformed the S&P 500 over the past decade. And as I wrap up drafting this, the market is generally reeling from the renewed threat of tariffs on China. Whether you believe Buffett’s difficulties are isolated, part of a broader transformation in investment management, or a contra-indicator, it’s a tough time to be an active manager.So What Explains the “Red Hot” M&A Pace?What would M&A activity look like if a few of the major consolidators were not pursuing a landgrab strategy?In contrast to the headlines, first quarter M&A activity should probably be characterized as “normal.” DeVoe’s first quarter transaction review shows 31 transactions, down one from the same quarter last year, and with the average size of the deal (sellers reporting just over $600 million in AUM) well down from last year. The trend in deal size has fallen consistently since 2016, and one wonders what it would look like if a few of the major consolidators, like Focus Financial, were not pursuing a landgrab strategy.The push from the private equity backed rollups has definitely improved liquidity opportunities for sub-$1 billion RIAs, but we suspect that opportunities for larger firms are mostly unchanged. Wealth management firms and independent trust companies have many options, whereas buyers of asset management firms are more selective.EpilogueIf you missed the article last week in the Wall Street Journal on Charles Schwab’s ascent, mostly at the expense of wirehouse firms, go read it now. Just as discount brokers revolutionized the retail investment industry and indexing took on asset management, a myriad of forces are trying to figure out how to capture what are perceived to be outsized profits in the wealth management space. There’s no Schwab-like trend in place yet, even though everyone is trying to claim there is.For all the talk, the deal volume of the consolidators trumpeted in all the headlines is a drop in the ocean compared to the number of RIAs and the assets they manage. So far, the model of an independent firm with five to fifty employees billing 100 basis points to manage the investible wealth of mass-market millionaires is proving to be highly resilient. Many of the trends supposedly driving consolidation, like technology, make independence more sustainable. And while some smaller RIAs are joining industry roll-ups, other wealth management groups are fleeing wirehouses to go independent. In the end, it’s business as usual.

Brigham Minerals IPO Brings Spotlight to Oil & Gas Market

Mineral Aggregators are Leading the Forefront in an Underwhelming Energy Sector

Initial public offerings in the upstream and midstream sectors of the oil and gas market have been lackluster at best for quite some time, and the trend has continued through the first quarter of 2019. Despite the rebounds in the energy sector and broader market to start the year, there has been a scarcity of energy equity capital markets activity, thus resulting in fewer IPOs in the E&P and upstream and is exacerbated by the fact that companies in this space have been underperforming relative to the broader market. This continued lack of activity has made this market fundamentally “underweight” due to the disproportionally small size of available public equities relative to the immense use and value of oil and gas in the national economy. However, in the midst of an underperforming energy market, there is a sector that has been an emerging bright spot: public mineral aggregators. Brigham Minerals (MNRL) is the latest mineral acquisition company to go public following a trend of other large mineral rights and royalty companies to IPO in recent years. Brigham began trading on April 18 at $18.00 per share on the New York Stock Exchange. While we have addressed trends in the mineral aggregators and royalty MLPs, we are taking a closer look into what these companies have to offer the investing public and why they have been so popular in recent years. We continue to see an uptick in IPO activity in this sector as the value of these companies addresses the current wants and needs of energy investors, i.e. high yield cash returns with low-risk characteristics. The timeline below shows how some of the major players in this space have appeared only within the last five years. [caption id="attachment_26224" align="aligncenter" width="680"]Source: Company filings and Brigham S-1[/caption] In this post, we will review the continued IPOs and valuation implications for the mineral aggregators market as well as examine Brigham’s operations and placement in this sector.Energy IPOs Slide While Minerals ShineIn the wake of the oil crash in 2014, there have been a total of 33 IPOs in the U.S. oil and gas market from 2015 through Q1 2019, excluding mineral aggregators. This contrasts sharply with the average of approximately 23 IPOs per year from 2011 – 2014. This decline is illustrated in the chart below, which tracks deal volume by year in various subsectors of the energy market.[caption id="attachment_26223" align="aligncenter" width="892"]Source: Gibson Dunn Presentation "IPOs and Capital Markets Developments in the Oil and Gas Industry," February 26, 2019[/caption] The declines of IPO activity in recent years has been consistent with overall investor sentiment in the upstream and E&P space in that investors have been eager for current yield, not the future growth that these companies have been pedaling. These companies have been reinvesting into additional acreage and capital expenditures, leaving next to no free cash flow and little in the form of dividends to investors. While E&P and upstream IPOs have been trending downwards overall in the past five years, IPOs for mineral aggregators have been increasing.Since many of these newer companies are typically in the high growth and investment phases, they have achieved the capital necessary for growth through private funding rather than through public channels. So why have mineral aggregators been so popular in the public capital markets in a sector that has been so unimpressive from an IPO standpoint?Mineral aggregators have the ingredients investors have been craving for some time. They are cash flow positive, high margin, and have dividend yields that provide healthy returns straight to the investor’s pocket. They also do not carry the typical risk profile of traditional E&P and upstream companies as mineral aggregators provide opportunities to be exposed to mineral plays and benefit from technological advances without taking operator risk.While E&P and upstream IPOs have been trending downwards overall in the past five years, IPOs for mineral aggregators have been increasing, currently averaging around four per year and are continuing at an increasing rate going into 2019.Valuation ConsiderationsBased in Austin, Texas, Brigham Minerals had initially set out to raise $100 million in their IPO, but then increased the amount to be raised to $261 million at $18 per share in an updated S-1 filed on April 9 due to higher than expected demand. Current holdings for Brigham are shown below:[caption id="attachment_26211" align="aligncenter" width="755"]Source: Company filings and Brigham S-1[/caption] [caption id="attachment_26212" align="aligncenter" width="1000"]Source: Company filings and Brigham S-1[/caption] Brigham is averaging approximately 4,579 boe/d of production on approximately 68,800 net royalty acres as of 12/31/2018, pro forma, with a little more than half of the production being oil. Net income attributable to common shareholders was $0.66 per share, and adjusted EBITDA per share came out to approximately $1.11 per share attributable to common. The large gap here is due to depreciation and depletion rates nearly doubling in 2018 due to higher depletion because of the significant increase in production volumes in the current year and a revised depletion rate after evaluation of current reserve reports. By investing directly in the cash flows, mineral aggregators are able to bypass some of the riskier and more costly upfront aspects of the process, turning their investment into a return more quickly.After going public, Brigham will have an influx of cash which it can use to acquire more mineral interests, leading to increased production and free cash flow. At first glance, this might appear to be similar to the reinvestment cycle for E&P companies, but there are important differences. The mineral interests acquired are a revenue stream that can almost immediately be paid out as dividends to investors because the investment is in properties that are already producing and the mineral aggregators receive a portion of the proceeds. Contrast this to an E&P company that reinvests its cash flows into new projects where it must purchase property, equipment, infrastructure, etc. There are large upfront costs that eat into this capital and frequently require taking on debt as well. Before their investors start to realize a return, E&P companies aim to recoup their expenses first, not to mention servicing the debt. By investing directly in the cash flows, mineral aggregators are able to bypass some of the riskier and more costly upfront aspects of the process, turning their investment into a return more quickly.Market cap at the time of the IPO launch was approximately $377 million, and accounting for cash and debt on the books as of the 12/31/2018 financials, we arrive at an estimated enterprise value of approximately $514 million.Below is a table of selected multiples using these calculated metrics as well as other comparable mineral aggregators: Compared to other competitors in the mix, it would make sense for multiples for Brigham to come in under the peer group given the lower production figures. However, utilizing proceeds from the IPO to continue to acquire additional royalty acreage could push the Brigham into a position that is comparable in size and value to those like Falcon and Kimbell, so as long as it can produce free cash flow to pay out high dividends that investors have become accustomed to receiving from these other companies. Location and Production MixBrigham’s operations and focus are semi-diversified compared to other publicly traded mineral aggregators and has the most in common with Kimbell in this respect. What do we mean by this? While Brigham is not as concentrated in a single basin like Viper (Permian focus) and Falcon (Eagle Ford focus), it’s more focused than Black Stone which is by far the most diversified in its class with approximately 89% of holdings falling into the “other” category due to being scattered across multiple, non-traditional plays. There are benefits and drawbacks to both concentrated versus non-concentrated strategies. Consider the table below: Brigham sets itself apart by its presence in the DJ and Williston basins. No other mineral aggregator has a concentrated or material focus there. As well activity picks up in this area, Brigham will benefit. However, it also misses out on activity in the Eagle Ford as well as gas driven plays such as the Haynesville and Appalachia. ConclusionAs we’ve noted before, this market has been frequently discussed among industry professionals for some time and has been featured regularly at oil and gas conferences. The vast market of the public royalty aggregators has been gaining momentum as investor demand for these investment vehicles is high. Given these factors, the chances are high that we see an increase in the number of IPOs from mineral aggregators in the future compared to upstream and E&P companies.In an industry that has seen a decline in public market activity that coincided with the steep drop in oil prices, mineral aggregators like Brigham have emerged as an attractive opportunity for investors looking to gain exposure to the industry with an opportunity to participate in the benefits sooner rather than later.At Mercer Capital, we have valued mineral and royalty rights located across the country. We understand how the location of your assets affects value and work to monitor transactions in each region to understand the state of the current market. Contact a Mercer Capital professional today to discuss your valuation and transaction advisory needs in confidence.

2019 Eagle Ford Shale Economics

Challenging For Valuation Title Belt

Investors and boxing fans have some things in common. First, they both prefer champions. Second, there tends to be attention on heavyweights, when the best fighters may be in a different class.Several attributes put the Eagle Ford among the most profitable shale basins in the U.S.In the oil patch’s proverbial basin battle of economics and relative value, the Eagle Ford Shale is coming on strong. Granted, the Eagle Ford Shale may not reside in the same heavyweight class as the Permian Basin. Indeed, the Permian is in a class of its own and even may be winning over Saudi Arabia’s behemoth Ghawar field in a battle for the title of the largest oil field in the world. However, from a pound for pound well economics standpoint, the Eagle Ford Shale is currently a formidable challenger to the Permian due to several advantages in key areas: breakeven prices, well costs, certain productivity metrics and proximity. These attributes put it among the most profitable shale basins in the U.S. Some well-known operators such as BP and Chesapeake have noticed and are putting big money behind this play.Ranked Contender Or Forgotten Champion?Although the Eagle Ford is a relatively mature basin compared to some other U.S. shale plays, the area has experienced a valuation resurgence over the past twelve months, and it’s not being driven by just the uptick in oil prices. Consider the transaction activity in the table below:[caption id="attachment_26150" align="aligncenter" width="1000"]Source: Shale Experts, Company Reports, EIA [/caption] Activity, dollars and commitment have all swelled. This activity was anchored by two deals: (i) BP’s purchase of BHP Billiton and (ii) Chesapeake’s Wildhorse acquisition. WildHorse and Chesapeake were the fourth and fifth largest drillers in the region, respectively in 2018. Chesapeake appeared to pay a little more attention to current production, while BP’s acquisition appeared more geared towards future acreage. It’s also worth noting that although BP bought assets in other areas such as the San Juan Basin, Wamsutter area and Anadarko Basin, it’s shedding those assets to focus, in part, on the Eagle Ford. Regardless, the relative Eagle Ford acreage prices more than doubled while production values increased generally in lockstep with commodity prices. In a time where oil and liquid production (as opposed to reserve accumulation) is the energy industry’s focus, the Eagle Ford Region is, according to the EIA, the second most prolific oil region in the United States from a myriad of standpoints: (i) overall oil production, (ii) per rig production and even (iii) DUC well count. Additionally, it is home to some of the lowest breakeven prices in the country, certainly from the standpoint of shale plays. Why are costs low? The answer lies in shallower wells, lower cost drilling, higher cuts (meaning there’s more oil and less water produced) and resultant premium commodity pricing near the Gulf Coast. In a time where Permian differentials were particularly wide in 2018, this pricing advantage was helpful to Eagle Ford shale producers. Why are costs low? The answer lies in shallower wells, lower cost drilling, higher cuts and resultant premium commodity pricing near the Gulf Coast.Producers are encouraged by this. At an industry conference last fall, Conoco Phillips’ Greg Leville said that there were certain areas where breakevens were as low as between $20 and $30 per barrel. EOG has noted that they can make money at $30 per barrel on some of their leases. This enthusiasm was characterized according to Marathon’s CEO Lee Tillman at another recent industry conference: “I would compare the returns in the Eagle Ford to anything,” he said, given its $4-5 million/well completion costs, oiliness and Louisiana light sweet pricing. “There's really nothing today on a zone-by-zone basis that can touch the Eagle Ford.” Costs can be particularly lower for operators in 2019 that will be focused on producing from existing DUC wells such as Murphy Oil.Other less choice areas of the Eagle Ford do have higher breakevens, but overall the play, particularly its oil window, boasts among the lowest costs in the country challenging the Permian in this respect. A picture of the generalized spread of breakeven prices in the play can be seen in the chart below.[caption id="attachment_26151" align="alignnone" width="1000"]Source: Company Reports & Investor Presentations[/caption] Fighting For Capital EfficiencyThe trends show that key producers (EOG, BPX and Chesapeake) are working towards consolidating their acreage. More money is going into the basin overall, but operators, wary of overspending, are being more strategic about their capex use. The trend is towards the fewest dollars and the most wells. Note particularly the well count below. It’s becoming a more relevant leading metric than rig counts these days. Rig counts can be somewhat misleading when it comes to well count and productivity as the ratios have changed with technology. The key takeaway is that these producers are all growing well counts significantly.[caption id="attachment_26152" align="aligncenter" width="1000"]Source: Company Reports & shaleexperts.com[/caption] In addition to this group, SM Energy’s capital plan is overall down from last year, but it is increasing its Eagle Ford spending. The hope is that with more experience than other basins, being longer in the tooth will pay off in the near and intermediate term. It also helps that gas produced in the basin will be very competitive in the oncoming LNG market growth on the Texas coast. Get Stronger Or Get Out Of The RingThe prognosis for the Eagle Ford is not all positive. The play struggles (as do other basins) with steep decline curves and production replacement, thus impacting rates of return. Economic critics of the shale plays warn of the “treadmill” effect of replacing production and the costs to do so. There is validity to this. Follow on wells in pad drilling have had productivity problems known as parent-child well interference. Carrizo and Equinor have changed their frac designs to attempt to counter this, and the downside risk to BP’s Eagle Ford bet is that they will be able to flatten their declines enough to keep Eagle Ford wells economical for longer periods of time. Many companies have questioned where Eagle Ford assets fit in their long-term plans. Encana, a reputable Canadian producer, has recently characterized their Eagle Ford acreage as “non-core.” Pioneer Resources has been selling their Eagle Ford positions over the past year, and Earthstone Energy is leaving the play. A long time region producer, Sanchez Energy, was recently delisted from the NYSE.Pound For Pound – A Strong Challenger For The Valuation TitleThese issues can be warnings to investors to be sure, but they can also be interpreted as a natural part of the consolidation cycle in the play as top producers commit and smaller or less successful operators step out of the proverbial ring. The good news for these exiting producers is that they are getting better prices as they leave. Where they cashed out around $8,000 per acre a year or more ago, many are getting closer to $18,000 per acre now. Even gas-heavy producers are more optimistic as the Eagle Ford is the single most proximate play to many oncoming LNG facilities in South Texas.Will the Eagle Ford win the profitability fight with other basins? It may not have the scale or heft of the Permian, but its profitability punches are as strong as anyone's.Originally appeared on Forbes.com.

RIAs Still Reeling from Last Year’s Sell-Off

Despite Recent Uptick, Investment Managers are Underperforming

Ordinarily, we’d expect investment manager stocks to outperform the S&P in a stock market rally. As the broader indices creep up, so does AUM and revenue. Higher top-line growth typically leads to even greater gains in profitability with the help of operating leverage. Assuming no change in the P/E multiple, RIAs stock prices should outpace the market in a bull run.This isn’t always the case though. So far this year, most classes of RIA stocks have underperformed the market despite its relatively sharp increase through the first three months. The explanation isn’t necessarily obvious. Investors are likely concerned about the industry’s prospects in the face of fee compression and continued asset outflows. Alternative asset managers were the sector’s sole bright spot as hedge funds tend to do well in volatile market conditions. However, expanding this graph over the last year shows that they too have underperformed the market over this time. The fallout over this time is primarily attributable to the decline in the (historical) earnings multiple. Since this multiple is a function of risk and growth, at least one of those factors is weighing on investors. We believe it is a combination of the two. Rising fee pressure and continuing demand for passive products have heightened the industry’s risk profile while dampening growth prospects. The forward multiple has recovered some this year, but that’s likely attributable to analysts’ downward revisions of forward earnings estimates in Q1 after the market decline from the prior quarter. As noted a couple of weeks ago, traditional asset managers have felt these pressures most acutely. Poorly differentiated products have struggled to withstand downward fee velocity and increased competition from ETF strategies. To combat fee pressure, traditional asset managers have had to either pursue scale (e.g. BlackRock) or offer products that are truly differentiated (something that is difficult to do with scale). Investors have been more receptive to the value proposition of wealth management firms as these businesses are (so far) better positioned to maintain pricing schedules. Implications for Your RIA Your company is probably facing the same industry headwinds and competitive pressures that publicly traded RIAs are dealing with.In all likelihood, your investment management firm is much smaller than the public RIAs, many of which have several hundred billion in AUM and thousands of employees across the country. It’s also probably unlikely that your business lost 20% of its value last year like most of the public “comps.” The market for these businesses was particularly volatile in 2018, and year-end happened to fall at the low end of the range. So far this year, most publicly traded RIAs have recovered some of these losses during more favorable market conditions.Still, we can’t totally ignore what the market is telling us about RIA valuations. We often get pushback from clients for even considering how the market is pricing these businesses (typically as a multiple of earnings) given how large these companies are relative to theirs. The reality though is that your subject company is probably facing the same industry headwinds and competitive pressures that publicly traded RIAs are dealing with. If investors have turned particularly bullish or bearish on the industry’s prospects, we have to consider that in our analysis.A (Less) Bearish OutlookThe outlook for these businesses is market driven—though it does vary by sector. Trust banks are more susceptible to changes in interest rates and yield curve positioning. Alternative asset managers tend to be more idiosyncratic, but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth managers and traditional asset managers are more vulnerable to trends in active and passive investing.On balance, the outlook for the rest of 2019 doesn’t look great given what happened to RIA stocks at the end of 2018, but the recent uptick suggests that it’s not as bad as it was a few months ago. The market is clearly anticipating lower revenue and earnings following the Q4 correction, which could be exacerbated if clients start withdrawing their investments. On the other hand, more attractive valuations could also entice more M&A, coming off the heels of a record year in asset manager dealmaking. We’ll keep an eye on all of it during what will likely be a very interesting year for RIA valuations.

Q1 2019 Asset Manager M&A Trends

On the Heels of a Record Year, Will Asset Manager M&A Trends Continue to be Strong in 2019?

Last year marked the busiest year for asset manager M&A in the last decade, and the trend is poised to continue into 2019 as business fundamentals and consolidation pressures continue to drive deal activity.Several trends which have driven the uptick in sector M&A in recent years have continued into 2019, including increasing activity by RIA aggregators and rising cost pressures. Total deal count during the first quarter of 2019 was flat compared to the same period in 2018, while deal count was up 35% for the twelve months ending March 31, 2019, compared to the comparative period ending March 31, 2018. Reported deal value during the first quarter of 2019 was down significantly, although the quarterly data tends to be lumpy and many deals have undisclosed pricing.2018 marked the busiest year for asset manager M&A in the last decade, and the trend is poised to continue into 2019.Consolidation has been a driver of many of the recent large deals, as exemplified by the largest deal of last year, Invesco’s (IVZ) acquisition of OppenheimerFunds. IVZ announced plans in the fourth quarter last year to acquire the OppenheimerFunds unit from MassMutual for $5.7 billion in one of the largest sector deals over the last decade. IVZ will tack on $250 billion in AUM as a result of the deal, pushing total AUM to $1.2 trillion and making the combined firm the 13th largest asset manager by AUM globally and the 6th largest by retail AUM in the US. The deal marks a major bet on active management for IVZ, as OppenheimerFunds’s products are concentrated in actively-managed specialized asset classes, including international equity, emerging market equities, and alternative income. Invesco CEO Martin Flanagan explained the rationale for scale during an earnings call in 2017:"Since I've been in the industry, there's been declarations of massive consolidation. I do think though, this time there are a set of factors in place that weren't in place before, where scale does matter, largely driven by the cost coming out of the regulatory environments and the low rate environments in cyber and alike." Martin Flanagan – President and CEO, Invesco Ltd. 1Q17 Earnings CallRIA aggregators continued to be active acquirers in the space, with Mercer Advisors (no relation), and United Capital Advisors each acquiring multiple RIAs during 2018. The wealth management consolidator Focus Financial Partners (FOCS) has been active since its July IPO as well. So far in 2019, FOCS has announced 11 deals (including acquisitions by its partner firms). Just last week, Silvercrest Asset Management announced the acquisition of Cortina Asset Management, a $1.7 billion small cap growth equity manager based in Milwaukee, Wisconsin.Consolidation Rationales The underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, aging shareholder bases, and slowing organic growth for many active managers. While these pressures have been compressing margins for years, sector M&A has historically been muted, due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation. Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure as long as it doesn’t inhibit performance."Absolutely, this has been an elevated period of M&A activity in the industry and you should assume … we're looking at all of the opportunities in the market." Nathaniel Dalton, CEO, Affiliated Managers Group Inc – 2Q18 Earnings Call"Increased size will enable us to continue to invest in areas that are critical to the long-term success of our platform, such as technology, operations, client service and investment support, and to leverage those investments across a broader base of assets." David Craig Brown, CEO & Chairman, Victory Capital – 3Q18 Earnings CallConsolidation pressures in the industry are largely the result of secular trends. On the revenue side, realized fees continue to decrease as funds flow from active to passive. On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs. Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to realize economies of scale, enhance product offerings, and gain distribution leverage.From the buyer’s perspective, minority interest deals ensure that management remains incented to continue to grow the business after the deal closes.Another emerging trend that has been driving deal volume is the rise of minority interest deals by private equity or strategic buyers. These deals solve or mitigate many of the problems associated with acquisitions of what are normally “owner operated” businesses (at least for smaller RIAs). Minority interest deals allow sellers to monetize a portion of their firm ownership (often a significant portion of their net worth). From the buyer’s perspective, minority interest deals ensure that management remains incented to continue to grow the business after the deal closes.Market ImpactDeal activity in 2018 was strong despite the volatile market conditions that emerged in the back half of the year. So far in 2019, equity markets have largely recovered and trended upwards. Publicly traded asset managers have lagged the broader market so far in 2019, suggesting that investor sentiment for the sector has waned after the volatility seen at year-end 2018.M&A OutlookWith over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies. Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth and margin compression. An aging ownership base is another impetus. The recent market volatility will also be a key consideration for both sellers and buyers in 2019.

An Overview of Salt Water Disposal

Over the last 12 years the oilfield waste water disposal industry has grown exponentially, both on an absolute basis, and by rank of its importance/size among the oilfield services. This growth has been largely driven by the increased volumes of waste water generated in the production of oil from shale plays. This post discusses the basics of salt water disposal which has become so important given the rise of hydraulic fracturing.The Impact of the Shale BoomThe shale revolution, starting in the Bakken formation in 2007 and ramping-up in the Eagle Ford and Permian basins beginning in 2011, was largely propelled by the combination of horizontal drilling and hydraulic fracturing (commonly, “fracking”).Over the last 12 years the oilfield waste water disposal industry has grown exponentiallyBecause shale hydrocarbon deposits are located in tight-rock formations, the naturally occurring produced water (water that is naturally present in oil and gas formations, referred to as “formation water”) to oil ratio is lower than in conventional reservoirs that have increased pore space and connectivity. To economically produce oil/gas from unconventional reservoirs composed of shale or tight (low permeability) rock, the reservoir must be stimulated by a process such as fracking.Fracking increases the hydrocarbon flow capacity by creating cracks (fractures) that are then filled with a permeable media (proppant) that allows oil/gas to move out of the rock formation and into the wellbore. Fracking requires very large volumes of water to be pumped into the reservoir to carry proppant and other fluids into the fractures. That water flows back after the frack is complete. When added to naturally occurring produced water, and produced water resulting from other stimulation operations (water flooding and/or steam flooding), fracking results in water/oil production ratios that can exceed 10:1. This results in enormous volumes of produced water (tens of billions of gallons each year), some of which is utilized in additional stimulation activities, but much of which must be disposed of.The Need for Disposal and MeansProduced water (also referred to as “brine”) contains a number of contaminants, both naturally occurring (salt, oils/grease, and organic/inorganic chemicals) and chemical additives utilized in the drilling and operation of the well. Even after treatment to extract some of the impurities, the resulting water (referred to as “salt water”) contains significant contaminants and must be handled carefully and disposed of properly.The method of salt water disposal depends on a number of factors: geology, technology, area infrastructure, and the prevailing climate in the areaThe method of salt water disposal depends on a number of factors, notably the geology of the formation from which the water is produced, as well as the technology and infrastructure available in the area and the prevailing climate in the area. While some particularly arid regions allow for disposal via evaporation from large holding pits, most salt water is disposed of at specialty disposal sites where the salt water is injected by way of a disposal well (salt water disposal, or SWD wells) into natural underground formations.Geographic DistributionA large portion of the U.S. SWD facilities are located in Texas due to the disproportionate amount of shale acreage in the state and the SWD conducive geology in Texas. Far fewer SWD facilities are located in other shale areas, such as the Marcellus and the Bakken, due to less favorable geological formations in those areas. The Marcellus in particular lacks favorable formations for disposal purposes with the number of recent operating SWD wells in Pennsylvania at less than 100, compared to more than 12,000 SWD wells in Texas.Location SelectionWhen siting a SWD facility, a number of factors come into play, including demand, proximity, and geology.DemandDemand might seem to be an easy consideration – just locate the facility in an area where oil and gas operators are generating large volumes of waste water. However, oil production and, therefore, waste water production, in particular areas can vary widely over both short and long periods of time.When siting a salt water disposal facility, a number of factors come into play, including demand, proximity, and geologyProduction in a particular field naturally declines over time as reserves are depleted, but can increase again with technology advances. Oil prices dictate if it’s economically viable for continued production in a particular field, with oil prices being notoriously unstable compared to many commodities due to supply and demand, country-specific political forces and even geopolitical forces.ProximityProximity to the area of waste water disposal demand is important. Proximity can be viewed both as distance and as the availability of the appropriate infrastructure (roads) to efficiently transport the waste water from the production site to the disposal site. Transporting oilfield waste water is a significant expense and for obvious reasons is tied directly to the transport distance. Many oil and gas wells are located in remote areas where the existence of roads, or lack thereof, plays into the SWD location decision.GeologySurface location isn’t the only consideration when choosing a SWD facility site. The location’s geology is just as important.A porous and permeable, non-hydrocarbon bearing zone that is not considered an aquifer under the UIC program is one possible geological formation appropriate for salt water disposal. A second possibility would be a previously depleted oil and gas zone, that is both porous and permeable.For either option, a clear barrier must exist between the target zone and all underground sources of drinking water ("USDWs"), and the drill area needs to be generally clear of any significant geologic faults.ConstructionSalt water disposal wells have very specific construction requirements in order to ensure that there will be no contamination of the area USDW or the environment in general. For example, in Texas, salt water disposal wells are constructed with three layers of casing to ensure that groundwaters are not impacted. The surface casing (the first layer) is a cement encased steel pipe that extends from ground level to a specific minimum distance below the deepest USDW level. The production casing, a pipe that is permanently cemented in the wellbore, is the second casing layer and runs the length of the well. The third protection layer contains the injection tubing string that guides the injected water to the bottom of the well for discharge into the target formation. This construction provides the most secure means of disposing of salt water developed to date in that all three pipes would have to fail at the same time for surrounding groundwater to be contaminated.RegulationRegulation of SWD facilities is significant and thorough. The 1974 Safe Drinking Water Act required the U.S. Environmental Protection Agency ("EPA") to set minimum requirements for salt water injection wells, along with many other wells utilized in disposing of various hazardous and nonhazardous wastes. These EPA established requirements are generally referred to as the Underground Injection Control ("UIC") program. Since the inception of the UIC program, wells classified for injection of oilfield waste liquids have been used to inject over 30 trillion gallons of oilfield salt water without endangering USDWs.Regulation of salt water disposal facilities is significant and thoroughThe UIC program established the necessary requirements for a state to enforce the program within their jurisdiction. In order to assume primacy, the states must demonstrate that their program for UIC enforcement meets the minimum requirements established by the UIC program. At the current time, 33 states and three U.S. territories have primacy for the UIC wells in their jurisdiction. Seven states share primacy with the EPA with the state typically handling one or more classifications of wells and the EPA overseeing the remaining classifications. The EPA maintains primary enforcement of the UIC programs in the remaining ten states and three U.S. Territories.EconomicsA commercial SWD well operator will typically charge between $0.50 and $2.50 per barrel of salt water. The wide range is a simple result of supply and demand. In areas where disposal demand is low, where SWD wells are abundant and have significant capacity availability, the per barrel rate trends towards the lower end of the range. That contrasted with areas where demand for salt water disposal is strong, but the disposal infrastructure, or capacity, is lacking, or the geology places limits on the injection of oilfield waste water, the commercial SWD operators are able to charge fees in the upper end of the range.A commercial salt water disposal well operator will typically charge between $0.50 and $2.50 per barrel of salt waterAnother consideration associated with disposal of oilfield waste water is the cost of transporting the salt water from the well site to the disposal site. Typically the transportation of waste liquids will cost the operator $1.00 per barrel per hour of transport time. In an area of SWD facility abundance, such as the Barnett shale, transport expense might only add $0.50 per barrel to salt water disposal expenses. However, in areas with few SWD facilities, such as some Pennsylvania locations, oilfield waste fluids have to be trucked to disposal facilities in Ohio or West Virginia, with the cost adding $4.00 to $6.00 per barrel.ConclusionWatch this space for future blog posts addressing the valuation issues faced by companies operating in this space.Mercer Capital has significant experience valuing assets and companies in the oil and gas industry. Because drilling economics vary by region, as touched on above, it is imperative that your valuation specialist understand the local economics impacting your company. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 auditors. These oil and gas related valuations have been used to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.Sourceshttp://www.oilandgas360.com/water-handling-in-oilfield-operationshttp://www.tech-flo.net/salt-water-disposal.htmlhttp://www.producedwatersociety.com/produced-water-101http://aqwatec.mines.edu/produced_water/intro/pw/http://www.epa.gov/sites/production/files/documents/21_McCurdy_-_UIC_Disposal_508.pdf

Valuations of Asset Managers Are Slow to Recover

Is the Decline in Active Management a Result of Increased Competition or Mediocre Performance?

Over the last year, the stock price declines of publicly traded asset managers were generally more significant than other investment managers and the broader stock market.As mentioned in our latest whitepaper, How to Value a Wealth Management Firm, wealth managers are more resistant to market volatility as shown by their superior performance to asset managers over the last year. Their resilience stems from the fact that client assets are correlated with the market, but client relationships are not.Asset management firms are more susceptible to market volatility, however, because during periods of volatility or market declines, asset management firms risk losing assets from both downward market movements and client outflows. Downward market movement clearly has a direct negative impact on AUM, but it can also lead to outflows and lower revenue as clients de-risk or reallocate to lower fee fixed income products.While market declines are a threat to the profitability and valuations of any asset management firm, active managers face the additional threat of relative underperformance driving outflows, even in periods of rising markets. Low fee passive strategies have become increasingly popular due in part to both the perceived underperformance of active managers and an increasing focus on fees. But to what extent have active fund outflows been driven by mediocre performance versus competition from passive strategies, and what is the impact on asset management firm valuations?Fund OutflowsIn general, asset managers are experiencing an industry-wide shift away from actively managed investment products. Over the last 15 years, more than half of all U.S. equity funds have merged or liquidated. According to MorningStar, 2018 was the “worst year for long-term fund flows since 2008.” Inflows were less than half the $350 billion average for the prior year, and outflows approximated 4% of beginning assets.At year-end, Morningstar predicted that if current trends in asset flows continued, passive U.S. equity funds would likely catch up with active funds’ market share in the next few months of 2019. Most of our clients expect this trend will continue for a few more years before stabilizing and ultimately reversing. January 2019 brought a more positive outlook for actively managed funds which “for the first time in five years outshone their passive counterparts.”Mediocre PerformanceHeadlines have recently brought attention to the mediocre performance of many active managers (“Active fund managers trail the S&P 500 for the ninth year in a row”). One of the primary reasons for active funds’ lackluster performance is the number of active funds who participate in closet indexing. Closet indexers claim to manage a unique portfolio designed to generate active returns while their active share (percentage of holdings that differ from the benchmark) is actually quite low. Last year, thirteen active fund managers agreed to voluntarily disclose their active share in order to increase transparency. Actively managed funds charge higher fees in exchange for the promise of excess return. Closet indexers typically generate returns in line with the benchmark but at a higher cost than a passive investment in the underlying benchmark.Competition from Passive AlternativesAccording to Morningstar’s semiannual Active/Passive Barometer (published in February), “just 38% of active U.S. stock funds survived and outperformed their average passive peer in 2018, down from 46% in 2017.” For the twenty years ending December 2015, the S&P 500 index averaged 9.85% a year, while the average equity fund investor earned a return of only 5.19%. There has been much written about the shift from active to passive investing, and high costs and active manager underperformance are largely to blame.ValuationsOn average the stock prices of asset managers fell 17% year-over-year. Trailing valuations fell by over 30% from a median of 15.8x trailing earnings in March 2018 to 10.5x trailing earnings in March 2019. The broader stock market has recovered somewhat from the pullback observed at year end, but asset manager valuations have improved more modestly. Forward multiples, however, are more in line with historical norms.Is the decline in active management a result of increased competition or mediocre performance? We think it’s both. In general, clients (especially institutional investors and high net worth individuals) are still willing to pay for superior performance. We think best-in-class asset managers could come out ahead of their passive counterparts in the long run, but the problem is that best-in-class asset managers are, by definition, few and far between.

Considerations for Endowments Divesting Fossil Fuels

Due to the historical popularity of this post, we revisit it this week. Originally published in 2018, the purpose of this post is to educate and advise those who have decided to divest their fossil fuel assets and are unsure of how to proceed.The American Council on Education reported in 2014 that college and university endowments are heavily invested in commodities, natural resources, private equity, and other illiquid assets. In the 1990s, endowments invested over 95% of their assets in traditional stocks and bonds. By 2013, less than 50% of endowment assets were invested in traditional equities. Currently, endowments have approximately 5% of their assets, $22 billion, invested in energy and natural resources. Over the last few years, many university students and church congregations have urged their trustees to consider divesting their endowments from fossil fuels. The Guardian in January 2018 explained “The divestment movement, primarily consisting of climate activists, is urging private and public institutions to rid their portfolios of all oil, gas, and coal stocks to send a financial and ethical message that fossil fuels are harmful and shouldn't be tolerated. So far, it's estimated that funds totaling $6 trillion have committed to divesting from fossil fuels.” Due to the favorable tax benefits of gifting assets to endowments upon death, your endowment may hold illiquid fossil fuel assets, such as mineral and royalty rights. You have received an annuity-like stream of payments every month but are now considering divesting. However, the shortage of a well-organized market for illiquid fossil fuel assets can cause a dilemma for trustees of endowments. How do you sell your royalty and mineral rights and what are they worth? The purpose of an endowment is to provide a permanent source of funding that maintains the operations of colleges, universities, churches, etc. To best serve its fiduciaries, an endowment should achieve the highest return possible. Congruently, when divesting, the endowment must ensure it achieved a fair price for its investments. This post does not weigh in on the discussion of whether endowments should or should not liquidate fossil fuels. Rather, we hope to educate and advise those who have decided to divest their fossil fuel assets and are unsure of how to proceed.The Growth of Illiquid AssetsThe growth of illiquid assets in endowments investment portfolios is not a surprising trend. While illiquid assets garner more downside risk, they also offer the potential for higher returns than those realized in the traditional equity marketplace. A proper fiduciary who weighs the risks and reward of illiquid assets over time will likely like include these assets in their portfolios. However, when it comes time to liquidate these assets, a trustee must act carefully. Selling illiquid assets requires a thorough understanding, and as trustee, it is your fiduciary duty to understand these transactions or seek the advice of someone who does.Divesting publicly traded fossil fuel stocks and bonds is relatively simple. While it can be beneficial to consider the timing of your sale with movements in the market, generally you can contact your portfolio manager or log onto your trading account directly and liquidate these stocks or ETFs within minutes.Unlike public equity investments, mineral interests and royalty rights investments cannot be liquidated at known market prices instantaneously. Rather, the price and the terms of the deal must be agreed to by both the buyer and the seller.What Are Your Mineral and Royalty Rights Worth?One of the most common methods used to value mineral and royalty rights is a discounted cash flow analysis. The holders of royalty rights receive a monthly payment similar to that of a bond holder or commercial real estate lessor. Thus, future payments can be predicted and then discounted back to the present. However, the payments to a royalty holder can drastically increase or cease entirely without the say of the royalty holder. This makes the prediction of future cash flows used to value the asset much more difficult. Future cash flows must consider the current and future oil price environment, future levels of production, decline curves, the financial strength of current operators, and many other factors. As we explain in our whitepaper, How to Value an Oil and Gas Royalty Interest, “To perform a royalty’s DCF analysis, production levels must be projected over the well’s useful life. Given that well production decreases at a decreasing rate, these projections can be calculated through deriving a decline rate from historical production. Revenue is a function of both production and price; as such, after developing a legitimate prediction of production volumes, analysts must predict future price. The stream of income (revenue less taxes and deductions) is then discounted back to present value using a discount rate that accounts for risk in the industry.”The guideline transaction approach can also provide a helpful indication of value. To develop an indication of mineral royalty interest value using the market approach, you can utilize data from market transactions of mineral interests in similar plays. Acquisition data can be utilized to calculate valuation multiples that take into account industry factors (or at least the market participants’ perception of these factors) far more directly than the asset-based approach or income-based approach. In many ways, this approach goes straight to the heart of value: mineral interests and royalty rights are worth what someone is willing to pay for them.Offer LettersAdding to the uncertainty surrounding the value of royalty rights, the majority of mineral interest and royalty right owners with whom we work receive a couple, if not dozens, of offer letters every year. While offer letters, like transactions, do provide an indication of what someone is willing to pay for the asset, the definition of fair market value includes both a willing buyer and a willing seller. Since these offers are only half of the equation, they should not be used in isolation as an indication of value. As shown in the excerpt from the offer letter below, the distinction between fair market value and offer prices is critical in order to protect yourself from brokers attempting to profit at your expense.Offer letters generally offer a multiple of average monthly cash flow on your revenue checks. These multiples can range widely, often from less than 60x to more than 200x monthly cash flow. Unfortunately, there is not one benchmark that can be applied to monthly cash flows across the nation, or even within one basin, so there is not an easy way to determine if you are receiving a fair price.Especially after the fall in oil prices in mid-2014, we saw many offers that used scare tactics to try to persuade royalty owners to sell their interests at absurdly low prices. Since the crash in oil prices, many royalty owners stopped receiving royalty checks; however, this does not mean their royalty interests are worthless. Even now that oil prices have recovered and production is at an all-time high, some offer letters seek to take advantage of inexperienced royalty owners by suggesting that recent acquisitions, drilling activity, or changes in production have increased the risk, and therefore, decreased the value of their investment. An understanding of royalty and mineral prices is not common to the average and even advanced investor and information about royalty and mineral rights is scare and difficult to find. This, unfortunately, means that these scare tactics often work.A recent offer letter to one of our clients read,“As you may know, Hess Corporation has sold their interest in this unit. But there is another risk factor, as well. While it's hard to see on your revenue checks, from 2015 to 2016 the production declined by 10.1%. The decline over the past 30 years has been 1.7%. While the decline has improved this year, it makes one wonder what the decline will be in the future. As a mineral owner in this unit, it certainly has my attention. I'm making this aggressive offer in the belief it will go back to historical declines.”This offer of 90x monthly cash flow was received in August, following the announcement of the acquisition. By October when the details of the acquisition had been further explained to the investor community, our client had received another offer for approximately 140x monthly cash flow.While there are legitimate online brokers who will buy your royalty interest for a fair price, the best solution is to know and understand the value of your asset before you start searching for a credible buyer.The Value of Mineral Interests and Royalty RightsAs explained in our post "Before Selling Your Oil and Gas Royalty Interest Read This," we believe there are three points you need to understand before selling your mineral interest and royalty rights.Understand what you are sellingRecognize production and price as value driversUnderstand the location’s impact The responsibility of divesting fossil fuels assets, especially for churches, often falls to a volunteer board that is tasked with much more than overseeing the divestiture of their fossil fuel portfolio. It is the board’s fiduciary duty to ensure that the endowment is operating in the best interest of its beneficiaries which means, they need to ensure they receive a fair price for their assets. At Mercer Capital we have valued mineral and royalty rights in located across the country. We understand how the location of your assets affects value and work to monitor transactions in each region to understand the state of the current market. Contact a Mercer Capital professional today to discuss your valuation and transaction advisory needs in confidence.

2019 CFA Institute Wealth Management Conference Recap

Last week, Matt Crow, Taryn Burgess, Zach Milam, and I attended the 2019 CFA Institute Wealth Management Conference in Fort Lauderdale. We didn’t get a total headcount, but attendance appeared to be up from last year’s event. There are probably a number of explanations for this, but perhaps the most plausible was the interest in this year’s focus on the psychological side of wealth management, which explored behavioral finance tendencies and how emotional decision-making can impact investment performance. For this post, we’ve elected to summarize some of these presentations and their implications for financial advisors.The Geometry of WealthBrian Portnoy, Head of Education at Magnetar CapitalIn The Geometry of Wealth, behavioral finance expert Brian Portnoy, Ph.D., CFA defines true wealth as “the ability to underwrite a meaningful life” or “funded contentment.” Dr. Portnoy distinguishes this concept from the blind accumulation of assets, which he likens to a continuous (and often unsatisfying) treadmill experience. He contends that living a meaningful life and tending to financial decisions should be complementary, not separate, pursuits and uses three basic shapes to help readers visualize how to adapt to evolving circumstances (circle), set clear priorities (triangle), and find empowerment in simplicity (square). Through this process, Dr. Portnoy maintains that true wealth is achievable for most people but only in the context of a life in which purpose and practice are thoughtfully calibrated. He addresses the following questions to accomplish this goal:How is the human brain wired for two distinct experiences of happiness and why can money ‘buy’ one but not the other?Are the touchstones of a meaningful life affordable?Why is market savvy among the least important sources of wealth but self-awareness is among the most?Can we strike a balance between pushing for more and being content with enough? Dr. Portnoy advises managers to help clients spend wisely (on experiences, others, and time savers) and hedge sadness as most investors are loss averse.How Client Engagement is Being DisruptedJulie Littlechild, Founder of Absolute EngagementJulie Littlechild’s book, The Pursuit of Absolute Engagement, discusses the trends that are disrupting client engagement and why many advisors aren’t keeping pace with client demands. She recommends that advisors answer these four questions to effectively respond to a client disruption (or at least stay one step ahead):Who are you designing the client experience to support? (Hint: Define an authentic niche, because you can’t design a compelling client experience around the needs of everyone)What does "extraordinary" look like through their eyes? (Hint: Actively involve clients in defining what extraordinary looks like, because you can’t base this on assumption)What is the client’s journey? (Hint: Understand the steps that clients go through and what they think, feel, and do at each stage because that will uncover their real needs)How will you support clients in their journey? (Hint: Define a communications plan that actively reflects the client journey and supports them along the way because that’s where innovation happens) By answering these questions and anticipating clients’ needs, advisors are able to support their clients on a deeper level by shifting their focus from "good service" to a "meaningful experience."The Behavioral InvestorDaniel Crosby, Chief Behavioral Officer of Brinker CapitalPsychologist and behavioral finance expert Dr. Daniel Crosby emphasizes the importance of understanding human nature and investor psychology in the portfolio construction process. Dr. Crosby contends that only through developing a deep understanding of why humans make decisions can we really ascertain how we should invest. Specifically, he says individuals should avoid making investment decisions while in a H-A-L-T phase, that is Hungry, Angry, Lonely, or Tired. By understanding the context of our decisions and our own behavioral shortcomings, we can become better investors and advisors over time. Similar to Brian Portnoy, Dr. Crosby posits that true wealth encompasses psychological wellbeing not just asset accumulation.Perception is Reality: Defining Your Value Proposition in a Competitive MarketplaceNikolee Turner, Managing Director of Business Consulting at Charles SchwabThis presentation stresses the importance of branding and perception in developing relationships and a strong referral network from existing clients. Nikolee Turner discusses how advisors can fine tune their value proposition to compel action from prospective clients and win new business. One way to accomplish this feat is through the use of firm success stories and concrete examples of helping clients realize their financial objectives. Turner found that such communication is often lacking as her firm’s research indicates that many advisors can’t even articulate their firm’s value proposition to prospective clients. As the competition for client assets intensifies, the need for effective communication and a dedicated referral program has never been greater. Mastering both, Turner contends, is critical for achieving growth goals and gaining market share.All the sessions were well-received, and we’d certainly recommend these presentations and their author’s publications to anyone interested in this topic. We’re looking forward to next year’s event in Seattle and hope to see you there.

From Enduro to Permianville

A Closer Look at Permianville Royalty Trust

In previous posts, we have discussed the relationship between public royalty trusts and their market pricing implications to royalty owners. Many publicly traded trusts are restricted from acquiring other interests, so they have relatively fixed resources, and the value of these trusts comes from generally declining distributions. In many cases, the royalty comes from a related operator, though this is neither required nor characteristic of all trusts. There are also other MLPs such as Kimbell Royalty Partners, Viper Energy Partners, Dorchester Minerals, and Black Stone Minerals that are aggregators consistently gobbling up new acreage. In this post, we explore the subject characteristics of Permianville Royalty Trust, formerly known as Enduro Royalty Trust.Market ObservationsIt’s been a while since we’ve looked at this group, and Permianville Royalty Trust isn’t the only change. Hugoton Royalty Trust voluntarily delisted from the NYSE last August after not being able to sustain a sufficient stock price. Over the previous two years, the performance of the remaining 20 publicly traded royalty trusts and partnerships has varied widely. The table below shows the performance and other key metrics of the 20 main oil and gas-focused entities that are publicly traded, as of March 28, 2019. [caption id="attachment_25737" align="alignnone" width="940"]Source: Capital IQ [/caption] Returns are pretty evenly split, with 9 positive and 11 negative. With oil prices rising 23% in the past two years and natural gas declining 8%, it’s not too difficult to pick out which trusts receive royalties from which commodity, though other factors such as timing and operator certainly play a role.For comparison, the chart below shows the two-year returns from Permianville Royalty Trust (PVL), crude oil, natural gas, the O&G150 Index, and a publicly traded E&P ETF called “SPDR S&P Oil & Gas Explore & Prod. (XOP)”. Interestingly, PVL has had little correlation with either crude (+25.9%) or natural gas (-37.0%) prices over the past two years, likely due to its exposure to both commodities and other notable activity specific to the Trust as discussed later.[caption id="attachment_25764" align="alignnone" width="940"]Source: Capital IQ [/caption] Permianville Royalty Trust Origination and SaleEnduro Royalty Trust was formed in May 2011 to acquire and hold a net profits interest (NPI) representing the right to receive 80% of the net proceeds from interests in certain oil and natural gas producing properties located in Texas, Louisiana, and New Mexico. These underlying properties were held by Enduro Resource Partners and are in both conventional and unconventional plays. The initial IPO occurred in November 2011 issuing 13.2 million units at $22. A second offering occurred in October 2013 issuing 11.2 million additional units at a reduced price of $13.85. No further offerings or redemptions have occurred, leaving the number of Trust Units outstanding at 33 million, including the 8.6 million units originally retained by Enduro.Seeking to rebrand from its former operator, the Trust opted to capitalize on the hype on opposite ends of Texas to reflect its holdings in the Permian and Haynesville Shale.On May 15, 2018, Enduro Resource Partners buckled under its debt load and filed for Chapter 11 bankruptcy. This significantly impacted the royalty trust, similarly to how SandRidge’s issues have plagued its royalty trusts. Three days later, the Trust declared a dividend of $1.13 million, down 42.5% from the prior month, further exacerbating the decline. The Trust’s share price declined 12.8% from May 10th to May 17th and fell to almost $3 per share a month after the announcement when it was trading closer to $4. On August 31, Enduro finalized a sale of the underlying properties and its outstanding Trust Units to COERT Holdings 1 LLC. This helped stabilize the stock price of the royalty trust as it increased from $3.4 on August 30th to $3.7 by September 6th. According to footnotes of an SEC filing, COERT Holdings paid an aggregate gross consideration of $35.75 million for the 8.6 million Trust Units held by Enduro. This implies a unit price of about $4.16, significantly higher than the price seen around this time.In connection with the sale, COERT assumed all of Enduro’s obligations (became the “Sponsor” of the Trust) with minimal disruption to unitholders anticipated. Notably, the portfolio consisted primarily of non-operated interests, easing any transition concerns. Seeking to rebrand from its former operator, the Trust opted to capitalize on the hype on opposite ends of Texas, changing its name to Permianville Royalty Trust to reflect its holdings in the Permian and Haynesville Shale. It should be noted, however, that not all of its holdings in East Texas are in the Haynesville.Permian + Haynesville = PermianvilleUnderlying PropertiesThe Permian has dominated shale production in the U.S. over the past year, but Haynesville Shale has made a push of its own recently. It surpassed the Bakken with 58 rigs in the first week of March, which it has only done for a brief period at the beginning of 2018 and before then in 2011 when it also had more rigs than Appalachia and the Eagle Ford. According to the EIA March Drilling Productivity Report, Haynesville only trailed Appalachia in new-well gas production per rig while legacy gas production has declined slower than both Appalachia and the nearby Eagle Ford. Despite these gains, the Permian still dominates in terms of production and the majority of Permianville Royalty Trust’s acreage is in the Permian basin with 88% of net acreage and 92% of net wells.[caption id="attachment_25756" align="aligncenter" width="500"]Source: Permianville Royalty Trust 10-K[/caption] As seen in the chart below, the majority of the Trust’s proved reserves are developed, oil reserves at 59%. Natural gas makes up approximately 38% of reserves, split between producing and undeveloped. This makes sense as the Permian is the main focus of the Trust, with Haynesville adding a bit of upside in terms of reserves with potential that have yet to begin producing. [caption id="attachment_25757" align="aligncenter" width="500"]Source: Permianville Royalty Trust 10-K[/caption] Operators and CustomersAs noted earlier, Permianville Royalty Trust is operated predominantly by operators other than COERT. Only 17 of 3,748 gross wells (0.5%) are operated by the Sponsor, and these wells are in the East Texas/North Louisiana region. Other operators include Aethon Energy Operating, BHP Billiton, EXCO Resources, and Indigo Resources. The primary operators in the Permian Basin are Apache Corporation, XTO Energy, and Occidental Petroleum. Most drilling activity for the underlying properties in 2018 was focused on the Permian Basin with six gross (0.5 net) wells drilled in 2018. In 2017, roles were reversed as six gross (0.5 net) wells were drilled in the Haynesville Shale. While capex budgets are determined by each individual operator and subject to change (as we saw many operators do in 2018) the Sponsor anticipates capex for 2019 to range between $5 million to $7 million prior to consideration of the 80% NPI.The top purchasers of the oil and gas produced from the underlying properties are displayed in the chart below. The realized prices are also included. Notably, the realized price on natural gas increased in 2018 despite declines on the NYMEX, likely because most of the gas harvested is near the Henry Hub.[caption id="attachment_25758" align="aligncenter" width="500"]Source: Permianville Royalty Trust 10-K*Applicable NPI Period per 10-K[/caption] Termination of the TrustA traditional royalty interest typically continues into perpetuity. In contrast, many public royalty trusts have a set termination based on a specific date and/or production level. Permianville Royalty Trust differentiates itself as it is not subject to any pre-set termination provision such as time or production. The Trust will dissolve upon the earliest of the following:The Trust sells the NPI (subject to approval from at least 75% of unitholders);The annual cash proceeds received by the Trust attributable to the NPI are less than $2 million for two consecutive years;75% of unitholders vote in favor of dissolution; orThe Trust is judicially dissolved. Upon dissolution, the trustee would then sell all of the Trust’s assets and distribute the net proceeds of the sale to the trust unitholders. Net profits allocable to NPI have been $15.2 million, $7.5 million, and $9.3 million in the past three years, mitigating concern the Trust would be dissolved in the near-term.Disposal of Interests Related to Permianville Royalty TrustNPI received by unitholders exclude the sale of underlying properties, but this does not prevent the sale of assets; however, unitholders will be compensated if a sale occurs. Without a vote of approval, the Trust is only able to release the net profits interest associated with a lease that accounts for up to 0.25% of total production for the past 12 months without consent of unitholders. The sale also cannot exceed a fair market value of $500,000, and both limits are common features of royalty trusts. COERT sold a couple of producing wells and corresponding acreage in Glasscock County for approximately $62 thousand in January 2019.With the large capital outlays required, companies must be conscious of their cost of capital, frequently increasing debt to fund new projects.To make a larger sale, approval originally required consent from 75% of unitholders. However, at a special meeting in August 2017, unitholders approved amendments to the Trust Agreement decreasing this figure to a simple 50% majority. The next month, the Trust under Enduro’s stewardship divested $49.1 million worth of its underlying properties. Net of transaction expenses, the 80% NPI, and an indemnity holdback, the Trust distributed nearly $38 million to unitholders, a special dividend amounting to about $1.15 per share. By comparison, the Trust has only distributed about 90 cents per share in regular monthly dividends over the past three years. As expected, shares of the Trust spiked upon announcement of the special dividend, then decreased by approximately the amount of the dividend once paid a month later.Divestitures are much more common in the oil and gas industry than the general market as companies seek to develop expertise in core regions. With the large capital outlays required, companies must be conscious of their cost of capital, frequently increasing debt to fund new projects. The need to service this debt sometimes causes E&P companies to divest certain holdings. This is why industry participants frequently refer to transactions as A&D (acquisitions and divestitures) as opposed to M&A (mergers and acquisitions) in other industries.Such disposals, like the divestiture made by Permianville Royalty Trust, can have either positive or negative impacts on unit/shareholders. Ultimately, it depends on the sale price achieved. For royalty trusts, large divestitures lead to special dividends that represent an expedited yield. This could be a positive as such investments are typically seeking a return of their capital with declining distributions. According to the principles of time value of money, it is better to receive cash sooner rather than later. However, such divestitures could lead to different tax treatment and alter the expected return profile for investors. Also, if prices or production turn out to be higher than expected, the upfront sale can have a negative impact in the long-run. This is particularly interesting for Permianville Royalty Trust as it does not have a defined termination date.ConclusionThe performance of Permianville Royalty Trust has varied over the past two years, as it divested assets, changed its name and sponsor, and experienced commodity price volatility. Those who initially sold their units after Enduro filed for bankruptcy may wish they had held on longer. This is certainly true for people who couldn’t wait for oil prices to rebound following the crash in 2014 and likely anyone who sold prior to the announcement of the special dividend in 2017. After the Q4 dip in prices, the Trust also announced its largest monthly dividend since July 2014 concurrent with its 2018 10-K filing, boosting share price further.[caption id="attachment_25763" align="alignnone" width="940"]Source: Capital IQ [/caption] When investing in a public royalty trust or using it as a pricing benchmark for private royalty interests, there are many items to consider that are unique to each royalty trust. The source of income, region, operator, sponsor, termination (or lack thereof), and other key aspects make each trust unique. We have assisted many clients with various valuation and cash flow questions regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.

Buy-Sell Agreements for Investment Management Firms

An Ounce of Prevention is Worth a Pound of Cure

Due to the historical popularity of this post, we revisit it this week. Originally published in 2016, the purpose of this post is to equip ownership to understand the consequences of their buy-sell agreements before a controversy arises, and to make informed decisions about the drafting or re-drafting of the agreement to promote the financial health and sustainability of their firm.The classic car world is full of stories of “barn finds” – valuable cars that were forgotten in storage for decades, found and restored and sold for mint. Similar to the one pictured above, a Ferrari 250 GT SWB California Spyder once owned by a French actor and found in a barn on a French farm in 2014. The car was one of 36 ever made and one of the most valuable Ferraris in existence. Once the Ferrari was exhumed, it was lightly cleaned and sold, basically as found, for $23 million at auction. As difficult it is to imagine such a valuable car being forgotten, what we see more commonly are forgotten buy-sell agreements, collecting dust in desk drawers. Unfortunately, these contracts often turn into liabilities, instead of assets, once they are exhumed, as the words on the page frequently commit the signatories to obligations long forgotten. So we encourage our clients to review their buy-sell agreements regularly, and have compiled some of our observations about how to do so in the whitepaper below. You can also download it as a PDF at the bottom of this page. We hope this will be helpful to you; call us if you have any questions.IntroductionAlmost every conversation we have with a new RIA client starts something like this: “We hired you because you do lots of work with asset managers, but as you get into this project you need to understand that our firm is very different from others.” Our experience, so far, confirms this sentiment of uniqueness that is not at all unique among investment managers. Although there are twelve thousand or so separate Registered Investment Advisors in the U.S. (not to mention several hundred independent trust companies and a couple thousand bank trust departments), there seems to be a comparable number of business models. Every client who calls us, though, has the same issue on their plate: ownership.Ownership can be the single biggest distraction for a professional services firm, and it seems like the RIA community feels this issue more than most. After all, most asset managers are closely held (so the value of the firm is not set by the market). Most asset managers are owned by unrelated parties, whereas most closely held businesses are owned by members of the same family. A greater than normal proportion of asset management firms are very valuable, such that there is more at stake in ownership than most closely held businesses. Consequently, when disputes arise over the value of ownership in an asset management firm, there is usually more than enough cash flow to fund the animosity, and what might be a five-figure settlement in some industries is a seven-figure trial for an RIA.Avoiding expensive litigation is one reason to focus on your buy-sell agreement, but for most firms the more compelling reasons revolve around transitioning ownership to perpetuate the firm. Institutional clients increasingly seem to query about business continuity planning, and the SEC has of course recently proposed transition planning guidelines. There are plenty of good business reasons to have a robust buy-sell agreement in any closely held company, but in RIAs there are client and regulatory reasons as well.SEC Proposed RuleEvery SEC-registered investment adviser must adopt and implement a written business continuity and transition plan that reasonably addressed operational risks related to a significant disruption or transition in the adviser's business.Business Continuity PlanningTransition PlanningMaintenance of critical operations/systems, as well as protection, backup and recovery of dataPolicies and procedures to safeguard, transfer, and/or distribute client assets during a transitionAlternate physical office locationsPolicies and procedures to facilitate prompt generation of client specific information necessary to transition each accountCommunication plans for clients, employees, vendors and regulatorsInformation regarding the corporate governance structure of the adviserIdentification and assessment of third-party services critical to the operationIdentification of any material financial resources available to the adviserKey Elements of the SEC’s Proposal: “Adviser Business Continuity and Transition Plans,” 206 (4)-4Buy-Sell Agreement BasicsSimply put, a buy-sell agreement establishes the manner in which shares of a private company transact under particular scenarios. Ideally, it defines the conditions under which it operates, describes the mechanism whereby the shares to be transacted are priced, addresses the funding of the transaction, and satisfies all applicable laws and/or regulations.These agreements aren’t necessarily static. In investment management firms, buy-sell agreements may evolve over time with changes in the scale of the business and breadth of ownership. When firms are new and more “practice” than “business,” these agreements may serve more to decide who gets what if the partners decide to go separate ways. As the business becomes more institutionalized, and thus more valuable, a buy-sell agreement – properly rendered – is a key document to protect the shareholders and the business (not to mention the firm’s clients) in the event of an ownership dispute or other unexpected change in ownership. Ideally, the agreement also serves to provide for more orderly ownership succession, not to mention a degree of certainty for owners that allow them to focus on serving clients and running the business instead of worrying about who gets what benefit of ownership.The irony of buy-sell agreements is that they are usually drafted and signed when all of the shareholders think similarly about their firm, the value of their interest, and how they would treat each other at the point they transact their stock. The agreement is drafted, signed, filed, and forgotten. Then, an event occurs that invokes the buy-sell, and the document is pulled from the drawer and read carefully. Every word is parsed, and every term scrutinized, because now there are not simply co-owners with aligned interests – but rather buyers and sellers with symmetrically opposed interests.Our Advice: Key Considerations for Your Buy-Sell AgreementAt Mercer Capital we have read hundreds, if not thousands, of buy-sell agreements. While we are not attorneys and do not attempt to draft such agreements, our experience has led us to a few conclusions about what works well and what doesn’t. By “working well,” we mean an enduring agreement that efficiently manages ownership transactions and transitions in a variety of circumstances. Agreements that don’t work well become the subject of major disputes – the consequence of which is a costly distraction.The primary weaknesses we see in buy-sell agreements relate to issues of valuation: what is to be valued, how, when, and by whom. The following issues and our corresponding advice are drawn from our experience of agreements that performed well and those that did not. While we haven’t seen everything, we have been more involved than most in helping craft agreements, maintaining compliance with valuation provisions, and resolving disagreements.1. Decide What You Mean By “Fair”A standard refrain from clients crafting a buy-sell agreement is that they “just want to be fair” to all of the parties in the agreement. That’s easier said than done, because fairness means different things to different people. The stakeholders in a buy-sell at an investment management firm typically include the founding partners, subsequent generations of ownership, the business itself, non-owner employees of the business, and the clients of the firm. Being “fair” to that many different parties is nearly impossible, considering the different motivations and perspectives of the parties.Founding owners. Aside from wanting the highest possible price for their shares, founding partners are usually desirous of having the flexibility to work as much or as little as they want to, for as many years as they so choose. These motivations may be in conflict with each other, as ramping down one’s workload into a state of partial retirement and preserving the founding generation’s imprint on the company requires a healthy business, which in turn necessarily requires consideration of the other stakeholders in the firm. We read one buy-sell agreement where the founder had secured his economic return by requiring the company, in the event of his death, to redeem his shares at a value that did not consider the economic impact of his death (the founder was a significant rainmaker). One can only imagine, at the founder’s death, how that would go when the other partners and employees of the firm “negotiated” with the estate – as if a piece of paper could checkmate everything else in a business where the assets of the firm get on the elevator and go home every night.Subsequent generation owners. The economics of a successful RIA can set up a scenario where buying into the firm can be very expensive, and new partners naturally want to buy as cheaply as possible. Eventually, however, there is symmetry of economic interests for all shareholders, and buyers will eventually become sellers. Untimely events can cause younger partners to need to sell their stock, and they don’t want to be in a position of having to give it up too cheaply. Younger partners also tend to underestimate the cost of building their own firm instead of buying into the existing one; other times, they don’t.The firm itself. The company is at the hub of all the different stakeholder interests, and is best served if ownership is a minimal consideration in how the business is run. Since hand-wringing over ownership rarely generates revenue, having a functional shareholder’s agreement that reasonably provides for the interests of all stakeholders is the best case scenario for the firm. If firm leadership understands how ownership is going to be handled now and in the future, they can be free to do their jobs and maximize the performance of the company. At the other end of the spectrum, buy-sell disputes are very costly to the organization, distracting the senior-most staff from matters of strategy and client service for years, and rarely ending with a resolution that compensates for lost business opportunities which may never even be identified.Non-owner employees. Not everyone in an investment management firm qualifies for ownership or even wants it, but all RIAs are economic eco-systems in which all employees depend on the presence of a stable and predictable ownership.Clients. It is no surprise that the SEC made ownership continuity planning part of its recent proposed regulations for RIAs. The SEC may not care, per se, who gets the benefits of ownership of an investment management firm, but they know that the investing public is best served by asset managers who have provided for the continuity of investment management in the event of changes in the partner base. Institutional clients are often very interested in continuity plans, so it is to the benefit of RIAs to have fully functioning ownership models with buy-sell agreements that provide for the long-term health of the business. As the profession ages, we see transition planning as either a competitive advantage (if done well) or a competitive disadvantage (if disregarded) – all the more reason to pay attention.The point of all this is to consider whether or not you want your buy-sell agreement to create winners and losers, and if so, be deliberate about defining who wins and who loses. Ultimately, economic interests which advantage one stakeholder will disadvantage some or all of the other stakeholders, dollar for dollar. If the pricing mechanism in the agreement favors a relatively higher valuation, then whoever sells first gets the biggest benefit of that, to the expense of the other partners and anyone buying into the firm. If pricing is too high, internal buyers may not be available and the firm may need to be sold (truly the valuation’s day of reckoning) to perfect the agreement. At relatively low valuations, internal transition is easier and business continuity is more certain, but the founding generation of ownership may be perversely encouraged to not bring in new partners, stay past their optimal retirement age, or push more cash flow into compensation instead of shareholder returns as the importance of ownership is diminished. Recognizing and ranking the needs of the various stakeholders in an RIA is always a balancing act, but one which is probably best done intentionally.Buy-Sell Agreements and Contract TheoryThe 2016 Nobel Prize in Economics was awarded to Professors Oliver Hart (Harvard) and Bengt Holmstrom (MIT) for their work in developing contract theory as a foundational tool of economics. The notion of contract theory organizes participants in an economy into principals (owners) and agents (employees), although the principal/agent relationship can be applied to many economic exchanges.Agents act on behalf of principals, but those actions are at least partially unobserved, so contracts must exist to incentivize and punish behavior, as appropriate, such that principals can be reasonably assured of getting the benefit of compensation paid to agents. The optimal contract to accomplish this weighs risks against incentives. The problem with contracts is that all of them are incomplete, in that they can’t specify every eventuality. As a consequence, parties have to be designated to make decisions in certain circumstances on behalf of others.Contract theory has application to the design of buy-sell agreements in the ordering of priority of stakeholders in the enterprise. If the designated principal of the enterprise is the founding generation, then the buy-sell agreement will be written to protect the rights of the founders and secure their ability to liquefy their interest on the best terms and pricing. Redemption from a founder’s estate at a premium value would be an example of this type of contract.If, on the other hand, the business is the designated principal of the enterprise, and all the shareholders are treated as agents, then the buy-sell agreement might create mechanisms to ensure the long-term profitability of the investment management firm, rewarding behaviors that grow the profits of the business (with greater ownership percentages or distributions or performance bonuses) and punish agent actions that do not enhance profitability.If the clients of the firm are the designated principals of a given RIA, then the buy-sell agreement might be fashioned to direct equity returns to agents (partners or non-owner employees) based on investment performance or client retention. An example of this would be carried interest payments in hedge funds and private equity.2. Don’t Value Your Stock Using Formula Prices, Rules of Thumb, or Internally Generated Valuation MetricsSince valuation is usually the most time consuming and expensive part of administering a buy-sell agreement, there is substantial incentive to try to shortcut that part of the process. Twenty years ago, a client told us “asset management firms are usually worth about 2% of AUM.” We’ve heard that maxim repeated many times, although not so much in recent years, as some firms have sold in noteworthy transactions for over twice that, while others haven’t been able to catch a bid for much less.We have written extensively about the fallacy of formula pricing. No multiple of AUM or revenue or cash flow can consistently estimate the value of an interest in an investment management firm. A multiple of AUM does not consider relative differences in stated or realized fee schedules, client demographics, trends in operating performance, current market conditions, compensation arrangements, profit margins, growth expectations, regulatory compliance issues, and a host of other issues which have helped keep our valuation practice gainfully employed for decades.Imagine an RIA with $1.0 billion under management. The old 2% of AUM rule would value it at $20.0 million. Why might that be? In the (good old) days, when RIAs typically garnered fees on the order of 100 basis points to manage equities, that $1.0 billion would generate $20 million in revenue. After staff costs, office space, research charges and other expenses of doing business, such a manager might generate a 25% EBITDA margin (close to distributable cash flow in a manager organized as an S-corporation), or $2.5 million per year. If firms were transacting at a multiple of 8 times EBITDA, the value of the firm would be $20.0 million, or 2% of AUM.Today, things might fall more into the extremes of firms A and B, depicted in the chart below. Assume firm A is a small cap domestic equity manager earning 65 basis points on average from a mix of high net worth and institutional clients. Because a shop like that can earn a relatively high EBITDA margin of 40% or so, a $20 million valuation is a little less than 8x, which in some circumstances might be reasonable.Firm B, on the other hand, manages a range of fixed income instruments for large pension funds who are expert at negotiating fees. Their 30 basis point realized fee average doesn’t leave much to cover the firm’s overhead, even though it’s fairly modest because of the nature of the work. The 15% EBITDA margin yields less than a half million dollars in cash flow, which against the rule of thumb valuation metric, implies a ridiculous multiple. The real problem with short cutting the valuation process is credibility. If the parties to a shareholders agreement think the pricing mechanism in the agreement isn’t robust, then the ownership model at the firm is flawed. Flawed ownership models eventually disrupt operations, which works to the disservice of owners, employees, and clients.3. Clearly Define The “Standard” of Value Effective for Your Buy-Sell AgreementThe standard of value essentially imagines and abstracts the circumstances giving rise to a particular transaction. It is intended to control for the identity of the buyer and the seller, the motivation and reasoning of the transaction, and the manner in which the transaction is executed.Portfolio managers have a particular standard of value perspective, even though they don’t always think of it that way. The trading price for a given equity represents market value, and some PMs would make buying or selling decisions based on the relationship between market value and intrinsic value, which is what they think the security is worth based on their own valuation model. Investment analysts inside an RIA think of the value of their firm in terms of intrinsic value, which depending on their unique perspective could be very high or very low. CEOs, in our experience, think of the value of their investment management firm in terms of what they could sell it for in a strategic, change of control transaction with a motivated buyer – probably because those are the kinds of multiples that investment bankers quote when they meet with them.None of these standards of value are particularly applicable to buy-sell agreements, even though technically they could be. Instead, valuation professionals such as our group look at the value of a given company or interest in a company according to standards of value such as fair market value or fair value. In our world, the most common standard of value is fair market value, which applies to virtually all federal and estate tax valuation matters, including charitable gifts, estate tax issues, ad valorem taxes, and other tax-related issues. It is also commonly applied in bankruptcy matters.Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60. It is defined in the International Glossary of Business Valuation Terms as:The benefit of a fair market value standard is familiarity in the appraisal community and the court system. It is arguably the most widely adopted standard of value, and for a myriad of buy-sell transaction scenarios, the perspective of disinterested parties engaging in an exchange of cash and securities for rational financial reasons fairly considers the interests of everyone involved.The standard known as “fair value” can be considerably more opaque, having two different origins and potentially very different applications. In dissenting shareholder matters, fair value is a statutory standard that varies depending on legal jurisdiction. In many states, fair value protects minority shareholders from oppressive actions by providing them with the right to payment at a value equivalent to that which would be received in the sale of the company. A few states are not so generous as to providing aggrieved parties with undiscounted value for their shares, but the trend favors not disadvantaging minority owners in certain transactions just because a majority owner wants to remove them from ownership. The difficulty of statutory fair value, in our experience, is the dispute over the meaning of state statutes and the court’s interpretations of state statutes. Sometimes the standard is as clearly defined as fair market value, but sometimes less so.If a shareholders agreement names the standard of “Fair Value,” does it mean statutory fair value, GAAP fair value, or does it really mean fair market value? It pays to be clear.The standard of value is critical to defining the parameters of a valuation, and we suggest buy-sell agreements should name the standard and cite specifically which definition is applicable. The downsides of not doing so can be reasonably severe. For most buy-sell agreements, we recommend one of the more common definitions of fair market value. The advantage of naming fair market value as the standard of value is that doing so invokes a lengthy history of court interpretation and professional discussion on the implications of the standard, which makes application to a given buy-sell scenario more clear.Which Fair Value?Making matters more complex, fair value is also a standard under Generally Accepted Accounting Principles, as defined in ASC 820. When GAAP fair value was originally established, members of the Financial Accounting Standards Board, which is responsible for issuing accounting guidance, suggested that they wanted to use a standard similar to fair market value but didn’t want their standard to be governed and maintained by non-related institutions such as the U.S. Tax Court.GAAP fair value is similar to fair market value, but not entirely the same. As GAAP fair value has evolved, it has become more of an “exit value” standard, suggesting the price that someone would pay for an asset (or accept to transfer a liability) instead of a bargain reached through consideration of the interests of both buyers and sellers.The exit value perspective is useful from an accounting perspective because it obviates financial statement preparers’ tendency to avoid write-downs in distressed markets because they “wouldn’t sell it for that.” In a shareholder dispute, however, the transaction is going to happen, so the bid/ask spread has to be bridged by valuation regardless of the particular desires of the parties.4. Avoid Costly Disagreement as to “Level of Value”Just as the interests and motivations of particular buyers and sellers can affect transaction values, the interest itself being transacted can carry more or less value, and thus the “level of value," as it has come to be known, should be specified in a buy-sell agreement.A minority position in a public company with active trading typically transacts as a pro rata participant in the cash flows of the enterprise because the present value of those cash flows is readily accessible via an organized exchange. Portfolio managers usually think of value in this context, until one of their positions becomes subject to acquisition in a takeover by a strategic buyer. In a change of control transaction, there is often a cash flow enhancement to the buyer and/or seller via combination, such that the buyer can offer more value to the shareholders of the target company than the market grants on a stand-alone basis. The difference between the publicly traded price of the independent company, and value achieved in a strategic acquisition, is commonly referred to as a control premium.Closely held securities, like common stock interests in RIAs, don’t have active markets trading their stocks, so a given interest might be worth less than a pro rata portion of the overall enterprise. In the appraisal world, we would express that difference as a discount for lack of marketability. Sellers will, of course, want to be bought out pursuant to a buy-sell agreement at their pro rata enterprise value. Buyers might want to purchase at a discount (until they consider the level of value at which they will ultimately be bought out). In any event, the buy-sell agreement should consider the economic implications to the RIA and specify what level of value is appropriate for the buy-sell agreement. Fairness is a consideration here, as is the sustainability of the firm. If a transaction occurs at a premium or a discount to pro rata enterprise value, there will be “winners” and “losers” in the transaction. This may be appropriate in some circumstances, but in most RIAs, the owners joined together at arm’s length to create and operate the enterprise and want to be paid based on their pro rata ownership in that enterprise. That works well for the founders’ generation, but often the transition to a younger and less economically secure group of employees is difficult at a full enterprise level valuation. Further, younger employees may not be able to get comfortable with buying a minority interest in a closely held business at a valuation that approaches change of control pricing. Ultimately, there is often a bid/ask spread between generations of ownership that has to be bridged in the buy-sell agreement, but how best to do it is situation specific. Whatever the case, the shareholder agreement needs to be very specific as to level of value. We even recommend inserting a level of value chart, like the one you see above, and drawing an arrow as to which is specified in the agreement.One thing to avoid in buy-sell agreements is embedded pricing mechanisms that unintentionally incentivize the behavior of some partners to try to “win” at the expense of the other partners. We were involved in one matter where a disputed buy-sell agreement could be read to enable other partners to force out a minority partner and redeem their interest at a deeply discounted value.Economically, to the extent that a minority shareholder is involuntarily redeemed at a discounted value, the amount of that discount (or decrement to pro rata enterprise value) is arithmetically redistributed among the remaining shareholders. Generally speaking, courts and applicable corporate statutes do not permit this approach in statutory fair value matters because it would provide an economic incentive for shareholder oppression.By way of example, assume a business is worth (has an enterprise value of) $100, and there are two shareholders, Sam and Dave. Dave owns 60% of the business, and Sam owns 40% of the business. As such, Dave’s pro rata interest is worth $60 and Sam’s pro rata interest would be valued at $40. If the 60% shareholder, Dave, is able to force out Sam at a discounted value (of, say, $25 – or a $15 discount to pro rata enterprise value), and finances this action with debt, what remains is an enterprise worth $75 (net of debt). Dave’s 60% interest is now 100%, and his interest in the enterprise is now worth $75 ($100 total enterprise value net of debt of $25). The $15 decrement to value suffered by Sam is a benefit to Dave. This example illustrates why fair value statutes and case law attempt to limit or prohibit shareholders and shareholder groups from enriching themselves at the expense of their fellow investors. Does the pricing mechanism create winners and losers? Should value be exchanged based on an enterprise valuation that considers buyer-seller specific synergies, or not? Should the pricing mechanism be based on a value that considers valuation discounts for lack of control or impaired marketability? Exiting shareholders want to be paid more and continuing shareholders want to pay less, obviously. What’s not obvious at the time of drafting a buy-sell agreement is who will be exiting and who will be continuing. There may be a legitimate argument to having a pricing mechanism that discounts shares redeemed from exiting shareholders, as this reduces the burden on the firm or remaining partners and thus promotes the continuity of the firm. If exit pricing is depressed to the point of being punitive, the other shareholders have a perverse incentive to artificially retain their ownership longer and force out other shareholders. As for buying out shareholders at a premium value, the only argument for “paying too much” is to provide a windfall for former shareholders, which is even more difficult to defend operationally. Still, all buyers eventually become sellers, so the pricing mechanism has to be durable for the life of the firm.5. Don’t Forget to Specify the “As Of” Date for ValuationThis seems obvious, but the particular date appropriate for the valuation matters. We had one client (not an RIA) spend a quarter million dollars on hearings debating this matter alone. The appropriate date might be the triggering event, such as the death of a shareholder, but there are many considerations that go into this.If the buy-sell agreement specifies that value be established on an annual basis (something we highly recommend to manage expectations and avoid confusion), then the date might be the calendar year end. The benefit of an annual valuation is the opportunity to manage expectations, such that everyone in the ownership group is prepared for how the valuation is performed and what the likely outcome is given various levels of company performance and market pricing. Annual valuations do require some commitment of time and expense, of course, but these annual commitments to test the buy-sell agreement usually pale in comparison to the time and expense required to resolve one major buy-sell disagreement.If, instead of having annual valuations performed, you opt for an event-based trigger mechanism in your buy-sell, there is a little more to think about. Consider whether you want the event precipitating the transaction to factor into the value. If so, prescribe that the valuation date is some period of time after the event giving rise to the subject transaction. This can be helpful if a key shareholder passes away or leaves the firm and there is concern about losing clients as a result of the departure. After an adequate amount of time, it becomes apparent as to the impact on firm cash flows of the triggering event. If, instead, there is a desire to not consider the impact of a particular event on valuation, make the as-of date the day prior to the event, as is common in statutory fair value matters.6. Appraiser Qualifications: Who’s Going to Be Doing the Valuation?Obviously, you don’t want just anybody being brought in to value your company. If you are having an annual appraisal done, then you have plenty of time to vet and think about who you want to do the work. In the appraisal community, we tend to think of “valuation experts” and “industry experts.”Valuation experts are known for:Appropriate professional training and designationsUnderstanding of valuation standards and conceptsPerspective on the market as consisting of hypothetical buyers and sellers (fair market value mindset)Experienced in valuing minority interests in closely held businessesAdvising on issues for closely held businesses like buy-sell agreementsExperienced in explaining work in litigated mattersIndustry experts, by contrast, are known for:Depth of particular industry knowledgeUnderstanding of key industry concepts and terminologyPerspective on the market as typical buyers and sellers of interests in RIAsTransactions experienceRegularly providing specialized advisory services to the industryIn all candor, there are pros and cons to each “type” of expert. We worked as the third appraiser on a disputed RIA valuation many years ago in which one party had a valuation expert and the other had an industry expert. The resulting rancor bordered on the absurd. The company had hired a reasonably well-known valuation expert who wasn’t particularly experienced in valuations of investment management firms. That appraiser prepared a valuation standards-compliant report that valued the RIA much like one would value a dental practice, and came up with a very low appraised value (his client was delighted). The departing shareholder hired an also well-known investment banker who arranges transactions in the asset management community. The investment banker looked at a lot of transactions data and valued the RIA as if it were a department at Blackrock. Needless to say, that indicated value was many, many times higher than the company’s appraiser. We were brought in to make sense of it all. Vetting a valuation expert for appropriate credentials and experience should focus on professional standards and practical experience.Professional Requirements. The two primary credentialing bodies for business valuation are the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA). The former awards the Accredited Senior Appraiser designation, or ASA, and the latter the Accredited in Business Valuation, or ABV, designation. Without getting lost in the weeds, both are substantial organizations that require extensive education and testing to be credentialed, and both require continuing education. Also well known in the securities industry is the Chartered Financial Analyst charter issued by the CFA Institute, and while it is not directly focused on valuation, it is a rigorous program in securities analysis. CFA Institute offers, but does not require, continuing education.Practical Requirements. Experience also matters, though, in an industry as idiosyncratic as investment management. Your buy-sell agreement should specify an appraiser who regularly values non-depository financial institutions such that they understand the dynamic differences between, say, an independent trust company and a venture capital manager. While there are almost 12,000 RIAs in the U.S., the variety of business models is such that you will want a valuation professional who understands and appreciates the economic nuances of your firm.In any event, your buy-sell agreement should specify minimum appraisal qualifications for the individual or firm to be preparing the analysis, but also specify that the appraiser should have experience and sufficient industry knowledge to appropriately consider the key investment characteristics of RIAs. Ultimately, you need a reasonable appraisal work product that will withstand potential judicial scrutiny, but you should not have to explain the basics of your business model in the process.7. Manage Expectations by Testing Your AgreementNo matter how well written your agreement is or how many factors you consider, no one really knows what will happen until you have your firm valued. If you are having a regular valuation prepared by a qualified expert, then you can manage everyone’s expectations such that, when a transaction situation presents itself, parties to the transaction have a reasonably good idea in advance of what to expect. Managing expectations is the first step to avoiding arguments, strategic disputes, failed partnerships, and litigation.If you don’t plan to have annual valuations prepared, have your company valued anyway. Doing so when nothing is at stake will make a huge difference if you get to a situation where everything is at stake. Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled. Going ahead and getting a valuation done will help to center, or reconcile, those expectations and might even lead to some productive revisions to your buy-sell agreement.Putting It All TogetherIf you have not yet crafted a buy-sell agreement for your RIA, you can see that there is much to consider. Most investment management firms have some shareholders agreement, but in many cases the agreements do not account for the many circumstances and issues briefly addressed in this whitepaper. That said, our advice is to first pull your buy-sell agreement out of the drawer and read it, carefully, and compare it to the commentary in this paper. If you don’t understand something, talk with your partners about what their expectations are and see if they line up with the agreement. Consider having a valuation firm review the agreement and tell you what they might see as issues or deficiencies in the agreement, and then have the firm appraised. If there is substantial difference of opinion in the partner base as to the value of the firm, or the function of the agreement, you know that you don’t actually have an agreement.On the positive side of the equation, a well-functioning agreement can serve the long-term continuity of ownership of your firm, which provides the best economic opportunity for you and your partners, your employees, and your clients. Strategically, it may well be the lowest hanging fruit available to enhance the value of your company, and your own career satisfaction.WHITEPAPERBuy-Sell Agreements for Investment Management FirmsView Whitepaper

Second Quarter 2019 | Segment Focus: Building Materials

Ongoing trade tensions and uncertainty have cast a cloud over future business investment. State and local governments have increased spending on much-needed infrastructure projects.

E&P Second Quarter 2019

Region Focus: Permian Basin

Region Focus: Permian Basin // WTI crude prices began and ended the second quarter around $60 per barrel, while natural gas prices continued to slide as the calendar turns to summer.

Transportation & Logistics Newsletter

Second Quarter 2019

O(i)l Faithful

Eagle Ford Region Overview

Nearly a quarter of the way through 2019, prices have rebounded somewhat after a tumultuous end to 2018. First quarter energy prices again moved in opposite directions, with crude prices increasing steadily over the period while natural gas prices decreased from $2.94 to $2.80 per Mcf by mid-March despite peaking at over $3.50 in mid-January.Location, Location, LocationBorrowing the mantra of many real estate agents, sometimes it’s all about location, location, location. This is quite clear for oil and gas plays, particularly when looking at the acreage multiples paid across various regions. Eagle Ford Shale has quietly delivered solid results, overshadowed by some of the other shale plays, particularly the Permian to the west. The Eagle Ford’s location provides a distinct advantage, however, as it is closer to higher Brent-related pricing seen on the Gulf Coast. Its higher cut of oil also opens it up to Louisiana Light Sweet pricing. Even though the attention on the Permian has increased both acreage multiples and congestion due to transportation issues, it has been less of a concern in the Eagle Ford because the product has a shorter distance to travel to get to market.While proximity to better pricing is clearly a boon, location within the region also plays a large role.While proximity to better pricing is clearly a boon, location within the region also plays a large role. The Eagle Ford has areas where the cost of supply is as low as $20 to $30 per barrel according to Greg Leveille, Chief Technology Officer of ConocoPhillips. EOG Resources, the largest operator in the region, has noted similar supply costs as well. According to Thomas Tunstall, senior researcher with UTSA’s Institute of Economic Development, “EOG has some of the choicest leases in the Eagle Ford. They have indicated publicly that they can make money at $30 per barrel.” This has a considerable impact particularly with WTI prices currently trading around double that figure.According to Bloomberg, breakeven prices tell a similar story. While the West Eagle Ford has the highest breakeven of these regions, the East Eagle Ford has the lowest. Though it can be difficult to isolate reasons for these differences, Bloomberg’s breakeven prices in the table below do seem to corroborate the assertion that location plays a role as the eastern portion of the Eagle Ford is closest to the Gulf Coast with the Brent and LLS pricing.Free Cash Flow vs Potential — Safe vs SexyAs we noted last week, operators in the Eagle Ford have enjoyed the reliable production inherent in a later life-stage play. Along with the pricing benefits noted above, companies that have operated in the region for a while have been able to benefit from experience. Todd Abbott, Marathon Oil’s VP of Resource Plays South, attributed the company’s success in the region to drilling innovation and efficiency and repeatability of a stable drilling program. He further noted, “We are completing wells in a quarter of the time it took us to complete them in 2012.” This notion was furthered by ConocoPhillips’ CTO Leveille who touted innovations in well-spacing and stacking have allowed the company to achieve a 20% field-level recovery factor in the Eagle Ford Shale. Technical innovations and experience have led to free cash flow for operators, which is something investors have been seeking. It also allows for diligence in capital spending, where investors have also begun to prioritize capital efficiency over capital expenditure. In fact, according to Marathon’s Abbott, the Eagle Ford has been able to effectively subsidize its efforts in regions such as the Permian and Oklahoma Stack as it is generating the free cash flow that the others are consuming. Still, the Eagle Ford lacks some of the luster of other plays.Valuation ImplicationsTo further understand the current production profile of the Eagle Ford and oil and gas plays in general, we can compare them to a typical company. In the early stages, companies retain earnings to fund growth opportunities as the return on investment can be quite high. As the company matures, however, there are fewer high return investments to be made, and companies tend to pay more dividends. Returns shift from capital appreciation from retained earnings to a yield in the form of dividends paid as a reward for years of investment. The Eagle Ford is in the stage of paying dividends.As has been the case for some time now, operators in the Permian continue to lead the other regions in terms of EV/production multiples, also known as price per flowing barrel. The Bakken was about on par with the Permian at the end of 2018, but it slid back towards the Eagle Ford, which edged up over the past three months. Multiples continue to trail levels seen in the past as enterprise values have been somewhat lower and production figures have increased.Rig Counts and ProductionAccording to calculations based on data from Baker Hughes, rig counts in North America decreased 4.2% in the last three months, but increased 3.6% over the last twelve months. Eagle Ford Shale had the highest annual increase at 15.5%, but its 82 rigs only represent 8.0% of total rigs in North America. Despite a 4.5% decline in the past three months, the Permian Basin continues to lead the way with 464 rigs, representing about 45% of the total. By comparison, the Eagle Ford has the second most rigs, just outpacing Appalachia at 79 and the Bakken with 56.Despite the increase in rig counts, production increases over the past year for both oil (14.4%) and gas (8.3%) have trailed production gains seen in other regions. This is likely due to the older nature of the play, and its stage in the production cycle. The lack of production growth does not mean there is low production, however. It continues to provide solid production, with crude oil production on par with the Bakken, and significantly above Appalachia, known for its natural gas. The Eagle Ford also leads the Bakken in terms of natural gas production. Much of the attention, particularly in Texas, has been on crude as opposed to natural gas. Despite this, the graph above shows natural gas production in the Permian has increased significantly in the past year. As noted earlier, the Eagle Ford’s location, specifically its proximity to the Henry Hub in Louisiana, may be a reason why the chasm between the amounts of natural gas produced in the two regions hasn’t increased further than it has. Much like crude, operators focused on natural gas in the Eagle Ford have benefitted from higher pricing as well as lower costs. According to Michael J. Wieland, President and CEO of Laredo Energy VI LP, the economics of dry gas in the Eagle Ford are particularly strong. Wieland further estimated finding and development costs at 50 cents per thousand cubic feet (Mcf) and netbacks of about $2/Mcf. SilverBow Resources’ EVP and CFO, Gleeson Van Riet, said the company has drilled 20 of the top 50 Eagle Ford gas wells and that the play is the best place to be in the U.S. for natural gas because it has best prices, good infrastructure and is located in the demand growth area. SilverBow (formerly Swift Energy) is the Eagle Ford’s only public pure-play in dry gas. Whether an operator focuses on crude oil, natural gas, or both, neither seems to be in short supply in the region. End of an Era?While there is plenty of current production in addition to cash flow, there are concerns about the longevity of the region. Even regional giant EOG is looking to diversify. On a recent earnings call, EVP of Exploration & Production Ezra Yacob noted expanding exploration in those areas will “help increase the quality of our inventory” and “should hopefully shallow the decline that these unconventional plays are kind of known for.” The company still plans to drill about the same number of wells in the region in 2019, after posting a 9% crude oil production increase. The Eagle Ford represented 43% of EOG’s crude production last year, so diversifying to other regions doesn’t necessarily indicate a bearish view. Instead, it seems to be in line with the strategy alluded by Marathon, using the cash flow generated in the Eagle Ford to pay for growth in other plays.Despite the older nature of the play, many people around the industry believe there is plenty of value still under the subsurface in south Texas.Despite the older nature of the play, many people around the industry believe there is plenty of value still under the subsurface in south Texas. Director at BMO Capital Markets Max van Adrichem called the Eagle Ford a good alternative to “some of the more mature basins which may not have enough running room to get you through 5 to 10 years.” Martin Thalken, Chairman and CEO of pure-play Eagle Ford operator Protégé Energy III, supports this line of thinking. He commented the Eagle Ford “is still in the early innings” on applications like primary EOR and refracturing. John Thaeler, CEO of Vitruvian Exploration IV also employed a baseball analogy, saying “the dry gas Eagle Ford is just in the second inning.” Marathon’s Abbott agrees, “We believe there is a lot of running room left in the Eagle Ford for Marathon and the rest of the industry.”ConclusionCrude prices have rebounded since the turn of the year, while natural gas prices have remained steady. Pricing will always be dynamic in a global commodity environment, but the economics of certain plays tend to be less fluid. While it may not offer the potential of the Permian, the Eagle Ford is poised to leverage its experience and location to deliver solid returns.We have assisted many clients with various valuation needs in the upstream oil and gas space in both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

WHITEPAPER | How to Value a Wealth Management Firm

Because valuation is a relative concept (one asset is only “worth” something when compared to the worth of other assets), the value of a wealth management firm is very much about context. The particular transactional purpose of a valuation is a context. The firm being valued is a context. The state of the wealth management industry is a context. Each context provides a perspective on the expected returns of an investment in a wealth management firm.This whitepaper is intended to give a brief overview of relevant considerations of these perspectives on the value of wealth management firms. It is not intended to be an exhaustive presentation of every consideration, but as the industry has grown up, so has the understanding of most participants that simply saying firms are worth “2% of AUM” is not enough. As professional valuation practitioners, we always viewed such rules of thumb with disdain, and welcome the attitudes of those who take the financial analysis of their own firms as seriously as they do the analysis of the securities they manage for their clients.ContentsThe Anatomy of a Wealth Management FirmWhen You Need a ValuationWho Should Value Your Wealth Management Firm?How Your Appraiser Will “Scope” Valuing Your FirmValuation Methodology

M&A in the Eagle Ford Shale

Over the last twelve months, the Eagle Ford Shale region has experienced steady growth and healthy transaction activity.According to the Society of Petroleum Engineers, crude production from the south Texas play climbed steadily throughout the year and continued to achieve its highest marks ever. New, upstart independents came back to the region, including one led by the former head of Occidental Petroleum, as investors looked beyond the neighboring Permian Basin with its crowded top-tier acreage and pipelines. And operators began joining forces to increase the scale of their operations, headlined by Chesapeake Energy’s merger with Wildhorse Resource Development.The region’s strengths, such as its low cycle times, high oil cuts and Louisiana Light Sweet crude and Brent oil pricing, has facilitated free cash flow and made the area attractive to both investors and operators.As long as entry costs and well costs remain reasonable, the Eagle Ford Shale has strong potential for continued economic growth.Recent Transactions in the Eagle Ford RegionDetails of recent transactions in the Eagle Ford Shale, including some comparative valuation metrics are shown below.Chesapeake Closes Acquisition of WildHorse for Nearly $4 BillionChesapeake has made several major transactions over the last nine months. In the middle of 2018, the company sold its entire stake in the Utica Shale, and experts speculated that the company would put the sales proceeds towards an acquisition in the Eagle Ford or Powder Basin area.Following the deal, Chesapeake is now the top acreage holder in the Eagle Ford with approximately 655,000 nets acres, pro forma.Chesapeake closed a deal with Houston-based WildHorse Resource Development with a transaction value of $3.977 billion. The consideration for the transaction consisted of either 5.989 shares of Chesapeake common stock or a combination of 5.336 shares of Chesapeake common stock and $3 cash, in exchange for each share of WildHorse common stock. Chesapeake intended to finance the cash portion of the WildHorse acquisition, which was expected to be between $275 million and $400 million, through its revolving credit facility.In a statement, Chesapeake’s CEO, Doug Lawler said: “In 2018, Chesapeake Energy continued to build upon our track record of consistent business delivery and transformational progress through both financial and operating improvements. The addition of the WildHorse assets to our high-quality, diverse portfolio, combined with our operating expertise and experience, provides another oil growth engine with significant oil inventory for years to come and gives us tremendous flexibility and optionality to help achieve our strategic goals.”Following the deal, Chesapeake is now the top acreage holder in the Eagle Ford with approximately 655,000 nets acres, pro forma.Trends and OutlookInvestor Returns and Free Cash FlowOne of the most attractive features of the Eagle Ford region for the last year has been the returns. The Eagle Ford generates solid economics and cash flow, which operators use to fund exploration projects both nearby and elsewhere. Portions of the Eagle Ford generate some of the best economics in shale, and the region is forecasted to generate stable production into the 2020s.Coupled with the fact that the Eagle Ford is one of the lowest costing basins in the U.S., reliable production and capital efficiency in a mid-life stage play has been translating to free cash flow, something investors have been vocal about trying to obtain from the oil and gas industry as a whole for quite some time.Portions of the Eagle Ford generate some of the best economics in shale, and the region is forecasted to generate stable production into the 2020s.Todd Abbott, VP of Resource Plays South for Marathon Oil Corp., recently said at the DUG Eagle Ford conference in San Antonio that Marathon is seeing “fantastic” returns with reliable production, capital efficiency, and free cash flow.At the same conference, Stephen Chazen, chairman, president and CEO of Magnolia Oil & Gas, noted “General investors want reasonable growth, earnings per share, and free cash flow.” The recently formed small independent company generated free cash flow in excess of capital on acquisition spending and ended 2018 with $136 million of cash on the balance sheet, an increase of approximately $100 million compared to the end of the third quarter.These kinds of results show that the region has been a cash flow generator for the year and has been a main driver for most of the recent and anticipated transaction activity, especially companies under $1 billion in market capitalization.Anticipated Large Operator Divestitures in 2019In recent reports from Shale Experts, several larger operators in the Eagle Ford area are potential candidates for divestiture. Following Q4 2018 earnings calls, five operators have indicated that they are open to selling all or parts of their Eagle Ford assets in 2019. Collectively, the net acreage under consideration totals to over 100,000 net acres. Below are four of the company responses to Shale Experts’ questions regarding where Eagle Ford assets fit into their portfolios:Encana Corp. - After purchasing Newfield, Encana now considers the Eagle Ford as non-core.Pioneer Natural Resources - They have been actively selling pieces of their Eagle Ford asset since 2018.Matador Resources - Matador will outspend cash flow this year, and therefore an Eagle Ford asset sale might help plug that gap.Earthstone Energy - Earthstone is trying to convert itself into a Permian-only player. Reports from Shale Experts expect they will be looking to offload their Eagle Ford assets in the near-term. In addition to the reports above, Norway’s Equinor announced plans to explore the sale of its Eagle Ford assets as well. Equinor has an ownership interest in the Eagle Ford Shale formation located in south Texas through a joint venture with Repsol. Through transactions in 2013 and 2015, Equinor obtained full operatorship in the joint venture and increased its working interest to 63%. The company’s net acreage position in Eagle Ford at the end of 2018 was approximately 71,000 net acres and production of 43,000 boe/d. In a recent interview, Al Cook, the company’s head of strategy, said that Equinor is looking to add to its large position in Appalachia in an attempt to chase natural gas-rich acreage. This move is consistent with trends we identified last quarter in our transaction analysis of the Marcellus-Utica region. Any divestiture of assets by these operators would pose an interesting opportunity, especially for aforementioned smaller operators to acquire acreage and capitalize on the cash flow generating ability of the region to facilitate growth and increase returns. We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

What Wealth Managers Need to Know About the Market Approach

The market approach is a general way of determining the value of a business which utilizes observed market multiples applied to the subject company’s performance metrics to determine an indication of value. The “market” in market approach can refer to either public or private markets, and in some cases the market for the subject company’s own stock if there have been prior arms’ length transactions. The idea behind the market approach is simple: similar assets should trade at similar multiples (the caveat being that determining what is similar is often not so simple). The market approach is often informative when determining the value of a wealth management firm.There are generally three methods that fall under the market approach.Guideline Public Company MethodGuideline Transaction MethodInternal Transaction Method All three methods under the market approach involve compiling multiples observed from either publicly traded guideline companies, comparable transactions in private companies, or prior transactions in the company’s own stock and applying the selected (and possibly adjusted) market multiples to the company’s performance measures.Multiple MultiplesThe most common multiples used when valuing wealth management firms are enterprise value (EV) to EBITDA1, EV to AUM, and EV to revenue multiples. The multiples used are generally categorized into “activity” multiples and “profitability” multiples. Activity multiples are multiples of AUM and revenue whereas profitability multiples are multiples of earnings metrics (e.g. EBITDA).Both profitability and activity multiples have their advantages and disadvantages.Both profitability and activity multiples have their advantages and disadvantages. Activity multiples can provide indications of value for a subject wealth management firm that are only a function of the chosen activity metric—typically AUM or revenue. Such an indication is not a function of the profitability of the firm, which can be an issue because the underlying profitability of a firm is the ultimate source of value, not revenue or AUM. The benefit of activity metrics is that they can be used without explicitly making normalizing adjustments to a wealth management firm’s profitability. The caveat, however, is that applying market-based AUM and revenue multiples to the subject wealth management firm’s activity metrics is essentially transposing the realized fee structures and EBITDA margins of the guideline companies onto the subject firm—an implicit assumption about normalized profitability and realized fees which may or may not be reasonable depending on the specific circumstances.Profitability multiples, on the other hand, explicitly take into account the subject firm’s profitability, which on its face is a good thing. Profitability metrics are not without their drawbacks, however. Differences in risk or growth characteristics will, all else equal, result in different EBITDA multiples. If the risk or growth prospects of the subject company differ from the guideline companies that informed the selected EBITDA multiple, then the appropriate multiple for the subject company will likely differ from the observed market multiple.Subject Company MeasureOnce a market-based profitability multiple is obtained that reflects the risk and growth prospects of the subject firm, the next question is often: which EBITDA (or other profitability metric) is the multiple applied to? Reported EBITDA?Management adjusted EBITDA?Analyst adjusted EBITDA? Wealth management firms frequently require significant income statement adjustments—the largest of which is typically related to normalizing compensation—and so the answer to the question of which EBITDA to apply the multiple to can have a significant impact on the indicated value.It’s often said that “value is earnings times a multiple.” While there is some truth to be had there, the simplicity of the statement belies the reality that the question of the appropriate multiple and the appropriate earnings is rarely straightforward, and buyers and sellers may have very different opinions on the answer.Guideline Public Company MethodThe guideline public company method is a method under the market approach that uses multiples obtained from publicly traded companies to inform the value of a subject company. For wealth managers, the universe of publicly traded firms is relatively small – there are only about two dozen such firms in the U.S.The chart below shows historical EV / LTM EBITDA multiples for publicly traded RIAs with less than $100 billion in AUM (the size range which most of our clients fall in). As can be seen, the public companies have generally traded in a band of 8-11x LTM EBITDA, although the pricing at the end of 2018 had fallen to a historically low multiple of just over 5 times, partly due to increased market volatility observed at year-end. When valuing small, privately held wealth management firms, the use of multiples from publicly traded companies—even the smallest of which is still quite large compared to most privately held RIAs—naturally brings up questions of comparability. How comparable is a wealth management firm with, say, $1-10 billion in AUM and a few dozen employees to BlackRock, which manages over $6 trillion? The answer is probably not very. The comparison of the small, privately held RIA to BlackRock is obviously extreme, but it illustrates the issues of comparability that are frequently present when using publicly traded companies to value privately held wealth management firms. In our experience, the issues of comparability between small, privately held companies and publicly traded companies are frequently driven by key person risk/lack of management depth, smaller scale, and less product and client diversification. These differences point towards greater risk for privately held RIAs versus the publicly traded companies, which, all else equal, suggests that the privately held RIAs should trade at a lower multiple to that observed in the public markets. The growth prospects for privately held RIAs can differ from publicly traded companies as well. Because small, privately-held RIAs tend to be focused on a single niche, the growth prospects tend to be more extreme, either positive or negative, compared to publicly traded guideline companies. A subject company’s singular niche may be growing quickly or shrinking, whereas the diversified product offerings of publicly traded companies are likely to have some segments that are growing and some that are shrinking, resulting in a moderated overall growth outlook. The growth prospects, of course, impact the multiple at which the subject company should trade. In some cases, we’ve seen RIAs much smaller than the guideline public companies transact at a premium to the then-prevailing observed public company multiples because of the RIA’s attractive growth prospects. More often, however, the higher risk of the privately held RIA dominates, and the justified multiple is lower than the guideline public company multiples. As a general rule, a smaller RIA means a smaller multiple. Despite the less than perfect comparability between publicly traded companies and most privately held RIAs, publicly traded companies provide a useful indication of investor sentiment for the asset class and thus should be given at least some consideration. However, due to differences in risk and growth characteristics, adjustments to the multiples observed in the guideline companies may need to be made. Guideline Transactions MethodGuideline transactions of private companies in the wealth management space provide additional perspective on current market pricing of RIAs. The guideline transactions method uses these multiples to derive an indication of value for a subject firm.The transaction data is appealing because the issues of comparability are generally less pronounced than with the guideline public companies. There are caveats to the guideline transactions method, however. One unique consideration for the use of the guideline transactions method in the wealth management industry is that deals in the industry almost always include some form of (often substantial) contingent consideration (earn-out). The structure of such contingent consideration will be tailored to each deal based on the specific concerns and negotiations of the buyers and sellers. In any event, the details of the earn-out payments are often not publicly available. The lack of available information on deal terms can make it difficult to determine the actual value of the consideration paid, which translates into uncertainty in the guideline transaction multiples.The lack of available information on deal terms can make it difficult to determine the actual value of the consideration paid, which translates into uncertainty in the guideline transaction multiples.Another important consideration is that deals in the industry occur for unique reasons and often involve unique synergies. It’s not always reported what these are, and the specific factors that motivated a particular guideline transaction may not be relevant for the subject company. The type of buyer in a guideline transaction is another consideration. Private equity (financial buyers) will have different motivations and will be willing to pay a different multiple than strategic buyers.Despite an uptick in sector deal activity over the last several years, there are still relatively few reported transactions that have enough disclosed detail to provide useful guideline transactions multiples. Looking at older transactions increases sample size, but it also adds transactions that occurred under different market conditions, corporate tax environments, and the like. Stale transaction data may not be relevant in today’s market.Internal Transaction MethodThe internal transactions method is a market approach that develops an indication of value based upon consideration of actual transactions in the stock of a subject company. Transactions are reviewed to determine if they have occurred at arms’ length, with a reasonable degree of frequency, and within a reasonable period of time relative to the valuation date. Inferences about current value can sometimes be drawn, even if there is only a limited market for the shares and relatively few transactions occur.However, even arms’ length transactions in the subject company stock occur for unique reasons and often involve unique synergies which means even these implied multiples are not always a clear indicator of value.Rules of Thumb: Where They Come From and Why They (Sometimes) Make No SenseObserved market multiples are often condensed into “rules of thumb,” or general principals about what an investment firm is or should be worth. These rules provide a simple, back-of-the-envelope way of quickly computing an indicated value of a wealth management firm. However, rules of thumb are not one-size-fits-all. Consider the example below, which shows a “2% of AUM” rule of thumb applied to two firms, A and B: Both Firm A and Firm B have the same AUM. However, Firm A has a higher realized fee than Firm B (100 bps vs 40 bps) and also operates more efficiently (25% EBITDA margin vs 10% EBITDA margin). The result is that Firm A generates $2.5 million in EBITDA versus Firm B’s $400 thousand despite both firms having the same AUM. The “2% of AUM” rule of thumb implies an EBITDA multiple of 8.0x for Firm A—a multiple that may or may not be reasonable for Firm A given current market conditions and Firm A’s risk and growth profile, but which is nevertheless within the historical range of what might be considered reasonable. The same “2% of AUM” rule of thumb applied to Firm B implies an EBITDA multiple of 50.0x—a multiple which is unlikely to be considered reasonable in any market conditions. We’ve seen rules of thumb like the one above appear in buy/sell agreements and operating agreements as methods for determining the price for future transactions among shareholders or between shareholders and the company. The issue, of course, is that rules of thumb—even if they made perfect sense at the time the document was drafted—do not have a long shelf life. A lot can change that can make a once sensible rule of thumb seem outlandish due to changes at the firm itself or in the broader market for wealth management firms. Reconciliation of ValueThe market approach provides useful information about the current market conditions and investor sentiment for wealth management firms, but the method also has limitations and important considerations that need to be made, many of which are specific to the wealth management industry. Any valuation is as of a specific date and should reflect the market and universe of alternative investments as of that valuation date—which ultimately is what market approach indications of value are informed by. On the other hand, the fundamentals of a subject company may suggest a valuation that differs from market-based indications. Whatever the concluded value—it should make sense in light of both the current market conditions and indications of value developed under the income approach.1 Wealth management firms tend to have little “DA”, so EBITDA is typically approximately equal to EBIT and operating income.

What Wealth Managers Need to Know About the Income Approach

There are three general approaches to determining the value of a business: the asset-based approach, the income approach, and the market approach. The three approaches refer to different bases upon which value may be measured, each of which may be relevant to determining the final value. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) based on those most indicative of value for the subject interest. The chart below summarizes the methods typically used to value wealth management firms under each valuation approach. This week, we take a look at how the income approach is used to value wealth management firms. What is the Income Approach?The income approach is a general way of determining the value of a business by converting anticipated economic benefits into a present single amount. Simply put, the value of a business is directly related to the present value of all future cash flows that the business is reasonably expected to produce. The income approach requires estimates of future cash flows and an appropriate discount rate with which to determine the present value of future cash flows.Methods under the income approach are varied but typically fall into one of two categories:Single period capitalization of free cash flowDiscounted future cash flow model (DCF)Single Period Capitalization ModelThe simplest method used under the income approach is a single period capitalization model. Ultimately, this method is an algebraic simplification of its more detailed DCF counterpart. As opposed to a detailed projection of future cash flow, a base level of annual net cash flow and a sustainable growth rate are determined. The denominator of the expression on the right (r – g) is referred to as the “capitalization rate,” and its reciprocal is the familiar “multiple” that is applicable to next year’s cash flow. The multiple (and thus the firm’s value) is negatively correlated to risk and positively correlated to expected growth. There are two primary methods for determining an appropriate capitalization rate—a public guideline company analysis or a “build-up” analysis. The most familiar method applies the P/E ratio from a guideline public company analysis. A build-up analysis can be based upon the Capital Asset Pricing Model (CAPM) or Adjusted CAPM (ACAPM). Both the P/E ratio and the built-up capitalization factor articulate the risk and growth factors that investors believe underlie earnings measures. Discounted Cash Flow ModelWealth management firms are frequently valued using the DCF method because this method allows for detailed modeling of revenue and expense items over the discrete projection period. A discrete projection period of three to five years is typically employed so that AUM trends, fee levels, and operating expenses can be modeled with reasonable certainty based on the current trends and business model. Beyond the discrete projection period, it is assumed that the business will grow at a constant rate into perpetuity. In circumstances where no changes in the business model or capital structure are expected, a single period capitalization method may suffice.The discounted cash flow methodology requires three basic elements:Forecast of expected future cash flowsDetermination of terminal valueSelection of an appropriate discount rateDCF Element #1: Forecast of Expected Future Cash FlowsA DCF model requires a base level of cash flows to use as a starting point to model future growth and profitability.The base rate of profitability is determined by a wealth manager’s current revenue and cost structure, with possible adjustments made. It is often said that wealth managers generate revenue while they sleep, as revenue is a function of assets under management and is typically not performance or commission based. The fee-based revenue model used by most wealth management firms allows us to determine an ongoing (run rate) level of revenue by multiplying assets under management at any given day by the business’ average realized fee structure.The base rate of expenses for wealth management firms is typically based on reported expenses over the most recent annual period, with adjustments made for various items (the most significant of which typically relates to normalizing compensation).Projecting Cash Flow for Wealth ManagersWe typically view the discounted cash flow method as superior to the single period capitalization approach as it is more dynamic and allows for the discrete forecasting of cash flows. Projections of future cash flows rely on many assumptions as explained below.Assets Under Management Trends in AUM growth should include new business gained and expected market returns based on overall asset allocation. When determining growth in AUM, it is important to ask what has historically driven growth and if it is reasonable to assume that this trend will continue. For example, has a firm’s historical AUM growth been driven by market movement or by new client generation? Markets have good years and bad years, but strong client relationships (and the ability to generate new ones) result in a continual source of new assets to manage. As mentioned in a prior post, "Client assets (AUM) do correlate to a great extent with the market, but client relationships do not." Without proper relationship management, assets leave and revenue suffers.Markets have good years and bad years, but strong client relationships (and the ability to generate new ones) result in a continual source of new assets to manage.Further complicating new AUM generation, many wealth managers have aging customer bases and are struggling to attract younger clients who are more likely to choose passive alternatives. As managers struggle to gain new clients in light of the competitive environment, effective marketing has become increasingly important.Realized FeesProjected realized fees are typically evaluated in light of historical levels. However, fee compression has plagued the industry in recent years, and in light of increasing fee consciousness among clients, many wealth managers are cutting fees in order to stem outflows.CompensationWealth management is a relationship business, and relationships require the time and energy of a dedicated staff. The majority of a typical wealth management firm’s expenses are personnel expenses, which include salaries, bonuses, and other benefits for employees and owners. Compensation generally tracks revenue closely, making operating leverage more pronounced with non-compensation related expenses than compensation related expenses.Compensation programs tend to evolve in wealth management firms and over time take on a life of their own. Inevitably, compensation programs tend to be intertwined with business models and ownership. The valuation process typically includes an analysis of the compensation program to formulate a normalized margin that can be used to value the firm.The valuation process typically includes an analysis of the compensation program to formulate a normalized margin that can be used to value the firm.The compensation structure for owners is often affected by the tax environment. The corporate structure of a firm (C Corp vs S Corp or other pass-through entity), as well as the current federal and state tax environment, frequently determines whether firms pay out profit as bonuses or distributions. For example, in states with high corporate tax rates but no personal income tax, income is more likely to be paid out in the form of bonus compensation rather than distributions in order to reduce taxable income at the corporate level.Non-Compensation Operating ExpensesMarketing expenditures have increased as wealth managers seek to attract new, often younger, clients. We have seen an increased focus on branding as wealth managers seek to connect with clients on a more personal level. Additionally, spending on technology has increased as wealth managers update their platforms to increase transparency and cater to younger clients who prefer to manage their accounts online. This increased reliance on technology has allowed some wealth managers to reduce overhead combatting margin compression.With some exceptions, wealth managers’ non-compensation operating expenses are generally fixed in nature, which allows wealth managers to take advantage of operating leverage over time.DCF Elements #2-3: Terminal Value & Discount RateOnce it is assumed that the business will achieve a constant level of performance, the remaining cash flows are capitalized and represented by a terminal value. An appropriate discount rate is used to discount the forecasted cash flows and the terminal value to the present.The sum of the present values of all the forecasted cash flows (both the discretely forecasted periods and the terminal value) is the indication of value for a specific set of forecast assumptions.Reconciliation of ValueYour firm’s valuation should clearly articulate the observations, assumptions, adjustments, and empirical data upon which the income method is based. If your valuation provider cannot develop and report their analyses in a manner that you sufficiently understand, get clarification or a new appraiser. You may not agree 100% with the conclusion, but you should understand the methods used and recognize your wealth management firm in the report.Additionally, your firm’s valuation should make sense in light of industry trends and valuations observed within the public and private markets.Next week, we will look more closely at the market approach and how it can be used to better understand the value of wealth management firms.

How to Value Your E&P Company

Our whitepaper "How to Value Your Exploration and Production Company" provides an informative overview of the valuation of exploration and production (E&P) companies. Because of the historical popularity of this post, we revisit it this week.There are numerous scenarios under which some form of an ownership transition occurs, and in all scenarios, a business owner must invariably address the question of value. A lack of knowledge regarding the value of a business can be very costly. Opportunities for successful liquidity may be missed or estate planning could be incorrectly implemented based on misunderstandings about value. In addition, understanding how exploration and production companies are valued may help to understand how to grow the value of a business and maximize returns when it comes time to sell.Download the full whitepaper or read a brief summary below.WHITEPAPERHow to Value Your Exploration and Production CompanyDownload WhitepaperImportant Industry FactorsA review of the oil and gas industry is important in establishing a credible value for any business operating in this space. Such a review should consider a wide range of issues (far too many to list in full here), with primary considerations as outlined below.Price Volatility. The oil and gas industry is characterized by high price volatility. The size and global nature of the oil and gas market means that these prices are influenced by countless economic – and sometimes political – factors affecting individual producers, consumers, and other entities that comprise the global market.Technology. Technology in the oil and gas industry changes rapidly and has the potential to materially impact the market. Adoption of innovative drilling techniques, such as horizontal drilling and hydraulic fracturing, has made oil and gas production quicker, easier, and relatively cheaper.Regulation. The oil and gas industry is heavily regulated by various entities, and regulations on operations can have a costly impact on the industry. The regulatory environment is constantly changing and regulations vary across regions and countries.Variation by Oil and Gas Play. Drilling economics vary by region. There are geological differences between oilfields and reserves that make it harder (thus more costly) to drill in some places than others. Accordingly, the value of any E&P company is strongly influenced by its location, and it is important to consider geological differences when valuing E&P companies.Financial ConsiderationsWhen valuing a business, it is critical to understand the subject company’s financial condition. E&P companies rely on their oil and gas reserves to produce revenue. Understanding the drilling economics is crucial in understanding a company’s value.A break-even analysis is a helpful tool used to analyze drilling economics. A break-even analysis can be used to compare how much it costs to produce one barrel of oil versus the revenue generated per barrel. This can reveal whether a company is losing money through the production process and determine at what price a company can be profitable.An analysis of a company’s working capital, leverage, and interest coverage ratio can help paint a better picture of a company’s financial position.To properly consider a company’s current financial position, it is important to understand management’s plan for future development of wells. Since oil is a depleting asset, in order to continue at current levels of production, oil companies must continuously explore for reserves and develop new wells. Thus, when valuing an E&P company in today’s market, it is important to consider the company’s ability to meet its capital needs. An analysis of a company’s working capital, leverage, and interest coverage ratio can help paint a better picture of a company’s financial position.E&P companies have extremely high operating costs, in large part due to the magnitude of exploration expenses. Exploration endeavors, although not always successful, are extremely costly. For this reason, many in the oil and gas industry prefer to look at EBITDAX multiples rather than EBITDA multiples. EBITDAX represents EBITDA before exploration expenses and tends to be a better metric to compare E&P companies because it negates the effect of a company’s selected accounting policy.What Does the Valuation Process Entail?There are three commonly accepted approaches to value: asset-based, market, and income. In the realm of business valuation, each approach incorporates procedures that may enhance awareness about specific economic attributes that may be relevant to determining the final value.Mineral reserves are an E&P company’s main generator of value, but because they are depleting assets and are often owned through working interests, their value can be tricky to understand. Reserves are typically divided into two groups: proved and unproved reserves. Proved reserves are further classified as proved developed producing reserves (PDP), proved developed non-producing reserves (PDNP), and proved undeveloped reserves (PUDs); unproved reserves are further classified as probable and possible. The valuation methodology used depends on the type of reserve. Generally, the income approach is the most supportable approach for valuing proved reserves and the market approach is generally used to value PUDs and unproved reserves.The Income ApproachThe income approach can be applied in several different ways. For companies operating in the oil and gas industry a discounted cash flow analysis is most common because reserves produce unequal annual cash flows that can be projected by a petroleum engineer in a reserve report. This approach allows for the consideration of characteristics specific to the subject company and their reserves.These future production estimates from reserve reports can be used to project revenue throughout the remaining life of a well. Estimates of future cash flow can be discounted back to the present using an appropriate discount rate (rather than the 10% industry standard used to calculate PV-10).While the income approach is typically a reliable estimate of value for proved reserves, it is not always helpful in determining the value of PUDs and unproved reserves because the production of unproved reserves is ambiguous. Rather, we generally use the market approach.The Market ApproachThe market approach utilizes pricing multiples from guideline transaction data or valuation multiples from a group of publicly traded companies to develop an indication of a subject company’s value. In many ways, this approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.In many ways, the market approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.While geography may not factor into the selection of guideline public companies in many industries, the location of an E&P company is one of the most important factors to consider when selecting similar companies in the oil and gas industry. Drilling economics vary across play; thus, it would be inaccurate to select a company operating in the Permian Basin as a comparable company to one operating in the Bakken Shale in North Dakota.Acquisition data from industry acquisitions can be utilized as a multiple on the subject company’s performance measure(s). For unproved reserves in particular, because production is uncertain, the market approach provides the most meaningful indication of value. Using an EV/acreage multiple derived from transactions of similar companies, analysts can gauge the value of a company’s unproved reserves.Synthesis of Valuation ApproachesA proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations. This is why industry “rules-of-thumb” are dangerous to rely on in any meaningful transaction. Such “rules-of-thumb” fail to consider the specific characteristics of the business and, as such, often fail to deliver insightful indications of value.Mercer Capital has long promoted the concept of managing your business as if it were going to market. In this fashion, you promote the efficiencies, goals, and disciplines that will maximize your value. Despite attempts to homogenize value through the use of simplistic rules of thumb, our experience is that each valuation is truly unique given the purpose for the valuation and the circumstances of the business.Mercer Capital has experience valuing businesses in the oil and gas industry. We encourage you to extend your business planning dialogue to include valuation. For more information or to discuss a valuation or transaction issue in confidence, do not hesitate to contact us.

The Anatomy of a Wealth Management Firm

A Closer Look at a Business that Continues to Pivot with Client Needs

From Broker to AdvisorWealth management firms represent a critical link between asset management firms (who develop investment products) and the highly fragmented retail client channel. The dominant model by which the wealth management industry connects retail clients with asset managers has changed significantly over the last several decades. The predecessor to the modern-day financial advisor is the wirehouse stock broker who rose to prominence during the bull market run of the 1980s and 90s. Typically compensated on a commission basis, the broker was as incentivized to churn client assets as he was to grow them because pay was tied to transactions rather than performance – at least directly. The result was often a gradual transfer of wealth from the customer to the broker, whose interest ran counter to most investors. Oversight was minimal, and many regulators were not properly incentivized themselves. Change was desperately needed.Fortunately, the business has come a long way since the Wolf of Wall Street days. Evolving client expectations, increased transparency, and stronger fiduciary standards have expedited the broker-to-advisor conversion in recent years. Brokerage houses fueled by commissions have largely been replaced by wealth management firms whose fee schedules vary with client assets instead of trades executed on their behalf. A financial advisor’s office now bears more resemblance to a law firm than Stratton Oakmont or Gekko and Co. The industry has definitely become more boring, which is good news for those in need of competent financial advice.This evolution has had some obvious benefits for advisors as well. Client attrition rates have plummeted since the broker days as customers are far more likely to stick around when their advisor’s interests are aligned with their own. High retention rates make it easier to retain the employees who service these accounts, enabling partners to build an actual business rather than a collection of brokers that switches firms every few years.Recurring revenue from asset-based fees is also more predictable than commission income. A wealth management firm’s ongoing or run-rate revenue is simply the product of its current AUM balance and effective realized fee percentage. This predictability makes it easier to forecast hiring needs and project future levels of profitability. These apparent financial advantages combined with the fact that the fee-based model is more appealing to clients explains why the number of broker-dealer firms has declined 24% over the last decade, while the number of RIAs has grown by over 20% just in the last five years, according to FINRA and the SEC. Asset flows also demonstrate the apparent advantages of the fee-based, fiduciary model; RIAs as a group are growing AUM at a faster rate than other distribution channels and manage a growing share of total AUM. Look for these trends to continue as investors become more educated on fee structures while regulators crack down on conflicts of interest and suitability concerns.Characteristics of Today’s Wealth Management FirmAccording to ThinkAdvior and a report from Investment Advisor Association (IAA), the typical (i.e. average) SEC-registered investment advisor has the following characteristics:Works with a team of nine employeesHas $359 million in regulatory assets under managementManages 124 client accountsHas at least one pension/profit-sharing plan as a clientExercises discretionary authority over most accountsDoes not have actual physical custody of client assets or securitiesIs organized as a U.S.-based limited liability company headquartered in California, Connecticut, Florida, Illinois, Massachusetts, New Jersey, New York, Ohio, Pennsylvania, or Texas Even though some of the firms included in the report outlined above are not wealth managers, they are generally representative of the wealth management industry since 94% of their clients are individuals rather than institutions. The report also states that over 95% of RIAs are compensated as a percentage of AUM while just under 4% charge commissions, so it doesn’t include many broker-dealers or RIA/BD hybrids. Perhaps also in contrast to the Wall Street era, 86% of RIAs reported no disciplinary history at all. The IAA report also states that 57% of RIAs are “small businesses,” employing ten or fewer non-clerical employees, with 88% employing less than 50 people. Unfortunately, this end of the size spectrum is not gaining market share relative to their larger counterparts. The report found that RIAs with over $100 billion in AUM grew at a faster pace than smaller advisors last year both in terms of the number of firms and AUM. The benefits of scale and branding are largely to blame for this discrepancy, and it seems likely that this trend will continue into the foreseeable future.How Does Your Wealth Management Firm Measure Up?According to RIA in a Box’s annual survey, the average advisory fee in 2017 was 0.95%, down from 0.99% in the prior year. A little math (0.95% x $359 million) implies average annual revenue of $3.4 million. According to the InvestmentNewsAdvisor Compensation & Staffing Study, the average operating margin for an RIA was 22.8% in 2017, so here’s how the “typical” advisory firm P&L breaks out:While the numbers for 2018 haven’t come out yet, we suspect they’ll be down across the board. The major indices were down 5% to 10% for the year, and realized fees have been on the skid for quite some time. Declining AUM and revenue combined with generally higher costs associated with rising compensation expenses means margins will likely be compressed as well. Valuations of publicly traded RIAs in 2018 echoed these concerns:[caption id="attachment_24163" align="alignnone" width="833"]Source: S&P Global Market Intelligence[/caption] The silver lining for wealth management firms is that they (generally speaking) outperformed other classes of RIAs last year and are up so far in 2019. Their superior performance is likely attributable to a more adhesive customer base that won’t jump ship after a few quarters of poor returns. Wealth managers are also generally less susceptible to fee pressure than traditional and alternative asset managers that have struggled to justify their higher rates with the rise of low-cost ETFs and other passive investment products. Wealth management and financial advisory services are primarily based on client service rather than performance relative to a benchmark, so these firms have been able to stave off fee pressure and client attrition for the most part. The ability to keep this up will likely depend on their capacity to continue servicing clients while connecting with their next generation. It’s a tall order, but most wealth managers have learned to cope with this reality for quite some time. We suspect they’ll continue to do so.

Takeaways from AOBA 2019: “It was the best of times, it was the worst of times…”

I ventured into the Arizona desert again this year to Bank Director’s Acquire or Be Acquired Conference (“AOBA”) in Phoenix in late January. This year I was struck by the dichotomous outlook for the banking sector that reminded me of Dicken’s famous line: “It was the best of times, it was the worst of times…”The Best of TimesThe weather was lovely. Phoenix/Scottsdale is the place to be in late January, and this year did not disappoint with sunny weather and a high of around 70 each day. At the same time, much of the country was feeling the effects of a severe polar vortex that caused temperatures to plunge well below zero in the Upper Midwest and Great Plains. Many of the attendees from that area were forced to stay a day or two longer due to airline cancellations.The operating environment for banks reflected a similar analogous dichotomy. Take the market for example. Most banks produced very good earnings in 2018, and many produced record earnings due to a good economy, the reduction in corporate tax rates, and margin relief as the Fed raised short-term interest rates four times further distancing itself from the zero interest rate policy (“ZIRP”) implemented in late 2008.The Worst of TimesNonetheless, bank stocks, along with most industry sectors, were crushed in the fourth quarter. The SNL Small Cap US and Large Cap US Bank Indices declined 16% and 17% respectively. Several AOBA sessions opined that valuations based on price-to-forward earnings multiples were at “financial crisis” levels as investors debated how much the economy could slow in 2019 and 2020 and thereby produce much lower earnings than Wall Street’s consensus estimates.Within the industry the best of times vs. worst of times (or not as good of times) theme extended to size. Unlike past eras when small (to a point) was viewed as an advantage relative to large banks, the consensus has flipped. Large banks today are seen as having a net advantage in creating operating leverage, technology spending, better mobile products for the all-important millennials, and greater success in driving deposit growth.Additionally, one presenter noted that larger publicly traded banks that are acquisitive have been able to acquire smaller targets at lower price/tangible book multiples than the multiple at which the shares issued for the target trade in the public market and thereby incur no or minimal dilution to tangible BVPS.TechnologyThe most thought provoking sessions dealt with the intensifying impact of technology. Technology is not a new subject matter for AOBA, but the increasingly larger crowds that attended technology-focused sessions demonstrated this issue is on the minds of many bankers and directors. While technology is a tool to be used to deliver banking services, I think the unasked question most were thinking was: “What are implications of technology on the value of my bank?”Several sessions noted big banks that once hemorrhaged market share are proving to be adept at deposit gathering in larger metro markets while community banks still perform relatively well in second-tier and small markets. Technology is helping drive this trend, especially among millennials who do not care much about brick-and-mortar but demand top-notch digital access. The efficiency and technology gap between large and small banks is widening according to the data, while both small and large banks are battling new FinTech entrants as well as each other.Not all technology-related discussions were negative, however. Digital payment network Zelle (owned indirectly by Bank of America, BB&T, Capital One, JPMorgan Chase, PNC, US Bank, and Wells Fargo) has grown rapidly since it launched in 2017. Payment volume in dollar terms now exceeds millennial-favorite Venmo, which is owned by PayPal. Also, JPMorgan Chase rolled-out a new online brokerage offering that offers free trades for clients in an effort to add new brokerage and banking clients while also protecting its existing customer franchise.Steps to Create ValueIn addition to the best of times/worst of times theme, I picked up several ideas about what actions banks large and small can take to create value.Create a Digital/FinTech Roadmap for Your BankThere was a standing room only crowd for the day one FinXTech session: “The Next Wave of Innovation.” This stood in stark contrast to the first AOBA conference I attended which was during the financial crisis. Technology was hardly mentioned then and most sessions focused on failed bank acquisitions. Clearly, this year’s crowd proved that technology is top of mind for many bankers even if the roadmap is hazy. A key takeaway is that a digital technology roadmap must be weaved into the strategic plan so that an institution will be positioned to take advantage of the opportunity that technology creates to enhance customer service and lower costs. Further, emerging trends suggest that technology may help in assessing credit risk beyond credit scores. To assist banks in creating a FinTech roadmap, Bank Director recently unveiled a new project called FinXTech Connect that provides a tool bankers can use to consider and analyze potential FinTech partners.Become a “Triple Threat” BankDuring our (Mercer Capital) session, Andy Gibbs and I argued for becoming a “triple threat” bank, noting that banks with higher fee income, superior efficiency ratios, and greater technology spending were being rewarded in the public market with better valuations all else equal (see table below). While we do not advocate for heavy tech spending as a means to an ill-defined objective, the evidence points to a superior valuation when technology is used to drive higher levels of fee income and greater operating leverage. For more information, view our slide deck.Plan for the Good and Bad Times, Especially for the Bad TimesWhile there was a lot of discussion about an eventual slowdown in the economy and an inflection in the credit cycle, several sessions highlighted that a downturn will represent the best opportunity for those who are well prepared to grow. The key takeaway is to have a plan for both the good and the bad economic times to seize opportunity. Technology can play a role in a downturn by helping add customers at very low incremental costs.Best Practices around Traditional M&AOn the M&A front, two M&A nuggets from attorneys stood out as well as a note about MOEs (mergers of equals):Sullivan & Cromwell’s Rodgin Cohen suggested that buyers should determine what the counterparty wants and structure the transaction to achieve the counterparty’s objectives. Also, buyers need to “ride the circuit” to meet with potential acquisition candidates well before a decision to sell is made, while sellers need to know what they want to achieve before launching a sales process.Howard & Howard’s Michael Bell, a leading attorney to credit unions, had an interesting session where he noted commercial bankers should actively court credit unions as potential acquirers in a marketing process because credit unions’ lower operating cost structures and tax-exempt status can produce a better cash price for the seller.A few sessions discussed the potential for MOEs to create value for both banks’ shareholders through creating scale and by combining banks with different areas of strength. In addition, MOEs create an opportunity to upgrade technology while addressing costly legacy systems, including extensive branch networks. All three themes were addressed in two large MOEs announced in 2019 by TCF/Chemical and BB&T/SunTrust.ConclusionWe will likely be back at AOBA next year and hope to see you there. In the meantime, if you have questions or wish to discuss a valuation or transaction need in confidence, don’t hesitate to contact us.

Four Themes from Q4 2018 Earnings Calls

We Read the Earnings Calls so You Don’t Have to

Commodity prices exhibited significant volatility to end 2018 with steep declines in crude prices and a spike in natural gas prices that subsequently fell back. The general market also declined over the period, making it difficult to parse reasons for various stock price gyrations. While lower prices aren’t ideal for industry operators, earnings calls remind wary investors that there’s more to price than what trades on the NYMEX. Executives this quarter also note a shift in focus when it comes to capital outlays.We take a look at some of the earnings commentary of large players in the oil and gas space to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Hedging Protects Operators from Lower Crude Prices Our 2019 crude oil hedge positions remain unchanged. We have 95,000 barrels of oil per day hedged for calendar 2019 with $60 WTI put option contracts. We expect option premium amortization will be approximately $29 million per quarter in 2019. –John Rielly, CFO, Hess CorporationIt is notable that we remain the only publicly traded U.S. producer that is 100% hedged on expected natural gas production in 2019. –Glen Warren, President and CFO, Antero Resources CorporationIn order for operators to mitigate risk and volatility in commodities such as crude oil and natural gas, many companies will engage in hedging, mostly by use of derivative instruments. This ability to effectively pay a fixed price over future periods of time, commonly in the form of commodity futures and various option contracts, allows for more certainty and stability in cash flows particularly when prices exhibit volatility. This is particularly important for an industry that requires significant capital outlays and long term budgeting plans. While hedging is certainly beneficial when markets behave as they did in Q4, it is important to realize these contracts come at a cost as noted in the Hess quotation above. In response to analyst questions, Hess Corp’s CEO noted future hedging would be of a similar structure where they “protect the downside but we don’t cap the upside.”Hedging protects E&P companies from adverse price realization, effectively propping up operations when commodity prices fall. These instruments tend to smooth results, so revenue does not drop too severely in bad times, though its costs do lower profits in times of rising prices. When valuing E&P companies, the increased cost would be a calculated reduction in value; however, hedging lowers volatility and risk. If companies sought to save this cost and expose themselves to commodity risk, it could be subject to a higher discount rate to account for these risks. Ultimately, hedging is a form of insurance and is a cost of doing business.Theme 2: Local Pricing and Transportation Issues Also Obscure Prices Achieved by Operators2018 was a volatile year for oil prices, especially in the Permian. As you can see on Slide 4, we successfully navigated a challenging midstream takeaway situation throughout the year and delivered a realized oil price that comfortably outpaced both, our peers and local Midland prices. Even more importantly, our proactive marketing strategy delivered ample flow assurance without burdening our long-term pricing structure. So we would expect to stay near the top of the class on this measure in coming years. –Matt Gallagher, President and CEO, Parsley Energy, Inc. [caption id="attachment_25161" align="aligncenter" width="459"]Source: Parsley Energy Earnings Presentation, Slide 4[/caption] Our strategy is to have multiple export markets here to provide us flexibility to move our oil into the highest value market. So, we can get about 70% of our oil to the coast to get the Brent influenced pricing. –John Rielly, CFO, Hess CorporationThe ability to sell this oil at Brent-related pricing has had a very positive impact on both margins and returns in 2018. For instance during the fourth quarter, we moved about 90% of our oil to the Gulf Coast which had the effect of increasing our oil margins by over $9 per barrel. –Rich Dealy, Executive Vice President & CFO, Pioneer Natural Resources Company [caption id="attachment_25167" align="aligncenter" width="527"]Source: Bloomberg[/caption] A recurring theme throughout 2018 was the pricing differentials between localized prices and those seen on different exchanges such as the standardized Cushing, Oklahoma. The Brent-WTI spread was also pronounced throughout the year, with an average spread of $6.79 per barrel, peaking at $11.37 in June. Capacity constraints from a lack of infrastructure in place to bring the product to market played a role in this, and operators in all regions dealt with localized pricing differentials. As we see from these quotes, many operators are seeking markets where they can achieve higher pricing, particularly those related to Brent in the Gulf Coast.Higher prices received for a given level of production increases profit for E&P companies, but transporting the product to these markets incurs increased costs too. Ultimately, companies must balance the increased revenue with the incrementally increased costs to make sure returns are realized from this strategy.Theme 3: Lower Prices Reign in CapEx BudgetsLast month we discussed various capital budgets through three different pricing scenarios, but we've decided to limit our full capital spend in 2019 to $4.5 billion. This represents a $500 million or a full 10% reduction from 2018. By maximizing efficiencies, we are reducing spending to adjust to a lower oil price environment. –Vicki Hollub, President and CEO, Occidental Petroleum CorporationIf we get extended in an extended low-price environment and really would have to go really more into 2020, the tail-end of 2019 into 2020, in that case an extended low-price environment we have the flexibility as we mentioned to reduce our annual CapEx by as much as $1 billion and that’s principally by reducing rigs in the Bakken. –John Hess, CEO, Hess CorporationIn an effort to align spending with cash flow projections both Appalachia and Permian producers are reducing 2019 capital budgets, which results in lower supply growth in 2019 with an even more meaningful supply impact in 2020. –Glen Warren, President and CFO, Antero Resources CorporationAntero will remain flexible depending on the commodity price outlook. We will remain disciplined, spending within cash flow in a low case but have the ability to prudently grow production to maximize free cash flow if commodity prices improve ultimately delivering an appropriate mix of return of capital to shareholders and further deleveraging. –Paul Rady, Chairman & CEO, Antero Resources CorporationMany CapEx budgets for 2019 and beyond were revised downward after the steep drop in oil price as it makes less sense for operators to ramp up production under these conditions. As is noted above, CapEx budgets will remain flexible as an increase in prices would induce operators to produce more in the short-term.Higher CapEx spending in the near term increases revenue for E&P companies, though this will ultimately decrease overall return if the operator does not scale back production until prices rise again.Theme 4: Market Not Paying for Growth Without ReturnCapital discipline has been the buzzword in the E&P industry throughout most of 2018, and certainly as we enter 2019. At Marathon, we have a very clear working definition of capital discipline […] It means prioritizing sustainable free cash flow generation at conservative prices over growth for growth sake. We've been very clear that production growth is simply an outcome of our disciplined capital allocation process, and given our commitment to returns and cash flow, we emphasize high-value oil growth to drive both high margins and capital efficiency. And with sustainable free cash flow, capital discipline for us is also a commitment to return capital back to shareholders, through both our peer competitive dividend and thoughtful share repurchases. –Lee Tillman, Chairman, President, and CEO, Marathon Oil CorporationThe steps we took in 2018 will be really important when it comes to 2019 in the sense that we in our 2019 plan can point to a significant CapEx decrease about 11% compared to 2018, while at the same time delivering a strong 15% increase in production. So, we're very excited about what 2019 holds when we can show that kind of capital efficiency gains. –Tim Dove, President & CEO, Pioneer Natural ResourcesWell, I think, first of all, we are slowing down growth, if you look at this year compared to the prior two years, we've been well into the 20s in terms of growth percentages. We have moved this down. We have a range now which centers on 15%. Obviously, we can ratchet within that range at a moment's notice. It's based on how much activity we want to execute on. But fundamentally, we've taken significant steps to increase basically return of capital to shareholders and we wouldn't have a $2 billion share repurchase plan if that wasn't the case. But I think we have to go further. –Tim Dove, President & CEO, Pioneer Natural ResourcesParsley expects to see an 8% to 10% plus year-over-year improvement on capital efficiency during 2019. We expect both productivity gains and CapEx savings to drive this improvement as detailed down the right hand side of the slide. –Matt Gallagher, President and CEO, Parsley Energy, Inc. [caption id="attachment_25160" align="aligncenter" width="519"]Source: Parsley Energy Earnings Presentation[/caption] As a consequence to reductions in capital budgets, companies are emphasizing capital efficiency over capital expenditures. The market has indicated that a perpetual cycle of growth not sharing the returns with investors is becoming less appealing. Doug Leggate, a Merrill Lynch analyst and frequent participant on industry earnings call Q&A sessions, posed this question directly to Pioneer, specifically noting the share price had not increased since March 2016 despite production doubling in that time frame. The CEO’s response is our third quotation above. Companies will need to strike a balance between funding their growth operations, paying down debt, and returning capital to investors in the form of dividends and share repurchases.Capital efficiency, that does not negatively impact long-term growth prospects, would increase the value of E&P companies as it focuses on increasing returns. In the typical Gordon Growth model for determining intrinsic value of a stock, it gives investors a return in the form of dividends as opposed to capital appreciation, which is only rewarded if the market is willing to pay for it.

Warren Buffett and the Intrinsic Value of Investment Management

A Few Reflections on the 2019 Berkshire Hathaway Shareholder Letter

In a world where non-stop financial commentary is as commonplace as it is tedious, one man’s market insights get an unusual amount of attention: Warren Buffett’s annual shareholder letter. Buffett is an ironic icon of the investment management industry. He’s made his fortune from active investment management, but regularly articulates his skepticism of the same. He’s doubtlessly inspired more people to found RIAs than any other individual, yet his firm, Berkshire Hathaway, is not an RIA. And his annual treatise on the performance of his company is full of common-sense wisdom that, based on Berkshire’s track record, is anything but common. Buffett’s annual letter may be the most anticipated event of the financial reporting season, and this year’s letter – released on Saturday – did not disappoint. My favorite passage, decrying the use of “adjusted EBITDA” as a proxy for operating earnings, recounted a story from another famous American:Abraham Lincoln once posed the question: “If you call a dog’s tail a leg, how many legs does it have?” and then answered his own query: “Four, because calling a tail a leg doesn’t make it one.” Abe would have felt lonely on Wall Street.The Rap on GAAPAlso common to Buffett’s annual letter was his comparing and contrasting intrinsic value (what assets are “worth”) and market value (how assets are “priced”). Readers of this blog don’t need any further explanation of why he would revisit such a topic each year, but Buffett actually opened this year’s letter with the issue because of a change in accounting rules which requires Berkshire Hathaway to mark the value of its positions in public equities to market on its balance sheet, and report any corresponding gains or losses on the company’s P&L.This new fair value reporting requirement makes sense at first glance (why not use market pricing if available?), but Buffett effectively and emphatically deconstructs this accounting standard by noting that 1) it doesn’t require the company to adjust the value of Berkshire Hathaway’s marketable securities for taxes on embedded capital gains paid at the realization of market value, and 2) it doesn’t have a corresponding standard for the company’s interests in entire businesses which, because they are owned outright by Berkshire, aren’t publicly traded. So while Berkshire Hathaway’s holdings of Apple and American Express are marked to market, GEICO is held at cost.During the volatile fourth quarter of 2018, Berkshire Hathaway’s marketable securities portfolio registered “gains” and “losses” by this standard of $4 billion on several individual days (an amount equivalent to the company’s reported earnings for the entire year). Yet Buffett notes the companies owned by Berkshire Hathaway generated operating earnings in 2018 that exceeded their previous high (in 2016) by 41%! The Oracle’s message is clear: GAAP is actually obscuring Berkshire Hathaway’s performance rather than reporting it.Does the Market Obscure the Value of Investment Management?Market pricing of investment management firms over the recent past has shown a similar level of volatility, such that owners of RIAs, BDs, and trustcos (our clients) may be wondering what the impact of market behavior is on the “value” of their firms. It’s a simple question with a complicated answer.[caption id="attachment_25140" align="aligncenter" width="1000"] It’s been a rough six months for our indices of traditional asset management and wealth management firms. The drop in broader equity indices brought about even greater selling of investment firms, despite the fact that wealth managers usually have a strong allocation to fixed income and are, therefore, less exposed to market downturns. Even as equities recovered, the damage to market pricing for investment management firms has persisted.[/caption] In the valuation community, there are three traditional approaches to value: asset, income, and market. The asset approach is a basket of balance sheet focused methodologies that aren’t usually considered to mean much to the value of firms where it is commonly stated that the “assets get on the elevator and go home each night” (more on that later). The market approach can be tricky to apply to the valuation of a closely held asset manager.The market approach can be tricky to apply to the valuation of a closely held asset manager. How does one compare the public pricing of a behemoth like Franklin Resources to, say, a niche institutional equity manager with $3.0 billion in AUM? If BEN is priced at 6x EBITDA or 10x EBITDA, is that relevant to a firm with one strategy and a couple dozen employees? Moreover, if – over the past six months – BEN dropped 15%, appreciated to a recent high, then dropped 20%, and is now priced roughly even with where it was six months ago (which is what has happened), does that mean the value of a closely held asset manager oscillated similarly?Buffett, of course, uses what he perceives as market mispricing to buy securities at a discount to what he thinks they are worth. By “worth,” he means intrinsic value. As illustrated by the discussion above, it’s sometimes difficult to derive intrinsic value from market approaches. The income approach, however, is useful.I won’t drag you through all the numbers, but I modeled a sample wealth management firm through 32 years of market gyrations to see what impact market movements had on the discounted cash flows of the business (a decent empirical estimate of intrinsic value). My inputs were:Starting AUM of $1.0 billionModest accretion of client assets under management (net of client withdrawals and terminations)Aggregate average portfolio returns of 6.5% after feesDistinction between fixed and variable costs (mostly compensation) in the expense baseDiscount rate of 15% and a terminal multiple of 8x net I ran ten-year DCFs over each year of the model to see 1) if there was a positive buildup of value estimated under this income approach, and, 2) what was the resulting multiple implied in each year of the analysis. With a 32-year time series, this gave me 22 point estimates of value. The result of this exercise suggests the stability of intrinsic value for investment management firms, regardless of market circumstance. There was a general upward trend in the estimate of intrinsic value over the forecast period, even in bad market conditions, probably because an upward trending market and a successful client acquisition program are more than enough to overcome the inevitable downturns. The multiple implied by these intrinsic value estimates ranged from 7.25x EBITDA to 9.25x EBITDA, with the average and median multiple falling near 8.0x. The multiple derived was, obviously, dependent on the discount rate, but the point is that the range was fairly tight regardless of market circumstance.Narrative over Numbers: What Is the Intrinsic Value of Investment Management?One reason Buffett’s letter is more widely read than this blog is he doesn’t simply bombard his readers with numbers. He also tells the story of his investments in a narrative format which makes sense without reference to margins and the cost of capital. In recent years Buffett has not failed to extol the virtues of his investment in GEICO. He loves the property & casualty insurance business because people give them money (premiums) in advance of them having to give some of it back (claims) and in the meantime they can invest the money (float). That float has helped build Berkshire Hathaway’s investment base into the powerhouse it is today. The story tells the numbers even better than the numbers tell the story.It really isn’t fair to say that the assets of our clients’ firms get on the elevator and go home every night.The narrative of investment management goes a long way to explaining the intrinsic value of an RIA. It really isn’t fair to say that the assets of our clients’ firms get on the elevator and go home every night. No doubt the talented teams which staff these firms are hugely responsible for their success – and those assets don’t increase or diminish in value with market volatility. But the team is only part of the story. Client assets (AUM) do correlate to a great extent with the market, but client relationships do not. In fact, bad markets can put clients into “play,” offering opportunities to pick up new relationships and new AUM from competing firms. The opposite is also true—strong client relationships are a source of assets to manage, in good times and bad, and serve to underpin the intrinsic value of an investment management firm.Finally, the intellectual property of a firm: the investment management process, the client service experience, and the marketing program which drives new client acquisition all work to ensure that a firm has a steady (if not always stable) stream of revenue and profitability in bull markets and bear markets.Avoiding the Curveball of Market PricingMost partners in RIAs instinctively view the value of their firms from the perspective of intrinsic value. We generally agree with this, but caution that market pricing still offers information and parameters which can’t be ignored, especially in a world of alternative returns. Our assignments often revolve around the concept of “fair market value” – and the second word in that standard cannot be ignored.Even in a fair market value framework, though, it can be useful to remember that buyers and sellers of investment management firms usually don’t perceive the value of these firms to be nearly as volatile as market pricing of publicly traded RIAs. A useful perspective is that of the antique car market. With few exceptions, even cars which eventually become very collectible experience steep depreciation during the first couple of decades after their manufacture. Most never recover, but those with some discernible mystique eventually become worth what they initially sold for, some of those sell for their initial price adjusted for inflation, and a precious few become worth much more. The value of this last group of sought after automobiles, however, is not the steel and glass and rubber, but the intangibles of beauty and engineering prowess. Speed and scarcity don’t hurt either.A focus on building intangible assets cements the foundation of intrinsic value for investment management firms, in good markets and bad. Do that and you’ll have a warehouse full of Gullwings.

Leveraging FinTech to Survive & Thrive in the Digital Age

Developing a fintech strategy for your bank to enhance profitability, efficiency, shareholder value and customer satisfaction can be challenging.

The Rise of FreightTech

To the lay person, transportation may seem like the farthest end of the spectrum from the technology industry – telephone orders and paper shipment tracking. But those in the know understand just how tech-enabled the industry has become. Advancements in machine learning, artificial intelligence, and predictive technology could have the power to disrupt the way goods are transported, stored, and tracked. And investors are clearly willing to take bets on that.

David Smith Joins Mercer Capital and Opens Houston Office

Mercer Capital is pleased to announce that David Smith, ASA, CFA has joined the firm and leads the firm’s Houston office.Smith, formerly the leader of the Houston valuation practice of HSSK, has over 20 years of business valuation experience. He values businesses, business interests, and intangible assets for financial reporting, corporate tax, corporate M&A, employee stock ownership plans, and gift and estate tax purposes.David joins the firm's Oil and Gas industry team. Throughout his career, he has worked extensively with clients in the oil and gas industry. He has performed numerous valuations in the oil and gas exploration, oil and gas field services, oil and gas equipment, and gathering system and pipeline industries.David holds the Accredited Senior Appraiser designation from the American Society of Appraisers and the Chartered Financial Analyst designation from The CFA Institute.“We are very pleased to have David join us. He brings a depth of experience and expertise to the firm,” commented Matt Crow, Mercer Capital’s president. “David has a stellar reputation in the Houston market and will build a strong team for the firm in Houston. We are committed to the Texas market and David’s addition allows us to continue to serve that market with the highest quality valuation and consulting services.”Bryce Erickson, Mercer Capital's Oil and Gas industry team and Dallas office leader, remarked, "Given David's experience, his addition greatly strengthens our ability to serve our oil and gas clients. We couldn't be happier to have him on board."Smith said, “I was initially interested in Mercer Capital because of their strong reputation. Once I met the people, I knew it was the right decision. Mercer Capital is one of the most respected business valuation and financial advisory firms in the nation. Their work and people are highly regarded. I’m looking forward to building the Houston office and am happy to be part of this great team.”For more information about David, view his CV.

Limited Partners, What Are Your Rights?

Legal Rights and Valuation Considerations For Your Limited Partner Interest

A partnership is a business owned by two or more individuals. In its most basic form, a partnership typically falls into one of three categories: a general partnership, a joint venture, or a limited partnership. While the specifics of these three types can vary depending on the goals of the business, they all share similar features.For the purposes of this post, we will be examining benefits and rights we have come across in performing valuations over various types of partnership structures and their relation to value. And while Mercer Capital has worked with complex legal structures in the scope of our work, we do caveat that we are examining these issues through the lens of informed business professionals. If you have specific matters regarding your investment that require legal advice, you should consult an attorney.How Does a Limited Partnership Work?A limited partnership is a type of partnership that has at least one general partner and one or more limited partners. Under this structure, the partners unite to conduct business and only the general partner is liable beyond the extent of the amount of money invested. Each limited partnership has a general partner who is responsible for the day-to-day management of the business. While a general partner is typically an individual, it is not uncommon for separate entities, such as a management company, to fill this position. This type of general partner structure is seen commonly in private equity and hedge funds. The general partner has complete control of operations, and they assume the debts and liabilities of the partnership. Since the general partner is in charge of the successful operation of the business, they are typically compensated in the form of management fees, performance fees, or both depending on the structure and purpose of the entity.Because limited partners do not participate in the day-to-day operations, their financial liability is limited to the amount of invested money into the partnership.In addition to a general partner, the limited partnership also has to have at least one limited partner. Sometimes referred to as “silent partners,” limited partners do not have to do anything except invest in the business and receive a share of the profits. Because limited partners do not participate in the day-to-day operations, their financial liability is limited to the amount of invested money into the partnership, similar to owners (members) in a limited liability company (LLC). In order to maintain this “limited” status, though, limited partners may not contribute more than 500 hours of work towards the limited partnership or else they may be considered a general partner.The tradeoff to this financial limit of liability is that limited partners have no say in management or business decisions. They are also only compensated in the form of dividends or capital appreciation pro rata or as otherwise agreed upon in the partnership agreement. More to the point, they do not have the ability to request dividends or sell/partition the underlying assets directly. We will show further below how this lack of ability directly impacts value of a limited partner’s interest.However, this does not mean that limited partners do not have other rights and entitlements to ensure that their investment is appropriately utilized. First, we will look at activities in which limited partners may participate and still retain limited liability.Safe HarborsAs mentioned, limited partners are not only limited by the amount of their investment but also in their involvement in business operations. However, there are some activities in which a limited partner can engage which will not impact their level of liability, these are known as, “safe harbors.” These activities may include the following:Serving as an agent, contractor or employee of the companyServing as a board member, officer, director or shareholder of the company, provided they do not own a majority shareProviding consultation to the general partner(s) of the companyRequesting or attending a meeting of partnersActing as a surety for the partnership to guarantee or assume its specific obligationsVoting on changes that may affect the nature of the limited partner relationship Many limited partners do not realize they have these safe harbor activities allowing them to exercise a level of power while protecting their liability and maintaining limited status. Best practice, of course, would be to consult your partnership agreement or attorney to ensure that no conflicts arise.Rights as a Limited PartnerAlthough not a requirement, the vast majority of partnerships are born through a partnership agreement (sometimes referred to as a limited partnership agreement or “LPA”). This contract is between two or more partners and is used to establish the rules and responsibilities of the parties conducting business, such as capital contributions, withdrawals, profit and loss distribution, and financial reporting.Contained within partnership agreements are specific rights and duties outlined for both limited partners and those acting as the general partner. The rights of limited partners in a limited partnership, LLP, or even an LLC theoretically share similar to those of a shareholder in a corporation.In the absence of specific provisions in a partnership agreement, there are generally rights available to a limited partner in conjunction with the safe harbor activities mentioned above. A summary of rights we have encountered include the following:Voting within safe harbor provisionsInspection of books and recordsAbility to bring derivative actionAssignment of interest without dissolution of partnershipRight to withdraw from partnershipApplication for dissolution of partnership if business purpose cannot be fulfilled Specific rights available to you may vary depending on the facts, circumstances, and structure of your partnership. To fully understand what is available to you, be sure to review your partnership agreement or consult an attorney.Valuation ConsiderationsKnowing your rights as a limited partner is important so that you can stay informed and ensure that your investment is deployed and utilized correctly. Another important item to understand is the valuation considerations of your limited partnership interest.We can differentiate the roles and responsibilities fairly easily as general partners do the work to ensure successful operation and limited partners provide the capital, let the general partners work, and earn a passive return. From a valuation standpoint, it may be harder to conceptualize how much a limited partner interest is worth compared to a general partner, a different limited partner, or even the entire partnership as a whole. We refer to our “Levels of Value” chart to provide a visualization of where a limited partnership interest may fit in terms of a valuation hierarchy. A limited partner that owns a minority interest in a private partnership falls at the bottom of this chart. But how do we get down there from the net asset value? There are likely multiple tiers of discounts applicable to a limited partner interest. The first is the portion attributable to the general partners. This is made in accordance with their capital contribution, though it is frequently small as the general partner receives payment through management fees. Secondly, because limited partners lack the ability to make the decisions afforded to general partners, they will likely be subject to a minority interest discount. There have been observed ranges of 7-10% for the minority discount, but this amount can be much higher or even lower. It all depends on specific characteristics of the partnership. This brings us to the marketable minority level of value in the above chart. However, limited partner interests aren’t typically marketable, meaning limited partners do not have the ability to freely dispose of their interests like they could sell shares in a publicly traded company for instance. Knowing your rights as a limited partner is important so that you can stay informed and ensure that your investment is deployed and utilized correctly.This brings us to our final discount, the marketability discount. There is a wide range of potential marketability discounts and again, these depend on the characteristics of the partnership in question. At Mercer we have seen marketability discounts range between 20-45%, but similar to the minority interest discount, these discounts can go much lower or even much higher depending on multiple factors regarding the partnership. Frequently, these discounts are considered in tandem with any minority interest discount applied, and the total effective discount must be considered.An example of this tiered discounting is provided below of a limited partnership with a total Net Asset Value of $100,000 and a general partner interest of 1%. In order to illustrate the calculation of value at the non-marketable minority interest level, we have used a minority interest discount rate of 5% and a discount for lack of marketability of 20%. The result of the calculation yields a conclusion of value at $75,240 with an effective discount rate of 24%. This shows how a limited partner whose net asset value share of $95,000 can be discounted to reflect the lack of control over their position and the lack of marketability for a sale or assignment of interest. ConclusionKnowing rights entitled to a limited partner in connection with understanding the relative value of their investment enables limited partners to make informed decisions.Mercer Capital is an employee-owned independent financial advisory firm with significant experience (both nationally and internationally) valuing assets, companies, and partnership interests in the energy industry (primarily oil and gas, biofuels, and other minerals). Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors.As a disinterested party, we can help you understand the fair market value of your limited partnership interest. Contact a Mercer Capital professional today to discuss your limited partnership valuation questions in confidence.

Labor Shortage in Trucking Sector

The trucking industry is wedged between a rock and a hard place when it comes to driver recruitment. Trucking companies are simultaneously exploring self-driving technology, while still convincing new entrants to the labor market that commercial driving is a career choice that will pay off. Punctuating the less-than-glamorous work and lifestyle conditions of the occupation, those entering the labor force realize that the career path could be upended in the near-term by the economic cycle and disrupted in the long term by the impending evolution of autonomous transportation. With several companies (like Tesla) beginning deployment of self-driving trucks, and numerous others deep in development of the technology, young workers may fear choosing a vocation that trucking companies are actively planning to automate.

How to Value an InsurTech Company

FinTech companies are the emerging and hyped sector of the financial services industry. Looking at FinTech’s recent activity, people can see that many of these companies begin as start-ups and a few exciting years later, are able to raise millions of dollars in hopes of becoming the next “unicorn” – an industry term describing a tech company valued at a billion dollars or more. While this business trajectory may seem simple and attractive, FinTech companies usually have a highly complex structure made up of many investors of different origins, including venture, corporate, and/or private equity, all with different preferences and capital structures.Valuing a FinTech company can be very complicated and difficult, but carries important significance for employees, investors, and stakeholders for the company. While all FinTech companies have large differences, including what niche (payments, solutions, technologies, etc.) they operate in or what stage of development the company is in, understanding the value of a FinTech company is critically important. More specifically, within the FinTech industry, an exciting niche termed InsurTech is emerging and threatening to change the traditional state of the insurance industry.InsurTech NicheInsurTech is a fast growing niche that operates in a massive global insurance industry with premium revenues of about $5 trillion annually. InsurTech is the term applied to many companies that are using technology to disrupt the traditional insurance industry landscape. InsurTech has high growth prospects and the potential for InsurTech to innovate and disrupt remains large. Funding for InsurTech companies in recent years has spiked, especially for early-stage companies. Incumbents in the insurance industry have been slow to adopt disruptive, high-growth InsurTech, partly because insurance is so massive and has been around for such a long time. Additionally, many traditional insurance companies can benefit from InsurTech solutions that serve to enhance customer satisfaction and improve the efficiency of operations by leveraging technology and enhancing the delivery of certain insurance offerings and solutions through digital channels.Technology and innovation have disrupted many other long-established industries, such as the impact of medical technology in the healthcare industry. Insurance players, who maintain legacy systems believe that established customer connections will reduce the threat of InsurTech. However, this may not be the best strategy because insurance is often purchased begrudgingly. The historically strained relationship between customers and carriers is a rather vulnerable point along the insurance value chain. InsurTech companies can offer innovative technology that creates more touchpoints for customers and reduces many customer pain points.Market ConsiderationsUnderstanding how well a given InsurTech company is doing within this FinTech niche is one of the most important factors in determining its value. Market dynamics such as market size, potential market available, and growth prospects are important to understand. A valuation will consider absolute market value, existing competitors, and existing incumbents. The regulatory environment is another important consideration when valuing an InsurTech company. Financial services, such as banks and insurance companies, are heavily regulated, so understanding the rules and regulations is necessary for developing an accurate valuation.Like other FinTech niches, certain solutions within InsurTech are relatively new and have the potential to disrupt the entire insurance industry. Since many industry incumbents have been slow to adopt this new technology, the range of this innovation has yet to be fully felt and rules/regulations have yet to change. While regulatory stability may seem favorable now, concrete rules and regulations are complex and can be hard to predict as regulators react to rising InsurTech involvement. Understanding these complexities is important to valuing InsurTech companies, as these regulations could help or hinder an InsurTech’s growth potential.Company ConsiderationsWhen valuing a startup, quantitative information (financial and operating history) is limited; therefore, qualitative information can be extremely important in determining a company’s value. The quality and experience of the management team can be important. Knowledge of the insurance industry including understanding customer preferences, technology integration, the competitive and regulatory environments can enhance an InsurTech’s company value.An InsurTech company’s ownership of intellectual property and other intangible assets, like strategic partnerships, all else equal, should be considered and could increase a company’s value, assuming they are in place and well documented. When in place and demonstrated, intangibles are an important qualitative consideration.The stage of development of a FinTech company can also impact its value. Companies typically set milestones and track their own progress, and meeting these milestones might affect their valuation. Milestones usually include initial round financing, proof of concept, regulatory approval, obtaining a significant partner, and more.Milestones are important to set and track as the more milestones a startup meets, the less uncertainty exists and the more value is created. For example, an InsurTech company with established technology, increased customer touchpoints, and the potential to increase revenues will be more valuable to a potential acquirer than a newer startup. In addition, meeting later stage milestones often provide greater value than meeting early stage milestones. When the valuation considers future funding rounds and the potential dilution from additional capital raises, a staged financing model is often prepared and the valuation will vary at different stages as shown below.Valuation ApproachesAs InsurTech companies enhance business operations and reduce costs, valuations for these companies will become more important. There are three common approaches to determining business value: asset approach, income approach, and market approach. Each valuation approach is typically considered and then weighted accordingly to provide an indicated value or a range of value for the company, and ultimately, the specific interest or share class of the company.The Asset ApproachThe asset approach determines the value of a business by examining the cost that would be incurred by the relevant party to reassemble the company’s assets and liabilities. This approach is generally inappropriate for technology startups as they are generally not capital intensive businesses until the company has completed funding rounds. However, it can be instructive to consider the potential costs and time that the company has undertaken in order to develop proprietary technology and other intangibles.The Market ApproachThe market approach determines the value of a company by utilizing valuation metrics from transactions in comparable companies or historical transactions in the company. Consideration of valuation metrics can provide meaningful indications for startups that have completed multiple funding rounds, but can be complicated by different preferences and rights with different share classes.Regardless of complications, share prices can provide helpful valuation anchors to test the valuation range. Market data of publicly traded companies and acquisitions can be helpful in determining key valuation inputs for InsurTech companies. For early-stage companies, market metrics can provide valuable insight into potential valuations and financial performance once the InsurTech company matures. For already mature enterprises, recent financial performance can be compiled to serve as a valuable benchmarking tool.Investors can discern how the market might value an InsurTech company based on pricing information from comparable InsurTech companies or recent acquisitions of comparable InsurTech companies.The Income ApproachThe income approach can also provide a meaningful indication of value for a FinTech company. This relies on considerations for the business’ expected cash flows, risk, and growth prospects.The most common income approach method is the discount cash flow (DCF) method, which determines value based upon the present value of the expected cash flows for the enterprise. The DCF method projects the expected profitability of a company over a discrete period and prices the profitability using an expected rate of return, or a discount rate. The combination of present values of forecasted cash flows provides the indication of value for a specific set of assumptions.For startup InsurTech companies, cash flow forecasts are often characterized by a period of operating losses, capital needs, and expected payoffs as profitability improves or some exit event, like an acquisition, occurs. Additionally, investors and analysts often consider multiple scenarios for early-stage companies both in terms of cash flows and exit outcomes (IPO, sale to a strategic or financial buyer, etc.), which can lead to the use of a probability weighted expected return model (PWERM) for valuation.Putting it TogetherGiven their complexity, multiple valuation approaches and methods are often considered to provide lenses through which to assess value of InsurTech and FinTech companies and generate tests of reasonableness against which different indications of value can be evaluated.It is important to note that these different methods are not expected to align perfectly. Value indicators from the market approach can be rather volatile and investors often think longer-term. More enduring indicators from value can often come from income approaches, such as DCF models.Valuation of an InsurTech company can be vital to measure realistic growth, to plan progression, and to secure employee and investor interest. Given the complexities in valuing private FinTech and InsurTech companies and the ability for the market/regulatory environment to shift quickly, it is important to have a valuation expert who can adequately assess the value of the company and understand the prevalent market trends.

Q4 2018 Call Reports

Volatility Drives Investors to Low-Fee Passive Strategies

Reflective of the headwinds that the industry is currently facing, asset managers generally underperformed broad market indices during the fourth quarter of 2018. As the broader indices stumbled, many RIA stocks plummeted with falling AUM balances and management fees. As we do every quarter, we take a look at some of the earnings commentary of pacesetters in investment management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Q4 volatility drove investor outflows.Volatility was the dominant theme as 2018 came to a close. U.S. equity markets set record highs during the quarter only to see those gains erased by late December. The selloff experienced toward year-end sent the equity markets into correction territory with virtually every asset class ending the year with negative returns. — Philip James Sanders, CEO, CIO, & Director, Waddell & ReedTurning next to flows. There are a couple of high-level themes that shaped our quarter. In general, elevated market volatility in the fourth quarter increased industry-wide client risk aversion, which led to slowing sales activity and delayed funding. In addition, we had elevated levels of retail redemptions in equities and liquid alternatives due to fourth quarter seasonality, which in the case of liquid alternatives was exacerbated by significant outflows from products with challenging recent performance relative to benchmark. — Nathaniel Dalton, President and Chief Executive Officer, Affiliated Managers Group, Inc.Gross flows for the quarter were strong at $4 billion, while net flows were negative $1 billion as many investors retreated from higher-risk asset classes and rotated into cash. — David Craig Brown, CEO & Chairman, Victory Capital Holdings, Inc.At the end of 2018, the market drawdown, volatility, and industry-wide outflows dominated attention. Our AUM declined by more than 17%, and our stock price declined by more than 30%. — Eric Richard Colson, Chairman, President, & CEO, Artisan Partners Asset Management, Inc.Theme 2: Previously, industry pacemakers suggested that the return of volatility to the markets offered opportunities for active managers. However, recent volatility has pushed investors to more passive strategies. While volatility can, at times, provide a favorable backdrop for active managers, and we firmly believe that research and insight can identify differentiated ideas for investors, the flow toward passive strategies remains steady in 2018. — Philip James Sanders, CEO, CIO, & Director, Waddell & Reed Financial, Inc.Our ETF business, VictoryShares, had positive net flows of $121 million in the fourth quarter, bringing full year of 2018 net flows to $1.1 billion. We continue to be pleased with the strong momentum and market share gains we're seeing in VictoryShares and note that we have experienced positive net flows every quarter since our acquisition of the business in 2015. — Terence F. Sullivan, CFO and Head of Strategy, Victory Capital Holdings, Inc.Clients who faced large tax bills while their equity mutual funds delivered negative active returns experienced this firsthand and shifted to ETFs in the fourth quarter. […] I truly believe it's becoming more recognized, the superior nature of the ETF structure versus a mutual fund. We have heard many instances where many mutual funds who had negative NAV at the end of the year, but they also had capital gains, taxes that they were identifying to their clients. And the clients, I think, in many cases, just got quite aggravated by paying taxes with the negative NAV. Obviously, with an ETF, you control your tax basis. And I think this is becoming a bigger and bigger issue. Tax navigating for the long term, your tax position, for taxable individuals and institutions, is very important. — Laurence Douglas Fink, Chairman & CEO, BlackRock, Inc.Theme 3: Recent fee compression is largely attributable to a shifting asset class mix on lower equity balances and passive inflows. Much of this attrition is likely to be temporary in nature. I would say that as you think about the fee movement, it is driven by asset mix shift. That if you think about it, was a bit magnified in the fourth quarter given the volatility. I think it's important to focus on mixed shift versus erosion because that is truly what we're seeing here. It's about the asset classes that we're having momentum in. And I would also say that it is not a permanent movement. We have asset classes, and therefore fees that range quite broadly as we've discussed in the past. And we have seen and would expect to see momentum in some of those asset classes that higher–have higher fees, and therefore, could move it in the other direction. — Terence F. Sullivan, CFO & Head of Strategy, Victory Capital Holdings, Inc.Our effective fee rate, what you see trending down, it's really—it is a mix shift topic for us. And you would imagine, in risk-off environments, people putting money in money funds, et cetera, that you see that happen. Oppenheimer [Funds] during the period had the exact opposite. There is an aggressive—or I should say aggressive, quite successful in emerging markets and in international equities, and those are higher capabilities. And again, that is sort of the natural flow of things within an organization. So client demand will drive those mix shifts. There's very little we can do about it. — Martin L. Flanagan, President, CEO, Director, Invesco Ltd.For the fourth quarter, aggregate fees decreased 27% to $1.2 billion from a year ago, and the ratio of aggregate fees to average assets under management declined year-over-year from 82 basis points to 63 basis points, entirely driven by lower performance fees. Notably, the ratio advisory fees to average assets under management remain flat year-over-year. — Jay C. Horgen, CFO & Treasurer, Affiliated Managers Group, Inc. In summary, we continue to see many of the same trends we have highlighted in previous quarters.The industry is still evolving to increased fee pressure.Scale remains at the forefront of conversation as demonstrated by recent M&A activity.Rising yield curve and equity market volatility continue to pull assets into fixed income products. Q4 was rough, to say the least, for most asset managers as both AUM and effective fee rates declined. However, most saw some normalization of flows in January. We will continue to follow changes in asset mix, which will drive fee rates in 2019.

Credit Quality at a Crossroads

Last week, the Mercer Capital Bank Group headed south for a scenic trip through the fields of the Mississippi Delta, including the town of Clarksdale located about 90 miles from Memphis. Clarksdale’s musical heritage runs deep with such performers as Sam Cooke, John Lee Hooker, Son House, and Ike Turner born there, while Tennessee Williams spent much of his childhood there. Explaining the Delta’s prolific artistic output, Eudora Welty, a Mississippi writer, noted the landscape stretching to the horizon and the juxtaposition of societal elements – all these forces churning like the Mississippi river nearby.Despite its gritty roots, Clarksdale now is experiencing its own hipster renaissance. It may not be Brooklyn, but the Bank Group noticed signs for last weekend’s Clarksdale Film Festival. Visitors can stay at a refurbished cotton gin, enjoying their Sweet Magnolia Gelato made from locally sourced ingredients. Presumably, craft cocktails are available as well, this being the Delta.Beyond these recent additions to the tourist landscape, though, one attraction put Clarksdale on the map – the Crossroads. At the intersection of Highways 49 and 61, the bluesman Robert Johnson (who lived from 1911 to 1938), as the story goes, met the Devil at midnight who tuned his guitar and played a few songs. In exchange for his soul, Johnson realized his dream of blues mastery.The point of this article is not that Lucifer lurked behind the revaluation of asset prices in the fourth quarter of 2018. Instead, the market gyrations laid bare the dichotomy between bank expectations regarding asset quality and the market’s view of mounting credit risk that was overlaid by a need to meet margin calls among some investors. Indeed, credit quality faces its own crossroads.Highway 49Along Hwy. 49 lies the town of Tutwiler, about 15 miles from Clarksdale. There, in 1903, the bandleader W.C. Handy heard a man playing slide guitar with a knife, singing “Goin’ where the Southern cross’ the Dog.” Handy adapted the song, which references the juncture of two railroads, thereby making it one of the first blues recordings.From Call Report data, which includes 3,644 banks with total assets between $100 million and $5 billion, signs of credit quality deterioration remain virtually undetectable.Loan growth continued apace in 2018, maintaining the community banking industry’s recent 10% annual growth rate (Figure 1, which shows the trailing twelve month change in loans). Notably, commercial real estate loan growth decelerated in 2018. Although this presumably pleases the regulatory agencies, competition from non-banks (e.g., insurance companies) and budding risks surrounding certain sectors (e.g., retail) likely explain the slowdown.In absolute terms, nonperforming loans (nonaccrual loans plus loans more than 90 days past-due) declined in each year between 2014 and 2017 (Figure 2). As of September 30, 2018, however, NPLs increased by 4% over December 31, 2017, led by farmland NPLs (up 37%, or $258 million), agricultural production NPLs (up 32%, or $90 million), and commercial and industrial NPLs (up 8%, or $149 million). Given loan growth, though, the ratio of NPLs to loans continued to decline, falling slightly from 0.81% to 0.79% between December 31, 2017 and September 30, 2018.Annualized charge-offs for the year-to-date period ended September 30, 2018 also compare favorably to the comparable prior year period, foreshadowing a possible post-recession low in the net charge-off ratio for fiscal 2018 (Figure 3). As they are wont to do, regulatory agencies noted some concerns regarding asset quality. However, consistent with our research into the community banking industry’s asset quality trends, the OCC also observed that “credit quality remains strong when measured by traditional performance metrics.”1 Despite its view of building credit risk, the OCC rated 95% of banks’ underwriting practices as satisfactory or strong in 2018, virtually unchanged from the 2017 level.2 Economic growth, corporate profits, and employment trends also support a sanguine view of credit quality. While also observing weaker underwriting – for example, covenant concessions – rating agencies predict better credit performance among leveraged loans and commercial mortgage backed securities in 2019. For 2019, Fitch Ratings projects a 1.5% leveraged loan default rate, down from 1.75% in 2018. Further, commercial mortgage-backed security delinquencies, which declined by 103 basis points to 2.19% between year-end 2017 and 2018, are expected to range between 1.75% and 2.00% in 2019. The Amazonification of the retail sector, which led to retail bankruptcies and defaults on loans secured by regional malls, contributed to higher delinquency and default rates in 2018 but may subside in 2019. The view from Hwy. 49, before reaching the Crossroads, looks favorable from the banking industry’s standpoint. Highway 61In the words of the writer David Cohn, the Mississippi Delta begins in the lobby of the Peabody Hotel (in Memphis) and ends on Catfish Row in Vicksburg, Mississippi.3 While his observation alludes to the economic as well as the geographic extremes of the Delta region, Highway 61 is the Delta’s spine connecting Cohn’s poles.One of the more concerning statistics is the level of corporate debt. Though household debt trended down following the Great Recession (see Figure 4), nonfinancial business debt has reached near record levels as a percentage of GDP.4 According to Morgan Stanley, BBB-rated corporate debt surged by 227% since 2009 to $2.5 trillion. This leaves approximately one-half of the investment grade corporate bond universe on the cusp of a high-yield rating. Moody’s migration data suggests that BBB-rated bonds have an 18% chance of being downgraded to non-investment grade within five years, which may overwhelm the high-yield bond market.5 Regulatory agencies also observed looser underwriting. For new leveraged loans, the Federal Reserve noted that the share of highly leveraged large corporate loans – defined as more than 6x EBITDA – exceeds previous peak levels in 2007 and 2014, while issuers also are calculating EBITDA more liberally by making aggressive adjustments to reported EBITDA.6 From the OCC’s perspective, competitive pressures from banks and non-banks, along with plentiful investor liquidity, have led to weaker underwriting particularly among C&I and leveraged loans. According to the OCC, community banks are not immune. An example of weaker underwriting cited by the OCC is “general commercial loans, predominately in community banks” for which it compiles a list of shortcomings: “price concessions, inadequate credit analysis or loan-level stress testing, relaxed loan controls, noncompliance with internal credit policies, and weak risk assessments.”7 Despite unemployment rates below 4% and some evidence of rising wages, consumer loan delinquency rates have risen in 2018 (Figure 5). Some lenders, such as Discover, already have begun reducing exposure to heated sectors like unsecured personal loans. Fears of a downturn crystallized in the fourth quarter of 2018 with the Federal Reserve’s December rate increase, trade friction with China, and signs of economic slowdowns in countries such as Germany. Option-adjusted spreads on corporate debt, after remaining quiescent through 2017 and most of 2018, widened suddenly, approaching levels last observed in 2016 when oil prices collapsed (Figure 6). According to Guggenheim, the fourth quarter spread widening implies a 3.2% high yield corporate debt default rate, up from 1.8% for 2018.8 The perspective gleaned from Hwy. 61 is not necessarily alarming, but it does suggest that, directionally, risk is rising. The CrossroadsCredit lies at a crossroads, consistent with a late cycle economic environment. Reported credit metrics are not improving significantly, nor are they worsening; conditions suggest continued low charge-offs and loan loss provisions in the nearterm. However, the market sniffs rising risks in various corners of the economy, most notably in corporate debt. Howlin’ Wolf sang, “Well I’m gonna get up in the morning // Hit the Highway 49.” Where are banks headed? Macroeconomic conditions ultimately will be determinative, but banks should avoid complacency in this environment marked by conflicting signals and aggressive competition. The poorest loans, in retrospect, often are originated in times such as these.End Notes1 OCC Semiannual Risk Perspective, Fall 2018, p. 1.2 OCC Semiannual Risk Perspective, Fall 2018, p. 22.3 Cohn, David, Where I Was Born and Raised, 1948.4 Federal Reserve, Financial Stability Report, November 2018, p. 18.5 Guggenheim Investments, Fixed Income Outlook, Fourth Quarter 2018, pp. 1 and 8.6 Federal Reserve, Financial Stability Report, November 2018, p. 20.7 OCC Semiannual Risk Perspective, Fall 2018, pp. 11 and 24.8 Guggenheim Investments, High Yield and Bank Loan Outlook, January 2019.

Do The Upstream Sector's Mosaic Of Indicators Create A Clear Picture?

Considering the precipitous drop in oil prices at the end of last year, 2018 finished with somewhat unexpected results in the upstream sector. Take the OGJ 150, one of the industry’s upstream indexes. It was on a roller coaster. It began the year at 1,858 and generally climbed for the first three quarters. It peaked on October 9th with a closing of approximately 2,021. It then took a fall and finished the year at 1,522 about 18% off from the start of the year. However, it has since climbed back up in January and closed last week at 1,646.Questions and opinions abound. Causes, concerns, opportunities and optimism are being bandied about. There are several indicators out there that are sending mixed messages. Pricing, supply, DUC counts, LNG growth, bankruptcy activity, capex budgets and merger and acquisition trends are out there to name a few that interplay with each other. They create a visual of what is happening and what could happen going forward. We’ll look at a few of these to try to get more clarity.Prices (Bearish)As U.S. crude oil prices plunged by 40% in the fourth quarter of 2018, from $75 in the beginning of the quarter to $45 per barrel at the end of December, valuations dropped alongside prices. What were the causes? Reasons started with concerns about potential increasing of U.S. shale output, inconsistency in Russia and OPEC’s execution of their production deal and fears of a global economic slowdown. Even OPEC’s deal with Russia to cut 1.2 million barrels per day during the December 6-7 meeting couldn’t stop oil prices from falling. The sharp decline once again demonstrates that higher prices fostered by supply-side management have a difficult time lasting.On the other hand, natural gas prices benefited from seasonal fluctuations. Prices jumped to over $4.80 per mcf in mid-November due to several factors including an early and colder winter hitting North America. In its December edition of the Short-Term Energy Outlook, the EIA reported the price of Henry Hub averaged $4.15/MMBtu in November, up 27% from October. Higher inventory helped to smooth price volatility in the energy market, but U.S. natural gas inventories began the season at a 15-year low. This will most likely be a temporary issue, as reserves are plentiful and the LNG market will begin to offtake more supply in 2019.[caption id="attachment_24731" align="alignnone" width="640"]Source: Bloomberg[/caption] It is relatively rare to see the inverse relationship between crude oil and natural gas prices. A more than 50% increase in natural gas prices was coupled with nearly 30% downturn in crude oil prices during a seven-week period from early October to mid-November. Long oil short natural gas, once a popular trade by speculators, was punished during this unusual period of time. Natural gas prices ended the year at $2.94 per Mcf, a 2.3% decrease for the fourth quarter and essentially flat for the year. Supply and Demand (Bullish)In 2019, it is expected that the U.S. will continue to lead the growth in oil supply worldwide. Improving pipeline capacity, particularly in West Texas, and the combination of horizontal drilling and hydraulic fracturing continue to drive higher and more efficient production in the U.S. Good news is that a lot of this supply will be at a lower cost to producers because part of the costs has already been sunk. Drilled but uncompleted wells (“DUCs”) which jumped to new records in 2018 will likely be drawn down as a lower cost production alternative. This will contribute to supply growth.According to the December Short-Term Energy Outlook, the EIA expects global liquid fuels consumption to increase by 1.5 million barrels per day in 2019. Growth is largely coming from China, the U.S. and India. U.S.-China trade tensions remain high entering 2019 and have shaken up most if not all industries, and oil and gas is not an exception. China is the second largest in terms of oil consumption and surpassed the U.S. as the world’s largest crude oil importer in 2017. Slower growth in China is looming for the demand side of crude oil. In 2019, the continuation of worldwide central banks tightening pressures global economic growth and the prices of assets and commodities. Higher rig counts and higher capital expenditures by major oil & gas companies worldwide during the recovery also cause concerns of oversupply. According to Baker Hughes, as of December 28, 2018, the rig count in the U.S. was 1,083, 16.6% higher from December 29, 2017.LNG (Bullish)U.S. LNG daily production hit record high of 5.28 Bcf during the week of Christmas, according to S&P Global Platts. Large-scale additions to production capacity in 2018 included Shell’s Prelude and Inpex’ Ichthys, both offshore Australia, and Novatek expanded its Yamal LNG facility, while demand is slowing down in Asia, the biggest LNG market in the world. Europe is likely to play the key role in absorbing all the additional production as geopolitical factors, pipeline capacity issues and the controversial Nord Stream 2. Also, Gazprom’s contract for gas transit via Ukraine is expiring at the end of this year and surprise during negotiation is always possible among Russia, Ukraine and Europe.Going forward, LNG capacity will grow significantly in the U.S. The ability to send U.S. gas overseas will be a welcome reprieve for an oversupplied domestic gas market. This could create positive price pressure in gas markets. However, this could also have more localized effects as opposed to widespread.Bankruptcies (Mixed to Bearish)After ebbing for the past several years, bankruptcies in the energy sector increased slightly in number and dollars. According to the latest bankruptcy tracking report from Haynes and Boone LLP, bankruptcies upped a notch in 2018.[caption id="attachment_24732" align="alignnone" width="606"]Source: Haynes and Boone LLP[/caption] Thoughts on these statistics are mixed. With the drop in prices in the second half of 2018, concern could mount that more bankruptcies may be ahead. The good news is that many companies have already restructured their balance sheets over the past few years and oriented their business models to operate at $50 oil and $3 gas. Therefore, they can have some stability in this pricing environment. However, at the same time, a number of public companies made announcements of significant reductions in their 2019 exploration and production budgets. This could lead to an increase in filings for remaining producers who may have tighter cash positions in the event of capex and budgetary strains. Capital Spending for 2019 (Mixed)North American E&P spending as a whole is expected to lag behind international markets but is estimated to grow 9% in 2019, according to a global E&P report released from Barclays. Barclays noted, however, “spending is exposed to more downside risk given the recent oil price collapse,” which isn’t fully captured in budgets that have been approved thus far. It’s also important to note that not all companies have announced 2019 plans yet.Several companies (such as Apache, Diamondback, Parsley, Centennial, Halcon and Chesapeake) are expecting to make budgetary reductions.[caption id="attachment_24733" align="alignnone" width="640"]Source: Shale Experts[/caption] However, several others (such as Anadarko, Pioneer and Devon) appear to be looking to maintain or even increase rig counts in the Permian Basin in 2019. [caption id="attachment_24734" align="alignnone" width="640"]Source: Shale Experts[/caption] Hess Corp announced a 2019 E&P capital and exploratory budget of $2.9 billion slated for 2019, up from $2.1 billion in 2018. Approximately 75% will be allocated to high return growth assets in the Bakken and Guyanna. ConocoPhillips has set a capex budget for 2019 of $6.1 billion, which is comparable to its 2018 capex, excluding any acquisition costs. Approximately $3.1 billion will be allocated to rigs across the Eagle Ford, Bakken and Delaware plays. M&A (TBD)Activity in this realm has been relatively slow lately. This is probably due to the drop in oil prices. However, this pricing could also portend more M&A activity. Upstream valuations are trading at relative lows compared to the wider stock market. This could combine for more transactions in 2019. Companies plan for longer term pricing and long term expectations, using the futures curve as an indicator, are still around $54 going out about five years.There is a lot of capital in the marketplace that is waiting to be placed. If these conditions continue, it could give rise to more deals and more dollars in 2019.ConclusionThe indicators are out there, and one thing’s for sure—they don’t all align. Economist Karr Ingham, while recognizing the challenges of some of these bearish signals, remains optimistic. “The growth in Texas crude oil production even in the face of lower prices, rig counts, drilling permits and employment compared to 2014 peak levels remains the story of the year.”Valuations have suffered in 2018, but if the structural undergirding of the recovery over the past few years is strong, then the U.S. upstream sector should still be able to not only survive but thrive in 2019. Whatever happens, this muddied picture will become more clear as the year gets going.Originally appeared on Forbes.com.

RIP to the Father of Index Investing

John Bogle’s Legacy Endures with the Prominence of Passive Investing

Perhaps John Bogle’s greatest legacy is not founding Vanguard (nearly $5 trillion in total AUM), but his common sense (and yet often contrarian) approach to long-term investing. “In investing you get what you don’t pay for. Costs matter. So intelligent investors will use low-cost index funds to build a diversified portfolio of stocks and bonds, and they will stay the course. And they won’t be foolish enough to think that they can consistently outsmart the market,” Bogle told the New York Times in 2012.“Don’t look for the needle in the haystack. Just buy the haystack.” – John Bogle on the merits of passive investing over active managementUnfortunately, most investors haven’t stayed the course. For the twenty years ending December 2015, the S&P 500 index averaged 9.85% a year while the average equity fund investor earned a return of only 5.19%. High costs and market timing are largely to blame, which is why passive investing has dominated active management over this period.Ironically, the king of active management is a huge fan of Bogle’s. You may recall Warren Buffett’s bet with Protégé Partners that an index fund would outperform their selection of hedge funds over a ten-year period. Buffett’s investment vehicle was Vanguard’s S&P 500 Admiral Fund (VFIAX), which outperformed Protégé’s fund of funds for nine of the ten years. Buffett’s advice on investing is right out of Bogle’s playbook, “Stick with big, ‘easy’ decisions and eschew activity.” Easier said than done, unfortunately.Most active managers probably feel differently. According to the Associated Press, investors paid 40% less in fees for each dollar invested in mutual funds during 2017 than they did at the start of the millennium. That’s great for investors, but not so good for mutual fund providers and active managers.“Stick with big, ‘easy’ decisions and eschew activity.” – Warren BuffettStill, there might be a silver lining to all this for some active managers. It’s hard to envision a world without stock pickers and market timers. After all, what would happen to asset prices if nobody paid attention to them? For the active managers that have survived the so-called flowmageddon to passive products, there’s ample opportunity to pick up market share and less competition for undervalued assets. Best-in-class asset managers could very well come out ahead over the long run.The problem is best-in-class asset managers are scarce. Over 90% of active managers underperformed the S&P 500 over the last market cycle. Such underperformance has led to all sorts of problems for the industry, including asset outflows and fee pressure that pushed most of these businesses into bear market territory last quarter.Active managers can’t blame Bogle for their recent woes. He merely shed light on an obvious deficiency in their value proposition (alpha in excess of fees), and investors have responded accordingly. What’s especially problematic is the recent trend seems to be accelerating. An estimated $369 billion flowed out of long-term U.S. active mutual funds in 2018, versus net inflows of $72 billion in 2017. By comparison, outflows were a little more than $200 billion in 2008.So if you’re a contrarian like Bogle, is now the time to get back into active management? It could be. Most active managers haven’t beaten the market since 2008, so they’re long overdue, especially if you consider their outperformance during bear markets:In addition, high dividend ETFs often underperform their active counterparts since many of them are programmed to buy the highest yielding securities, regardless of fundamentals. Interestingly enough, actively managed Vanguard Dividend Growth has outperformed the Vanguard Dividend Appreciation ETF since 2007 even after fee considerations.Still, we think Bogle would advise most investors to keep it simple and stick with passive investing. He has undoubtedly saved millions of investors around the world from the higher fees and (often) subpar performance of active management. So, next time you imbibe, pour one out for John Bogle and, perhaps, the active management industry as well.

Five Questions to Ask Your P&L

A Great Start to 2019 is a Thorough Lookback at 2018

Earlier this month, the RIA group at Mercer Capital took some time to outline our points of focus for the year ahead. Group consensus is that the investment management industry is facing an unprecedented number of cross-currents, making the vision for 2019 anything but 20/20. Last year was kind of a “meh” year for investment management, with a couple of interesting IPOs and an impressive level of M&A activity, but also generally unhelpful financial markets and pronounced multiple contraction across the space. Add to that a surplus of economic uncertainty and a deficit of political stability, and we see ample ground to speculate as to the future of the RIA community. But indulging in guessing games gives you little reason to follow this blog, so we’ve decided to spend more time this year giving perspective as to what money managers can control.A Not-So-Random Walk Through Your Income StatementNow that January is almost over, we know that many of you have wrapped up quarterly investor communications and can now take a moment to think about your firm’s operations, direction, and other practice management issues. A useful place to begin your plan for 2019 is doing some fundamental research on your own business, starting with the P&L. It’s easy to take internal financials for granted, but if you take a step back and consider your results from operations as if you were an outsider doing due diligence, you’ll give yourself the opportunity to gain an insight or two that is directly relevant to the outlook for your RIA. Here are five questions to organize a review of your financial statements. Simple enough, but these five questions lead to about five hundred more.1) What Do Your Revenue Trends Tell You About the Overall Health of Your Business?One of the more unique characteristics of investment management firms is that, for the most part, run rate revenue can be calculated on any particular day, given closing AUM and a realized fee schedule. But revenue is a flow rather than a stock, and the trends in what generate revenue for an RIA say plenty about the overall health of the firm. This diagnostic works best at a granular level.Breaking down trends in revenue into trends in AUM and realized fees is revealing. In fact, one of the first things we do when researching a new client is to develop a quantitative history of their revenue to evaluate the success of their marketing plan, investment management skills, client retention, and value to the marketplace.You may be a $2 billion manager today, but what about five years ago, and how did you get here from there? Retracing your steps can be a revealing exercise, regardless of what sort of investment management firm you operate.You may be a $2 billion manager today, but what about five years ago, and how did you get here from there? Retracing your steps can be a revealing exercise.Regarding trends in assets under management, we’ve noticed over the years that wealth management firms tend to focus on net inflows, and asset management firms pay more attention to investment performance. We recommend you look at both. New clients gained net of terminations has implications for the effectiveness of your marketing and client service models, as do new contributions from existing clients net of withdrawals. Keep in mind that this latter measure may also be indicative of the demographics of your client base, especially if you have more retail clients (as opposed to institutional). Wealth management firms pay less attention to investment performance, but we sense those days are changing. We learned last year that the CFA Institute is studying ways to extend GIPS (Global Investment Performance Standards) to wealth management firms, and while this may still be years away, you should start thinking about being ahead of the trend. The most successful firms won’t hesitate to study their firm’s performance from as many perspectives as possible, looking for ways to improve.As for fees, it has been widely reported that the industry is coming to terms with what investment management services are worth to different types of clients. Early warnings of an army of robo-advisors turned out to be hype, but there is clearly fee pressure (or at least fee consciousness) in every sector of the industry. What matters to you is your fee schedule. What are you earning today versus last year, and can you trace that by the product or service you offer over time? Are changes in your realized fees earned a product of changes in client composition or product offerings, or are you having to price existing products to existing clients more competitively to gain or retain business?2) What Are Your Labor Costs Relative to Market?Whether you’re part of an asset manager, wealth manager, trust company, or any other sort of investment consultant, your biggest cost is labor. Twenty years ago, RIAs could afford mostly to ignore labor costs because the growth of the industry, heady fees, and favorable markets offered operating leverage that would reliably outrun any margin pressure from overpaying people. Those days are gone, however, and what we hear regularly is clients looking for ways to become more disciplined about compensation. Unfortunately, that isn’t easy to do.Although there are several significant compensation studies performed regularly in the investment management industry, the data isn’t very useful to actually set compensation levels for staff or owners. Data is usually given in ranges, which can be very broad, and it’s difficult to compare positions across firms since even titles like “portfolio manager” can mean different things in different offices. In addition, perceptions of what is necessary to recruit and retain staff can vary. We’ve had some clients in secondary markets report that labor costs were lower there than in gateway cities. Others report that it takes more money to recruit talent to secondary markets because qualified talent wants to live in New York and San Francisco. This issue becomes more acute the more specific a skillset is needed on an asset management team.We think it’s more useful to think about labor costs holistically. How does your compensation program relate to your overall business model? Is the plan scalable? Does the plan create an appropriate tradeoff between returns to labor and returns to capital (distributions), or are you disguising senior talent compensation as a benefit to ownership? There is no one answer. Wealth management firms necessarily look more at individual production as it relates to compensation, although in ensemble practices it may be more appropriate to consider sharing in firmwide profitability. Asset managers lean more toward paying for strategy performance, although doing so can be difficult in persistently unfavorable markets.Labor costs are the biggest tradeoff to margin, and at some level speak to the scale and efficiency of the RIA. That said, one has to expect margins to vary based on the type of investment management business. An institutional manager with a concentrated strategy benefits from extraordinary operating leverage as compared to most wealth managers. But margins, and the trend in margins, can tell a story about your business model, and how you are staffing it.3) Is Your Technology Spending Appropriate for Your Business Model?Robo-advisors may not have made a dent in the industry yet, and indeed may never, but technology is becoming more essential to the RIA community anyway, and that trend isn’t going to abate. The challenge, at this point, is to identify what tech spending is worthwhile, and what is just spending for its own sake. Technology is a big bucket and means different opportunities to different people.We see a great deal of spending on IT across the investment management firm spectrum, but it seems like the jury is still out in many cases as to whether or not firms are seeing a real payoff from it. Is your technology spending focused on marketing (like Salesforce) or compliance? Are you trying to fuel growth, reduce costs, or improve client service?Do your tech spending habits suggest that you have a real technology strategy, or are mostly reactive? And have you made a conscious decision to have your firm be on the leading edge of tech for asset management (sometimes the bleeding edge), or are you content with being on the trailing edge. Tech is such a challenge for the industry that many firms have dedicated a position in the organization to follow this area of practice management. At the very least, others are making it part of the job qualification for a chief operating officer.4) Are Your Marketing Dollars Actually Growing Your Business?When the investment management industry was growing steadily because of new investors and market tailwinds, marketing and distribution were concepts that RIAs could take for granted. Mixed markets and mature investment allocations have changed all of that, and firm leadership who got into the business because they liked picking stocks have been slowly waking up to the reality that they’re in sales.When the investment management industry was growing steadily because of new investors and market tailwinds, marketing and distribution were concepts that RIAs could take for granted.One value to disaggregating changes in revenue, as discussed above, is seeing the effectiveness (or lack thereof) of your firm’s marketing plan. Taking a hard look at how much you spend on marketing and where it's being spent is another worthwhile use of your time. Performance matters to clients, but alpha alone won’t attract new clients or retain as many of your existing assets as you might like.We heard an excellent presentation on differentiating your marketing message last fall, led by Megan Carpenter at Fi Comm Partners. The upshot of the presentation is that financial services are, from a client’s perspective, generic. Developing a unique way to differentiate and communicate your service offering keeps you from becoming a commodity and having to auction yourself to your clients.We’re not a marketing consulting firm, but we notice firms having a difficult time connecting their spending on growth initiatives, like marketing, with the actual growth of the firm. You may not be able to develop a measurable, one-to-one relationship between your spending on distribution and the growth of your business, but if you can’t articulate – even to yourself – the relationship between your monetary commitment to growth and your client asset acquisition rate, then it might be time to find a way to do that.5) Is Your Profit Margin Threatened by Ownership Issues?The profitability of an RIA speaks to more than just the results from operations. Often, where profits go is more telling than where they came from.Is your firm fully distributing? That is, are you able to pay out all, or mostly all, of your profits as distributions? If so, then you must be funding most of your growth initiatives, in terms of human capital development and marketing, within your normal expense structure. Will this remain the case, or will you be required to use profits to fund partner buyouts or firm acquisitions? Is your ownership on board with those reallocations of distributable cash flow? Just like compensation tends to be sticky in downturns, most RIA partners don’t like the feeling of reductions in distributions – even if they understand it intellectually.Are your distributions an investment in future leadership, a payment for current key partners, or a royalty for founders? Depending on how you structure ownership, you can utilize distributions for any one or all of these, but it’s likely your RIA did this without even realizing it. Part of the wisdom that comes from interrogating your financial statements is making what was accidental intentional, and in the process developing some greater degree of control over your firm’s destiny.Are your distributions an investment in future leadership, a payment for current key partners, or a royalty for founders?How sustainable is your profit margin? If markets took a sustained 20% hit, would that wipe out your profitability? Is your buy-sell agreement up to date or could an ownership dispute derail your business? What is the trend in the margin (growing, shrinking, stable) and why?For a professional service firm, distributions can be an effective way to reinvest in the business – given that the business is one of human capital rather than machinery and equipment. The question to consider is whether or not you’re using distributions as a way to grow, sustain, or monetize your business model.If Your Financial Statements Told a Story, How Would it End?The investment management industry has been transitioning from one where a rising tide lifted all boats to one of winners and losers. Issues that could once be overlooked by clients, like performance and pricing, no longer are. As a consequence of client behavior, issues that could once be overlooked by RIA leadership, like staffing and ownership transition need serious attention. We seem to be entering a period where there will be a premium on intentionality and accountability, and the financial results of your operations for last year are an informative source of objective commentary on how you’re doing.If a picture is worth a thousand words, then a detailed P&L is worth several thousand. Just make sure that your financial statements tell the same story about your business that you tell yourself. If you’re not allocating resources to support the business you think you’re running, make a New Year’s resolution to seek greater alignment.

Risk and Return

Working Interests and Royalty Interests

Because of the historical popularity of this post, we revisit it this week. Originally published in 2017, this post helps you, the reader, understand the various risk factors which pertain to mineral interests. U.S. Mineral Exchange defines a mineral interest as “the ownership of all rights to gas, oil, and other minerals at or below the surface of a tract of land.” Last week we reviewed the three types of mineral interests – royalty interests, working interests, and overriding royalty interests. This week we analyze the risks associated with working interests versus royalty interests. An overview of royalty interests and working interests is included below:Royalty Interest – an ownership in production that bears no cost in production. Royalty interest owners receive their share of production revenue before the working interest owners.Working Interest – an ownership in a well that bears 100% of the cost of production. Working interest owners receive their share of the profit after (i) royalty owners have received their share and (ii) after all operating expenses have been paid. Central to corporate finance is the principle that returns follow risk. As the risk of an investment increases, so do potential returns and potential losses; lower risk means less expectation for reward. The Oil and Gas Financial Journal illustrates oil and gas investment risk in the following graphic:When valuing mineral interests, it is important to consider the nuances of each type of mineral interest. Given that risk and asset values are indirectly related, it is important to keep in mind the various risk factors which pertain to the mineral interest. We’ll begin by examining the various risks surrounding both types of interests.RiskBoth working interests and royalty interests are exposed to fluctuations in oil and gas prices. When crude oil prices fell in mid-2014, so did the value of working interests, whose worth is based on the present value of the cash flows generated from production, and the value of royalty interests, whose value is based on future payments of revenue. Further, both working interests and royalty interests face the risk of depletion as oil and gas wells are depleting assets. Even if the price of oil and gas is stable from one year to the next, a well may have 30% less production in its second year. This can dramatically decrease the yield of particular royalty and working interests.Holders of working interests can mitigate the risk of depletion by drilling new wells or improving production of existing wells. While this gives a working interest holder more flexibility, it also requires a substantial investment in CAPEX. Working interest holders accept all fiscal burdens associated with the drilling process.Royalty interest holders, on the other hand, bear no cost of production but are at the mercy of their operators. Only the working interest owner can decide to halt production when prices drop and to increase production when the drilling environment is favorable. The Oil and Gas Financial Journal compares buying a royalty interest to “buying an income strip in producing wells, and the risks are primarily price volatility and depletion.”Each type of interest has unique attributes, but the fact that working interest owners are responsible for operating expenses makes working interests inherently riskier than royalty interests which are characterized by monthly “mailbox money” precipitated by zero costs. We see this when examining the volatility of select E&P companies who spun off their royalty interests into royalty trusts structured as MLPs.The royalty trusts above generally demonstrate less volatility, which is often used as a proxy for financial risk, than their parent E&P companies. The principles of risk and return, however, tell us that because there are fewer risks associated with royalty interests they will yield lower returns than their riskier counterparts. Royalty interests range in percentage ownership of revenues from 0.025%-25%, meaning that, at the highest royalty interest, at least 75% of revenue is still funneled to the working interest owners. Due to differences in risk, royalty interests are unlikely to generate the magnitude of returns that working interests can experience. At the same time, they are less likely to experience the same degree of loss.ReturnThe standardized measure of investment performance for a given unit of time is return. Investment returns have two components. The first, yield, measures the current income (distributions) generated by an investment. Capital appreciation, the second component, measures the increase in value during the period. As shown below, total return is the sum of yield and capital appreciation.Royalty trusts commonly make substantial distributions because they generate revenue as long as their operators are drilling and they have minimal operating expenses. Thus it is important to examine total return when comparing interests in E&P companies, who own working interests, and royalty trusts who own royalty interests. In the chart below we examine the total returns of the companies introduced above and their associated royalty trusts.As expected, the E&P companies which hold working interests show higher returns and steeper losses than their associated royalty trusts.We have assisted many clients with various valuation and cash flow issues regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.

Mineral Interest Owners: How to Know What You Own

As we’ve discussed, there are plenty of factors to consider when determining the value of mineral interests. While some mineral owners may be very well attuned to decline curves and local pricing dynamics, others may only casually monitor the price of oil and gas to get a general sense of the trend in the industry. This post is geared towards those mineral interest owners who have less knowledge on the subject and should serve as a guide for those seeking to learn more about what they own. We frequently receive calls from mineral interest owners who know little about what they own other than the operator’s name on the check and the amount they receive each month. Besides just the amount paid by the operator, royalty checks provide valuable information to mineral owners that can help determine the value of their minerals.How to Read a Royalty CheckThe information on royalty checks is beneficial because it gives mineral interest owners plenty of granular detail on how the operator calculates their monthly payment. The problem is that companies may issue checks with differing formats (see two examples below) and they can be hard to read. However, with a trained eye, mineral interest owners can learn to read these checks and glean valuable insight into what is driving the value of their interests.The first example is a check one might actually receive in the mail. The second is a sample check provided by an operator to help owners understand what it means. Regardless of the operator, there are a few key items that appear on every check:Ownership PercentageProduct CodeCountyOwnership PercentageA lease arrangement is designed to be a mutually beneficial agreement. Mineral owners own the rights to a valuable commodity, but they lack the ability to harvest it themselves. Operators come in with the equipment and requisite knowledge necessary to extract minerals from the ground. In exchange for the right to drill on the property, operators pay mineral owners a fraction of the revenue generated from the production. This fraction can appear on a check as a string of numbers like 0.0234375. You may be wondering, where does this number come from? This is the product of the net mineral acreage owned multiplied by the royalty percentage negotiated.Most of the United States uses the Public Land Survey System which is divided into townships and further into sections. A township is 36 sections and a section is 640 acres (or one square mile).[1] Sections are further broken down into quadrants, or some other division as the land is passed down over time. For instance, a lease could specify “all of the mineral interest under the E ½ SE ¼ of 11-2N.” This is read “The east half of the southeast quarter of Section 11, township 2 North.” As depicted below, this would be the rectangle in the bottom right quarter, and would represent 80 net mineral acres. That is: 640 acres per section times ¼ times ½. The lease would go on to specify the royalty percentage to be paid, like 3/16. This will frequently be presented in some form similar to the follow: “To pay Lessor for gas (including casinghead gas) and all other substance covered hereby, a royalty of 3/16 of the proceeds realized by Lessee from the sale thereof.” This simply means the operator will pay a royalty of 3/16 of revenue generated from production on the property. Multiplied by the 80 net mineral acres that make up the 640 acre section, we arrive at: 80/640 x 3/16 = 0.0234375Owners will note much larger dollar figures on their checks which represent the gross revenue the operator receives from production of the minerals. This gross value is multiplied by the ownership percentage, which determines the amount actually received by the owner on their check. Knowing the net mineral acreage owned (not determined by the operator) can help determine the royalty rate the mineral owner is being paid, which helps to understand the value ultimately being paid for their interests.Product CodeThe information on royalty checks is beneficial because it gives mineral interest owners plenty of granular detail on how the operator calculates their monthly payment.The revenue received by both the operator and ultimately the owner depends on both the quantity produced and the price achieved. As of the writing of this article, crude oil prices are trading around $53 per barrel for West Texas Intermediate (WTI), the most commonly tracked figure for U.S. crude oil. By comparison, natural gas is trading around $3.04 per Mcf at the Henry Hub, the most common benchmark for natural gas in the country. Knowing what is being produced: oil, gas, NGL, or a combination of these is crucial to understanding the value of the interests. Owners can figure this out by looking at the product code on their checks, which can be expressed as either a letter or number. Our first example lists the product code as 204, and the legend at the bottom of the check indicates that gas is being produced. Even less clearly, our second example shows the letter “G” under the “P” column, and which, according to the legend, means gas is being produced. This can be far from intuitive without some sort of key describing each item.When oil prices decline, as they have since the beginning of October, mineral owners who receive royalty checks based on oil production can expect to see smaller figures on their checks. But the price isn’t purely based on the value listed on an exchange. It also depends on location and infrastructure to bring the commodity to market.CountyThe county where the minerals are produced is another common feature of royalty checks. However, it is not clearly stated as “Gaines County” for example. In our first example, we see the check says /TX/ Gaines which tells us the mineral interests are in Gaines County, Texas, which is located in the prolific Permian Basin. Again, this isn’t very clear just from looking at the check, and someone not from the region may not automatically know the names of counties in different states.Knowing the county where the minerals are located can go a long way to understanding their value. For instance, oil production in the Permian Basin has increased significantly in recent years and has been a very attractive place for industry players. However, a lack of pipeline infrastructure has led to oversupply, meaning operators were forced to take a discount to the WTI price. Mineral owners have no control over where and when operators choose to produce, and current production leads to more upfront revenue, but taking a discounted price to get the revenue upfront could ultimately be detrimental to mineral owners in the long term, given the way production tends to decline significantly.Other Sources of InformationWhile royalty checks are tangible pieces of information sent frequently to mineral owners, there’s more information out there that owners can turn to. The lease agreement itself can be the primary source for determining what you own. While many may look the same, lease agreements are ultimately an economic agreement between two parties and can have a variety of different clauses. However, there are frequently instances where our clients do not have access to these key documents. In the case of interests being passed down or donated, clients are usually dealing with legacy arrangements with operators and may not have all the documents that spell out the specific rights with their particular lease.Royalty checks provide valuable information to mineral owners that can help determine the value of their minerals.There are other potential sources of information published online that owners can access free of charge. For instance, in Texas, there’s the Texas General Land Office and Texas Railroad Commission where mineral owners can, among other things, zoom in on plots of land and see well locations. Mineral owners can also learn about historical drilling permits and activity by region. The FDIC also publishes sales of oil and gas interests which can be helpful to see actual sales prices for mineral interests observed in the market.ConclusionRoyalty checks are hardly intuitive, and not everyone would bother asking too many questions when they regularly receive a check in the mail. However, without putting in some research, it can be hard to know if the next check will be higher or lower, or if there will even be one next month. That’s where it becomes crucial to understand what drives the value for mineral interests and what are the relevant risk factors. For those looking to sell their interests, or simply looking to understand the value of what they own, an appraisal can be a helpful tool in understanding both the value of mineral interests, and what drives this value. It is important to seek advice from someone who has experience valuing mineral interests and is well-versed in all potential sources of information.Mercer Capital is an employee-owned independent financial advisory firm with significant experience (both national and internationally) valuing assets and companies in the energy industry (primarily oil and gas, bio fuels and other minerals). Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors.As a disinterested party, we can help you understand the fair market value of your royalty interest and ensure that you get a fair price for your interest. Contact anyone on Mercer Capital’s Oil and Gas team to discuss your royalty interest valuation questions in confidence.[1] Exampled based on a presentation at the National Association of Royalty Owners (NARO) 2018 Conference in Denver, CO

2018 Was a Banner Year for Asset Manager M&A

Asset manager M&A was robust throughout 2018 against a backdrop of volatile market conditions. Several trends which have driven the uptick in sector M&A in recent years continued into 2018, including increasing activity by RIA aggregators and rising cost pressures. Total deal count during 2018 increased 49% versus 2017 and total disclosed deal value was up nearly 140% to $18.0 billion. In terms of both deal volume and deal count, asset manager M&A reached the highest levels since 2009. M&A was particularly strong in the fourth quarter when Invesco Ltd. (IVZ) announced plans to acquire the OppenheimerFunds unit from MassMutual for $5.7 billion in one of the largest sector deals over the last decade. IVZ will tack on $250 billion in AUM as a result of the deal, pushing total AUM to $1.2 trillion and making the combined firm the 13th largest asset manager by AUM globally and the 6th largest by retail AUM in the U.S. The deal marks a major bet on active management for IVZ, as OppenheimerFunds’ products are concentrated in actively-managed specialized asset classes, including international equity, emerging market equities, and alternative income. Invesco CEO Martin Flanagan explained the rationale for scale during an earnings call back in 2017: "Since I've been in the industry, there's been declarations of massive consolidation. I do think though, this time there are a set of factors in place that weren't in place before, where scale does matter, largely driven by the cost coming out of the regulatory environments and the low rate environments in cyber and alike." Martin Flanagan, President and CEO, Invesco Ltd. – 1Q17 Earnings CallRIA aggregators continued to be active acquirers in the space, with Mercer Advisors (no relation), and United Capital Advisors each acquiring multiple RIAs during 2018. The wealth management consolidator Focus Financial Partners (FOCS) has been active since its July IPO as well. In August, FOCS announced the acquisition of Atlanta-based Edge Capital Group, which manages $3.5 billion in client assets. FOCS also announced multiple sub-acquisitions by its affiliates during the second half of 2018.Consolidation Rationales The underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, aging shareholder bases, and slowing organic growth for many active managers. While these pressures have been compressing margins for years, sector M&A has historically been muted, due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation. Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure as long as it doesn’t inhibit performance."Absolutely, this has been an elevated period of M&A activity in the industry and you should assume … we're looking at all of the opportunities in the market." Nathaniel Dalton, CEO, Affiliated Managers Group Inc – 2Q18 Earnings Call"Increased size will enable us to continue to invest in areas that are critical to the long-term success of our platform, such as technology, operations, client service and investment support, and to leverage those investments across a broader base of assets." David Craig Brown, CEO & Chairman, Victory Capital – 3Q18 Earnings CallConsolidation pressures in the industry are largely the result of secular trends. On the revenue side, realized fees continue to decrease as funds flow from active to passive. On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs. Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to realize economies of scale, enhance product offerings, and gain distribution leverage.Market ImpactRecent increases in M&A activity come against a backdrop of a long-running bull market in asset prices that finally capitulated in late 2018. Over the past several years, steady market gains have more than offset the consistent and significant negative AUM outflows that many active managers have seen. Now that the market has pulled back, AUM, revenue, and earnings are likely to be lower for many asset managers.The recent market pullback will impact sector deal making in several ways. Notably, earnings multiples for publicly traded asset managers have fallen considerably during 2018, which suggests that market sentiment for the sector has waned as the broader market has declined. While the lower multiple environment is clearly less favorable for sellers, market volatility may force some smaller, less profitable firms into selling in order to remain viable. For buyers, the lower multiple environment may make the sector look relatively underpriced though some may be spooked by the recent volatility.M&A OutlookWith over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies. Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth. An aging ownership base is another impetus. The recent market volatility will also be a key consideration for both sellers and buyers in 2019.

Oilfield Services in 2018

A Year in Review

Companies in the energy sector and the broader market experienced an interesting year showing steady and strong growth in Q1-Q3 and met volatility in Q4, which effectively erased gains on the year and even resulted in negative returns.The oilfield services (OFS) sector, in particular, was impacted heavily during last quarter’s downturn driven primarily by fears of oversupply in the market and E&P companies cutting back and looking for discounts. Oil prices steadily rose from about $47 per barrel in August 2017 to over $73 per barrel in October 2018 as OPEC and a Russia-led pact of non-OPEC members coordinated efforts to bring supply production into balance.However, reports of increased global supplies, including from countries such as Saudi Arabia, Russia, and the U.S. resulted in prices falling again. WTI experienced a 44% decline from a 2018 high of $75 per barrel to lows of around $43 in late December. The OSX, the index tracking OFS sector stock performance, was sideways for the most of 2018 and fell in tandem with the fourth quarter oil crash, resulting in an all-time low for the index of $80. The large and rapid hits were reminiscent of the declines experienced in 2014, and operators have been playing it close to the chest in terms of spending. Volatile oil prices and E&P spending will be among the major factors contributing to overall OFS performance going into the new year. M&A ReviewTransaction activity for the oilfield services sector for 2018 was near identical to 2017 in terms of number of deals, and total deal value saw a slight uptick. Low volatility and stable growth that defined 2017 markets and steadily increasing oil prices for most of 2018 have allowed for moderate transaction activity compared to the two years prior to 2017. This environment has also facilitated OFS companies to be more methodical in acquisitions compared to the past.As we discussed in a prior post, factors influencing transaction activity shifted from financial stress and cost efficiencies to economies of scale and enhanced offerings especially in technology and other efficiencies. The following table shows select transactions that occurred in 2018 with relevant enterprise value multiples, as companies sought strategic growth opportunities. Despite the fourth quarter turmoil, transactions from October to December constituted over 30% of total year deals. The observed mix of transactions for the year covered a broad spectrum of subsectors within the OFS sector. Contract drilling and well servicing/completion companies appeared to have slightly more transaction activity compared to other subsectors, but there was not an apparent trend identified within subsector deal activity.Fewer Bankruptcies for 2018Bankruptcies in the energy sector have ebbed since 2015 and 2016, but the recent slump in commodity prices do not point toward continued improvement for 2019, according to the latest bankruptcy tracking report from Haynes and Boone LLP.During 2018, the OFS bankruptcy filings decreased both in number to 12 filings and in aggregate debt of $3.85 billion compared to 2017 which consisted of approximately 40 filings and aggregate debt of $35 billion.However, with oil prices dropping over a third of its value in the final quarter of the year, a number of public companies made announcements of significant reductions in their 2019 exploration and production budgets, directly impacting prospects for many OFS companies. In turn, this could lead to an increase in filings in the first quarter of 2019 in the event of capex and budgetary strains.But while a number of companies are expecting to make budgetary reductions, several are looking to maintain or even increase spending in 2019.Spending and Outlook for 2019Analysts with Moody’s Investors Service believe that the health of the OFS sector is still quite weak with many burdened by high debt and added pressure brought by the drop in crude prices in late 2018. But the sector could see a 10% to 15% increase in overall earnings in 2019 as E&Ps increase spending. The key factor alluded here is that spending for many of these companies is anticipated to follow later in the year after riding out Q4 2018 shocks.Spending for many of these companies is anticipated to follow later in the year after riding out Q4 2018 shocks.Sajjad Alam, vice president-senior analyst for Moody’s, said in his report, “Most of that growth will likely come only later in 2019 after the heightened oil-price volatility of late 2018. Infrastructure constraints in the Permian Basin will also limit OFS operators’ ability to raise prices early in 2019.”Limited spending is a concern for OFS companies as many E&Ps weigh the choices surrounding budget appropriations. But many companies and private equity firms still appear to be committed to proposed capex budgets of increased spending on much needed infrastructure.Hess Corp announced a 2019 E&P capital and exploratory budget of $2.9 billion slated for 2019, up from $2.1 billion in 2018. Approximately 75% will be allocated to high return growth assets in the Bakken and Guyanna.ConocoPhillips has set a capex budget for 2019 of $6.1 billion, which is comparable to its 2018 capex, excluding any acquisition costs. Approximately $3.1 billion will be allocated to rigs across the Eagle Ford, Bakken, and Delaware plays.North American E&P spending as a whole is expected to lag behind international markets but is estimated to grow 9% in 2019, according to a global E&P report released from Barclays. Barclays noted, however, “spending is exposed to more downside risk given the recent oil price collapse,” which isn’t fully captured in budgets that have been approved thus far.Value ConsiderationsFrom a valuation perspective, we examined a selection of guideline company groups for relative value changes over time. One way to observe this relative value change is to look at enterprise value, adjusted for cash, relative to total book value of net invested capital (debt and equity) held by the company or “BVIC.” Any multiple over 1.0x indicates valuations above what net capital investors have placed into the firm.Take for example, Land Contract Drilling and Services subsectors: EV/BVIC multiples have fallen since the middle of the year and even below observed 2017 levels. Investors were not expecting to receive adequate return on capital deployed at these companies. After analyzing our guideline companies for oilfield services and equipment overall, observed average and median multiples for 2018 were below 1.0x for 2018. The only outliers within this sector are pressure pumping and fracking concentrated businesses, which are more directly tied into the value expansion in the oil patch. The demand for pumpers’ technology and services has driven through the fourth quarter woes, showing that the market recognizes the contributions from these companies. ConclusionAs the energy sector brings in the new year, continued strategic M&A and fewer bankruptcies indicated positive signals for the health of the sector, but the fourth quarter collapse in oil prices have had companies and analysts alike cautious on the outlook for 2019 as evidenced in value considerations above.Ultimately OFS is weak right now due to multiple factors; however, there are reasons for optimism in the sector and growth opportunities during these uncertain times.Several companies underperformed to close out 2018, and many have made adjustments to conserve cash through debt restructurings, leverage reduction, and stringent capital discipline. Although oil prices have rebounded somewhat in the first weeks of January, volatility is still a primary concern when it comes to forward planning.U.S. spending is expected to increase in the next year, but many budgets among larger North American E&Ps have been reduced or have yet to be unveiled, which could mean further reduction of spending compared to preliminary estimates.Ultimately OFS is weak due to multiple factors stemming volatility, general market uncertainty, and the price crash; however, steady and methodical M&A during the year coupled with very few bankruptcy filings and prospects for late E&P spending increases offer optimism in the sector and growth opportunities during uncertain times.In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.Whether you are selling your business, acquiring another business or division, or have needs related to mergers, valuations, fairness opinions, and other transaction advisory needs, we can help. Contact a Mercer Capital professional to discuss your needs in confidence.

Trust Banks' Performance and the Role of Technology

Trust banks have generally lagged the broader indices since the financial crisis of 2008 and 2009. Against a bearish backdrop for the industry, all three trust bank stocks declined in the last few months of the year with falling client asset balances and rising labor costs.Rough year for trust bank stocks, especially State Street Northern Trust and BNY Mellon performed more in line with the market and traditional banks while State Street’s underperformance is largely attributable to investor skepticism surrounding its purchase of Charles River Systems last summer. Customers Demand Improved Technology OfferingsAs noted during a Conversation with Jay Hooley and Ron O’Hanley at State Street, the industry is going through a “time of unprecedented change.” Investment firms are devoting more time and resources to keep up with the most recent technological offerings and improve the overall client experience. These dynamics are especially true for trust banks where increased regulation has encouraged advancement in data management.IT investment is outlined as a clear priority for success. BNY Mellon invested $2.4 billion in IT last year and plans to spend another $2.7 billion going forward to develop their operating platform. Northern Trust utilizes technology in order to provide momentum to its growth strategies and cut costs “to take advantage of new technologies such as robotics to slim down its permanent workforce.”Another example of trust banks’ directing resources to technological development is State Street’s recent acquisition of Charles River Systems for $2.6 billion. Charles River is a financial data firm that runs a software platform used by more than 300 asset management firms. According to Ron O’Hanley, President and CEO of State Street, “This acquisition represents not only a significant investment in our future but also the recognition that the ability to assist clients in managing their data needs and extract insights from their data is increasingly the most important differentiator for our industry.”Investors disagreed as STT’s share price declined sharply after the announcement (pessimism surrounding the acquisition) as the 38% increase in total assets under custody from the acquisition will not be met with proportional increases in revenue. At the moment, investors are questioning if State Street’s focus on data management in addition to asset management will, in fact, create shareholder value in the long run.Is Pricing Indicative of Performance in a Down Market?Trust bank trailing and forward multiples have fallen in line with the broader market. A quick glance at year-end pricing shows the group valued at 9-13x (forward and trailing, respectively) earnings, down from 14-16x at year-end 2017 as the outlook on future cash flows has stalled with the recent market correction. Despite trust banks’ underperformance during 2018, investment management fees increased year-over-year (as of the third quarter, the most recent information available). Servicing fees varied by company. State Street saw a decline in serving fees due to what it explains as “client transitions and challenging industry conditions.” BNY Mellon’s fees were relatively flat and Northern Trust saw an increase in servicing fees partially due to the UBS fund administrator acquisition which closed in late 2017. But, as a whole, trust banks saw improved net interest margins due to higher U.S. market interest rates and increases in trading services with the recent uptick in volatility. Are Investors Too Bearish on State Street? State Street’s stock price has been hammered even more than the industry as a whole. State Street’s ETF business has historically helped it outperform peers. However, legacy contracts have disabled them from cutting fees in order to remain competitive. State Street has begun restructuring its ETF business, but it will take time to regain its market position. Despite these challenges, State Street’s share of the U.S. ETF industry was at an all-time low by July of this year. Despite the recent struggles with its ETF business and the market’s perception of the Charles River acquisition, State Street ($34 trillion in AUCA) is still on track to surpass BNY Mellon ($34.5T AUCA) as the largest custody bank by in terms of assets under custody/administration.Trust Companies are Bullish on TechnologyTrust Companies are relying on technology to ease some of the pressure from their customers on cost. More barriers to entry have developed in the industry as regulators have made it harder to obtain approval to operate as a custody bank. This stricter regulation has forced these companies to adopt technological platforms which, if done properly, can provide a valuable service to its customers.Mercer Capital assists RIA clients with valuation and related consulting services for a variety of purposes. In addition to our corporate valuation services, Mercer Capital provides transaction advisory and litigation support services to the investment management industry. We have relevant experience working with independent trust companies, wealth management firms, traditional and alternative asset managers, and broker-dealers to provide timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Q4 2018 Review and Outlook for 2019

Oil Prices: 40% Off From Its Four-Year HighIn the fourth quarter of 2018, U.S. crude oil prices plunged by 40%, from $75 in the beginning of the quarter to $45 per barrel. The sanctions on Iran, OPEC’s third-largest producer, seemed to be the last push to higher prices in late September. The recovery since 2016 has been primarily driven by the supply side of the equation: OPEC’s production cut lowered inventory, and geopolitical tensions (such as Iran and Venezuela). The years-long recovery ended in just three months. The reasons include concerns about swelling U.S. shale output, rising crude oil inventories, inconsistency in Russia and OPEC’s execution of their production deal, and fears of a global economic slowdown. OPEC’s deal with Russia to cut 1.2 million barrels per day during the December 6-7 meeting couldn’t stop oil prices from falling. The sharp decline once again proved higher prices driven by supply almost always have a difficult time lasting.Natural Gas Prices: A Roller Coaster Ride in the Fourth QuarterNatural gas prices soared to $4.70 per mcf in mid-November due to several factors including an early and colder winter hitting North America. It's relatively rare to see the inverse relationship between crude oil and natural gas prices, which happened in the fourth quarter of 2018. A more than 50% increase in natural gas prices was coupled with nearly 30% downturn in crude oil prices during a seven-week period from early October to mid-November. Long oil short natural gas, once a popular trade by speculators, was punished during this unusual period of time. Natural gas prices ended the year at $3.25 per mcf, a 9.8% increase for the fourth quarter and 10.1% rise for the year. The roller coaster ride exhibits the notion that there are few long-term supply issues in natural gas in North America.Outlook for 2019It was truly a dramatic quarter for the industry. The fourth quarter of 2018 marked the end of the two and a half-year oil price recovery that began in 2016, while natural gas prices reached their highest point since 2014. Volatility disrupted capital intensive industries in general. Large investments consisting of millions, or even billions, may take years to complete while circumstances may totally change within a short period, such as the fourth quarter of 2018 we just experienced. However, many producers make capex decisions based on long-term expectations. The latest World Bank commodities price forecast released on October 29, 2018 shows Brent crude will average $74.0 in 2019 and approximately $69.2 from 2020 to 2023.According to the December Short-Term Energy Outlook, the EIA expects global liquid fuels consumption to increase by 1.5 million barrels per day in 2019, with growth largely coming from China, the U.S., and India. Trade tensions between the U.S. and China remain high entering 2019 and have shaken up most, if not all, industries, and oil and gas is no exception. China ranks second in oil consumption and surpassed the U.S. as the world’s largest crude oil importer in 2017. Slower growth in China is looming for the demand side of crude oil. In 2019, the continuation of worldwide central banks tightening pressures global economic growth and the prices of assets and commodities. Higher rig counts and higher capital expenditures by major oil & gas companies worldwide during the recovery also cause concerns of oversupply. According to Baker Hughes, as of December 28, 2018, rig counts in the U.S. were 1,083, 16.7% higher than December 29, 2017.Improving pipeline capacity and the combination of horizontal drilling and hydraulic fracturing continue to drive higher and more efficient production in the U.S.In 2019, it is expected that the U.S. will continue to lead the growth in oil supply worldwide. Improving pipeline capacity and the combination of horizontal drilling and hydraulic fracturing continue to drive higher and more efficient production in the U.S. According to the EIA, U.S. crude oil production recently set a record of 11.5 million barrels per day in September 2018. For a single week in November 2018, the U.S. was a net exporter of crude oil and petroleum products. EIA expects U.S. crude oil production will average 10.9 million barrels per day in 2018, up from 9.4 million barrels per day in 2017, and will average 12.1 million barrels per day in 2019.U.S. LNG daily production hit a record high of 5.28 Bcf in Christmas week, according to S&P Global Platts. Large-scale additions to production capacity in 2018 included Shell’s Prelude and Inpex’ Ichthys, both offshore Australia, and Novatek expanded its Yamal LNG facility, while demand is slowing down in Asia, the biggest LNG market in the world. Europe is likely to play the key role in absorbing all the additional production given geopolitical factors, pipeline capacity issues, and the controversial Nord Stream 2. Also, Gazprom’s contract for gas transit via Ukraine is expiring at the end of this year and surprise during negotiation is always possible among Russia, Ukraine, and Europe.The EIA expects Brent spot prices will average $61 per barrel in 2019 and that West Texas Intermediate (WTI) crude oil prices will average about $7 dollar per barrel lower than Brent prices next year, while Henry Hub natural gas spot prices to average $3.11 per MMBtu in 2019. With ongoing oversupply concerns, stabilizing geopolitical tensions, and lower forecasts for global oil demand, it appears in 2019 oil prices have a long way to recover to its previous high in 2018.

2019 Outlook: Gasping for Air Replaces 2018’s Rainbow Chasing

What a difference a year makes. A year ago corporate tax reform had been enacted that lowered the top marginal tax rate to 21% from 35%. Banks were viewed as one of the primary beneficiaries through a reduction in tax rates and a pick-up in economic growth. Now investors are questioning whether bank stocks and other credit investments are canaries in the U.S. economic coalmine.As 2018 draws to a close, bank fundamentals are very good; however, bank stock prices have tanked. SNL Financial’s small-, mid-, and large-cap bank indices have fallen by more than 20% since August 31, which meets the threshold definition of a bear market (i.e., down 20% vs. 10% for a correction). Markets, of course, lead fundamentals, and corporate credit markets lead equity markets. Among industry groups, bank stocks are “early cyclicals”, meaning they turn down before the broader economy does and tend to turn up before other sectors when recessions bottom. Large cap banks peaked in February while the balance of the industry peaked in the third quarter after having a fabulous run that dates to the national elections on November 8, 2016. The downturn in bank stock prices corresponds with weakening home sales, widening credit spreads in the leverage loan and high yield bond markets, a ~40% reduction in oil prices, and a nearly inverted Treasury yield curve. To state the obvious: markets—but not fundamentals so far—are signaling 2019 (and maybe 2020) will be a more challenging year than was assumed a few months ago in which the economy slows and credit costs rise. The key question for 2019 then is: how much and is a slowdown fully priced into stocks? Our next issue of Bank Watch will entail a deep dive into credit, but for this issue, we observe that a global unwind of leverage is underway as the Fed extracts liquidity from the system. Bond buying (QE) and ultra-low rates helped drive asset prices higher. The reverse is proving true, too. Bank FundamentalsBank fundamentals are in good-to-great shape. During the third quarter all FDI-Cinsured institutions reported aggregate net income of $62 billion, up 29.3% from 3Q17. Excluding the impact of lower taxes, 3Q18 pro forma net income would have been about $55 billion, up 13.9% from 3Q17. The data is more nuanced once the industry is segregated by asset size, however.As shown in Figure 3, ROA and ROE have nearly rebounded to the last pre-crisis year of 2006. Importantly, capital has increased significantly and, thereby, provides an additional buffer whenever the next downturn develops. As it relates to 2019, bank fundamentals are not expected to change much other than credit costs are expected to increase from a very low level in which current loss rates in all loan categories are below long-term averages. Wall Street consensus EPS estimates project mid-single digit EPS growth for the largest banks, primarily as a result of share repurchases and a slightly higher full year NIM, while regional and community bank consensus estimates reflect upper single digit EPS growth from the same factors and somewhat better loan growth. However, credit and equity markets imply the consensus is too high given the sharp widening in credit spreads and drop in bank stock prices the past several months. Although markets lead fundamentals, market signals about magnitude are less clear. Given continuing growth in the U.S. economy that on balance will be helped by lower oil prices, it seems reasonable that an increase in credit costs the market is forecasting will be modest, and as a result, bank profitability will not be meaningfully crimped in 2019. The Fed: 2019 Rate Hikes Seem UnlikelyWhenever the Fed embarks on an extended rate hiking campaign, the saying goes the Fed hikes until something breaks. The market is signaling that the December rate hike—the ninth in the current cycle—that pushed the Fed Funds target from 2.25% to 2.50% when the yield on the 10-year UST bond was ~2.8% may be one of those moments. What’s unusual about the current tightening cycle is it represents an attempt by the Fed (but not the BOJ, ECB or SNB) to extract itself from radical monetary policies in which the Fed is raising short-term rates and shrinking its balance sheet at the same time. Given the flat yield curve, it is hard to see how the Fed will hike the Fed Funds another couple of times as planned for 2019, unless the Fed wants to invert the yield curve or unless intermediate- and long-term rates reverse and trend higher. Presumably the $50 billion a month pace in the reduction of its US Treasury and Agency MBS portfolio will continue. Alternatively, perhaps the Fed will bow to the market and not raise rates in 2019 and slow or even halt the reduction in its balance sheet to stabilize markets. As it relates to bank fundamentals, the impact on net interest margins will depend upon individual bank balance sheet compositions. Broadly, however, a scenario of no rate hikes implies less pressure to raise deposit rates, and rising wholesale borrowing rates should stabilize. The result, therefore, should be a little bit better NIMs than a slight reduction if the Fed continues to hike given that deposit rate betas for many institutions are well over 50% now. More important for banks if the Fed pauses vs continues to hike would be the impact on asset values (higher all else equal) and, therefore, credit costs. Bank Valuations: Support but Never a Stand-Alone CatalystA synopsis of bank valuations is presented in Figure 4 in which current valuations for the market cap indices are compared to the approximate market top around August 31, November 8, 2016 when the national election occurred, and multi-year medians based upon daily observations. An important point is that valuation is not a catalyst to move a stock; rather, valuation provides a margin of safety (or lack thereof) and thereby can provide additional return over time as a catalyst such as upward (or downward) earnings revisions can cause a multiple to expand or contract.Bank stocks—particularly mid-cap and large-cap banks—enter 2019 relatively inexpensive to history. The stocks are cheap relative to 2019 consensus earnings with large cap banks trading around 8x and small cap banks at 10x; however, the market’s message is that the estimates are too high. It is hard to envision that estimates are dramatically too high as proved to be the case in 2008 unless the economy is poised to roll-over hard, which seems unlikely. Assuming no recession or a shallow recession, then, the modest valuations may result in bank stocks having a good year even if fundamentals weaken and analysts cut estimates because the limited downside in earnings had been adequately priced into the stocks by late December.Bank M&A: Slowing Activity for 2019 LikelyOutwardly, 2018 has been another good year for bank M&A even though activity slowed in the fourth quarter. There were few notable deals other than Fifth Third’s pending acquisition of Chicago-based MB Financial valued at $4.8 billion at announcement and Synovus Financial’s pending acquisition of Boca Raton-based FCB Financial Holding valued for $2.8 billion at announcement. Even before bank stocks rolled over the shares of both Fifth Third and Synovus severely underperformed peers as investors questioned the exchange ratios, cost saving assumptions, credit risk (especially at FCB), and whether the buyers could keep the franchises intact as key personnel defected elsewhere.The national average price/tangible book multiple expanded to 173% from 166% in 2017 and about 140% in 2014, 2015 and 2016 before the sector was revalued in the wake of the national election. The median P/E of 25x was within the five-year range of 21x to 28x.The total number of bank and thrift transactions through December 24 totaled 261, which equated to 4.4% of the commercial bank and thrift charters as of year-end 2017. During 2014–2018, the number of acquisitions exceeded 4% each year except for 2016 when activity at the beginning of the year was hampered by weak stock prices as a result of a slowing economy that was marked by a collapse in oil prices and sharply wider credit spreads. Weak bank stock prices crimp the ability to negotiate deals because most sellers are focused on absolute price rather than relative value when taking the buyer’s shares as consideration; and, buyers usually are unwilling to increase the number of shares being offered given a limitation on minimum acceptable EPS accretion and maximum acceptable TBVPS dilution. A notable late year exception occurred when Cadence Bancorporation opted to increase the number of shares it will issue to State Bancorp by 9.6% because the double trigger in the merger agreement signed during May when Cadence’s share price was much higher came into play. Although there is no change in the driver of consolidation such as succession issues, shareholder liquidity needs, and economies of scale, a slowdown in M&A activity in 2019 is likely because bank stocks will enter the year depressed. Deals that entail some amount of common share consideration will be tough to structure unless sellers will be willing to take less, which most will not do with operating fundamentals in good shape for now. All cash deals will be impacted less, but all cash deals are more prevalent among very small institutions in which pricing usually occurs at a discount to those that entail some proportion of common shares. Summing It UpThe market is shouting fundamentals will weaken in 2019 after a long period of gradual improvement following the Great Financial Crisis, which most likely will be reflected in sluggish loan growth and modestly higher credit costs; however, bank stocks may surprise to the upside as they did to the downside in 2018 provided a) there is no recession or a shallow one; and, b) the Fed relents and does not hike further and potentially slows the run-off of its excess bonds (and liability reserves). For clients of Mercer Capital who obtain year-end valuations, rising stock prices since the presidential election may be reversed partially, given the compression in market price/earnings and price/tangible book value multiples that occurred in 2018.

RIA Stocks Suffer Worst Quarter Since the Financial Crisis

Most Traditional and Alternative Asset Managers in Bear Market Territory After Turbulent Year for Global Equities

Following a decade of (fairly) steady appreciation, RIA stocks finally capitulated with the market downturn and growing concerns over fee compression and asset flows. As a leading indicator, such a decline suggests the outlook for these businesses has likely soured over the last year or so.What Goes up Must Come Down…Prior to last year, RIA stocks benefited immensely from the bull run that began in March of 2009, besting the market by over 60% during this favorable period for asset returns.[caption id="attachment_24166" align="alignnone" width="814"]Source: S&P Global Market Intelligence[/caption] In 2018, this trend reversed course, and the return of market volatility and negative returns precipitated a broad decline across all industry sectors. [caption id="attachment_24163" align="alignnone" width="833"]Source: S&P Global Market Intelligence[/caption] Traditional active managers have felt these pressures most acutely as poorly differentiated products struggled to withstand downward fee velocity and at the same time have been a prime target of regulatory developments. To combat fee pressure, traditional asset managers have had to either pursue scale (e.g. BlackRock) or offer products that are truly differentiated (something that is difficult to do with scale). Investors have been more receptive to the value proposition of wealth management firms as these businesses are (so far) better positioned to maintain pricing schedules as a result. Reflective of the headwinds that the industry faces, asset managers generally underperformed broad market indices during the fourth quarter. As the broader indices stumbled, many RIA stocks plummeted with falling AUM balances and management fees. The operating leverage inherent in the business model of most asset managers suggests that market movements tend to have an amplified effect on the profitability (and stock prices) of these businesses as displayed by their performance in the last quarter. [caption id="attachment_24165" align="alignnone" width="820"]Source: S&P Global Market Intelligence[/caption] Does Size Matter for RIAs?The corresponding RIA size graph seems to affirm this. The larger firms generally outperformed smaller RIAs, though all categories were down in the quarter. Still, this trend is, admittedly, a bit misleading since the smallest category of publicly traded RIAs (those with less than $10 billion AUM) was down nearly 30% during the quarter, although this is the least diversified category of RIAs with only two components. As such, this category is subject to a high degree of volatility due to company-specific developments. Most of our clients are in this size category, and we believe it is highly unlikely that these businesses lost almost a third of their value (in aggregate) over the quarter as suggested by the graph below.[caption id="attachment_24166" align="alignnone" width="821"]Source: S&P Global Market Intelligence[/caption] Generally speaking, larger RIAs typically attract higher valuations due to the benefits of scale and a more diverse AUM base. Still, capacity constraints can be an issue, particularly for niche and small cap investment products. So, unless you’re BlackRock, there’s probably a sweet spot for optimal asset size. A (More) Bearish OutlookThe outlook for these businesses is market driven, though it does vary by sector. Trust banks are more susceptible to changes in interest rates and yield curve positioning. Alternative asset managers tend to be more idiosyncratic, but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth managers and traditional asset managers are more vulnerable to trends in active and passive investing.On balance, the outlook for 2019 doesn’t look great given what happened to RIA stocks last quarter. The market is clearly anticipating lower AUM, revenue, and earnings with the recent correction, which could be exacerbated by asset outflows if clients start withdrawing their investments. Friday’s steep advance could be a silver lining, though volatility remains high. More attractive valuations could also entice more M&A, which is still relatively subdued despite the recent uptick in dealmaking. We’ll keep an eye on all of it in what will likely be a very interesting year for RIA valuations.

Cooler Weather Could Heat Up Appalachia

As the calendar turns to 2019, we turn our attention to the Appalachia region, and not by coincidence. Cooler temperatures in the winter months tend to lead to increased natural gas prices and consumption, and the Appalachia region is the largest natural gas producer in the country. Fourth quarter energy prices moved in opposite directions—crude prices declined steadily over the period and natural gas prices increased from about $3.0 to $3.5 per Mcf, peaking at over $4.8 in mid-November.November Price SpikeIn its December edition of the Short-Term Energy Outlook, or STEO, the EIA reported the price of Henry Hub averaged $4.15/MMBtu in November, up 87 cents, or 27% from October. It attributed this increase to colder temperatures and lower inventory levels. The EIA estimated that inventory in the U.S. stood at 3.0 trillion cubic feet at the end of November, which was 19% lower than the five-year average.Increased production, spurred by the season and higher prices, has increased supply to meet demand to a degree.Declining nearly 26% since its peak six weeks prior, the run-up in natural gas prices appears to have only been temporary. As we discussed with crude oil in our Q2 newsletter, higher inventory helps to smooth price volatility in the energy market. During this part of the year, natural gas inventories are drawn down as people fire up their heating units, but this year the initial draw down of inventories hamstrung as U.S. natural gas inventories began the season at a 15-year low. Increased production, spurred by the season and higher prices, has increased supply to meet demand to a degree. Milder weather forecasts and energy substitutes (coal) have reigned in prices as well.As we alluded to recently, the price spike was also due in part to short covering by hedge funds in response to the rapid decline in crude prices. Worried investors diverted funds from oil to gas to compensate for accumulating losses in oil. Given the smaller nature of the gas market compared to oil, there was an uptick in activity and prices. Quickly rising prices led to an overbought market that subsequently corrected and has been trending downward with trading volume throughout the end of the year.Appalachian Ethane Storage HubAt the beginning of December, the U.S. Department of Energy published a report to Congress on the feasibility of establishing an ethane storage and distribution hub in the United States, specifically, the Appalachia region. The report noted that significant production growth is expected to occur in the Permian and Appalachia, though the latter trails the former in terms of current infrastructure (95% of ethane storage in the U.S. is located near the Gulf Coast). Storage hubs balance seasonal supply and demand variations, and are crucial to smooth volatility, as evidenced by the November activity. The report notes that a distribution hub near the Marcellus and Utica plays would help allay geographic concentration risk along the Gulf Coast that is susceptible to severe weather events (e.g. Hurricanes Harvey and Irma). While such a hub would provide a competitive advantage, the report crucially notes it would not be in conflict with further expansion of infrastructure in the Gulf Coast.U.S. Secretary of Energy Rick Perry, who signed the report, said, “There is an incredible opportunity to establish an ethane storage and distribution hub in the Appalachian region and build a robust petrochemical industry in Appalachia.” While the report focused on the economic benefits of a hub, detractors note the lack of consideration of environmental costs. It remains to be seen how this will impact production and pricing in the region, but it would undoubtedly be a boon for the region and the industry.Rig Counts and ProductionAccording to calculations based on data from Baker Hughes, rig counts in North America increased 2.9% in the last three months and 16.6% over the last twelve months. The Permian Basin led the way and currently has just fewer than 500 rigs, representing about 46% of total rigs in the U.S. By comparison, the Appalachia region has had below 80 rigs since July 2015 though it has remained relatively consistent, above 70 since last May.Though production has spiked, Appalachia significantly lags the other regions in terms of total production.Oil production in the Marcellus and Utica plays has increased by 45.1% in the past year, growth even higher than the Permian. Though production has spiked, particularly in the second half of the year (up 34.8% since June alone), it’s important to recognize the magnitude: Appalachia significantly lags the other regions in terms of total production.Natural gas is the major focus of the region, where production has increased 15.5% in the past year, trailing both the Permian (34.1%) and the Bakken (25.1%). Again, size plays a role in these growth figures as Appalachia has about 2.5x the production than the next largest play, the Permian. A deeper dive into the DUCs tells a slightly different story, however, with the inventory of drilled but uncompleted wells declining 17% in the region over the past 12 months. This could temper the rate of growth for production for the region in 2019 if drilling in the regions doesn’t increase.Valuation ImplicationsAppalachia has consistently lagged the other regions in terms of EV/production multiples, also known as price per flowing barrel. The Permian took center stage in 2017 but has retreated back to the rest of the pack. The lower multiple seen in Appalachia is largely due to declines in enterprise values, though increasing production has played a role as well.Despite the recent increase in price, the EIA expects increased production in 2019 will cause the average price of natural gas to drop 6 cents, compared to 2018, to $3.11. This could explain why key players in the region are seeing lower stock prices.Range Resources is the largest natural gas producer in the Marcellus, but it has not seen a positive impact from higher prices over the past few months. The company’s share price has dropped further than the overall market, but this cannot solely be attributed to swings in natural gas prices. While Range’s share price has dropped along with the recent slide, it did not get the same treatment when the market spiked in mid-November. Since its long-term debt obligations do not begin to mature until 2021, the drop in share price has had a significant impact on its enterprise value. Range is uniquely positioned with capacity on the Mariner East 1 pipeline that will allow it to tap into the rising global demand for NGLs, so there is potentially an upside to its current price.ConclusionNatural gas prices have followed a curious path in the past three months with index prices spiking at the Henry Hub, but gas being flared in record proportions and even given away at a loss in the Permian. While pricing will remain dynamic, there are certainly positives for natural gas producers heading into 2019 with the potential for an ethane storage hub in the Appalachia region and a ramp-up in production of NGLs to satisfy the global market.We have assisted many clients with various valuation needs in the upstream oil and gas space in both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

RIA Valuation Insights: Best of 2018

Happy New Year to all our readers and subscribers! Here are the five most popular posts from 2018.1. S Corp RIAs Disadvantaged by the Tax Bill: New but UnimprovedFor this post, Matt Crow likens Ford’s lackluster revamp of its Mustang model to the tax bill’s impact on RIA S corps. As with the Mustang II, the Tax Cuts and Jobs Act took a good thing and made it not so good for certain pass through entities by effectively reducing the tax advantage that S corps have over C corporations, especially for non-distributing firms. The TCJA also excluded investment management firms from the QBI deduction beyond a certain income limit. While the tax bill’s reduction on C corp rates was generally beneficial to market returns and AUM balances, it did not necessarily enhance the tax efficiency of S corp RIAs as many industry participants had hoped.2. Summer Reading for the RIA Community – Focus Financial’s IPOThis pre-IPO post emphasized many of the concerns we had on Focus’s valuation that investors seem to be grappling with now. Specifically, heavy (and controversial) adjustments to reported earnings, continuing net income losses, “organic growth” questions, and the recent market downturn are all weighing on FOCS, which has lost nearly half its value since September. We’ll keep an eye on this one for its broader implications on RIA aggregators in the wealth management space.3. The Role of Earn-outs in Asset Management M&AThis post is really just a link to our whitepaper on the topic since there’s frankly too much to write about in the blog format. Despite the relatively high level of sophistication among RIA buyers and sellers, contingent consideration remains a mystery to many industry participants. We offer this whitepaper to explore the basic economics of earn-outs and the role they play in negotiating RIA transactions.4. The Haves and Have-Nots of the RIA IndustryThis post explores why wealth managers have recently outperformed their asset manager peers and what this means for the broader industry moving forward. Fee compression and the rise of passive management have seemingly benefited wealth management firms to the detriment of asset managers in recent years. Volatility over the last few months has likely exacerbated this trend for many active managers, though some mean reversion may be long overdue.5. Asset Manager M&A Activity Accelerates in 2018Zach Milam discusses continuing gains in asset manager M&A despite the industry’s recent headwinds. RIA aggregators, a rising cost structure, and highly scalable business models are all culprits to yet another banner year for sector dealmaking. It will be interesting to see how the recent downturn will affect this trend in 2019, which we’ll also be blogging about in the coming months.

First Quarter 2019 | Segment Focus: Residential Construction

Housing market activity picks up after a tepid second half of 2018 as mortgage rates decline and ease concerns over affordability. 30-year mortgage rates and 10 year treasury yields declined 17 and 27 basis points respectively year-over-year.

E&P First Quarter 2019

Region Focus: Eagle Ford

Region Focus: Eagle Ford // After a sharp decline in crude prices and the stock market in general, the first quarter saw prices bounce back to finish about halfway between their Q4 peak and trough.

Portfolio Valuation: Private Equity & Venture Capital Marks & Trends

First Quarter 2019

Bob Farrell was Merrill Lynch’s Chief Market Strategist from approximately 1977 to 1992. His “Ten Market Rules” remain widely quoted on Wall Street today.

Transportation & Logistics Newsletter

First Quarter 2019

Value Drivers of a Store Valuation

Auto dealers, like most business owners, are constantly wondering about the value of their business. Dealers can actually influence the value of their store by understanding the value drivers of a store valuation and addressing them on a consistent basis. So what are some of the value drivers of a store valuation?

Six Different Ways to Look at a Dealership

So, how does a dealer evaluate their dealership? And how can advisers or formal business valuations assist dealers examining their dealership? There are at least six ways and they are important, regardless of the size.

‘Twas the Blog Before Christmas…

Mercer Capital RIA Holiday Quiz

‘Twas the blog before Christmas and throughout our staff Analysts were separating wheat from the chaffWe listened to Cramer (who sounds so serene) While gigabytes of spreadsheets danced on our screensWith equities swooning and bitcoin’s collapse Recovering hedgies are risking relapseAnd wealth managers nestled at home with a beer In hopes that a Santa-rally soon would appearAs midtown Manhattan glistened with snow You could almost forget fees had fallen so lowBut regardless of struggles, this is still a great biz So enjoy your Christmas with our RIA quiz!Merry Christmas! We will be back in January.If you're having trouble viewing the survey below, click here.(function(t,e,s,n){var o,a,c;t.SMCX=t.SMCX||[],e.getElementById(n)||(o=e.getElementsByTagName(s),a=o[o.length-1],c=e.createElement(s),c.type="text/javascript",c.async=!0,c.id=n,c.src=["https:"===location.protocol?"http://":"http://","widget.surveymonkey.com/collect/website/js/tRaiETqnLgj758hTBazgd8FDSSK_2BdJwgb90HhEfWcrTtFc_2Bo1XwLsGscpjK7cNEu.js"].join(""),a.parentNode.insertBefore(c,a))})(window,document,"script","smcx-sdk"); Create your own user feedback survey

M&A in the Marcellus-Utica Shale

The Beast in the East

The domestic natural gas market has benefitted from large expansion in recent years, and this can be largely attributed to the growth experienced in Appalachia. According to a Deloitte study, Appalachia was the world’s 32nd-largest natural gas producing region in 2007, with levels comparable to Bolivia and Kazakhstan. As of 2017, it was the third largest, trailing only the full United States and Russia.Companies already with an established presence are planning to put more wells online in the coming year and increase infrastructure to supply a growing demand in the natural gas market.Henry Hub prices have been hovering around $3/MMBtu for over three years and recently have increased to just over $4/MMBtu in November due to a combination of expectations of colder than usual weather and short squeezes, increasing trading and price influencing in a market that is much smaller than oil. Despite the long-term low price environment, supply and demand have increased, driven primarily by the increased demand needs from the power sector. Economic viability of recoverability has not been impacted in light of the lower prices as Deloitte estimates that 50 years’ worth of natural gas can be recovered for less than $3/Mcfe.Despite the continued growth, transaction activity in the Marcellus-Utica in 2018 was slower than in 2017. Some companies have been moving in to capitalize on the increased demand for natural gas, as indicated by the energy outlook by the EIA, while others are restructuring their balance sheets in order to focus primarily on oil. While companies may not be rushing to the Marcellus-Utica in a similar manner as the Permian, companies already with an established presence are planning to put more wells online in the coming year and increase infrastructure to supply a growing demand in the natural gas market.Recent Transactions in the Marcellus-Utica Details of recent transactions in the Marcellus-Utica, including some comparative valuation metrics are shown below. Overall, deal count and average deal size have decreased from twelve months ago. There have been a handful of large deals though that show increased interest in the area.Ascent Resources Acquires 113,400 Acres in OhioAscent Resources, a company founded by Aubrey McClendon after he left Chesapeake Energy, announced that it is buying 113,400 Utica Shale acres in multiple deals along with 93 operating wells located in eastern Ohio for a total of $1.5 billion. The new acreage puts Ascent at over 300,000 Utica acres and catapults the company into one of the largest privately owned E&P drillers in the U.S. The selling companies are CNX Resources and Hess (each selling their share of a joint venture for $400 million each), Utica Minerals Development and a fourth, unnamed seller.The CNX and Hess JV sale marks a complete exit in the play, and both companies plan to utilize proceeds to fund share repurchase programs, pay down debt, and focus on growth opportunities in other established plays, such as the Bakken.Chesapeake Energy Sells Entire Utica Position to EncinoIn an even larger deal, Chesapeake Energy disposed of its entire interest in the Utica Shale to Encino Acquisition Partners for about $2 billion. EAP is backed by the Canadian Pension Plan Investment Board and Encino Energy. Chesapeake sold its stake in the Utica Shale to strengthen its balance sheet and further shifts its focus from gas production to oil, Chesapeake CEO Doug Lawler said in an interview. “We will absolutely be driving for a greater percentage of oil production in our portfolio,” Lawler said. “We hope to achieve that through organic growth, exploration and future acquisitions.”The sale to Encino Acquisition Partners includes 320,000 net acres in Ohio’s Utica Shale and 920 wells that currently produce about 107,000 barrels of oil equivalent per day. The purchase price also includes a $100 million contingent payment based on future natural gas prices. With a sale price of approximately, $2,222 per acre, this appears to be in line with the median transaction amount for 2018.Observed M&A Trends in the Marcellus-Utica Large Exits and Balance Sheet AdjustmentsSimilar to trends we observed last year in the Marcellus-Utica, large companies that have had established presences are moving out of the play entirely to focus on higher margin assets. Demand for natural gas is very high, but the inexpensive extraction costs paired with longer laterals for extraction have allowed supply to catch up, causing prices to remain low and relatively flat in the long term, with the exception of the high trading volume experienced last month.The price run-up in November, however, appears to be short-lived, and the commodity appeared to be overbought. High expectations and rising EIA forecasts for domestic production explain why the U.S. gas futures market has held backwardation even though near-term pricing has spiked. Futures prices for 2019 and 2020 have declined back to the $2.50 to $3.00 range, and with margins remaining low for the foreseeable future, it makes sense for companies to adjust their balance sheets and unload assets that are not meeting their margin goals.Continued Ease of M&AAlthough the low price and low margin environment has caused some to exit the Marcellus and Utica plays, the stable prices environments make mergers and acquisitions easier, with public companies in a better position to make deals than private equity investors.The stable prices environments make M&A easier, with public companies in a better position to make deals than private equity investors.According to Robert Hagerich, Senior Vice President at Macquarie Capital (USA) Inc., established public companies are looking to expand acreage and existing holdings, and can use their stock as currency to buy leases that are adjacent to their holdings with operating midstream infrastructure and production volumes that can be immediately booked with the purchasing company. On the other hand, private equity buyers are usually financing the exploratory drilling that expands the core fairways of the shale plays essentially buying an option on improved prices. This trend began in the later part of 2017, and it has continued into 2018. "Stable pricing brings buyers to the table," says Hagerich. "Buyers are looking for leases that are exposed to the core areas of the shales, contiguous acreage, leases held by production, ownership of the gathering system and access to more than one transportation pipeline." The low volatility nature of the natural gas market compared to oil or LNG facilitates M&A activity and allows for consolidation opportunities as observed from the merger of Blue Ridge Mountain Resources and Eclipse Resources Corp. in August and the heavy consolidation activity from EQT in 2017. The Marcellus-Utica continues to be a powerhouse for natural gas production and doesn’t show signs of slowing down anytime soon. Strategic transactions in the area allow companies to focus on assets that drive their core business and others to consolidate in the area and supply the growing demand for natural gas in the U.S. We have assisted many clients with various valuation needs in the upstream oil and gas in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Is Focus Financial an All-Terrain Investment Vehicle?

Management Claims Their Model is Recession Proof; Unfortunately, it isn’t Analyst Proof.

Last week was turbulent for equities around the globe, but Focus Financial (Nasdaq: FOCS) was hit particularly hard. Less than five months since IPO, Focus closed Friday at $27.45, decidedly below where the offering priced at $33, and not much more than half the share price achieved less than three months ago. [caption id="attachment_23631" align="alignnone" width="756"]Source: Bloomberg[/caption] I was thinking about Focus Financial last week when I found myself in traffic behind a Hummer H1. The H1 was the original Hummer, built by AM General based on their military vehicle, the Humvee. An H1 is immense, weighing in at about 8,000 pounds. H1s were capable of climbing boulders and steep grades and fording streams and rivers as deep as 30 inches. Because of these extreme characteristics, the public initially overlooked how difficult the vehicle was to park, maintain, and even keep fueled. Sales of the H1 peaked in the mid-90s. In 1998 GM bought the brand and started producing a more civilian variant, the H2, and then an even smaller (albeit still very large) H3. About a decade later, GM gave up as the public lost interest. Hummer executives must have been frustrated when the media lampooned their products for being ungainly and inefficient. After all, Hummer never pretended to be anything else. I sensed a similar frustration in Rudy Adolf’s voice last week as he pleaded Focus Financial’s case at the Goldman Sachs U.S. Financial Service Conference. The recent share price performance of Focus clearly suggests the market is losing interest in the issue, and it doesn’t seem to have anything to do with Brexit or yield curve inversions. Instead, the analyst community seems to have soured on the Focus story, which is strange to us because the story hasn’t really changed since the company filed the first version of its S-1 back in May. Focus's Business ModelFocus translates their stake in EBPC into a preferred interest such that they have a beneficial asymmetric payoff.To revisit the narrative, Focus Financial’s principle business is acquiring preferred cash flow stakes in RIAs. The preferred cash flow stake is a percentage (often half) of a “partner” RIA firm’s earnings before partner compensation (EBPC). Focus translates their stake in EBPC into a preferred interest such that they have a beneficial asymmetric payoff. The selling firm’s continuing partners retain all of the downside profit risk and share pro rata with Focus in the profit upside. The partner firms retain a considerable degree of autonomy in that Focus doesn’t really effect operational control, doesn’t rebrand the partner firms using the Focus name, and doesn’t require partner firms to sell Focus branded investment products.As we have asserted previously, there is good and bad in the practice of transacting preferred stakes. In theory, the practice puts a floor underneath Focus’s revenue stream in the event of bad markets. Focus management suggests that only 75% of partner firm revenues are AUM driven, the portfolios generating those fees are only 56% invested in equities (44% fixed income), and there is a 70/30 split of partner firms that bill in advance versus those that bill in arrears. Focus management states that this means a 10% change in equity valuation only moves Focus’s results by 2.9% in the same quarter (10% times 75% times 56% times 70%) and 1.3% in the following quarter (10% times 75% times 56% times 30%). The granularity of this data may be more enticing than it is useful. We know the reality of market impact on Focus is much more complicated, as changes in the margins of partner firms, the impact of bad markets on non-fee revenue, and the cumulative impact on fee producing assets all weigh in on cash flows. Further, we wonder if a sustained bear market wouldn’t gut the management companies of Focus’s partner firms, as sustaining Focus’s cumulative preferred distributions would deprive the management companies of the partner firms from cash flows needed to maintain market compensation.Differing PerspectivesThe analyst community is fixated on Focus’s growth prospects, accuses the company of underperforming expectations in the third quarter, and is worried that the current market behavior will impede M&A opportunities. Focus management responds that M&A is lumpy, and that their experience in the credit crisis a decade ago suggests that bad markets can slow larger deals, but small transactions still occur. Further, management does not believe the company underperformed in the third quarter, just that the analysts expected too much of them.Management has stayed on message of 20% revenue growth and 20% growth in adjusted net income, but the problem is that word, “adjusted.”That comment – that the analyst community oversold Focus – caught my attention. Having gone public at $33 per share on heavily adjusted earnings, Focus doesn’t have a history of profitability to form a reliable foundation for value. If Focus had IPO’d at $18 and drifted up over the first few months to the mid-20s, it would be viewed today as a success. I’m not suggesting that $18 was a more appropriate valuation at IPO, but an excessive valuation at offering can be an albatross for a public company – and that may be how we eventually see this situation.Management has stayed on message of 20% revenue growth and 20% growth in adjusted net income, but the problem is that word, “adjusted.” Adjusted means they can grow by acquisition, but they’ll be expending cash and equity to fund that growth. Organic growth is estimated at 10%, but it includes acquisitions by partner firms. Management justifies this because broker-dealers include advisor recruiting in their organic growth rates. That’s a risky justification, because the economics of broker-dealers has been eroding for decades, and many see the practice of paying to poach advisors as a sign of an industry in distress.Nine months ago, the investment banking community wanted to see Focus as the ultimate RIA – but it was never that. Focus is a complex feat of financial engineering which demonstrates, above all, how difficult it is to build a consolidation model in the investment management community. We think it’s inappropriate to fault management for doing what they said they would do in the S-1. Nonetheless, like anyone who’s ever driven a Hummer, they could be in for a rough ride.

Before Selling Your Oil and Gas Royalty Interest, Read This

Because of the historical popularity of this post, we revisit it this week. Originally published earlier this year, this post helps you, the reader, think through important issues when considering selling your oil and gas royalty interest. There are many reasons that you may want to sell your oil and gas royalty interest, but a lack of knowledge regarding the worth of your royalty interest could be very costly. Whether an inflow of cash would help you make ends meet or finance a large purchase; you no longer want to deal with the administrative paperwork or accounting cost of reconciling monthly revenue payments; or you would prefer to diversify your portfolio or move your investments to a less volatile industry, understanding how royalty interests are valued will ensure that you maximize the value. There is a market for royalty interests, making them fairly liquid; therefore, most of the time, the difficulty is not finding a buyer, but determining whether the buyer’s offer is appropriate.Understanding how royalty interests are valued will ensure that you maximize the value.Given that many royalty owners have little connection with the oil and gas industry aside from the monthly payments they receive, buyers may bid substantially below a royalty’s fair market value hoping to earn a profit at the expense of an uninformed seller. As such, it is critical that royalty owners looking to liquidate their interest understand its value to ensure that they can identify legitimate bids.Before attempting to sell your mineral interest, understand these issues.Understand What You Are SellingA royalty interest represents a percent ownership in the revenue of an E&P company. Royalty interest owners have no control over the drilling activity of the operator and do not bear any costs of production. Royalty interest owners only receive revenue checks when their operator is producing minerals but see no monthly payments when production is suspended.1Recognize Production and Price as Value DriversThe value of a royalty interest is based on the present value of expected future cash flows, which are a percentage of an operator’s revenue.An operator’s revenue is dependent upon production and price. Thus, when determining the value of a royalty interest, it is critical to understand a well’s future potential for production and the market forces that affect price.Production: The Decline Curve’s ImpactAs oil and gas is extracted from a well, its production declines over time. Every well has a unique decline curve which dictates production. A decline curve graphs crude oil and natural gas production and allows us to determine a well’s Estimated Ultimate Recovery (EUR). A variety of factors can affect the shape of a well’s decline curve. For example, decline curves are generally much steeper if the well is drilled using unconventional techniques, like horizontal drilling, or hydraulic fracturing. When determining the value of an oil and gas royalty interest, it is critical to understand a well’s EUR because the value of your royalty interest is dependent upon future production.Price: Local and Global Market ForcesOil and gas prices are affected by both global and local supply and demand factors. The oil and gas industry is characterized by high price volatility. The size and global nature of this market mean that these prices are influenced by countless economic – and sometimes political – factors affecting individual producers, consumers, and other entities that comprise the global market. Most operators, however, sell their oil and gas at a slight discount or premium to the NYMEX because of local surpluses or shortfalls. Thus, it is important to understand the local market as well.Understand Location’s ImpactDrilling economics vary by region. There are geological differences between oilfields and reserves that make it harder to drill in some places than others. Whereas some wells can be drilled using traditional, conventional techniques like vertical drilling, less permeable shale wells must be drilled using unconventional methods, like horizontal drilling or hydraulic fracturing. These unconventional methods tend to bear higher operating costs. Location also tends to influence drilling and transportation costs, ultimately making breakeven prices and profits vary across and within regions. Although a royalty interest owner is paid before any operating expenses are accrued, an operator considers break-even pricing when determining whether to continue operating a well or suspending operations. Accordingly, the value of any royalty interest is strongly influenced by its location, and it is important to consider geological differences when valuing any mineral interest.Proceed with CautionWhile there are legitimate online brokers who will buy your royalty interest for a fair price, it is important to be on the lookout for those who aim to profit at your expense.Beware of online royalty brokers who only consider rules of thumb such as 4x to 6x annual revenue. While industry benchmarks can be a helpful aid, they should not be relied upon solely to determine value, as they do not consider specific well economics.A lack of knowledge regarding the worth of your royalty interest could be very costly.If the entity valuing your interest is also an interested party, it is critical to remember that they have an incentive to quote a low value.Mercer Capital is an employee-owned independent financial advisory firm with significant experience (both nationally and internationally) valuing assets and companies in the energy industry (primarily oil and gas, bio fuels and other minerals). Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors.As a disinterested party, we can help you understand the fair market value of your royalty interest and ensure that you get a fair price for your interest. Contact anyone on Mercer Capital’s Oil & Gas team to discuss your royalty interest valuation questions in confidence.End Note1 For more information on mineral interests see our post, Three Types of Mineral Interests.

Accounting for Risk in Oil and Gas Reserve Valuations

Reserve Adjustment Factors and Risk-Adjusted Discount Rates

One of the most complex aspects of oil and gas valuation is accounting for the risk associated with proved developed nonproducing reserves (PDNP), proved undeveloped reserves (PUD), and the less certain probables and possibles (P2 and P3 Reserves).When valuing proved developed producing reserves, estimates of future production, pricing, and expenses are based on historical results. However, production projections and expense forecasts are more speculative when it comes to PDNP reserves as they are not based on recent production history, and are even more abstract when it comes to PUD reserves since the wells have not yet been successfully drilled.Accounting for RiskGenerally, there are three ways to account for the additional risk associated with PDNP, PUD reserves, probables, and possibles:Using a risk-adjusted discount rate (RADR),applying a reserve adjustment factor (RAF), orutilizing a modified option pricing model. In this post, we outline the basics of risk-adjusted discount rates and reserve adjustment factors. Some of the best guidance on measuring this risk is published by the Society of Petroleum Evaluation Engineers (SPEE). Every year at its annual meeting in June the SPEE presents the results to its annual survey to better understand the parameters used in property evaluation. The SPEE Survey is a global study, however, the majority of participants evaluate U.S. properties. The June 2018 survey had a total of 266 responses with over 80% of participants spending over half of their time evaluating U.S. properties. It covers a wide range of topics such as futures prices, costs and escalation, accounting for risk, reserve disclosures, and probabilistic methods. The survey presents the average RAF and RADR, as well as the 10th percentile, 50th percentile, and 90th percentile results, based on the reserve type.What are RADRs and RAFs?A RADR is used to discount future cash flows to their present value while compensating for the additional risk associated with estimating future production from PDNP, PUD, P2, and P3 reserves. A RADR is higher than a discount rate used in a typical discounted cash flow analysis associated with companywide cash flows. Risk-adjusted discount rates generally fall within the range of 10% to 27%, according to the SPEE Annual Survey.Reserve adjustment factors are applied to the present value of all future cash flows after a standard discount rate has been applied. RAFs vary widely; PDNP reserves generally have RAFs of 100% (no discount), while we have observed appraisals that have applied an RAF of 0% (implying a 100% discount) to PUD, P2, and P3 reserves.There are many qualitative factors that should be considered when determining the appropriate RAF or RADR.The current pricing environment. Is it economical to drill or start producing in the region given the current pricing environment for oil, natural gas, and NGLs?Regional infrastructure issues. Is the necessary infrastructure in place to move products to market or is future production dependent upon increasing infrastructure out of the region?Outlook/health of operators. For non-operators, there is additional risk associated with this relationship with a third party. Is the operator considering exiting the region due to the local drilling economics? Does the operator have enough capacity to bring new projects online? Is the operator financially stable or at risk of going out of business? These are just some of the many pertinent questions to ask when analyzing the risk associated with PDNP and PUD reserves.Applying a RAF or RADRGenerally the application of a RADR and RAF are interchangeable; however, it is important to avoid double counting risk when determining an appropriate discount rate to use in conjunction with a RAF.The examples below show typical valuations of PUD reserves. The first applies the 50th percentile result of the SPEE Survey for the reserve adjustment factor (60%) and the second uses the 50th percentile result for the risk-adjusted discount rate (20%).The results presented in the survey do not necessarily present reserve adjustment factors and risk-adjusted discount rates that compensate for the same level of risk, as shown by the lower valuation conclusion reached when using the RADR from the 50th percentile. For a test of reasonableness, it is important to consider the implied risk-adjusted discount rate based on the selected RAF. In the example above, a 60% RAF is approximately equivalent to a 15.25% risk-adjusted discount rate.Market Evidence for RAFs and RADRsThere is evidence in the public marketplace that undeveloped reserves are priced at a discount to their proven producing counterpart. For example, a recent acreage transaction in Gaines County was priced at a significantly lower acreage multiple than a transaction in Cochran County Texas, although the acreage was relatively close (only one county away). The acreage in Gaines County is in the Midland Basin, but the acreage in Cochran County is in the Northern Shelf; thus, in theory, the acreage in Gaines County is considered to be of higher quality. The acreage in Gaines County, however, consisted entirely of undeveloped acreage whereas the acreage in Cochran consisted of mostly producing acreage. The transaction of undeveloped acreage in Gaines County of the Midland Basin transacted at a 76% discount to acreage in Cochran County in the Northern Shelf, which equates to a reserve adjustment factor of 24%. While there are unique aspects of every transaction which make them hard to compare, there is a logical case to be made for the appropriateness of reserve adjustment factors and risk-adjusted discount rates. In the valuation profession, the most commonly used standard of value is “fair market value” which is defined as: The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.[1]A hypothetical investor would weigh the risks associated with the development of PUD reserves and would consider an investment in these assets to be inherently riskier than an investment in PDP reserves. As valuation professionals, we account for this risk by application of a RADR or RAF.Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, biofuels, and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.[1] American Society of Appraisers, ASA Business Valuation Standards (Revision published November 2009), “Definitions,” p. 27.

Edelman/Bach Rift Highlights Challenges to RIA Partnerships

Partner-Level Conflicts at Firms of All Sizes Continue to Fragment the Industry

The recent controversy surrounding Ric Edelman’s cease-and-desist letter to his former partner, David Bach, is another reminder of how difficult it can be to sustain wealth management partnershipsdespite their (sometimes) obvious advantages. This week’s post explores the sources of these disputes and what you can do to avoid them.No Family Feuds in this BusinessUnlike most closely held businesses, RIAs are rarely owned by related parties. One would think that this lack of corporate nepotism would alleviate some of the ownership tensions and succession planning issues that many family businesses struggle with, but that is hardly the case. These businesses can be very valuable once they hit a certain scale, so there tends to be a lot to fight over when ownership disputes arise.How Disputes AriseThe recent Edelman-Bach debacle is just a high profile example of what’s going on at RIAs across the country as an industry with aging ownership looks to transition to the next generation of leadership. Edelman’s case may be more involved since it pertains to an alleged theft of trade secrets and two of the most recognized names in the advisory business, but it still shows how easily a mutually beneficial arrangement can devolve into a costly, litigious affair with no apparent winners. A lot of our work at Mercer Capital revolves around resolving the valuation component of these disputes, so we see this acrimony firsthand.This case shows how easily a mutually beneficial arrangement can devolve into a costly, litigious affair with no apparent winners.Unfortunately for our clients, this trend is not showing any signs of rolling over. A near decade of favorable market returns and wirehouse defections mean these businesses are more valuable than ever, and their numbers continue to increase. These realities, combined with an aging ownership base, likely portend more shareholder disputes and business partnerships that may not work out in the end. For an industry built on relationships, it seems ironic that so many RIA principals don’t get along, but perhaps this is more reflective of enterprising, type A personalities that often clash over firm direction and succession planning. In our business, we call them business divorces, and they can be every bit as rancorous (or amicable) as their marital counterparts.Ways to Avoid a Failed PartnershipSometimes partnerships don’t work out, and fortunately, there are things you can do on the front end to mitigate the likelihood of a costly business divorce that can take years to fully resolve. Here are a few preemptive maneuvers to consider as you’re evaluating a potential arrangement with another RIA principal or firm.Do Your DiligenceThis may seem obvious, but we often see business divorces that would have easily been avoided with an adequate amount of research on the counterparty. This requires a much deeper dive than a cursory review of AUM history, client retention rates, fee structures, production levels, etc. This process should involve several rounds of interviews with your prospective partner(s) and his or her staff, meetings with counsel over the anticipated deal terms, and even some correspondence with the partner’s major clients to understand his or her value-added proposition and likelihood of retention after the deal. This may seem like a huge hassle and distraction from your current job, but no amount of investigation is as costly and time-consuming as a failed partnership.Hire Advisors to Establish Pricing and TermsEven those who are experienced in the world of RIA transactions benefit from some outside perspective on what an appropriate value is for the acquired firm and/or how to structure the partnership moving forward. For larger transactions, it is common for both sides to hire representation (both legal and transaction-oriented), but it is not unusual for the two parties to jointly retain a single advisor for smaller deals to save costs. In most transactions and partnership pairings, there can be a widely disparate view on pricing and/or terms, and often it’s up to the advisors to bridge the gap and move the deal forward if doing so is in the best interest of their client.Negotiate a Buy-Sell Agreement While Your Incentives are AlignedIt’s also a good idea to have counsel draw up appropriate agreements (buy-sell, partnership, etc.) that govern not just the initial deal terms, but also the mechanism for future buy-outs and the dispute resolution protocol if one of the parties decides to part ways. People don’t usually plan for what happens if things don’t work out, but doing so can save you a lot of hassle down the road.Ask Yourself, "Can I Work With this Individual(s) on a Daily Basis?"You’re usually not just pairing with a co-owner but a co-worker as well, which means you’ll likely be spending a lot of time together after the partnership. Personality disputes are the leading causes of business divorces just as culture clashes are the primary contributors to failed acquisitions in our experience. Somehow, this usually gets overlooked when a firm or individual is looking for a business partner even though it should be the first thing on their mind. Business and partner combinations can look great on paper but quickly turn sour if the two parties simply don’t mesh. We see it all the time, and the fall-out typically leaves both sides worse off than they were before the deal.The best time to manage a dispute with a new partner is before it happens – or better yet – before he or she is your partner.The list goes on, but these are the main things to think about before signing up a new partner or acquiring another firm. We don’t know exactly how the Edelman-Bach dispute is going to play out, but it will likely be very costly and distracting for both of them. Perhaps this discourse could have been avoided with a bit more diligence and contemplation.We’re not saying that all RIA business combinations are doomed for failure. Such partnerships can be (and often are) mutually beneficial arrangements for all parties involved. We’re just reminding you that the best time to manage a dispute with a new partner is before it happens – or better yet – before he or she is your partner.

Issue No. 3 | Data as of Year-End 2018

Feature Articles: Measuring Up: Through the Puzzle of Dealership Metrics Performance Statistics and NADC Spring Conference Recap

Non-Operated Working Interests: Are You Investing in the Operator, the Oilfield, or Both?

Joint Ventures in Oil and Gas

Joint ventures (JVs) are fairly ubiquitous in the energy sector with as much as 71% of upstream investment through alliance or JV relationships. Companies will often enter into JVs to share the sheer capital intensive load of upstream and midstream activities.An oil and gas JV in its most basic form is fairly straightforward. A company will take on the operator role by working the field and constructing or managing the infrastructure in a given area, and another company will assume a non-operator role by providing capital so that each player is mutually benefited. Those entering into these relationships may contribute assets, capital, technologies, or even combinations of the aforementioned in order to access advantages such as scale, risk sharing, or entry into a specific market or play and both share in the future costs.Megaprojects of over $1 billion are largely structured as JVs and are especially useful to capitalize on synergies, infrastructure, and risk sharing. In an EY study of 365 megaprojects, JVs made up 85% of the projects in upstream activities and over 50% were in LNG and pipeline projects. On the surface, this may seem like an effective way for companies to structure a hedge and mitigate systematic risk through diversification of assets, but in reality, the benefits of a JV are much harder to realize. Management considerations quickly become complicated and time horizons tend to be short-lived. Research has shown that as many as 70% of JVs in oil and gas tend to fail within 5 years. From a valuation perspective, struggling or failing JVs can put a strain on overall company value as future income streams are subjected to a greater amount of uncertainty and, thus, are further discounted. In addition, most JVs lack a defined exit plan as a study from Boston Consulting showed that only 19% of respondents had a clear exit strategy. Even in a well-structured JV agreement, the absence of an exit strategy in an environment of high failure rates inevitably results in large tangible and intangible exit costs that can erode the value the JV initially was set up to create. Does the success of the JV hinge on the quality of the oilfield or the technical ability of the operator?Put simply, executing a successful joint venture requires a number of items working in harmony such as solid due diligence, good location, cooperation between both firms, and a degree of luck on the bet they are making.It seems a bit contradictory that a large number of projects are structured as joint ventures if they have such a high failure rate. This begs the question, does the success of the JV hinge on the quality of the oilfield or the technical ability of the operator? The answer, we think, lies somewhere in the middle.Location, Location, LocationEven with the difficulties of maintaining a successful JV, many companies have been entering into joint ventures to take advantage of the oil boom that the U.S. has enjoyed for the past several years. Not surprisingly, a large portion of recently formed upstream JVs since 2016 has been in the Permian Basin, and several large midstream JVs have been formed in the Gulf of Mexico. Recently, Williams Companies Inc. announced that it is forming a joint venture with privately-held Brazos midstream in the Permian Basin to gain exposure to crude and NGL and position itself for potential midstream opportunities. Williams is offering their gas gathering assets for a 15% stake in Brazos as part of the JV terms, with Brazos retaining 85% in the venture as well as operatorship. Almost all of the assets including gas and crude pipelines, storage and a planned processing plant are coming from Brazos Midstream with Williams offering dedicated acreage, a small amount of gas gathering infrastructure and inexpensive sources of financing. Companies have been scrambling to get a piece of the pie in the more recent surge in demand for natural gas.Even though the Permian has seen a large amount of activity and natural gas prices remain low, companies have been scrambling to get a piece of the pie in the more recent surge in demand for natural gas. Royale Energy has recently entered in a JV with California Resources Corp. to drill 30 wells throughout the Rio Vista Field, the largest dry gas field in California. This agreement expands on a previous JV and will give Royale up to three years to drill in any of the formations on the property.The historic property is abundant with gas, producing approximately 4 trillion cubic feet from more than 15 stacked gas reservoirs, and according to Royale, “The joint venture will lead to multiple years of drilling activity at Rio Vista at a time of upward trending natural gas prices due to declining natural gas inventories nationwide.”These transactions are but a few of the many JVs structured in areas to take advantage of the location and the resources it has to offer in a demanding market. And while it may seem like a no-brainer for the non-operator to search out operators in successful plays, many have had a history of missing the mark when it comes to structuring effective non-operated portfolios resulting in value being left on the table or outright failure.Adding Value to Non-Operating PortfoliosOil and gas companies are typically skilled at maximizing value with their operated assets. But more often than not, these companies tend to take a backseat approach to their non-operating portfolios, almost akin to treating them like equity investments. The detached and unsystematic treatment conflicts with the shared responsibility for the success or failure of their ventures.Boston Consulting Group identifies three main sources of value loss due to failure of material participation by non-operators: A nonstrategic approach, inconsistency, and lack of priority.They also outline a four-step framework for non-operators to add value to their non-operational portfolios:Clear strategic intent about what each non-operating venture (NOV) asset contributes to broader company goalsSharp risk and opportunity assessmentConsistent NOV organization and governanceRigorous execution strategies for each NOV asset The critical factors within this framework that can really determine success within a JV are operator assessment and analyzing venture risk. Non-operators with longstanding relationships and clearly defined roles and objectives (for example, ExxonMobil and Shell’s continued relationship in the North Sea) would most likely apply a less stringent approach to assessing key operator risk. But those looking to invest in active plays in the U.S. from a non-operator perspective should assess operators on the following criteria:Level of experience and familiarity of the play/assetUnderstanding and application of proven technologiesHistory of productivity and efficiencyClear understanding of role within the partnershipStrong safety, environment, and previous contract records andAlignment on ethics. Venture risk must be analyzed by non-operators to properly determine uncertainties related to the underlying objective within the JV. Resource size, character, and technology application must be considered especially when undertaking more exploratory ventures. Commercial and economic uncertainties should also be analyzed since a major culprit for failing JVs are large cost overruns and other unexpected costs.Final ThoughtsA major benefit of a JV is to gain exposure to areas and effectively deploy resources and capital where it could be best used and thus create maximum value. As we have mentioned above, however, failure rates are very high in the short term mostly as a consequence of cost overruns due to inadequate planning. But the natural frictions associated with a JV make planning and communication all the more important. While non-operators need the proper location for success in a joint venture, they can get further through proper due diligence and planning concerning operators.We have assisted many clients with various valuation needs in operator and non-operator roles in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

How Generational Differences Should Define Advisors’ Interactions with Clients

A Review of The Gen-Savvy Financial Advisor by Cam Marston

Cam Marston and his firm, Generational Insights, provide research and consultation on generational issues. In his most recent book, The Gen Savvy Financial Advisor, Cam Marston provides a guide to tailoring your financial services to Matures, Baby Boomers, Generation Xers, and Millennials. Financial advisors have personalized their services to meet the needs and expectations of Matures and Baby Boomers, but Gen-Xers are in their prime earning years, Millennials are developing saving habits they will have for a lifetime, and both groups think about their personal finances differently than their parents and grandparents. Marston’s book highlights the challenges that financial advisors currently face trying to earn the business of a new generation of investors. Because wealth management is a business based on trust, clients need to be comfortable with their advisor, and as your client base becomes more diverse, establishing this connection may not be as easy as it once was. To meet the needs of each generation of investors, you must understand their distinct concerns. Are We Really That Different?Stereotyping generations is a risky business, but Millennials like me are accustomed to these stereotypes. My generation has been accused of ruining home-ownership, marriage, newspapers, chain restaurants, and department stores, while we are known to have a weird obsession with smartphones, avocados, and our dogs.Consumers’ buying habits have changed, but why does this matter for your wealth management firm?While it’s easy to shrug off these stereotypes, the reality is, I wrote much of this post sitting next to my dog I treat like a child, in the house I rent with two roommates, listening to music on a free music-sharing site. Cam Marston explains that consumers’ buying habits have changed, and financial services are no exception. But why does this matter for your wealth management firm?At risk of oversimplifying Cam Marston’s insight into simple generational differences, below is a brief summary of the defining features of each generation and Marston’s suggestions to meet the needs and expectations of each.MaturesMarston describes Matures as loyal rule followers who are demanding of respect. In general, they have under planned for retirement and are facing health concerns, but are a “small yet mighty” group. Marston suggests showing these clients deference and ensuring they are comfortable by providing quiet spaces for conversation, preparing for memory loss, inviting their children to meetings, and confirming they understand your technology platforms.Baby BoomersControlling over half of the wealth in the U.S., Marston describes Baby Boomers as competitive, nostalgic, idealistic, and young at heart. You can address the needs of these clients by meeting with them in person, showing optimism despite the fact that many are postponing retirement to take care of elderly parents and adult children who still live at home, and recognizing their successes.Marston further distinguishes between two subcategories of Baby Boomers: Leading and Trailing. Leading Boomers have begun to reach retirement age, have adult children, have simplified their lifestyle, and are moving investments to more conservative outlooks. Trailing Boomers, on the other hand, still have children in school and are more focused on paying for their children’s college and building personal wealth.Gen-XersUnlike most, Marston remembered to include Gen-Xers in his analysis, rather than ignoring this in between cohort to focus on Boomers and Millennials. Gen-Xers are at the peak of their careers; they are tech-savvy, loyal customers, whose referrals should be valued. They grew up in the information age which means that they are naturally curious and ask many questions.This provides a unique opportunity for financial advisors. Marston discerns that financial advisors can earn the respect of Gen-Xers by providing them with insight that they were not aware of after extensive research. Gen-Xers are a captive audience to a firm’s online database of educational resources.MillennialsNow the largest generation, Millennials are well-educated, issue-oriented, individualistic, and impatient. Millennials were greatly affected by the Great Recession which has led them to become risk-averse. This leads to an inherent disconnect between Millennials’ comfort level with stock exposure and their lengthy timeline to retirement, which suggests they should be investing aggressively. To meet the needs and expectations of Millennials, Marston suggests transparency, brevity, up-to-date technology offerings, and recognition of their individuality.Female Millennials have become the most well-educated generation in U.S. history; however, the majority of financial advisors are men (only 16% of CFA charterholders in the U.S. are women). Financial advisors are more often dealing with female individuals and heads of households, and Marston warns, “Be careful to not make any comments about appearances that may seem […] “creepy.” While I do not believe that Men are from Mars, Women are from Venus, sensitivity to the current gender environment is key in establishing relationships with female high-earners.The Great Opportunity of Wealth TransitionsValuation firms often view the number of multi-generational relationships in a firm as a measure of risk reduction. This is an increasingly important metric as Baby Boomers are expected to transfer $41 trillion of their wealth to their heirs; however, as Cam Marston notes, 60% of children fire their parents’ financial advisors after they inherit their parents’ wealth. Cam Marston devotes a chapter of his book on how to manage these generational transfers.A well-developed relationship with Baby Boomers should lead to an opportunity to work with their children.This transfer provides a great opportunity for financial advisors, who seek to maintain their relationship with Boomers’ children. Marston explains that a well-developed relationship with Baby Boomers should lead to an opportunity to work with their children. However, “The Common belief is that Millennials will not do business with their parents’ advisors. If you treat the Boomers’ children the same way that you treat Boomers, that will be true.”While Marston provides great insight into managing relationships with both Boomers and Millennials, I was left wanting more information on how to effectively manage these relationship transitions.We Can All Learn Something from Marston’s BookWhile this book is directed towards financial advisors, there is something for everyone in the client services profession to learn.The increasing importance of online first impressionsOffering varying levels of technology to ensure different age groups are comfortable with your offeringsBalancing formal and informal relationships As Cam Marston notes, it sometimes feels that you are just on a different wavelength than your prospective clients. While the soft skill tips in this book can help you connect with different generations, it is just as important to have a diverse staff of advisors who can connect with clients that have different backgrounds, diverse values, and unique needs. While advisors are adapting to earn the trust of different generations, this adaptation is not new. Advisors have always tailored their services to meet the unique needs of each of their clients. Today the needs of your clients may vary more, which may lead your meetings to look even more different, but your mission as an advisor is still the same: to bring financial security and prosperity to your clients’ lives.

Haynesville's Gigantic Gas Resurgence Could Be A Winner In LNG Export Race

Ever since producers took some big financial beatings after prices plummeted a few years ago, the Haynesville Shale play has positioned itself for an economic resurgence. For those following natural gas production in the U.S., this should not come as a surprise. It has a lot going for it.Haynesville’s Wells – Bigger, Faster, StrongerConsider the following:It’s a behemoth of a gas field that produces enormous wells. It’s been known for some time that the Haynesville has potential, but that is being realized further as more experience is developed among operators. For example, long lateral wells (some now stretch nearly two miles each) can produce up to 24 bcf of natural gas. Compared to the nearby Eagle Ford Shale, whose wells produce 12-15 bcf of natural gas, the Haynesville wells are big. In today’s low gas price environment, this matters quite a bit.The formation is more naturally pressurized than many others. This means, among other things, that more gas is produced in the first year. This is important, considering how expensive it is to drill these wells, and in turn, it means higher rates of return for investors (since time can erode returns according to present value theory).Breakeven prices have fallen. According to Chesapeake, which has the largest acreage position in the Haynesville, breakeven prices are currently between $2.00–$2.25 mcf. Even with price differentials of about $0.60 to Henry Hub, this provides an opportunity for profitable wells. Two or three years ago, this was considered an improbability. Investors have noticed. Amid the land rush for liquid plays such as the Permian Basin, some investors have quietly spent billions to reposition themselves in the Haynesville over the past few years at relatively low valuations. The most notable of which is Jerry Jones’ $620 million investment in Comstock Resources over the summer. Comstock has been one of the leading players in the basin for years and is confident that their experiences, amid a rough recent financial history, will propel them going forward. Lesser known private companies such as Aethon Energy and Indigo Natural Resources (which has contemplated going public) have also poured substantial investments into the play in the past few years.LNG Exports – A New Proverbial Finish LineThat said, one of the vexing problems that the natural gas sector often has is getting the product to relevant markets. The current situation in the Permian Basin is a prime example. Even though gas production is there, it doesn’t matter much if it can’t easily and inexpensively get to where it’s needed. And while the Haynesville has had its own struggles in this area, there may be solutions on the horizon to provide some relief. This is where the Gulf Coast LNG export resurgence comes into the picture.Currently, the ability to export LNG is relatively trivial. The continental U.S. has only two facilities operating with less than 4 bcf of capacity per day. That’s about to change. The Gulf Coast alone has nearly 8 bcf per day capacity under construction and another 6.8 bcf per day has been approved. Over 26 bcf per day has additionally been proposed. Facilities are being proposed up and down the coast from Brownsville, Texas to Pascagoula, Mississippi. [caption id="attachment_23202" align="alignnone" width="640"]Source: Federal Regulatory Energy Commission[/caption] Along with capacity, transportation is getting easier too. The widening of the Panama Canal has certainly helped. In addition, certain transit restrictions on LNG vessels were lifted just last month. Over the past two years, 372 LNG transits have passed through the canal; and incredibly, earlier this year three tankers crossed at the same time. This is incentivizing the investment and engineering race to get capacity built and shipped to foreign markets. Most recently, Germany initiated stepstoward installing an LNG import facility.Haynesville’s Head Start – A Shorter And Cheaper Race To RunIn the race to chase efficiencies, the Haynesville’s proximity to the Gulf Coast provides a big opportunity for investors.What are the options to service the strongly growing demand? There’s a plethora of potential gas sources in the U.S. to fit the bill. Currently, the largest supply is the Marcellus and Utica shales in Appalachia, and this would seem to be a natural fit except that there is a problem. Prices for gas in the region are far below Henry Hub prices. In addition, transportation costs tower above other plays due to the multi-state journey it needs to take to get to the Gulf Coast. By the time the gas arrives at its destination, it would almost certainly lose money for producers. Margins are simply too tight right now in the gas business and efficiency is becoming increasingly critical.In the race to chase efficiencies, the Haynesville’s proximity to the Gulf Coast provides a big opportunity for investors. At a recent conference, Tom Petrie, a leading energy investment banker, gave some estimates of transportation costs from proximate U.S. gas basins. Not surprisingly, the Haynesville was by far the cheapest at $0.25 per mcf. [caption id="attachment_23203" align="alignnone" width="587"]Source: Oil and Gas Investor, Petrie Partners[/caption] In a business where the window for profitability is small, pennies per mcf matter a lot. Naturally this dynamic calls for more localized gas. Considering the Gulf Coast concentration of LNG facilities, the Haynesville, Eagle Ford and other nearby plays may have a leg up with proximity and infrastructure ability to get gas to facilities. The Haynesville looks like it could have an international role to play in energy markets going forward. That is a golden opportunity to create value. As for the Marcellus and Utica shales in Appalachia, they might miss out on this one. It makes one wonder, why haven’t LNG applications shown up in Pennsylvania yet? Originally appeared on Forbes.com.

Q3 2018 Call Reports

Coping with Rising Volatility and Fee Pressure

While equity market volatility was relatively subdued during the third quarter, 2018 as a whole has seen much higher volatility than last year. This volatility may be an opportunity for active asset managers, although the industry continues to face fee pressures and increasing costs. Scale is increasingly important for asset managers as assets flow into lower fee products due to secular trends in the industry and de-risking during recent periods of heightened volatility.As we do every quarter, we take a look at some of the earnings commentary of pacesetters in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Periods of heightened volatility may drive some client rebalancing, but there may also be opportunity for active managers. [W]hen I see this volatility, it's actually a good thing because what it shows is the value of prudent fiduciary advice, which is what our partners are really focusing on. So as I said in my remarks, in so many ways, I like the volatility. I think it's a good thing. And I don't see some major impact in terms of our flows or if there's one thing we learned in 2008, our client retention remained excellent. And what really helped was ultimately the very prudent approach that our partners took towards the constructing their portfolios. – Rudy Adolf, Focus Financial Founder, CEO & ChairmanAsset and wealth managers are rethinking their business models and looking for ways to operate more efficiently and rigorously managing risk in more volatile market environments. – Laurence Douglas Fink, Blackrock Chairman & CEOAnd I think the volatility is, as we said, is an opportunity for our investment teams as well as the business. And we've seen some rebalancing occur, but the relationships and the long-term clients are very strong, and we think the business is positioned very strong, so we don't see anything abnormal with regards to the rebalancing. – Eric Richard Colson, Artisan Partners Asset Management Chairman, President & CEOTheme 2: Scale is increasingly important in the industry as firms seek to gain distribution leverage and spread rising costs over a larger asset base.[W]e've talked about the opportunity to potentially leverage our collective scale and find ways to be more efficient. And we do see significant opportunities there. As I mentioned, we have early days with respect to procurement, and Pete and his team are working on the common financial platform. And those will yield some real efficiencies for us. And that will allow us to do three things - One will be to compete more effectively on price; secondly, to be able to invest more in our business as that's being required and needed; and then thirdly, to potentially return more for shareholders. – Joseph A. Sullivan, Legg Mason Chairman, President & CEO[I] think large acquisitions are very difficult. There's a lot of risk in them, I think, in just the brand and who you are as a firm. But I think, again, if the right situation came up where you think you can take out a lot of costs and create value, we're going to certainly look at that and be open to that. – Gregory Eugene Johnson, Franklin Resources Chairman & CEOIncreased size will enable us to continue to invest in areas that are critical to the long term success of our platform, such as technology, operations, client service and investment support, and to leverage those investments across a broader base of assets. – David Craig Brown, Victory Capital CEO & ChairmanTheme 3: Asset flows continue to be impacted by secular trends towards low fee passive products and the recent heightened equity market volatility.[W]e do see a continued move to passive, but we think the rate of that growth probably slows a little bit. [W]e are believers in active management. We believe that good, active managers do deliver alpha. You got to prove it. You got to earn your fees in that respect. People are looking for differentiated, uncorrelated returns. – Joseph A. Sullivan, Legg Mason Chairman, President & CEOThe other area where you're seeing, especially from the wires, which is starting to become a bigger driver of their business, and one of the reasons why we believe over the next five years, ETFs will double in size, is how more and more wires as they move more towards away from brokerage and more to a consultative relationship or advice, they're using more models. And in the models are heavily populated by different BlackRock and iShares products. – Laurence Douglas Fink, Blackrock Chairman & CEOWhile we saw a modest pickup in industry flows during the third quarter, primarily attributable to ETFs, we also saw accelerated derisking by many clients in an environment marked by continuing trade tensions, a further slowdown in emerging markets, and the steepening yield curve. – Gary Stephen Shedlin, Blackrock MD & CFOWe have seen fee pressure, which we've talked about on past calls. When you get into the very large allocations, especially in the public funds or the sovereign wealth funds, and when you get to the sizeable mandates, there's been a real shift in the market price of fees right now. They've gone much lower than we're willing to go. – Eric Richard Colson, Artisan Partners Asset Management Chairman, President & CEO

Four Themes from Q3 Earnings Calls

We Read the Q3 Earnings Calls so You Don’t Have to

Improvements in technology have driven the shale revolution. Among these improvements are both cost cutting by oilfield service providers and longer laterals from E&P companies. While capacity constraints from a lack of infrastructure has led to pricing differentials (particularly in the Permian Basin), a lack of inventory in the global oil market is expected to support higher prices, while also increasing price volatility.As we plan to do every quarter, we take a look at some of the earnings commentary of large players in the oil and gas space to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Regardless of Region, Longer Laterals are Driving Efficiencies for E&P Companies[W]e continue to capture efficiencies through longer laterals. Last year, our program averaged 8,000 feet, but our portfolio high-grading efforts and asset swaps are enabling us to push beyond that, especially in New Mexico. Our average lateral length for the entire program will increase 20% next year to 9,700 feet. – Jack F. Harper, President and CFO, Concho Resources, Inc.We expect to continue to improve returns through the use of longer laterals and optimizing completion techniques. – Taylor L. Reid, Director, President, and COO, Oasis Petroleum, Inc.[T]here's quite a bit of room for 15,000 foot and even longer laterals in the Eagle Ford, particularly in the Western area. […] On the Permian, it's really driven by the existing well in the lease geometry. So there's areas where there's quite a few 15,000 foot wells. – Herbert Vogel, EVP – Operations, SM EnergyThe well mix in the Eagle Ford during the third quarter included a higher proportion of western acreage wells. While the pay is thinner in the west, there's less faulting, which allows for longer laterals. The longer laterals you can drill, the better the efficiencies to be gained during drilling and completions. – Ezra Y. Yacob, EVP of Exploration and Production, EOG Resources, Inc.When you break down the value of drilling long laterals, there are three areas to consider: development efficiency; well performance; and capital efficiency. [… Development efficiency] is our ability to maximize access to the reservoir with a single wellbore, allowing us to develop more acreage and resource from a much smaller footprint. […] It’s still early in the game when it comes to evaluating well performance for long laterals […] but none of our reviews have indicated any adverse impact of lateral length to well performance. […] Longer laterals can significantly reduce and even eliminate a number of costs in areas such as well pad and road construction, top-hole drilling, drilling and completion mobilizations, surface facilities and reduce cycle times. […] We are now at the point where the time to drill an additional 5,000 to 10,000 feet of lateral length may only be a couple of days requiring minimal incremental capital to being spent. – Jeffrey L. Ventura, President and CEO, Range Resources Corp.Longer laterals allow companies a host of advantages in terms of cost, while not necessarily negatively impacting performance. While longer laterals have been used in the industry for some time now, industry players have been more vocal about the possibilities created by drilling longer laterals. Lateral length has consistently increased over the years. For example, the average lateral length per well in West Virginia was 2,500 feet in 2007, compared to more than 7,000 feet in 2016. Although they are not the common place, many operators have reported laterals in the 12,000 to 13,000 feet range.Longer laterals lower costs for E&P companies which increases firms’ values with more revenue reaching the bottom line. Of course, there are limitations. Longer laterals generally require the consolidation of acreage ownership.Theme 2: Oilfield Services Costs are Expected to Remain SteadyNew technology is increasing drilling speeds, drilling more consistent targets and lowering cost, all at the same time. Combined with cost reductions from local sand, water recycling and infrastructure projects, we are well on our way to achieving our stretch goal of reducing average cost 5% by year-end 2018. […] As we near the end of 2018, industry activity is slowing. Consequently, the service sector is experiencing a period of softness in the market. To take advantage of market conditions, we elected to secure some of our existing service providers through the fourth quarter for next year's program. This will capture favorable prices and sustain the operational continuity of these high-performing service providers into 2019. – Lloyd W. Helms, Jr., COO, EOG Resources, Inc.My perspective long term on service costs is that what [oilfield service] companies really needed was utilization and now we're seeing that across the industry. A lot of them are pretty much fully utilized. And we still see a lot of expansion within our industry today. That's what's going on when you look broadly. So, these service companies are getting healthier all the time. And so, instead of just forcing prices up, continually getting more efficient and with more utilization, we think it could stay in about the same plane that it's in today. – Harold G. Hamm, CEO, Continental Resources, Inc.[W]ith respect to service costs, what we're seeing at least at this point is not a lot of move overall in the service costs. There are pockets of small things that we've seen bump up. We're optimistic on the pressure pumping side that it's going to be flat to down. And so we're not anticipating a big move in service costs for 2019, but we'll continue to monitor that. – Thomas B. Nusz, Director and CEO, Oasis Petroleum, Inc.In regions where drilling has ballooned, service providers are fully utilized. New players are entering these markets to deal with the expansion, which has helped keep prices steady. In regions where there is less activity, some players are looking to lock in longer-term contracts to take advantage of lower costs. Regional market dynamics are different, though the impact on oilfield service costs appears to be the same.Increased activity means more revenue for E&P companies and oilfield service providers. However, if oilfield service providers are able to command a higher price, E&P companies, valuations will suffer. However, the majority of industry players believe that oilfield servicers will not continue to raise prices next year.Theme 3: Infrastructure Issues PersistCosts have started to stabilize as the industry awaits new long haul pipe capacity before increasing activity […] the drilled but uncompleted backlog has reached new highs and will likely be a catalyst for activity once the new pipeline projects are completed. The Midland discount to Cushing's WTI has narrowed as capacity may come online sooner than previously expected. The futures curve indicates that Midland barrels will be priced at a premium WTI in 2020 and beyond. – Timothy A. Leach, Chairman & CEO, Concho Resources, Inc.Range has also seen significant, improved in-basin pricing compared to last year as the Appalachian gas market is benefiting from new pipeline capacity additions in both northeast and southwest Pennsylvania […] Over the next couple of years, we expect basis to remain strong in southwest Pennsylvania as additional pipelines are placed into service that will keep that portion of the basin free-flowing in the other markets. – Jeffrey L. Ventura, President and CEO, Range Resources Corp.Although we expect to see oil differentials to be wider for the fourth quarter, we retain our existing annual guidance, although likely in the upper half of the guidance range. The productivity of the Bakken is driving a significant expansion of basin takeaway. We expect to see the expansion of existing pipeline capacity as well as new pipelines entering the basin. Some of this capacity will come online in the next few months with a strong ramp-up through 2019 and entering 2020. On the gas side, we expect fourth quarter gas differentials to remain strong and reiterate our annual guidance. Looking forward to 2019, we expect a significant expansion of gas processing capacity in the Bakken, expanding as much as 50%. – John D. Hart, SVP, CFO, and Treasurer Continental Resources, Inc.If you look at the DAPL [Dakota Access Pipeline] and size that line until you know that you've got expansion capabilities there that it's going to be almost 40% more capacity that's going to come on with that eventually. That was from their initial projections to where that's going to go. So, that's a good bit of capacity right there that they'll be adding. And the next is new construction. Obviously […] there's a lot more oil to come out of the Bakken. And so, these new pipeline projects are going to pay off beautifully as time goes on. So, there's going to be a lot of brownfield, greenfield pipe to be added. – Harold G. Hamm, CEO, Continental Resources, Inc.As we’ve discussed, differentials between the standardized Cushing, Oklahoma prices and more localized Midland prices have been climbing for much of the year and remained wide until the end of the third quarter due in large part to capacity constraints from a lack of infrastructure in place to bring the product to market. As we see from these quotes, infrastructure issues aren’t confined solely to the Permian as many operators are dealing with in basin pricing differentials. Infrastructure issues are curbing the gains that are typically associated with rising prices and production. Theme 4: Less Inventory in the Global Market Leads to Higher Prices and More VolatilityLooking at the macro environment, with the oil markets in a more balanced position, OECD commercial stocks have declined to below the 5 year rolling average. U.S. crude and product stocks, which account for around 40% of total OECD inventory, have reduced significantly over the last year to the middle of the range. With lower stock levels, the oil price remains volatile to any uncertainties, particularly around supply and geopolitics. Recent factors include the impact of U.S. sanctions on Iranian exports, supply disruption from Venezuela, together with production uncertainty from Libya and levels of spare capacity within OPEC. In summary, the oil price outlook has strengthened. We expect the oil market to remain volatile in the near term, characterized by lower stock levels and ongoing geopolitical factors. We expect current supply concerns to ease and continued robust demand growth to be matched by growth in the U.S. tight oil production and additional supply from non-OPEC countries. – Brian Gilvary, CFO, British PetroleumIt all comes back to supply and demand in the world, and we still see demand strong, about 1.5 million barrel to 1.8 million barrels of new oil. And on the supply side, hopefully, we can keep up with that. About 65% of that will come from the U.S. But if we go forward with the Iranian sanctions, as I anticipate, take another 800,000 barrels off the market, long term, things are going to get tight. And so, we expect it to be pretty close going forward through the end of the year. So, oil prices are going to be strong, and hopefully we'll have a cold winter to keep us there with natural gas. – Harold G. Hamm, CEO, Continental Resources, Inc.When there are supply constraints, price tends to go up. Despite increases in production in the United States, global oil production has experienced declines, causing global oil inventories to be drawn down amid strong demand. When there are lower levels of global inventory, there is less supply available to smooth volatility in the energy market.Higher crude prices should be a positive sign for the E&P industry. However, it must be viewed in the context of the global environment. With significant differentials experienced regionally, companies are not reaping the benefit of global price improvements. Further increased volatility makes it more difficult for companies to make accurate projections, which is particularly important given the size of the capital budgeting decisions required in the industry.

What is Your Firm’s “Brand” Worth?

Building the Value of an RIA Involves Making it More Than a Group of Professionals

The announcement from Merrill Lynch last week that they were cutting advisor compensation stood in stark contrast to a lawsuit filed in October by former Wells Fargo brokers, alleging that their practices had been impaired by association with the bank. While Merrill feels comfortable flexing their brand muscles by redirecting advisor cash flow back to the firm, Wells Fargo is accused of actually having negative brand value. These two situations highlight the dynamic interaction between investment management professionals and the firms they work for while demonstrating the significance of branding to build professional careers and advisory firm value.An Ensemble Product with an Ambiguous BrandA couple of weeks ago I was driving around Memphis enjoying the fall weather when I spotted a unicorn, or, more specifically, a Bricklin SV-1, decked out in fall colors. The Bricklin was an independently produced sports car with a small-block V-8 engine, two seats, a fiberglass body, and gullwing doors. Malcolm Bricklin debuted his eponymous car at a celebrity-studded event at the Four Seasons restaurant in New York in the summer of 1974. Despite the innovative nature and affordable price of the Bricklin, it wasn’t terribly quick (not unusual for cars of that era), reliable (the hydraulic pump for the gullwing doors would sometimes break if you tried to open two doors at once), or practical (it lacked both a spare tire and a cigarette lighter). Only 3,000 or so Bricks were sold in 1974 and 1975, and fewer than half of those are extant today.Brand substantiates the value of goodwill and makes a firm worth more than simply a collection of broker books.If the Bricklin were a metaphor for a cohort of RIA practices, it would be an “ensemble” practice. The company was run from Arizona but manufactured cars in Canada, shared taillights with the DeTomaso Pantera and the Alfa Romeo 2000, sourced its engine from American Motors and Ford, transmissions from Ford and Borg Warner, brakes that included parts from three manufacturers, and a steering wheel from Chevrolet. What Bricklin lacked was a compelling brand to pull it all together, so instead of projecting the image of a “best of everything” product, it came off as more of a Frankenstein.Reading through the industry news of late, we’ve been thinking about the role of branding in the investment management industry. Branding is more than a firm name or logo, it encompasses the identity of an RIA such that the practice is elevated above the practitioner, with the potential to benefit both. As such, we consider brand to be more than tradenames or logos; it is a concept that substantiates the value of goodwill and makes a firm worth more than simply a collection of broker books.Personal Goodwill and Corporate GoodwillIn the valuation community, there are techniques for determining whether a portion of a given enterprise’s goodwill is (in reality) allocable to one professional or to a group of professionals instead of the company. I’ll spare you the technical details, but suffice it to say that when an RIA matures to the stage that it can report a legitimate bottom line – i.e. that there are profits left over after covering both non-personnel costs and paying a market rate of compensation to all staff – then it has brand value that has generated a return on corporate goodwill. Profitability is evidence of brand value.Returns to Labor versus Returns to CapitalWhen the C suite at Merrill Lynch decides to cut advisor payouts, they are shifting cash flow returns from labor to capital. Advisors probably feel like they are being devalued, and arithmetically they are. But what Merrill is also doing is testing their brand value. Can they enhance their return on corporate goodwill by retaining more client fees from existing brokers at the risk of either disincentivizing their advisor network or even running them off to other wire-house firms or RIAs? Merrill's opting to remain in the broker protocol can be seen as confidence in their brand to attract, grow, and retain an advisor network. Whether that confidence is misplaced or not is something we’ll be able to answer definitively in time.Negative Goodwill?At the other extreme, the Wells Fargo lawsuit suggests the possibility that negative brand value at the firm level can impinge on an advisor’s income. Two brokers are alleging that the string of negative publicity at Wells Fargo made it difficult for them to build their books of business or even to maintain the level of business they built previously. Investment management is a reputation business, and the lawsuit suggests that even association with a tarnished brand can impair a career. It’s an interesting lawsuit because in blaming the firm for advisor performance, it suggests that the advisor/client relationship is more significant than the client’s relationship with the firm – otherwise the advisor could mend the relationship simply by changing firms. Yet the lawsuit is basing the damage claim on the bad reputation of the firm.Brand Value in the Independent ChannelOutside of the bulge-bracket broker channel, it is more common for personal goodwill and firm goodwill to overlap. There is a thread of conventional wisdom that suggests small RIA practices aren’t salable (i.e. don’t have enterprise goodwill). The reality is more nuanced, of course, but to the extent that the identity of a small RIA is really just that of the founder and principal revenue producer, then clients are difficult to transfer and the business is more difficult to transact. Building an RIA beyond dependence on the founder should be a focus of any firm wishing to build value.Building an RIA beyond dependence on the founder should be a focus of any firm wishing to build value.There’s more than one way to build brand value beyond the founder, as shown by high profile firms like Edelman Financial and Focus Financial. Edelman employs a highly centralized approach with uniform and templated marketing programs, and client service techniques. While Edelman has successfully built a large and profitable platform from this, the risk is that the secret sauce is vulnerable to being copied, and Ric Edelman is pursuing legal action against his former partner, David Bach, for just that. Focus Financial has employed a highly decentralized approach of acquiring cash flow interests in independent RIAs and then leaving their client-facing identities intact. You won’t find Focus’s name (much less the name of its founder, Rudy Adolf) on any of its partner firms, and thus individual firms (and Focus itself) are far less exposed to reputational risk from bad actors in individual offices. Besides this, Focus doesn’t base its business model on intellectual property that could be replicated elsewhere. What Focus lacks is a certain level of corporate identity and efficiency that comes from uniformity – we wonder how the Focus approach to branding will work over time.In the End, Brand Value is Defined by Your ClientMuch of the debate over the value of investment management firms can be distilled into one question: what is the value of a firm’s brand? More than "what’s in a name?", the question is an investigation into the relationship between client and investment management service provider. Do clients of your firm define their relationship as being with your firm, or with an individual at your firm? If you can answer that question, you know where your RIA is on the journey to building firm value.

Four Key Takeaways from NARO 2018

I recently attended the 38th Annual National Association of Royalty Owners (NARO) National Convention in Denver, Colorado. NARO is an organization that represents the interests of oil and gas royalty owners. The group promotes education and collaboration among its members for royalty owners to better understand their minerals, what goes into the royalty checks they receive, and the future of both production and legislation for the energy industry.The conference had educated speakers who talked on a broad range of topics, and the fast-paced and engaging lectures tied together nicely. Royalty owners learned about laws and court cases currently impacting other areas that could affect them in the future. They also learned about the future of production and consumption both in the U.S. and abroad. Additionally, speakers discussed how critical phrasing included (or not included) in their lease can have an impact on the royalties they receive and the importance of advocating on their own behalf. There were even more topics discussed, some of which could have their own blog posts devoted to them, but below are the key takeaways I drew from the conference.1. Regional Regulation and Legislation Doesn’t Stay RegionalA panel on Thursday discussed current legislative initiatives in various regions of the U.S., such as a court case in Pennsylvania (Briggs v. Southwestern Energy Prod. Co. 2017) currently dealing with the rule of capture. The rule of capture means that the first person to “capture” or extract oil from the ground is the owner of the resource.[caption id="attachment_22968" align="alignnone" width="404"]Source: Marcellus Drilling News[/caption] As illustrated in the above picture, sources of oil do not fall along property lines. Even if the oil comes from a common pool that extends to another property owner’s land, common law currently says the resource belongs to whoever can extract it. The court case in Pennsylvania is challenging this ruling, as it grapples with whether or not the “extraordinary means” associated with hydraulic fracturing could cause this means of production to be deemed trespassing. In other words, because fracking requires significantly more effort to extract the oil and could pose more environmental concerns, the impact it could cause to a neighbor’s property may mean that the extraction of oil that crosses property lines could be trespassing. Another big topic was Colorado’s Prop 112 that could increase setback measures to the detriment of royalty owners in the region. As it turns out, this Proposition was defeated 57% to 43%. Regardless of the outcome of these court cases and legislative initiatives, one thing became clear at the conference: rules and regulations, like drilling, have the ability to cross borders, whether they are state lines or property lines. 2. Net Exports Doesn’t Equal IndependenceDr. Mark Cronshaw is a natural resource economist with vast experience in the industry. He discussed different ways in which energy is produced and consumed in different plays and regions in the country as well as across the globe. Of particular note, he spoke on the notion of energy independence. We can view this through the following equation:Imports/(Exports) = Consumption - ProductionFor a long time, consumption has outpaced production, requiring imports to balance the equation. However, with consumption flat and increasing production, it is anticipated that production will surpass consumption in 2022, making the U.S. a net energy exporter. Keep in mind that becoming a net energy exporter does not necessarily equate to energy independence. While horizontal drilling and fracking have had a profound impact on U.S. production, exports of LNG, coal, gasoline, etc., are vital for the economy. The U.S. may produce more than it consumes, but trade is still necessary, meaning true “independence” is unlikely.3. What’s in Your Lease and Maybe More Importantly, What Isn’tJames Holmes, Esq. is an attorney in the Dallas area with diverse experience in oil and gas litigation, operation, and investment. He spoke on post-production deductions (PPDs), which is a continuous cause of concern for royalty owners. As we discussed a while back, PPDs are the expenses incurred in order to get the gas from the wellhead to market, such as gathering, compressing, processing, marketing, dehydrating, and transporting. Royalty owners benefit when their royalty percentage is applied to the ultimate price achieved when the gas is sold in the market. However, the oil and gas companies who bear the costs of making the product marketable would prefer to deduct the expenses they incur after extracting the gas. The laws governing the deductibility of post-production expenses are different depending on location.Compared to Texas trend states, Oklahoma trend states tend to be more favorable to royalty owners.Compared to Texas trend states, Oklahoma trend states tend to be more favorable to royalty owners, as they do not allow PPDs by default. Royalty owners are protected by common law in these states, whereas Texas trend states get their best protection from well-crafted lease agreements.If a lease in a Texas trend state uses the phrase “at the well,” that means the price on which the royalty percentage will be applied is the value of production when first taken out of the ground, or “at the well.” This is before it makes its way to a refiner, where the value will ultimately be higher. Even with clauses in a lease that specifically restrict PPDs, the phrase “at the well” can act like Pacman, gobbling up all helpful clauses and leaving royalty owners with less money on their royalty checks.The differences in the two trends and the states that follow each are enumerated in the table below: While Mr. Holmes emphasized handling these issues up front, particularly in Texas trend states, we learned from another speaker that sometimes implicit beats explicit. It seems obvious that a lease contract should have everything spelled out to protect the royalty owners, but John McArthur talked about implied covenants and how they can help. Implied covenants date back to a court case in 1905 that stated, “a covenant arising by necessary principle is as much a part of the contract—is as effectually a part of its term—as if it had been plainly expressed.” Just because something isn’t explicitly stated, doesn’t mean a producer can give royalty owners the short end of the stick. In general, they must act as a prudent operator and in good faith, along with the other main implied covenants listed below. 4. Royalty Owners Need to be Self AdvocatesMany royalty owners have reaped the benefits of consistent and long-lasting production. Mineral interests tend to be passed down from one generation to the next, which distances current owners from the process that was involved with negotiating the original lease. Economic and personal circumstances change, however, and this can leave royalty owners looking for a better lease arrangement.Frequently, leases are held by production meaning once an E&P company has drilled on the property, their lease will continue as long as they continue to produce. At a certain point, further production at a well may become disadvantageous to an operator if they cannot get a good enough price in the market. The location can also be depleted to the point that it is more expensive to produce than it would be in other areas.As the saying goes, “the squeaky wheel gets the oil.”Even if E&P companies don’t intend to produce any more, however, they are not motivated to terminate a lease. The end of a lease requires companies to incur expenses that do not produce revenue, like cleaning up and leaving the site. Additionally, when a company loses access to a reserve, it is removed from the company’s balance sheet. Although production of a reserve is not economical, removal from the balance sheet can impact a key metric used to assess a firm’s value in the marketplace.Therefore, the onus is on the royalty owner to terminate a lease, which can be done if there is not production in paying quantities (an implied covenant from Garcia v. King 1942). Additionally, royalty owners can also negotiate a new lease for new production in untapped zones, even if the acreage is leased, if the current operator is unable to reach these zones. As the saying goes, “the squeaky wheel gets the oil.”ConclusionThese takeaways are only some of the topics that were discussed at the NARO 2018 Convention, which provided an excellent platform for new attendees to become informed about the industry while still being beneficial to more experienced people who have been attending the conference for years. Going for the first time myself, I certainly learned about the issues that impact royalty owners most.In order to fully understand the operations of a business, an analyst must have knowledge of all aspects of the industry. Mercer Capital has over 20 years of experience valuing assets and companies in the oil and gas industry. We have valued companies and minority interests in companies servicing the E&P industry and assisted clients with various valuation and cash flow issues regarding royalty interests. Contact one of our oil and gas professionals today to discuss your needs in confidence.

What We’re Reading on the RIA Industry

Much of the sector’s recent press has focused on succession planning and M&A trends, so we’ve highlighted some of the more salient pieces on these topics and a few others that are making news in the asset and wealth management industries.Why Building a Multibillion Dollar Firm is Not for the Faint of Heartby Charles Paikert, Financial Planning Growing an advisory practice into an enterprise with value beyond its founders is tough work. Transitioning to a sustainable enterprise means hiring the right group of people to gradually assume management roles, but many firms lack experience developing personnel internally. Consequently, RIAs are increasingly making lateral hires or expanding through M&A.Mark Tibergien and Dan Seivert Listen Up! Dave Welling Explains Why Rising Private Equity Involvement in the RIA Business is Flat-Out Greatby David Welling, RIABiz (guest author) Many RIA industry commentators have decried PE firms investing in RIAs as little more than short-sighted financial engineers. In fact, many RIAs we’ve worked with wear employee ownership and lack of outside capital as a badge of honor. However, David Welling (CEO of Mercer Advisors, no relation) argues that PE capital may actually be a great thing for the industry and its clients. To be fair, Welling’s own firm has been PE-owned for 10 years, but nevertheless, he provides an interesting perspective on PE capital and its potential impact on growth and succession planning for RIAs.The Importance of Having Cultureby James J. Green, ThinkAdvisor In our experience, firm culture is a key factor that contributes to an RIA’s success. Culture is not one-size-fits-all, and there’s certainly more than one way to build a culture that “works.” However, what successful firms tend to have in common is that they are deliberate about building a culture that values great people and differentiates the firm from the competition. This article profiles registered rep Steve Rudolph and his IBD firm HW Financial Advisors, and how being deliberate about great culture has helped the firm grow to $600 million AUM with six advisors.Merrill Lynch Cuts Broker Payby Lisa Beilfuss, WSJ Merrill Lynch is cutting broker pay beginning in January. Merrill’s recently-announced compensation plan for 2019 includes a 3% penalty on brokerage and investment advisory production below $1.6 million annually. Many of Merrill’s 17,000 advisors see the move as an effort to promote cross-selling bank products, fees from which are not penalized under the new plan.Schwab Studies Zero-Fee Mutual Funds in Wake of Fidelity’s Zero-Fee Mutual Fund Launch, but Schwab CEO Walt Bettinger Still Wonders ‘What’s the Point?’by Brooke Southall, RIABiz Asset managers are taking note after Fidelity won the race to the bottom by launching two zero fee index funds in August. Schwab CEO Walt Bettinger revealed that the firm is vetting the idea of launching similar zero fee products at the firm’s Fall Business Update.Wealth-Management Firms Battle Over Millennialsby Rob Curran, WSJ Millennials’ financial assets are expected to grow to more than $11 trillion over the next 12 years. Clearly, this demographic is increasingly important for the wealth management industry, but it is unclear how well RIAs will attract millennials’ assets in the face of stiff competition from fintech products. On one hand, as millennials gain wealth and their financial lives become more complicated, they may gravitate to more traditional wealth management services. On the other, fintech products that started with a narrow focus are quickly expanding their product offerings and capabilities to meet growing demand.Top 6 Trends in Wealth Management: Chip Roameby Janet Levaux, ThinkAdvisor Some of these trends are no surprise – growing use of cost-conscious products, greater managed account assets, increasing RIA assets and number of RIAs, etc… Perhaps more surprising is the persistent importance of baby boomers’ assets in the industry. Despite the supposed battle for millennials’ assets, baby boomers’ assets are projected to grow from $26 trillion today (50%+ of the total) to $40.7 trillion in 2027 (40%+ of the total). In summary, succession planning remains a major issue for asset and wealth managers, and will likely remain so as the ownership base ages. For some “enterprise” firms, succession may be best handled internally. For others, PE or PE-backed aggregators may provide a sensible solution. For firms in the latter category, the same culture which makes those firms successful may be a barrier to raising outside capital. To further complicate matters, the industry backdrop remains one of declining fees, evolving products, and a shifting client base.

Royalty MLPs Are Devouring Mineral Assets To Fund Growing Investor Appetites

Last year Kimbell Royalty Partners went public in a $90 million IPO. In May of this year, Kimbell announced its acquisition of Haymaker Minerals for $404 million in cash and stock. To top it off, last month Kimbell priced a follow on public offering for $57 million. The Haymaker acquisition remains the largest corporate mineral acquisition so far this year and exemplifies the continuing growth in a relatively new niche of publicly traded MLPs: Royalty MLPs. With around $1 billion in corporate or mineral rights acquisitions so far this year by leading royalty MLPs and mineral aggregators Viper Energy Partners (VNOM), Kimbell (KRP) and Black Stone Minerals (BSM), the segment is consolidating fast in a historically opaque market. Going back decades, the royalty and mineral market has been dominated by smaller, private transactions oftentimes with information asymmetry in negotiations. The strategy for Kimbell and its peers: create liquidity and thus value in an attractive, yet relatively untapped marketplace.Royalty-focused MLPs and mineral aggregation has the potential to provide growth through acquisitions and distribution payments that public investors desire.Kimbell is the most recent entrant to the public market and is emblematic of the increasing capital stacks being deployed to buy up mineral rights all across the country. Private equity players such as Haymaker’s sponsors, KKR and Kayne Anderson Capital Advisors, LP have been growing participants in this space, especially after the drop in oil prices in 2014.On the investor side of the equation, individuals and institutions are looking for opportunities to be exposed to mineral plays and benefit from technological advances without taking operator risk. This is a primary attraction of these types of investments, and many of these investors’ best platform to do so is through public companies. More and more investors are looking to the mineral market to find investment growth. The emerging field of royalty-focused MLPs and mineral aggregation has the potential to provide this growth through acquisitions, as well as distribution payments that public investors desire. Kimbell’s acquisition of Haymaker is a good example of this.Royalty MLPs and aggregators (not to be confused with royalty trusts which do not actively aggregate minerals) have only recently entered the public investment sphere, although the oil and gas mineral market has been around since Colonel Drake begat the industry in 1859. Viper Energy Partners IPO’d in 2014, Black Stone Minerals followed in 2015 and Kimbell went public last year. Performance this year has generally been strong with Black Stone Minerals lagging. Viper Energy Partners has led the way this year in market value increase. Two factors appear to be pushing it ahead of its peers: (1) it is focused in the hot Permian Basin; and (2) about 39% of its acreage is operated by its sister company, Diamondback Energy (the “other” FANG stock).[caption id="attachment_22837" align="alignnone" width="683"]Source: Bloomberg[/caption] Growth aside, yields are the primary investment objective for these vehicles. Although potentially more volatile, the yields this year have been healthy as well. [caption id="attachment_22838" align="alignnone" width="640"]Source: Bloomberg[/caption] Alongside the acquisition, Kimbell converted its tax status from an MLP to a C Corp, a growing trend in light of the recent tax law changes. Now that the corporate tax rate is lower than the individual tax rate, the tax pass-through structure of an MLP does not provide the benefit it once did. Kimbell believes that this conversion will give the company access to a much broader base of investors and access to a more “liquid and attractive currency.” Tapping The Vast Mineral Royalty MarketKimbell estimates that the total oil and gas royalty mineral buying market is close to $500 billion, excluding overriding interests which are hybrid style mineral interests. These estimates suggest that public companies make up only about 2% of the total market or about $10 billion, with the two largest players, Black Stone Minerals and Viper Energy Partners, making up over $8 billion of that total market value. While the public minerals market is only made up of a handful of companies giving public investors a limited number of investment options, the private minerals market is highly fragmented. Organizations such as the National Association of Royalty Owners work to educate mineral owners, but they still only scratch the surface of the market. Small mineral aggregators can operate with a higher attention to acreage details. These small aggregators are able to focus more on negotiating directly with the landowners and handpick the acreage of their choosing. As a result, they expect higher yields than the public companies. While these yields are higher, the acreage is typically less diversified. Combined with their small size, these investments are inherently riskier than a larger, more diverse pool of assets, such as those held by public royalty trusts.Liquidity Discounts And Valuation OpportunityKimbell’s acquisition of Haymaker also demonstrates disconnect between the public and private markets and the discounts at which private LPs are valued. It appears that private royalty LPs simply do not have the same access to capital as the public MLPs or C Corps. This lack of access is potentially why KRP and Haymaker had distinctly different yields and why KRP was able to successfully negotiate such a highly accretive deal. Valuation professionals call this a liquidity or marketability discount. Mercer Capital sees this phenomenon quite often when valuing client’s privately held assets as demonstrated in the chart below, which highlights these “levels” of value. [caption id="attachment_22839" align="alignnone" width="640"]Source: Mercer Capital[/caption] Private equity investors and sponsors recognize this too. Haymaker’s sponsors most likely saw the potential behind the accretive mix of the two companies, which is why they were willing to accept roughly 50% of the purchase price in Kimbell shares. Not only was Kimbell public, its transition to a C Corp opened itself up to a broad array of inexpensive capital, less expensive than what Haymaker likely would have been able to find on its own. This access to cheaper capital makes it easier for Kimbell to grow through acquisitions and continue to increase returns and shareholder value.The Royalty Sector Is Just Warming UpThis is one of the biggest deals so far this year, but it may not be the last. Regardless of whether the MLP moniker sticks or they mostly become C Corp vehicles, the market remains vast, and public royalty aggregators are still at the front end of the consolidation trend. Oil and gas conferences regularly feature these firms now and they have become a regular part of the industry’s conversation. However, as more light shines on this market, efficiencies will grow and value will eventually get harder to find. In the meantime, there is opportunity to feed investors’ appetites and value seekers with oil and gas royalty minerals.Originally appeared on Forbes.com.

Views from the Road: What Do Community Banks, FinTech, and Buffalo Have in Common?

In the last few weeks, I presented at two events geared towards helping community banks achieve better performance: the Moss Adams Community Banking Conference in Huntington Beach, California and the FI FinTech Unconference in Fredericksburg, Texas. The FI FinTech Unconference had a recurring visual theme of the buffalo, which struck me as an insightful image for a FinTech conference.Much of the discussions at both conferences focused on the ability of community banks to adapt, survive, and thrive rather than thin out like the once massive North American buffalo herd. Both events had several presentations and discussions around FinTech and the need for community banks to evolve to meet customer expectations for improved digital interactions. Beyond thinking that I will miss the great views and weather I had for both trips, I came away with a few questions bankers should consider.How Can Community Banks Compete with Larger Banks?Larger banks are taking market share from smaller banks and have been gathering assets and deposits at a faster pace than community banks (defined as banks with less than $10 billion of assets) the last few decades. For example, banks with assets greater than $10 billion controlled around 85% of assets in mid-2018 compared to 50% in 1994. This is a significant trend illustrating how much market share community banks have ceded. Further, larger banks are producing higher ROEs, largely driven by higher levels of non-interest income (~0.90% of assets vs ~0.55%) and better operating leverage as measured by the efficiency ratio (~59% vs ~66%). The larger banks may widen their lead, too, given vast sums that are being spent on digital enhancements and other technology ventures to improve the client experience.Can FinTech Serve as a Value Enhancer and Help Community Banks Close the Performance Gap with Larger Banks?Most community banks are producing an ROE below 10%—an inadequate return for shareholders despite low credit costs. As a result, the critical role that a community bank fills as a lender to small business and agriculture is at risk if the board and/or shareholders decide to sell due to inadequate returns. Confronting this challenge requires the right team executing the right strategy to produce competitive returns for shareholders. FinTech solutions, rather than geographic expansion through branching and acquisitions, may be an option if FinTech products and processes can address areas where a bank falls short (e.g., wealth management).Can Community Banks Hold Ground and Even Win the Fight for Retail Deposits?Many community bank cost structures are wed to physical branches while customers— especially younger ones—are increasingly interacting with institutions first digitally and secondarily via a physical location. This transition is occurring at a time when core deposits are increasing in value to the industry as interest rates rise. In response, several larger banks, such as Citizens Financial, have increased their emphasis on digital delivery to drive incremental deposit growth. Additionally, as funding costs increase, some FinTech companies are being forced to consider partnerships with banks. Thus far, the digital banking push and the formal partnering of FinTech companies and banks are incremental in nature rather than reflective of a wholesale change in business models. Nonetheless, it will be interesting to see whether community banks can adapt and effectively use technology and FinTech partnerships to compete and win retail deposit relationships in a meaningful way.How Can Community Banks Develop a FinTech Framework?Against this backdrop, I see four primary steps to developing a FinTech framework:Identify attractive FinTech niches such as deposits, payments, digital lending, wealth management, insurance, or efficiency (i.e., tech initiatives designed to reduce costs)Identify attractive FinTech companies in those nichesDevelop a business case for different strategies (estimate the Internal Rates of Returns and IRRs)Compare the different strategies and execute the optimal strategyWhat Are Some Immediate Steps that Banks Can Take Regarding FinTech?The things that banks can do right now to explore FinTech opportunities are:Get educated. There are an increasing number of events for community bankers incorporating FinTech into their agenda and we have a number of resources on the topic as wellBegin or continue to integrate FinTech into your strategic planDetermine what your customers want/need/expect in terms of digital offeringsSeek out FinTech partners that provide solutions and begin due diligence discussionsHow Mercer Capital Can HelpMercer Capital can help your bank craft a comprehensive value creation strategy that properly aligns your business, financial, and investor strategies. Given the growing importance of FinTech solutions to the banking sector, a sound value creation strategy needs to incorporate FinTech.We provide board/management retreats to educate you about the opportunities and challenges of FinTech for your institution. We can:Help your bank identify which FinTech niches may be most appropriate for your bank given your existing market opportunitiesHelp your bank identify which FinTech companies may offer the greatest potential as partners for your bankHelp provide assistance with valuations should your bank elect to consider investments or acquisitions of FinTech companiesWe are happy to help. Contact us at 901.685.2120 to discuss your needs. Originally published in Bank Watch, October 2018.

2018 BNY Mellon/Pershing RIA Symposium Recap

Earlier this month, Matt Crow and I attended the BNY Mellon / Pershing RIA Symposium in San Francisco. The conference was well attended, and the presentations were excellent despite the constant drone of fair wage protesting outside the hotel venue. For this post, we’ve elected to summarize some of these presentations and their potential implications for your business.Compensation and Staffing – Key Trends and Best Practices for Advisory Firmsby Matthew Sirinides, Senior Manager, Research & Data, InvestmentNewsInvestmentNews conducts this longest-running industry benchmarking study in conjunction with its Study of Pricing and Profitability as a survey to 385 independent advisory firms, which supply compensation, AUM, client, fee, and profitability dataon an annual basis. As an appraisal firm that often has to normalize RIA owner compensation for valuation purposes, we’re naturally one of its subscribers. In this particular presentation, Mr. Sirinides summarized some of their key findings:The industry continues to perform well (AUM and revenue up ~20% and 12%, respectively, over the last year), but much of this is attributable to market gains over organic growth trends.Lead Advisors reported the highest average compensation increase at ~11% for the second year in a row. It’s unclear if this is what the crowd outside the building was protesting, but LAs have certainly done well in recent years.The industry’s total headcount continues to grow, and roughly one-third of the firms surveyed hired for a newly created position. Basically, the industry and its advisors did very well last year. We agree, but think you should be mindful of what’s driving a lot of this growth – nearly ten years of market appreciation, marking one of the longest and most aggressive bull runs in our stock market’s history. This advance has more than offset other adverse trends in pricing, asset flows, and organic growth patterns that we’ve been reading and writing about over this period. Revenue growth lagging increases in AUM suggests strains in fee pricing. Compounding lower fees with a market teetering on the brink of correction could mean significantly lower levels of ongoing revenue. Perhaps this is what has spooked the market for some RIA stocks in recent months. We would advise you to assess your sources of revenue growth (market gains versus new business development) before blindly staffing up in lockstep with AUM additions.Brand New Visibility: Thinking Differently About Your Brandby Megan Carpenter, CEO, FiComm PartnersMegan Carpenter’s presentation was also very informative since a strong brand name is often the most valuable asset not listed on a firm’s balance sheet. Ms. Carpenter noted that brand value and related reputational assets account for more than 30% of the S&P 500’s market capitalization according to The Economist, but advisory firms spend less than 2% of top-line revenue on marketing expenditures (per IN’s study). This disconnect probably explains why most RIAs are partnerships or sole practitioners rather than larger corporations with substantial enterprise value.If clients identify with your firm’s brand more than your first or last name, that’s probably a boon for your company’s value.FiComm Partners contends that one way to build lasting enterprise value is through a concept known as scalable marketing, which allows you to “be there without being there,” so your firm can reach new people you otherwise wouldn’t. Basically, establishing brand infrastructure with the right content creation and distribution allows the current owner/officers to step away from the business as the company’s own reputation and mobile outreach market themselves over time. This evolution becomes increasingly important as existing owners look to sell their business. If you can’t step away from the business (without the risk of substantial client loss or investing acumen), then your company probably does not have much transactional value to a prospective buyer. If clients identify with your firm’s brand more than your first or last name, that’s probably a boon for your company’s value (though maybe not your ego). We always recommend a gradual process of transitioning clients and management responsibilities, so you have something to sell when you decide to hang it up.The Gen-Savvy Financial Advisorby Cam Marston, CEO of Generational InsightsWhen I saw this presentation on the conference’s itinerary, I braced myself for two hours of millennial bashing like every other forum I’ve seen on this topic. Sure, there was some of that, but this session was primarily geared towards how advisors can most effectively communicate with clients across multiple generations. It’s been well-documented that Baby Boomers and GenXers have a hard time relating to Millennials and vice versa, so this topic was certainly in high demand. Mr. Marston approaches this dilemma by figuring out what seems to matter the most to each generation in selecting an advisor. Baby Boomers and older GenXers are drawn to track records, tenure in the marketplace, firm history, and brand recognition. Millennials and younger GenXers are more interested in how things will affect them personally and how you’ll impact their future livelihood.Given these discrepancies, many advisors have difficulty keeping the family relationship when it transfers to the next generation. Mr. Marston contends that this issue could be avoided by changing the message you have with different generations. Younger clients probably aren’t going to want to hear about you or the firm’s history (even with your family), but rather what you can do to meet their financial needs. You also have to change your marketing tactics as Millennials tend to find new advisors through social media and search engines as opposed to word-of-mouth referrals. Such a drastic change is not easy, but you can rest assured that your competitors are struggling with this as well. Adapting to this change now could really pay dividends when my generation finally moves out of our parent’s basement and starts saving for the future.We hope to see you at next year’s symposium. Special thanks to BNY Mellon / Pershing for putting on a great conference!

How to Interpret Breakeven Prices

Before mid-2014, few investors took notice of efficiency-oriented metrics, instead focusing on stories of new oil discoveries and the development of new wells and new technologies. Since the crash in oil prices, a new measure of success was brought to the forefront: breakeven prices.Since the crash in oil prices, a new measure of success was brought to the forefront: breakeven prices.Over the last couple of years, E&P companies have become more efficient, forced to create investor returns at $40 - $50/barrel oil. Well productivity has improved as companies drilled longer laterals and used less proppant. After the crash in oil prices, oilfield services companies lowered their prices to compete for limited work. As oil prices recovered, the price of oilfield services was slow to catch up. Additionally, companies have more capital discipline than they ever did at $100/barrel oil prices.Even as oil prices have started to recover, companies are showing lower breakeven costs than ever before. As shown in the chart below, breakeven prices in the Midland Basin fell by 50% from $87 in January 2014 to $44 in September 2018. As more companies present this metric and more investors rely on it as an indication of performance, it becomes increasingly important to understand what it actually measures, and if breakeven prices can be compared consistently from company to company. What is a Breakeven Price?The Wall Street Journal stated, “At its simplest, the metric represents the oil price that a company needs to generate enough cash so it can cover its capital spending and dividend payouts.” Most public E&P companies report breakeven costs in their investor presentations, oftentimes measuring themselves against peers. However, these companies rarely explain how they develop these metrics. Some companies, such as Chevron, don’t include covering dividends in this metric. Additionally, some companies look at project-specific breakeven prices which don’t always cover all spending and dividends.Many analysts and investors, including our oil and gas team, track Bloomberg New Energy Finance for region specific breakeven prices. Beginning in January 2014, Bloomberg began publishing monthly breakeven oil prices and breakeven natural gas prices for the following regions. According to Bloomberg, breakeven prices by region are sourced from BTU Analytics and provide: Average wellhead breakeven prices estimates for all wells turned to sales each month. Well economics calculations use a 10% discount rate. Well life is assumed to be 240 months. Gathering, processing, compression, fractionation, and operating expenses are estimated for individual basins and plays.While somewhat helpful, this definition leaves a lot unexplained. We talked to BTU Analytics so that we could better understand what it calculates.BTU Analytics’ data set includes 60,000 horizontal wells from 2013 to present across major basins in the continental U.S. Their data is collected at the well level and calibrated with production data from state agencies and reconciled with overarching trends discussed by major regional operators.BTU’s breakeven measure on Bloomberg is a half-cycle breakeven price, meaning that all operating costs from drilling to completion of the well are accounted for. Additionally, the costs to keep the well operating such as taxes, royalties, and gathering and compression costs are included. However, what is not included in Bloomberg’s breakeven calculation is just as important.What is Not Included in Bloomberg’s Breakeven Prices?Notably, the Bloomberg Breakeven Price does not include wellhead differentials. This means, that breakeven prices in the Permian are based off the WTI-Cushing benchmark, not off the regional hub which traded at as high of an $18 discount in August, according to pricing information from Bloomberg.As the Permian Basin struggles with bottlenecks, differentials have become exceedingly important to consider. Although there are plans underway to address the growing need for infrastructure in the Permian Basin, adjusting Bloomberg’s breakeven pricing to account for differentials observed at the wellhead is necessary to accurately understand a regions breakeven price.Additionally, according to Matt Hagerty at BTU Analytics,These breakevens exclude acreage acquisition costs which can vary significantly between operators and even across acreage for a specific operator.Other ConsiderationsAs mentioned previously, it is often difficult to compare breakeven prices across companies. Since BTU Analytics calculates each of these metrics, it would seem that they are more comparable across regions. But it is important to remember that these regional breakeven prices are averages and may not explain company or inter-regional dynamics.If we continue to rely on breakeven pricing, then it is pertinent that we better understand what is included in these calculations.In August of this year, breakeven prices in the Bakken fell below breakeven prices in the Permian. While we do not doubt the credibility of this metric, it leads us to consider the actual observations that make up this average. By mid-2016, the Bakken had only 22 operating rigs and even now has only 52 rigs as compared to 489 in the Permian. It would be interesting to get a deeper look at the standard deviation of breakeven prices in regions such as the Bakken, as these regions may exhibit a much wider range of breakeven prices.Even at $70 oil, investors and analysts alike are still talking about breakeven pricing, suggesting that this metric has survived the downturn. However, if we continue to rely on the metric, then it is pertinent that we better understand what is included in these calculations.Mercer Capital has significant experience valuing assets and companies in the energy industry. Our oil & gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil & gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil & gas valuations and associated oil & gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Asset Manager M&A Trends

Deal Activity Continues to Accelerate Through the Third Quarter 2018

Asset manager M&A was robust through the first three quarters of 2018 against a backdrop of volatile market conditions. Several trends which have driven the uptick in sector M&A in recent years have continued into 2018, including increasing activity by RIA aggregators and rising cost pressures. Total deal count during the first three quarters of 2018 increased 45% versus the same period in 2017, and total disclosed deal value was up over 150%. In terms of both deal volume and deal count, M&A is on pace to reach the highest levels since 2009. Thus far in the fourth quarter, M&A shows no signs of slowing down. Just last week, Invesco Ltd. (IVZ) announced plans to acquire the OppenheimerFunds unit from MassMutual for $5.7 billion in one of the largest sector deals over the last decade. IVZ will tack on $250 billion in AUM as a result of the deal, pushing total AUM to $1.2 trillion and making the combined firm the 13th largest asset manager by AUM globally and the 6th largest by retail AUM in the U.S. The deal marks a major bet on active management for IVZ, as OppenheimerFunds’ products are concentrated in actively-managed specialized asset classes, including international equity, emerging market equities, and alternative income. Invesco chief Martin Flanagan explained the rationale for scale during an earnings call last year: "Since I've been in the industry, there's been declarations of massive consolidation. I do think though, this time there are a set of factors in place that weren't in place before, where scale does matter, largely driven by the cost coming out of the regulatory environments and the low rate environments in cyber and alike. And, you have to be, as a firm, you have to be able to invest in the future. And I think a number of smaller-sized firms are finding that hard." Martin Flanagan, President and CEO, Invesco Ltd. – 1Q17 Earnings CallRIA aggregators continued to be active acquirers in the space, with Mercer Advisors (no relation), and United Capital Advisors each acquiring multiple RIAs over the last year. The wealth management consolidator Focus Financial Partners (FOCS) has been active since its July IPO as well. In August, FOCS announced the acquisition of Atlanta-based Edge Capital Group, which manages $3.5 billion in client assets. FOCS also announced several sub-acquisitions by its affiliates during the third quarter.Consolidation Rationales The underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, aging shareholder bases, and slowing organic growth for many active managers. While these pressures have been compressing margins for years, sector M&A has historically been muted. This has been due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation. Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure as long as it doesn’t inhibit performance."Absolutely, this has been an elevated period of M&A activity in the industry and you should assume alongside our proprietary calling effort, we're looking at all of the opportunities in the market." Nathaniel Dalton, CEO, Affiliated Managers Group Inc. – 2Q18 Earnings Call "[I] think again these trends towards greater regulation, greater exposure, greater need to diligence managers and all that kind of stuff, greater suitability, all these things are driving towards doing business with fewer managers, larger managers, more diversified managers…" Joseph Sullivan, CEO, Legg Mason, Inc. – July 2018 Earnings CallConsolidation pressures in the industry are largely the result of secular trends. On the revenue side, realized fees continue to decrease as funds flow from active to passive. On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs. Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to realize economies of scale, enhance product offerings, and gain distribution leverage.Market ImpactRecent increases in M&A activity come against a backdrop of a bull market in asset prices that has continued through the third quarter of 2018. Steady market gains have more than offset the consistent and significant negative AUM outflows that many active managers have seen over the past several years. In 2016, for example, active mutual funds’ assets grew to $11 trillion from $10.7 trillion, despite $400 billion in net outflows according to data from Bloomberg. Because of increasing AUM and concomitant revenue growth, profitability has been trending upwards despite industry headwinds that seem to rationalize consolidation.M&A OutlookWith over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies. Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms have struggled with organic growth. An aging ownership base is another impetus, and recent market gains might induce prospective sellers to finally pull the trigger, which could further facilitate M&A’s upward trend during the rest of 2018.

Automobile Dealership Valuation 101

Valuation of a business can be a complex process requiring certified business valuation and/or forensic accounting professionals.

BP & Diamondback Mergers Set Q3 Tone For Upstream Producers

The third quarter just wrapped for upstream producers. Stock performance has been volatile, infrastructure issues are lurking and the industry as a whole ended the quarter a notch above flat. However, approximately $21 billion in strategic acquisitions by BP and Diamondback Energy highlighted the continued optimism for the segment. BP’s merger looks particularly interesting as it focuses on the Eagle Ford while most investors have been looking to the Permian. BP’s earnings have yet to be reported, so stay tuned.BP’s Big DealBP brought on approximately 470,000 acres of rights and 90,000 barrels per day of current production.BP certainly wasn’t waiting for the industry’s current infrastructure issues to sort themselves out as they forged ahead with the biggest single upstream merger this year, a $10.5 billion acquisition of BHP Billiton. This is BP’s biggest acquisition in nearly 20 years. The primary assets acquired were spread across the Eagle Ford shale in South Texas, the Haynesville Shale in East Texas and to a lesser extent, the Permian Basin. Through this transaction, BP brought on approximately 470,000 acres of rights and 90,000 barrels per day of current production. BP was naturally enthusiastic about the deal, and after some review, this deal appears to have a lot of potential to create value for BP. Here’s why:This Is Not BP’s First Venture Into The Texas Shale PlaysBP dipped their toe into the Eagle Ford shale back in 2010, before they fully jumped into this deal. Joining with local dry gas powerhouse Lewis Energy, BP bought at $4,000 to 5,000 per acre for joint venture rights on the dry gas window of the Eagle Ford shale. Over the course of the past few years, BP has more than doubled per-well production in the Eagle Ford by utilizing improved production techniques. This experience, particularly in that region, could serve BP’s shareholders well going forward.There’s Commodity Price UpsideBP based their return models on $55 oil and $2.75 gas. As of the acquisition, oil prices were already in the mid-$60’s and closed around $75 this week. On the other hand, gas prices have been flat and returns have been driven by the cost side of the equation. Although only about 45% of the reserves purchased are liquids-based, it has the potential to boost returns and increase values.At First Glance, BP Does Not Appear To Have OverpaidWith over 80% of the assets weighted towards the lesser celebrated Eagle Ford and Haynesville plays, BP did not focus on the higher priced Permian Basin as much in this deal. Although the Permian’s stacked geology is superior, it is also more expensive. On a per net acre basis, BP paid just over $22,000 per acre.Diamondback Energy’s Big DealNot to be outdone, Diamondback Energy made two acquisitions within a week of each other that cost around $10.4 billion. Both transactions were in the Permian and were spread between the Delaware and Midland Basins. Both were similarly priced and are more oil and liquids heavy than BP’s acquisition, notable because margins for oil and liquids are generally much better than gas.The deals were notable because margins for oil and liquids are generally much better than gas.Diamondback’s larger deal was its purchase of Energen for $9.2 billion, providing 179,000 acres and about 90,400 barrels per day of current production. Diamondback also purchased AJAX Resources for $1.2 billion, gaining over 25,000 acres and about 12,130 barrels per day of production. Although smaller, this deal was more focused on acreage located in the Midland Basin.Betting On SuccessBased on implied production multiples of other companies, deal pricing for both Diamondback mergers was generally in line with current implied values and creates one of the largest pure-play Permian producers. All three transactions appear to either be generally in line with implied public company market valuations in their respective regions.Overall, upstream indexes were muddled in the third quarter, although earnings reports could shift the sentiment. BP and Diamondback are betting big that future quarterly (and annual) performance will be better.The Bigger PictureGenerally, oil prices started and ended the quarter in almost the same place – around $73-$74 per barrel, but it took a circuitous route, dropping down to $65 in mid-August before climbing back. West Texas, however, has been a different story. Differentials between the standardized Cushing, Oklahoma prices and more localized Midland prices have been climbing for much of the year and remained wide until the end of the third quarter. This gap has been created as a result of a supply traffic jam that has overwhelmed the Permian’s infrastructure. Production in Texas actually fell this summer due in large part to these issues, and this dynamic pervades beyond the Permian Basin. Appalachia and the Bakken have similar issues, although not discussed as often. Efforts are underway to alleviate these bottleneck issues in all of these areas, but it will continue to take time and capital. This extends not only from public markets, but private equity as well. Have these issues impacted productivity or activity? So far, the answer is no. Capex budgets, a harbinger of drilling plans, have continued to grow and be revised upward for many producers. Drilling and production figures continue to climb everywhere but West Texas. However, that is temporary. Noting the Permian’s drilled but uncompleted (“DUC”) well figure, the Permian’s effective inventory is waiting to be unleashed on the market. Could this be setting up strong earnings and production? One can only hope, and Diamondback and BP seem to think so. It appears the market may be transitioning from ascribing value on enthusiasm about potential shale production from undrilled reserves to realization of those reserves and more real dollars to show for it. Originally appeared on Forbes.com.

Alternative Asset Managers

Segment Focus

Alternative investment managers took off in the wake of the financial crisis when investors flocked to risk mitigating strategies and uncorrelated asset classes; however, during 2015 and 2016 these businesses floundered against a backdrop of strong equity market performance. Alt managers bounced back in 2017, and over the last twelve months, have continued to perform well. Despite improving performance over the last two years, the industry continues to face a number of headwinds, including fee pressure, expanding index opportunities, and relative underperformance.Segment StrugglesHedge fund managers, in particular, have struggled since the financial crisis. Although industry assets reached a record $3.2 trillion in 2018, net inflows have stagnated and the record AUM level is primarily due to market increases rather than investor interest in the asset class. At the same time, the industry is struggling with fee schedules that continue to decline and a plummeting number of new funds being established.1Despite improving performance over the last two years, the industry continues to face a number of headwindsMany of the hedge fund industry’s woes can be traced back to significant underperformance over the last decade. Since 2009, the S&P 500 index has dwarfed the performance of hedge funds (as measured by the HFRI Fund Weighted Composite Index), and this underperformance has driven outflows and fee declines. Part of industry’s underperformance may be attributable to the protracted bull market. While it may seem counterintuitive that strong market performance would be a bad thing for an asset manager, a long/short fund that seeks to generate positive returns regardless of which way the market moves is naturally going to underperform during prolonged periods of steady market increases. Recent volatility in the equity markets may alleviate this underperformance, but the numbers haven’t been reported yet.Other categories of alt managers have suffered many of the same difficulties as hedge funds in justifying their value propositions over the last decade. Alternative asset classes saw major inflows after the financial crisis due to their lack of correlation with traditional asset classes. Fast forward to today, the S&P 500 index has grown at a nearly 16% CAGR since bottoming out in 2009. Investors holding asset classes uncorrelated to U.S. equities over the last decade probably wish they hadn’t been with hindsight.While performance has been volatile, alt managers closed out the year ended September 30 up 7.8%Industry PerformanceThe industry has endured and performed reasonably well over the last year, at least in the eyes of market participants. While performance has been volatile, alt managers closed out the year ended September 30 up 7.8% — making them one of the better performing sectors of publicly traded asset managers over the past year. For all the problems the industry faces, most investors still value the diversification offered by alternative assets, particularly late in the economic cycle. While active management may not be as lucrative as it once was, it is still sought by many institutional investors to complement their passive holdings.Taking a closer look at the performance of the alt manager index’s constituent companies over the last year reveals that most of the positive performance was attributable to publicly traded private equity managers, with KKR, Blackstone (BX), and Apollo (APO) all beating the S&P 500 while Carlyle Group (CG) was up modestly. Oaktree Capital Management (OAK), which specializes in distressed debt, was down 5.8% while hedge fund manager Och-Ziff Capital Management (OZM) declined more than 50% over the last year on issues with succession and investment performance.Given the performance over the last year, the market appears to be reasonably optimistic about the prospects for most publicly traded alt managers, at least relative to other categories of asset managers. Some of the fundamentals are improving as well. Asset flows out of active products seem to have stabilized, and AUM growth has generally been outpacing fee compression in recent quarters. We think performance fees will likely continue to fall (in one form or another), but like active management, never be totally eliminated. So on balance, a modestly improving outlook for the industry appears justified.1 The Incredible Shrinking Hedge Fund. Bloomberg.

U.S. Energy and Private Equity

Show Me the Money

Private equity companies in the energy sector are positioned for an interesting opportunity. These companies have seen a surge of fundraising in recent years, leaving managers with large cash reserves or “dry powder” to be appropriately deployed. Despite the large amount of cash available, these firms are having trouble finding places to invest resulting in a decline in PE activity in 2016-2018 with deal counts dropping for the second year in a row by 8%. However, investments could see a marked increase in energy in the last quarter of 2018 and into 2019 as there is a climate of high demand for return on investment and low supply of cash needed for capital expenditures in upstream oil companies.Oil and gas prices in 2018 have been steadily increasing in the midst of strong demand and constrained supply, and the U.S. energy sector is at the center of this focus. Forecasts from the International Energy Agency (IEA) show that the U.S. is expected to supply almost 60% of the demand growth over the next 5 years as conventional discoveries outside of the U.S. have hit historic lows since the early 1950s.Supply-Side ProblemsU.S. companies seem adequately poised to capture business in the swelling energy market, but the mechanics needed to supply this demand growth are turning out to be somewhat problematic. Upstream management teams that survived the oil crash in 2014 have had to cut costs aggressively in order to stay afloat, with capex spending plummeting nearly 45% between 2014-2016. These cost cuts, while necessary a few years ago, have largely continued into 2018 and conflict with the strong increase in spending that is needed to improve daily output to reach current demand. Morgan Stanley believes this output has to increase by 5.7 million barrels per day by 2020 in order to keep up. This level of increased production has only happened once since 1984.Another issue facing supply is the lack of new oil discoveries. According to a study performed by Rystad Energy, discovered resources have fallen to an all-time low of around 7 billion barrels of oil equivalent in 2017. At current consumption rates, that is a replacement rate of around 11%, down from 50% in 2012. Not only are there fewer discoveries being made, but the sites found contain much less oil than prior discoveries.International AlleviationRussia and members of OPEC met in June and agreed to boost their collective output of oil production, amid U.S. sanctions on Iran, in order to help with the global shortfall and meet increased demand. Although there was no clear guidance on the increased output, the group has been tentatively aiming for an additional million barrels per day to overall production. World total oil supply has risen by approximately 680,000 barrels per day in July, but this was largely contributed by the Organization for Economic Cooperation and Development, a group of non-OPEC members that includes the U.S.In fact, from recent figures, Russia’s increased output amounted to only 20,000 barrels a day, and Saudi crude output actually decreased by 200,000 barrels a day. The decline in the oil production in Iran and Saudi Arabia and lackluster production boosts from Russia are proving that any alleviation in oil prices will come later as prices continue to rise. While the IEA agrees that the Saudis can supply over 12 million barrels a day, there is little incentive to do so as fiscal breakeven figures for Saudi oil production provided by the IMF show nearly $88 per barrel. Why turn on the spigots if there is no profit to be made?Shortfalls in CapexThe U.S. has been ramping up production to make up for the underwhelming boost in international output. For the U.S. to continue to operate at the required level to reach demand, large investments in capex are necessary. From a Deloitte study in 2016, the industry needs a minimum investment of about $3 trillion from 2016-2020 to ensure its long-term sustainability even in the case of non-linear demand. When paired against the operating cash inflows and the required cash outflows of listed entities, there is a gap of roughly $750 billion to $2 trillion to cover payouts, debt repayments, and upstream capex. Even if companies have enough operating cash flow to fund capex on the lower levels, capex may not have the first call on available cash. Other balance sheet focuses and maintenance of reduced payouts may command higher priority for that cash. So where does the money come from to close the capex gap and supply the growing demand? This is where private capital and U.S. shale come into play.Private Equity FactorsAs the price of oil steadily increases, private equity backers for these upstream companies should see a similar uptick in new fundraising. Historically, rising prices equates to higher investment returns. The scenarios outlined above create an opportunity for energy investors that is not likely to be seen again for many years. Not only is the demand outlook in the investors’ favor, but the return per dollar invested is attractive as well due to innovations in efficiency from U.S. companies, as mentioned in a prior blog post, in areas like the Bakken. Well completion times have fallen by roughly half since 2013, which allowed for U.S. upstream companies to profit on $30 per barrel.The disconnect between rising prices and the relative performance of publicly traded energy companies creates an opportunity for private ventures to collect properties and assets and start drilling. Global private equity raised a record of $453 billion from investors in 2017 leaving it with more than $1 trillion to put into companies and new business ventures. Subsequently, this has resulted in the record amounts of dry powder in $1 billion+ funds. Coming into 2018, U.S. oil and gas PE funds alone were holding around $52 billion in dry powder, which can be seen in the PitchBook figure below. EnCap Investments was the largest player holding approximately $6.75 billion to be deployed in its Energy Capital Fund XI. Other industry giants such as Riverstone Holdings and Blackstone are holding around $3 billion and $2.7 billion, respectively. With such a large influx of new capital waiting to be deployed, the energy sector offers attractive opportunities to capitalize on the high level of demand coupled with rising prices and need for capital. ChallengesThe challenges typically facing energy-focused private equity companies are that they tend to be risk-averse. New discoveries and new drilling are capital intensive in both cash and time. PE firms tend to gravitate toward established shale plays and, as a consequence, pay a hefty premium for a “sure bet.” As a result, one could argue the better use of capital would be making a long only bet on NYMEX and avoid the liabilities of owning an operating company.Additionally, the time horizons of these PE sponsors are often mismatched with the energy sector cycles. Cycles and manipulations by OPEC can occur over many years or even decades, while the typical time horizon for a PE sponsor is generally around 7 years.ConclusionPrivate equity firms are positioned to capture a rare investment opportunity in the U.S. energy sector.History has shown that there is a connection between higher oil prices and higher investment returns. In this relatively high price environment, private equity backers can supply the key ingredient of large capital injections to close the much-needed capex gap in U.S. upstream oil companies and enjoy the subsequent investment returns.We have assisted many clients with various valuation needs in the upstream oil and gas in North America and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

RIA Stocks Post Mixed Performance During 3Q18

During the recent market cycle, asset managers have benefited from global increases in financial wealth driven by a bull market in most asset prices. These favorable trends in asset prices have masked some of the headwinds the industry faces, including growing consumer skepticism of higher-fee products and regulatory overhang.Traditional active managers have felt these pressures most acutely, as poorly differentiated active products struggled to withstand downward fee velocity and at the same time, have been a prime target of regulatory developments. To combat fee pressure, traditional asset managers have had to either pursue scale (e.g. BlackRock) or offer products that are truly differentiated (something that is difficult to do with scale). Investors have been more receptive to the value proposition of alternative asset managers and wealth managers, and these businesses are (so far) better positioned to maintain pricing schedules as a result.Third Quarter PerformanceReflective of the headwinds that the industry faces, asset managers generally underperformed broad market indices during the third quarter. While major indices posted solid gains during the second quarter, the returns for asset managers were at best muted even though these businesses generally benefit from rising equity markets. The operating leverage inherent in the business model of most asset managers suggests that market movements tend to have an amplified effect on the profitability (and stock prices) of these businesses, and in recent quarters that has been the case. The reversal of that trend over the last two quarters may be indicative of investors’ increasing concerns about the headwinds the industry faces and the general uncertainty that arises late in the economic/market cycle. Taking a closer look at recent pricing reveals that traditional asset managers, which are perhaps the most affected by fee compression trends, ended the quarter down 5.9%. Trust banks were also down 5.9% during the quarter, driven by poor performance at State Street and BNY Mellon – the index’s two largest components – after both companies reported weak Q2 performance and STT announced that it would acquire financial data firm Charles River Systems at a poorly-received valuation of $2.6 billion (9x revenue). Alternative asset managers were up 12.2% and were the only sector to outperform the S&P 500. Alternative managers have generally performed well in recent quarters as the product segment is less impacted by fee pressure than traditional active products. Wealth managers were up 6.0% during the quarter, buoyed by market-driven increases in AUM, although these businesses face challenges with new client acquisition and maintaining pricing power. While wealth managers performed well during the quarter, they were outpaced by wealth management firm aggregator Focus Financial Partners (“FOCS”), which closed out the quarter up 44% since its noteworthy IPO in late July. FOCS, of course, is not an RIA, but since FOCS is an aggregation of RIA cash flows, some comparison between FOCS and RIAs is inevitable. FOCS is not necessarily a proxy for the performance of RIAs since the success of the FOCS business model depends on more than just the performance of its partner firms. This is particularly true now as FOCS is growing rapidly and investors are arguably more attuned to FOCS’s ability to string together acquisitions at attractive deal terms than on the performance of the partner firms post-acquisition. Over time, FOCS’s performance should bear some resemblance to that of the underlying partner firms, but right now the performance of FOCS might not be telling us much other than affirming the market’s conviction that it will continue to grow rapidly through acquisitions. Looking at the RIA size graph reveals that the mid-size public RIAs ($100-$500B AUM) were the clear winners over the quarter, up nearly 9%. RIAs with $10-$100B in AUM were down nearly 4.0%, while the largest category ($500B+ AUM) was down just over 6%. The smallest category of publicly traded RIAs (those with less than $10 billion AUM) was down over 18% during the quarter, although this is the least diversified category of RIAs with only two components. Due to the lack of diversification, the smallest category of RIAs is subject to a high degree of volatility due to company-specific developments. Most of our clients fall under this size category, and we can definitively say that these businesses (in aggregate) have not lost over 18% of their value since July as suggested by this graph. Market OutlookThe outlook for these businesses is market driven, though it does vary by sector. Trust banks are more susceptible to changes in interest rates and yield curve positioning. Alternative asset managers tend to be more idiosyncratic but still influenced by investor sentiment regarding their hard-to-value assets. Wealth managers and traditional asset managers are more vulnerable to trends in active and passive investing. The outlook for the industry during the rest of 2018 ultimately depends on how the industry headwinds continue to evolve and (as always) what the market does during the fourth quarter.

How to Value an Oil and Gas Mineral Royalty Interest

Well-informed buyers and sellers are critical to an efficient market for royalty interests because there is a specialized and relatively complex body of knowledge to consider in the transfer of these types of assets.Often called a net revenue interest (NRI), royalty interests do not bear the costs of production and only participate in the potential upside of a resource. The value of a royalty interest, however, is often difficult to observe because they are typically closely held. In addition, once discovered and drilled, the natural resources are physically depleted, resulting in a declining asset as opposed to a growing one.A lack of knowledge regarding the worth of a royalty interest can be very costly. A shrewd buyer may offer a bid far below the interest’s fair market value, opportunities for successful liquidity may be missed, or estate planning could be incorrectly implemented based on misunderstandings about value.Understanding how royalty interests are properly appraised will ensure that you maximize the value of your royalty, whenever and however you decide to transfer it.This blog post summarizes our whitepaper – providing an informative overview of the valuation of mineral royalty interests within the oil and gas industry. While there are a myriad of factors (mostly out of a royalty holder’s control) impacting the economics of a royalty interest, this blog post focuses on valuation methodology.What Does the Valuation Process Entail?Valuation approaches refer to the basis upon which value is measured.There are three commonly accepted approaches to determining value:Asset-based ApproachMarket ApproachIncome Approach In the realm of business valuation, each approach incorporates procedures that may enhance awareness about specific economic attributes that may be relevant to determining the final value of a given entity. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value for the subject interest under consideration. However, due to fundamental structural differences between businesses and assets, the available valuation methodologies tend to be utilized differently when valuing royalty interests. 1The Asset-Based ApproachThe asset-based approach can be applied in different ways, but the general idea is that the enterprise value of a business is given by subtracting the market value of liabilities from the market value of assets. While the asset-based approach can be useful when valuing companies operating within the oil and gas industry, this approach is not typically employed to determine the value of a royalty interest.Oftentimes a mineral royalty owner purchased land which included the mineral rights and an allocation of surface vs mineral rights was not performed. Additionally, considerable time may have passed between the time the surface and mineral rights were purchased and the valuation date. Adding to the ambiguity of the cost basis of the asset, mineral royalty interests are often family assets that are handed down for generations. For this reason, the asset-approach is rarely used to determine the market value of mineral royalty interests unless the mineral rights were recently purchased.The Market ApproachThe market approach utilizes transaction pricing from guideline transaction data or valuation multiples from a group of publically held companies to determine the value of a privately held enterprise or asset. To develop an indication of mineral royalty interest value using the market approach, you can utilize data from market transactions of mineral interests in similar plays. This data can be derived from direct transactions of mineral royalty interests or from publically traded royalty trusts and partnerships.Direct comparable transactions of mineral royalty interests are often the best indication of fair market value. However, the data with which to benchmark a subject mineral royalty interest against is often unavailable. If it is available, a careful comparative analysis must be made. Royalty trusts and partnerships hold various mineral royalty interests in wells operated by large exploration and production companies. Royalty trusts and partnerships tend to have very low, if any, operating expenses and can be an investment to provide exposure to oil and gas prices.Acquisition data from these trusts can be utilized to calculate valuation multiples on the subject royalty’s performance measure(s). This will often provide a meaningful indication of value as it takes into account industry factors (or at least the market participants’ perception of these factors) far more directly than the asset-based approach or income-based approach.Traditional oil and gas earnings multiples, such as EV/ EBITDAX, should not be used to calculate indication of values because royalty trusts do not have high operating costs and operational earnings margins are not a necessarily meaningful indication of performance for a royalty owner. Rather, a royalty trust's performance can be better understood by its distribution yield and potential for future revenue streams from new, undrilled wells.In many ways, this approach goes straight to the heart of value: a mineral royalty is worth what someone is willing to pay for it. However, the market approach is not a perfect method by any means for businesses or for mineral royalties.Royalty trust transaction data may not provide for a direct consideration of specific mineral royalty characteristics; it is imperative that the value conclusion be adjusted for differences in value level and in well economics, potential future drilling locations, among other factors. In any valuation, the more comparable the transactions are, the more meaningful the indication of value will be.The Income ApproachThe income approach can be applied in several different ways. Generally, such an approach is applied through the development of a cash flow or ongoing earnings figure and the application of a multiple to those earnings based on market returns. For mineral royalty interests, however, we oftentimes perform a discounted cash flow analysis. This approach allows for the consideration of characteristics specific to the subject mineral royalty, such as its well economics making it the most commonly used approach for mineral royalty interest valuations.To perform a royalty’s DCF analysis, production levels must be projected over the well’s useful life. Given that well production decreases at a decreasing rate, these projections can be calculated through deriving a decline rate from historical production. Revenue is a function of both production and price; as such, after developing a legitimate prediction of production volumes, analysts must predict future price values. The stream of revenue is then discounted back to present value using a discount rate that accounts for risk in the industry.Because revenue cash flows are the main driver of mineral royalty values, the income approach is the most reasonable and supportable valuation approach when determining the value of a mineral royalty interest.ConclusionA proper valuation of a mineral royalty interest will factor, to varying degrees, the indications of value developed utilizing the market-based and income-based approaches outlined above. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of the mineral royalty and its unique characteristics that provide relevance and credibility to these calculations. This is why industry "rules-of-thumb" are dangerous to rely on in any meaningful transaction.Such "rules-of-thumb" fail to consider the specific characteristics of an interest and, as such, often fail to deliver insightful indications of value. A mineral royalty owner executing or planning a transition of ownership can enhance confidence in the decisions being made only through reliance on a complete and accurate valuation of the interest.Mercer Capital's Oil & Gas team has extensive experience valuing mineral royalty interests. Despite attempts to homogenize value through the use of simplistic rules of thumb, our experience is that each valuation is truly unique given the purpose for the valuation and the circumstances of the interest. We hope this information, which admittedly only scratches the surface, helps you better shop for royalty valuation services and understand valuation mechanics.We encourage you to extend your wealth planning dialogue to include valuation of any mineral interests because, sooner or later, a valuation is going to happen. Proactive planning and valuation services can alleviate the potential for a negative surprise that could complicate an already stressful time in your personal life.For more information or to discuss a valuation or transaction issue in confidence, do not hesitate to contact us at (901) 685-2120 or (214) 468-8400.End Note1 Treasury Regulations 1.611-2(d) asserts that the income approach will not be used if the value of a mineral property can be determined using the cost-approach (under the asset approach) or the market approach. However, those circumstances are rare and not consistent with industry norms. The income approach is most often employed to estimate the fair market value of mineral properties such as this.

It’s Not Just Elon: Founder’s Syndrome Depresses the Value of RIAs as Well

About eight months ago, one of Elon Musk’s many business ventures, SpaceX, tested its Falcon Heavy rocket by launching Musk’s own Tesla Roadster into space. It’s now the fastest car in the universe, on a heliocentric orbit around the sun, complete with a mannequin in the driver’s seat named Starman. Given the career challenges he’s faced this year, Musk is probably ready to take the wheel himself.Entrepreneurship is an Investment ThemeInvesting in founder-led companies is a strategy favored by many investment managers, including some of our clients. The logic of the narrative is compelling: founders have interest, drive, and motivation. In our hometown of Memphis, the archetype for this is FedEx. Federal Express was a term paper in business school written by the founder, Fred Smith (who reportedly didn’t get a very good grade on the assignment). Founder-led businesses benefit from unique levels of dedication; Smith once covered Federal Express’s fuel bill with gambling winnings in Las Vegas. He devoted his inheritance and his life to the company and has retained a significant stake in the equity. Smith is now 74 years old and remains involved in the business. While the topic of succession comes up, key executive dependency is a comparatively minor topic when the company employs over 300 thousand people.Not all founders are like Fred Smith, though. While Tesla’s share price has proved remarkably resilient this year, it has had to be in light of the increasingly erratic behavior of founder, chairman, and CEO Elon Musk. From smoking pot in interviews to tweeting inaccurate insider information, Musk has made a mess of his leadership role in 2018 and highlighted the potential downside in founder-led companies.Every Company has FoundersTesla’s story is relevant to the investment management industry not just because many asset managers are invested in Tesla or otherwise invest in founder-led businesses. The Tesla story matters because most investment management firms are also founder-led businesses. The independent broker-dealer industry was born in the 1940s when wealthy investment professionals had to leave their commercial banking jobs because of Glass-Steagall. The majority of that generation of BDs are forgotten now because of consolidation or failed succession plans or both. The advent of ERISA in the 1970s brought about a new wave of money managers who built the RIA industry. The RIA industry is still expanding, despite a recent wave of consolidation.Most RIAs, independent trust companies, and hybrid RIA-BDs today are founder-led. The ones we work with are typically successful, having benefited greatly from the talents of their founders, whether in the discipline of attracting clients, choosing investments, or both. The trouble is that, while companies are usually designed to operate into perpetuity, founders ultimately suffer from mortality. Given the age of the RIA industry, many firms are facing succession issues, and many won’t survive it.When Vision Becomes a Blind SpotIf you’ve never read up on the theme of “founder’s syndrome,” then you’ve missed out on a key narrative that explains the valuation of many investment management firms. Founder’s syndrome is an organizational behavior in which a company is built around the personality of a prominent individual in a company, usually in a senior position, and often the founder himself or herself.Strong personalities can build strong organizations, but sometimes people start companies because they can’t work for anybody else. Can you imagine having Elon Musk as an employee? To the extent that the needs of a founder are made more important than the needs of the business, the business will suffer. If an RIA is a small enterprise that is more of a practice than an organization, this is no problem. In larger investment management firms, however, boards who once promoted the interests of a key professional may find themselves in the position of having to protect the business from that same person. While Bill Gross’s departure from PIMCO is a prime example, it is far from the only example. More often, we see situations where a creeping change in behavior leaves a senior professional with an outsized influence over the strategy of the firm, even when that strategy no longer serves the goals of the firm.If an investment management firm grows because of, rather than in spite of, its founder, then the next challenge arises, succession. Replacing a founder is nearly impossible because a leader in succession is necessarily going to have a different approach to running an organization. Second generation leadership is more likely to be more disciplined, cautious, and risk-averse. The organization itself will probably have to adjust to the second generation of leadership such that the needs of the company match the offerings of the executive.Diagnosing Founder’s SyndromeIf you’re wondering whether or not your RIA is suffering from founder’s syndrome, answer these three questions:Does your RIA, BD, or independent trust company principally exist to serve the psychological needs of your founder (i.e. an all-expenses paid ego trip)? The willingness of a founder to identify with their business is a key motivator that leads founders to work harder and longer to ensure the success of the enterprise. With success, the business returns the favor, and it’s at that point that the founder has to consciously decide whether their firm is really a business or simply an extension of themselves. This often shows up in compensation plans, when the founder(s) fail to draw a market-based line between their pay as employees and their returns as owners. Since small RIAs are owner-operator businesses, this can be easier said than done. But if the economics of the business are sufficiently segregated, then the founder is more likely to be working for the business, rather than the other way around.Is your founder unable to delegate? If your RIA’s success or failure rides on the skills, knowledge, and actions of your founder, then growth beyond a certain point will be difficult (if not impossible). Many founders are perfectionists and can’t accept work done differently than they would do it themselves. I once had a founder lead me through the office because he wanted me to meet the many talented people in his firm, only to instruct each one of them very thoroughly in exactly what he wanted them to tell me. Needless to say, if a founder cannot delegate, then the scale of their company will be necessarily limited to their own capacity to work.Is your founder willing to accept new leadership? Graceful exits are difficult, particularly when your name is on the door. While founders certainly have a role in “letting-go,” transition plans are an organizational responsibility, so boards and other senior executives share in the role of providing for the sustainability of the organization. The one theme I’ve consistently noticed is that transition takes much, much longer than people think it will. I learned long ago that people are a package deal – you take the good with the bad and you don’t get to pick and choose what parts of a person you accept. Like all founder-led companies, RIAs can benefit from the entrepreneurial zeal of the men and women who started them. Unfortunately, that same appetite for risk-taking can lead to reckless behavior, and the identification of a founder with a namesake enterprise can complicate succession planning. In any event, the risk associated with a founder-led RIA can lead to extreme results: taking advantage of a moon-shot opportunity, or a business that’s lost in space.

E&P Fourth Quarter 2018

Region Focus: Appalachia

Region Focus: Appalachia // As the new year begins, we turn our attention to the Appalachia region, and not by coincidence.

Fourth Quarter 2018 | Segment Focus: Nonresidential Construction

Key themes in construction industry mergers and acquisitions have been consolidation as retiring baby boomers look for exit opportunities and the rise of construction technology and software companies.

Refining | Year-End 2018

The first half of 2018 provided positive momentum for refineries that had increased revenues and margin expansion in the second half of 2017.

Transportation & Logistics Newsletter

Fourth Quarter 2018

Bakken Business

Companies that have maintained a presence in the Bakken since the downturn in oil prices are beginning to reap the rewards of their patience. Rising oil prices have begat increases in production, and efficiencies gained in recent years have led to higher margins and increased production. As noted in last week’s post about transaction activity in the region, while the Permian Basin has received much of the attention recently, the Bakken certainly appears to be back in business.Efficient and Engaged OperatorsContinental Resources, Hess Corporation, and Whiting Petroleum Corporation are among the biggest players in the region. Whiting has rebounded with its stock price up 141% in the past twelve months, and their related royalty trust Whiting USA Trust II has also shown improved performance. Speaking of the decline in oil prices, Continental’s CEO Harold Hamm said recently, “We would never have gained the efficiencies that we have today without going through that.” This can be further illustrated by looking at breakeven prices in the Bakken, which have dropped from about $77 in September 2014 to below $39 per barrel in the third quarter of 2018, lower than those seen in Texas.Greg Hill, President and COO of Hess, recently emphasized the importance of the Bakken in their portfolio, saying about 43% of Hess’ capex budget would be devoted to the region over the next three years, targeting $1 billion annually. He added that production constraints seen now in the Permian are very similar to those seen in the Bakken a few years ago.Infrastructure IssuesThe United States has long trailed other countries in terms of energy production. With the leaps and bounds made in production, the question for industry executives and investors alike is now what? Increased production has led to the need for better infrastructure, a problem currently besetting the Permian basin in particular. Extreme pricing differentials have occurred and plenty of natural gas coming off as a byproduct of oil production is being flared as a result.About 388 million cubic feet per day of natural gas was flared in June in North Dakota. Kinder Morgan, one of the largest energy infrastructure companies has proposed a $30 million natural gas pipeline that would alleviate 130 million cubic feet per day, with the project slated to begin construction mid-2019 and be finished by year-end, pending regulatory approval. Pipelines have been cast by industry executives as a safer alternative to rail transportation, though critics view this as a straw man argument. With the introduction of the Dakota Access pipeline (DAPL) in mid-2017, about half of the region's production (470,000 barrels per day of crude oil) will travel by this pipeline. Despite the DAPL and other pipelines like the one proposed by Kinder Morgan, rail travel will still figure heavily into the equation as refiners on the East and West coast have low pipeline connectivity and much of the oil from other regions ends up with one of the numerous refiners in the Gulf of Mexico.The Minneapolis Fed recently outlined five other projects aimed at increasing gas processing capacity, including a $100 million expansion of a natural gas processing plant near Killdeer, ND. While companies seek high levels of production to take advantage of higher oil prices, these infrastructure constraints have a negative impact. Hamm emphasized this point saying, “Instead of just producing oil, we’re going to make sure we produce shareholder return.”Rig Counts and ProductionAccording to Baker Hughes, rig counts in North America declined 1.0% in the last three months, but increased 11.4% over the last twelve months. The Permian Basin has led the way with an increase of 26.2% in the past year, leading them to have 46.5% of total rigs. Rig counts peaked in the Bakken in May 2018, reaching heights unseen since 2015, but the Bakken continues to trail the Eagle Ford, Permian, and Appalachia regions. While rig counts aren’t ballooning in Bakken, this may be because operators like Continental are focusing on completing wells that have already been drilled (“DUCs”), a cheaper alternative to drilling new ones.Although oil production in the Bakken has increased 9.9% in the past year, it lagged the other four regions covered with the Permian setting the pace with a 26.6% increase. Natural gas production in the Bakken increased 17.2% in that same time, again trailing the Permian’s growth of 25.5%. Given the Bakken only produces a little over a third as much crude oil and a fifth of the natural gas, it will be interesting to see if the Permian can maintain its torrid pace or if capacity constraints will allow others to close the gap.Valuation ImplicationsBefore the crash in oil prices, the Bakken was booming with the highest EV/production multiples, also known as price per flowing barrel. The Permian took center stage in 2017, but the Bakken is closing that gap as the Permian has come back to the pack a bit in 2018.ConclusionA rising tide raises all boats, and a rising oil price raises production in all regions. With the efficiencies gained, operators and investors in the Bakken and elsewhere will seek higher revenue and higher returns. Soaring production has led to unintended consequences such as flaring and inadequate infrastructure constraining capacity. Increasing this capacity will allow E&P Companies to increase returns and continue to ramp up production.We have assisted many clients with various valuation needs in the upstream oil and gas space in both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

WHITEPAPER | The Role of Earn-outs in RIA Transactions

The Role of Earn-outs in Asset Management M&A

M&A in the Bakken

Under the Radar

Over the past year, followers of the oil and gas industry have taken note of the multitude of transactions occurring in the Permian Basin with large deal values and hefty multiples. But the price differential between WTI and other benchmarks has grown over the last few months, and some attention has moved from the Permian to other domestic shale plays. The activity in other regions such as the Bakken was at one point slow (when compared to the Permian) causing the recent increase in production and the swapping of acreage to fly under the radar while many were focused on Texas.Transaction activity in the Bakken in 2017 marked the departure of a number of companies that were active in the play, such as Halcon Resources. At the end of 2017 and into 2018, the exodus from the Bakken to the Permian continued. Recently, the Bakken is being viewed as another viable option to the Permian Basin, which has seen a growing price differential due to insufficient infrastructure. This, and rising oil prices, has resulted in an increase in production in the region, leading to more transaction activity and inflows of capital.Recent Transactions in the BakkenDetails of recent transactions in the Bakken, including some comparative valuation metrics are shown below.Overall, the average deal size has decreased from twelve months ago when companies sold off large bundles of assets to clean up their balance sheets and survive in the low oil price environment. While deals today may be smaller in size, they are more strategic in nature.Whiting Acquires 65,000 Acres from OasisOne of the largest deals in the region over the last twelve months was Whiting Petroleum Corp. purchase of 65,000 acres from Oasis Petroleum Inc. in June for $283 million. A Seeking Alpha contributor noted that this transaction is a “case of one company believing that it can achieve better results in an area that the other company considered lower quality acreage.” This is observed in Oasis’ acceptance of a lower than average transaction price per acre, and Whiting’s willingness to pay an above average price flowing barrel.US Energy Acquires 1,600 Acres from APEGOne of the smaller deals was US Energy Corp.’s acquisition of 1,600 acres from APEG Energy LP (a related party) for $18 million. US Energy and APEG Energy II, LP announced a strategic partnership in October of 2017 in a deleveraging transaction. APEG Energy II is one of Angelus Capital’s (a private equity firm headquartered in Austin, Texas) funds focused on acquiring domestic oil and gas assets. Since then, US Energy has focused on cleaning up its balance sheet to focus on producing oil assets. Recently, US Energy has been working to add assets that will immediately increase production in the Williston Basin and South Texas.US Energy expects their most recent transaction “will create additional opportunities for development and acreage swaps that would permit the company to continue consolidating its leasehold position in the area.” US Energy paid $44,500 per flowing barrel, which is in line with average production multiples paid in the region but is somewhat lower than those observed last year. Deal values last year may have been based on the expectation that production would increase in the future, inflating current multiples. Now that production has picked back up in the Bakken, deal multiples appear to have normalized somewhat.Observed M&A Trends in the BakkenThe following are two good examples of transactions we are seeing in the region this year:Strategic Deals Between Regional OperatorsOne of the disadvantages of the Bakken, as compared to the Permian, is that it is an older play and many of its sweetest spots have already been drilled. However, age is often equated with wisdom, and the significant experience of operators who have been in this region since the early 2000s gives them a competitive edge. As Senior Beck, a senior director at Statas Advisors explained, “The Bakken’s maturity and production characteristics could lead to a growth in consolidation over the next few years.”Acquisitions of Property by Non-OperatorsAdditionally, the prominence of activity of non-operators in the Bakken has increased. Private equity funds like Angelus Capital, single-family offices, and other providers of capital that see an opportunity in the Bakken are buying acreage and partnering with the best operators in order to realize superior returns on investment.Combining these trends, Northern Oil and Gas Inc. is a non-operator who aims to be the Bakken’s “natural consolidator.” In July it completed its largest acquisition yet of 10,600 net acres for $100 million cash plus approximately $190 million of Northern Oil stock. Northern Oil is relying upon the superior abilities of longtime regional operators and the trend towards consolidation. However, it is also an example of a non-operator who has become more prominent in the last year.The Bakken may have gone unnoticed for a couple years after the downturn in oil prices in 2014, but it may be rising back to prominence as increases in efficiency and cost reductions impress investors.We have assisted many clients with various valuation needs in the upstream oil and gas in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Staffing for Value

With last week’s release of the 2018 InvestmentNews Compensation & Staffing Study, trends in pay and performance expectations are making the rounds in the RIA community. Even though we are a valuation firm, we are often asked to weigh in on compensation matters, as officer pay and firm value are typically intertwined. A few months ago, a client who reads our blog regularly sent me a photograph of his first car, a 1957 Chevy Handyman. The Handyman was a two-door version of Chevrolet’s station wagon series with less chrome and a powertrain oriented more to utility than the better known Chevy Nomad series. Because most Handymans were not well cared for (they were fleet vehicles that served manual laborers), examples like the one our client owned could be bought cheap. And because it was cheap, a teenager growing up on the West Coast, such as our client, had no qualms about using it to haul surfboards and damp surfers back and forth to the beach. Unfortunately, what can be bought cheap is often sold cheaper, and such was the fate of this particular Handyman. Today, a Handyman in prime condition is rare, and that which is rare, and sought after, appreciates.Stories like this drive the collector car market, and you can watch the appreciation curve on certain models mature as the demand created by nostalgia for first cars or dream cars meets the supply of accumulated wealth that comes later in life. Muscle cars from the 1960s have shot up in value over the past ten years because collectors who were teenagers in the 1960s have reached the peak of their careers, put their kids through college, amortized their mortgage, and can finally afford to buy back part of their youth at an auto auction. Professionals who follow the collector car market consider the price trends to be fairly predictable based on demographics.In the RIA community, regardless of firm size or type, there is a predictable relationship between staffing decisions (positions, expectations, compensation, etc.) and firm performance. It’s a well-worn phrase that the assets of professional service firms get on the elevator and go home each night, but that doesn’t tell the story of the value of the firm, which is not merely the assemblage of assets, but rather the organization, orientation, and utilization of those assets for a common purpose: serving client needs.Staffing Your ModelWe think compensation surveys offer interesting data, but that data needs to be filtered carefully to provide useful information. No two RIA business models are exactly alike, and staffing needs and compensation requirements of one model do not necessarily translate into another model. So while the averages of reported data are interesting, they have to be put into context to be meaningful.Some RIA models, for example, are highly vertical, focused on supporting the talents of one or two individuals at the top of the firm. In such a situation, compensation might be expected to be very top-heavy, as most employees of the firm serve to leverage firm leadership. This is common for niche asset management firms. Firms with a more horizontal orientation (lots of rainmakers contributing to the revenue stream) are inherently more sustainable, with less dependence on any one individual and an easier system to bring junior talent along into senior positions. Wealth management firms tend to exhibit this horizontal organization – at least most of the time. Aggregate compensation expense and margin can vary in both vertical and horizontal structures. It’s more important to know the “why” of your compensation structure than the “what.”Staffing for MarginMargins can be tricky to interpret. Too low and the viability of the firm is threatened by market downturns. Too high and the firm is vulnerable to market forces bidding away talent or bidding down fees. Since the key variable in firm profitability is compensation, it’s a good idea to keep an eye on your margins relative to market and your aggregate compensation expense relative to market. Most firms aren’t “average,” so there’s no expectation that you would be either. But the average is a benchmark to measure against, and if you can articulate why your margins and compensation costs are different than market averages, you’ll have a better handle on managing those numbers through different economic environments.Staffing for GrowthIn one sense, investment management firms are simply collections of people – and those firms can’t grow any faster than the people who compose the firms. Brent Brodeski published a useful article in Financial Planning a few months ago talking about the tradeoff between current profitability and growth. The message, which is worth reiterating, is that growth isn’t free. A common myth in the RIA industry is that, at a given scale, an upward trending market provides a tailwind that carries firms along whether they intentionally focus on growth or not. The problem is that RIA staff do not live forever, and without investing in subsequent generations of leadership and subsequent generations of clients, every firm will quietly begin to wind-down regardless of the market.Staffing for SustainabilityRIAs are business models that can, if managed thoughtfully, survive most any change in the business climate or market dynamic. Our oldest client firm dates to the 1940s, and during their 75-year history, they’ve experienced several changes in control ownership, client focus, and portfolio expertise. Adaptability is integral to sustainability. That said, having a staff that is motivated to adapt – not just be capable of it – helps provide for the firm’s needs as they change. A firm with 5% client turnover is a brand new firm every twenty years. Are you prepared to start over during the course of the next two decades? This is another place where benchmarking is useful as a reference rather than a rule. With many studies reporting that the average age of financial advisors now tops 50, does the average age of client-facing staff in your office suggest you are building the future firm or simply cashing in on what you built previously? This applies to your staff as a whole and to senior staff needs in particular. What would it cost to recruit a younger version of you today? Have you hired that person?Staffing for ValueWe often say that investment management is not a capital-intensive business, but the capital investment in a typical RIA is in human capital. Technology offers the promise of some relief, assuming regulatory requirements don’t consume those efficiencies over time. Most RIAs could operate at a higher margin than they report, but doing so would require understaffing – either in the number of employees or quality of employees – such that the clients of tomorrow aren’t being recruited, nor is the talent to service those clients being developed. Absent reinvestment in human capital, an RIA becomes a depreciating asset which, unlike collector cars, isn’t likely to evoke nostalgic interest years later.The one that got away

Beach Reading: Notice of Proposed Rulemaking – Qualified Business Income Deduction

Struggling to find a page-turning read for that late summer beach escape?May we recommend the 184 pages of blissful decadence that comprise the Internal Revenue Service’s August 2018 Notice of Proposed Rulemaking (NPR) regarding the Qualified Business Income (QBI) deduction under the Tax Cuts & Jobs Act (TCJA).Like a tightly wound murder mystery, the regulations weave a complex web.Tax code sections take the place of characters, the regulation’s intricacies unspooling as the narrative continues, relationships between Tax Code sections becoming (somewhat) clearer as the story (i.e., the regulation) progresses.As the NPR continues its inexorable march, certain storylines (i.e., planning opportunities) are forestalled, yet the NPR creates a glimmer of other opportunities.1The Abridged Version of the NPR in One SentenceBank shareholders are eligible for the 20% Qualified Business Income deduction.2 Intrigued?If so, the story continues.PrologueBefore examining the NPR, several tax-related trends are evident in 2018 regulatory filings.Effective tax rates are fallingMore banks are converting from S corporations to C corporationsSecurities portfolio allocations are evolvingDespite the attention it receives, tax reform is not solely responsible for improving bank profitability in 2018.Table 1 illustrates that pre-tax return on tangible common equity (ROATCE) has expanded in 2018, consistent with widening net interest margins for many banks and constrained credit costs.Effective tax rates declined from approximately 30% in the first half of 2017 to 21% in the comparable 2018 period, allowing banks to leverage the 50 to 100 basis point pre-tax ROATCE expansion into 150 to 200 basis points of after-tax ROATCE expansion.Table 2 indicates conversion activity from C corporation to S corporation status.Following tax reform, conversions increased significantly, as 53 banks changed their tax status in the first six months of 2018 versus nine in the prior year period.Nevertheless, this represents only a sliver of the approximately 2,000 banks taxed as S corporations.Several large S corporation banks elected to be taxed as C corporations in 2018; as a result, banks collectively holding $44 billion of assets converted in 2018, relative to only $5 billion in the prior year period.After passage of tax reform, some observers speculated that more conversion activity from S corporation to C corporation status would occur in states with relatively high personal tax rates, due to the $10 thousand limitation on the deductibility of state and local taxes.However, this trend is not yet apparent in conversion activity, as the states experiencing the most conversion activity include jurisdictions with both higher and lower personal tax rates.While more banks converted from S corporations to C corporations in 2018, relatively few did the reverse.As indicated in Table 3, nine banks converted from a C corporation to an S corporation in the first half of 2018, relative to 14 such conversions in the first half of 2017.Third, tax reform may influence banks’ investment portfolio positioning.While portfolio allocations reflect many factors, Chart 1 suggests that tax reform has affected investment strategies.Municipal securities remained relatively stable throughout 2017 at 28% of total securities; however, the proportion of municipal securities dropped to 26.9% at March 31, 2018 and 26.5% at June 30, 2018.This trend is consistent with our experience, where banks are not liquidating municipal securities due to tax reform but, at the margin, may prefer taxable alternatives for new purchases.RefresherInternal Revenue Code Section 199A provides a 20% deduction against the income reported by owners of sole proprietorships, partnerships, and S corporations.If only tax code provisions could be described in one sentence, though.The deduction may be taken against income generated by a Qualified Trade or Business (QTB).A QTB, in turn, is any business, other than a Specified Service Trade or Business (SSTB).In addition, certain W-2 income and asset limitations exist that may limit the 20% deduction.Lastly, individuals with income below certain levels may escape the SSTB and W-2 income/asset limitations; therefore, these owners would receive the 20% deduction whereas owners with higher incomes would not.The NPR provides guidance regarding, among other items, the definitions of QTBs and SSTBs.Other IssuesWhile banks definitely are eligible for the 20% Qualified Business Income deduction, several other items covered by the NPR may be of interest to bankers.Qualified Trade or Business DefinitionAn entity must be a Qualified Trade or Business to receive the 20% QBI deduction.From the TCJA, however, it was unclear if a QTB must be a “Section 162 trade or business.”While the Internal Revenue Code and regulations contain various definitions of a “business,” Section 162 contains a relatively restrictive definition.Unfortunately for taxpayers, the NPR adopts the Section 162 definition.While Section 162 has existed for many years, the regulations and case law interpreting the provision remain somewhat vague.One significant concern is that certain real estate entities will not be deemed Section 162 trades or businesses, therefore becoming ineligible for the 20% QBI deduction.For example, entities holding properties subject to triple net leases may face difficulties meeting the Section 162 requirements.From a credit standpoint, banks should be aware that tax savings expected by owners of certain real estate entities may not materialize.The TCJA’s Definition of an SSTBEntities providing professional services generally are deemed SSTBs.The business reality, though, is that some companies provide both a tangible product (like a widget) and services that would meet the definition of an SSTB (such as educational services regarding widgets).Will a company offering some consulting services, no matter how small a share of revenues, be deemed an SSTB?Under the TCJA, it was unclear.The NPR creates a de minimis exception for companies with small amounts of service revenues, although the thresholds appear relatively low to us.The TCJA also includes a “catch-all” provision deeming as SSTBs any businesses for which the reputation or skill of its owners or employees is a principal asset.This broad provision potentially captures a large swath of small businesses; for example, the reputation of a restaurant’s chef may result in the restaurant being deemed an SSTB.This result appears inconsistent with the TCJA’s statutory intent, and the NPR significantly limits the scope of the catch-all provision.The “Crack and Pack” StrategyCommentators noted that the TCJA created a tax planning opportunity for businesses deemed SSTBs.For example, consider a law firm that owns a building in which it operates.The law firm is an SSTB and its partners ineligible for the 20% deduction.The partners could transfer the building to a new real estate holding company, which is not deemed an SSTB.Therefore, the law firm partners have shifted income – via rent payments from the law firm to the real estate holding entity – from the SSTB (the law firm) to an entity qualifying for the QBI deduction (the real estate entity).Alas, the IRS cracked down on the “crack and pack” strategy.The NPR provides that income from a commonly-controlled entity that provides services to an SSTB is ineligible for the 20% deduction.However, the NPR may not entirely foreclose on all planning strategies.While the NPR limits the QBI deduction for commonly-controlled entities, commonality is deemed to exist if the businesses share 50% or more ownership.Therefore, the law firm may transfer its building to an entity owned equally by the law firm partners, an accounting firm’s partners, and a physician group.Since common control does not exist (i.e., neither the attorneys nor the accountants nor the physicians control more than 50% of the real estate firm’s ownership), the owners of the various services firms would be eligible for the 20% deduction on the real estate entity’s earnings.To bankers, business reorganizations triggered by the deduction limitations applicable to SSTBs may trigger lending requirements.ConclusionLike a good novel, the NPR’s “plot” is not fully resolved – some questions remain unanswered and multiple interpretations of other provisions are possible.Perhaps a sequel to the NPR is in order.Originally published in Bank Watch, August 2018.1As for literary criticism, Mercer Capital does not render tax or legal advice, and readers should consult with appropriate professionals regarding the application of Section 199A to any specific circumstances. 2 To expound upon our arbitrary one sentence limitation, it was relatively clear in the Tax Cuts & Jobs Act that bank shareholders are eligible for the 20% Qualified Business Income deduction, but the August 2018 NPR confirms this eligibility.

M&A Activity in the Oilfield Service Sector

From Surviving to Thriving

The oilfield service sector has recovered significantly since the crash in oil prices in mid-2014. As capex budgets have expanded, especially in the Permian Basin, demand for oilfield services such as drilling and pumping has increased. But what does this mean for transaction activity in the sector?The oilfield service industry was in consolidation mode over the last few years as smaller servicers struggled to survive in the low oil price environment which translated to lower day rates. Thus the relatively fewer transactions from 2015 through much of 2017 were mainly distressed sales.Now that oil prices have recovered, drilling activity has picked up, and day rates have increased, the reason for deals has changed. Rather than merging to survive, companies are acquiring in order to thrive. When discussing transactions in oilfield services sector over the past few years, maybe it should be called mergers THEN acquisitions.From Mid-2014 to Mid-2017 Oilfield Servicers Were SurvivingWhen oil prices fell, demand for oilfield services declined significantly. Despite the steep drop in prices, production did not fall through the floor because the cost of stopping and starting production can outweigh the loss incurred from lower oil prices. Still, the oilfield services sector felt the pain as many of its high value-added services occur at new sites rather than currently producing ones. With low oil prices, people became more judicious with how they deployed capital and new projects were largely tabled. Companies in financial duress were forced out of the market through consolidations and bankruptcy, as other sources of capital such as debt or additional equity offerings dried up due to the uncertainty surrounding future oil prices.M&A activity for the oilfield services sector was largely muted during the downturn in terms of both deal volume and value. Deal value would have been larger had Halliburton Company successfully completed its megamerger with its competitor Baker Hughes Inc. for an announced $34.6 billion. Instead of searching for synergies to boost revenue, companies were seeking to combine to eliminate duplicative expenses. In the case of Halliburton and Baker Hughes, the merger was expected to cut nearly $2 billion in annual costs according to the investor material seen below. Ultimately, this became the downfall of the deal as regulators denied it on grounds of decreased competition and reduced innovation on account of too much overlap in services. One year after the U.S. Justice Department blocked the deal due to anti-trust laws, General Electric bought a controlling interest (62.5%) in Baker Hughes. The combined entity resulting from GE’s investment caused GE’s combined revenue to surpass Halliburton, becoming the second largest company by revenue in the industry, trailing only Schlumberger. In early 2017, streamlining operations and eliminating expenses via consolidations was viewed as “the last big step to margin improvement,” according to the Coker Palmer Institutional. By the end of the year, there were 215 transactions in 2017, up 13% from 2016. As the tide began to turn, factors influencing transaction activity shifted from financial stress and cost efficiencies to economies of scale and enhanced offerings, particularly in digital technology. Oilfield Servicers Are Now ThrivingAs oil prices have recovered, up to $60 a barrel at the end of 2017 and peaking at $72 in May 2018, transaction activity has increased, but the reason for this increase in activity has changed. Companies that survived the downturn in oil prices stood to gain as rising oil prices aided margins and increased capex budgets for E&P companies. As break even prices became less of a concern for the industry, growth and innovation became the focus. Oilfield services companies depend on innovation to distinguish themselves in a highly fragmented industry, and when prices caused capital to flow out of the industry, companies were unable to fund the research and development necessary to innovate. Now, that trend is reversing with funding flowing into the sector to support growth and innovation. This is particularly important due to the capital-intensive nature of oilfield services, requiring significant investment to buy more equipment to meet growing demand.The following table shows some strategic transactions that have occurred thus far in 2018, as companies seek growth opportunities. However, we are starting to see more investment from other sources.Private Equity Firms Are Suppling Growth CapitalAfter years of industry executives searching for diamonds in the rough, institutional investors have joined the fray. Over the last twelve months, there has been an influx of funds from private equity firms and hedge funds as growth, innovation, and fragmentation are all desirable traits for these investors.In March, Morgan Stanley Energy Partners (MSEP), the energy-focused private equity arm of Morgan Stanley Investment Management, completed an investment in Specialized Desanders, Inc. a Canadian-based oilfield equipment company that specializes in efficiently removing sands and other solids during the well flowback and production process. MSEP’s investment seeks to accelerate growth in the U.S. market and expand their product offerings.In August, MSEP continued investing with its announcement of a partnership with Catalyst Energy Services. Proceeds from the investment will be used to buy state-of-the-art equipment which will allow the company to grow to meet increased demands for modern completion designs from E&P companies.Black Bay Energy Capital recently closed its inaugural fund with commitments of $224 million, exceeding their $200 million target. This includes six investments in oilfield service companies exhibiting rapid growth that “improve the efficiency and cost-profile of oil & gas producers.”These investments made by MSEP and Black Bay show the three trends currently being exhibited in transactions in the oilfield services sector: niche product or specialty, innovative offering or technology, and growth. Whether it be strategic investors or private equity sponsors, acquisitions we are seeing now are largely spurring revenue growth instead of eliminating expenses.ConclusionTransaction volume in the oilfield services sector ebbed and flowed with oil prices over the last few years. On the way down, companies cut costs to survive, and mergers played an important role in increasing efficiencies in order to survive. On the way back up, companies sought capital to propel growth and fund innovation. As the market shifts from backwardation to contango and back again, Mercer Capital is here to help throughout all stages and economic environments.In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.Whether you are selling your business, acquiring another business or division, or have needs related to mergers, valuations, fairness opinions, and other transaction advisory needs, we can help. Contact a Mercer Capital professional to discuss your needs in confidence.

Will Direct Indexing Become the Next ETF?

Since their launch in 1993, exchange traded funds (ETFs) have steadily attracted assets from mutual funds and active managers that have struggled to compete on the basis of performance and overall tax efficiency. Now many industry observers believe that the same may very well happen to ETFs with the recent rise of direct index investing (DII). For this week’s post, we look into the pros and cons of DII and the implications for the investment management industry. Exchange traded funds took market share from mutual funds because most active managers do not deliver on their value proposition. That is, most active managers underperform their relevant benchmark after fees. ETFs, by their very design, cannot underperform the index they track (ignoring tracking error, which is usually negligible) and are usually quite inexpensive. ETFs gained traction with this obvious advantage and have dominated asset flows over the last decade. After years of domination, ETFs appear to have a worthy contender in the form of DII. Both are intended to be a form of passive investing designed to track a certain index. The key distinction between the two is that a direct indexing investor actually owns the index’s underlying shares in a separately managed account, as opposed to units in a fund that track the index. Since owning all the stocks in, say, the S&P 500 or Wilshire 5000 (and in proportion to their market weighting) is not feasible for most investors, DII portfolios are usually comprised of a representative sample of securities that should mimic the index’s performance over time. Advantages and DrawbacksThis design creates certain advantages and disadvantages to direct indexing versus ETF investing. By only investing in a subset of a given index, DII can achieve alpha, unlike passive ETFs. Of course, direct indexing can also underperform a benchmark, and depending on the sample size, can expose investors to idiosyncratic risk factors that ETFs minimize or eliminate through diversification. DII is therefore not a purely passive investment vehicle, and advisors should make their clients aware of this fact.Just as ETFs are considered more tax efficient than mutual funds, DII has certain tax advantages over ETF investing. Since direct indexers are investing in the underlying shares as opposed to a fund that holds the underlying shares, they can harvest losses when some of these securities decline in value. DII also allows investors to avoid selling the top gainers, while ETF sales effectively involve selling every share of the underlying index pro rata. Over time, such efficiencies can lead to considerable tax alpha relative to ETF and mutual fund strategies.Direct indexers can also tailor their portfolios to their unique circumstances better than an “off the shelf” ETF. DII can selectively avoid certain sectors of the economy or pursue businesses with higher governance standards. Such customization can be highly beneficial to investors with significant portfolio concentrations or ESG mandates.Liquidity is also a concern with ETF investing. The rising popularity of ETF products has caused distortions in the market when their daily volume exceeds that of their underlying securities. This disparity can be exacerbated during sell-offs. On August 24, 2015, a sharp decline in the overseas markets led to trading halts in eight S&P 500 stocks, which precipitated a “liquidity traffic jam” for 42% of all U.S. equity ETFs. In one example, shares of the Vanguard Consumer Staples ETF (VDC) fell over 30% while the underlying holdings only dropped 9%.Still, DII is often more costly and time-consuming than ETF investing. Picking representative securities and building customized portfolios can require considerable resources that are not needed for ETF investing. Trading costs are also higher, albeit at a diminishing rate with advances in rebalancing automation and fractional share investing. Monitoring costs can also be greater, especially for portfolios seeking to minimize tracking error.Weigh Your OptionsOn balance, DII is not for everyone. It probably does not make sense for smaller accounts with no diversification issues to pursue such a potentially costly investment strategy. ETFs and robo-advisors are probably better suited for many retail investors, including the mass affluent.For high net worth clients with significant concentrations and/or ESG needs, on the other hand, direct indexing is likely the superior option. ETF products and robo-advisory firms are simply not equipped to provide the specialized level of services that DII can accommodate for these investors. This void creates opportunities for wealth management firms and their advisors. RIAs providing comprehensive wealth management services can tout direct indexing as a tax-efficient investment strategy that can be tailored to a client’s particular situation.This may sound familiar. Wealth management firms have been providing these kinds of services well before the invention of ETFs. The difference is that now, with advances in technology and lower transaction costs, these kinds of services can be profitably offered to most high net worth families and not just the ultra-wealthy. Given the growing number of high net worth investors and rising demand for personalized investment solutions, direct indexing should be a boon for the wealth management industry as these trends continue to play out.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Fidelity Wins the Race to the Bottom

Is Free the New Cheap?

Question: How many CFA charter holders does it take to change a light bulb? Answer: When you ask “how many,” are you asking for the mean, median, mode, a rolling average, variance or semi-variance to a certain population sample...?Paralysis by analysis often seems like a viable career track in finance, especially when it comes to product development. Even here, though, history offers a pattern of what to expect. Product development usually follows one of two paths in investment management: greater innovation or lower pricing. The former of these is a margin builder, while the latter can be a margin killer. After watching the price of trading drop for decades, it wasn’t so surprising when J.P. Morgan announced that it would offer free online trading for certain investors last month, but when $2.5 trillion manager Fidelity Investments announced they were going to be offering two “free” index funds, the industry rocked on its heels. Is this the next leg down for pricing of investment management, a publicity stunt by Fidelity, or something else altogether?Relating this, as I am wont to do, to historical events in the automotive history, I’m reminded of the down-market product disaster that Aston Martin attempted a few years back, the Cygnet. In 2011, faced with looming and more stringent EU emissions standards, Aston Martin decided the only way to comply was to market a high-volume, high-mileage micro-car that would average out with the automaker’s low-volume, low-mileage GTs. Developing an all-new car is prohibitively expensive, though, so a committee at Aston decided to license an existing eco-platform, the Toyota IQ, dress it up with leather and fancy badges, and sell it as a premium economy car. This offspring was priced at about a third of the MSRP of Aston’s other cars, but it was still three times as much as a Toyota IQ. So, was it an insanely cheap Aston Martin, or a ridiculously expensive Toyota? When Aston Martin launched the Cygnet (a name which accommodated an “ugly-duckling” appearance by suggesting it was the adolescent version of the company’s beautiful models like the DB9), their CEO stood on a mountain of product research on brand extension and projected annual sales of 4,000 units in the UK alone. Instead, Brits bought fewer than 300 baby swans over two years before Aston Martin gave up.The big asset gatherers like Fidelity, Charles Schwab, Vanguard, and Blackstone have been creating high volume, low price investment products at an increasingly prodigious rate for years. With many index products already available at ten basis points or less, the trip to zero was a short one for Fidelity and likely one they expect to recoup in other products and services once the client relationship is secured and the assets are in-house.Fidelity’s move was meant to look revolutionary, but it’s really revolutionary, and I don’t think it says much about where the investment management industry is going. Look no further than the progress of the robo-advisory business. I was an early subscriber to Financial Engines’s portfolio evaluation tools, but frankly lost interest in quarterly model analysis and dropped out after a couple of years. In the first ever “Robo Ranking” by Backend Benchmarking, the top-ranked robo-advisor is Vanguard’s Personal Advisor, mainly on the strength of its human advisor services that come with the algorithm in a competitively priced package. The lowest ranking robos scored poorly, in part, because of the lack of access to advisors.The ongoing theme of the repricing of investment management is that if value can be articulated and justified, reasonable fees can be charged. There is also ample evidence that human relationships are still highly valued in the RIA space. So while investment management products are subject to a high degree of price scrutiny and competition, investment management services are largely unaffected. It’s more likely that the fees available for investment management are being reallocated, rather than being diminished in aggregate. Time will tell.In short, I don’t know if the no-cost Fidelity products are going to go the way of the Cygnet, but I don’t think this is a Black Swan event either.

Oilfield Service Valuations

Missing The Party Or Just Fashionably Late?

Latecomers are inevitable at parties. They skulk in at the end, missing out on most of the fun, food and games that everyone else has been enjoying. Yet, savvy socialites aim to arrive fashionably late, after the labor of getting the party going but still in time to enjoy the night.When it comes to valuations, are oilfield servicers late to the proverbial oil patch valuation gala or just in time to enjoy the recovery?Energy Sector Performance ImprovingSince oil prices fell off a cliff in the summer of 2014, most other energy sectors have been climbing back in various phases of recovery:E&P company valuations are recovering as companies have benefited from increases in production, escalating acreage values, lower breakeven prices and a recuperating oil price. This is especially true in the Permian Basin. In fact, activity and production in West Texas is growing so fast that existing pipelines and infrastructure struggle to keep up.Meanwhile, US refiners, feasting on the spread between Brent and WTI, continue to see valuation gains as well. Refineries are busting at the seams, with current utilizations over 98%, and acquisitions abound. Refinery performance appears sustainable for the short to intermediate term, but in the long run, capacity may be a limiting factor.Even midstream and pipeline valuations, after taking a beating through the end of 2015, are recovering nicely. The current West Texas hydrocarbon traffic jam presents a growth opportunity for this sector.Past Oilfield Service Performance Oilfield service providers, drillers, pumpers and equipment providers enabled E&P companies to make impressive efficiency leaps. So, where do they stand today? One lens through which to view things is the OSX index–a popular metric to track sector performance. Since mid-2014, the OSX index does not exactly portray an inspiring comeback by oilfield service companies. In fact, looking at the index alone might lead one to think oilfield servicers have not even received an invitation to this reputed party, much less arrived. Earnings sunk in 2015 and bottomed out in 2016 as a result of producers cutting drilling and completion costs. Balance sheets went through significant write downs, impairments and asset sales. Not surprisingly, bankruptcies for the sector peaked in 2016 with 72 oilfield service companies filing for bankruptcy, up from 39 the year prior. It was a mess, to say the least. Oh, but how things have changed in the past two years. Current Oilfield Service Performance Higher oil prices, coupled with lower breakeven costs for producers, are making drillers, completers and a host of other servicers busier than a gopher on a golf course. Capex budgets for E&P companies, known as lead indicators for drillers and contractors, have taken off. While dormant for decades, proven drilling locations (PUDs) now multiply in light of new fracking technologies and their resultant economics. Drilling and completion budgets are not only growing for operators, but an increasing percentage of those budgets are being spent in West Texas.Utilization Rates and Day RatesSpecifically, as it pertains to oilfield service companies, two key metrics, utilization rates and day rates, have begun to align in a way not seen since 2014.By the end of 2017, utilization rates for certain rigs averaged around 80%, or almost fully utilized considering necessary downtime and transition from one drilling location to another. However, things are currently so hot that utilization rates have now risen to over 90%.Day rates, the measure of how much a servicer can charge an operator for every day the rig is operating, have been slower to increase. Increases in day rates started to move upward in the last six months or so. Estimates suggest that day rates will notch up 10-15% by the end of 2018. This is good news for oilfield servicers.Valuation TurnaroundNow that utilization rates and day rates are both trending upward, valuations should logically respond and by certain aspects, they are.Take, for example, a selection of guideline company groups: onshore drillers and pressure pumpers (fracking companies). One way to observe the degree of relative value changes is to look at enterprise value (sans cash) relative to total book value of net invested capital (debt and equity) held by the company or “BVIC”. Any multiple over 1.0x indicates valuations above what net capital investors have placed into the firm, which for drillers and pumpers is a notable threshold. While 2016 was an anomaly (due to the significant balance sheet changes mentioned above), the rest of the time frame shows a clear trend. In 2015, with a multiple below 1.0x, investors didn’t expect to get an adequate return on the capital deployed at these companies. However, as 2017 came to a close and now moving into mid-2018, that trend has reversed. All except Parker Drilling have met or exceeded their 2014 multiples, and the average is around 1.2x. This suggests that the market is recognizing intangible value again for assets such as developed technology, customer relationships, trade names and goodwill. For pressure pumping and fracking concentrated businesses, which are more directly tied into the value expansion in the oil patch, the trend is clear. Intangible asset valuations have grown even faster, more heavily weighted towards pumpers’ developed technology that is driving demand for these companies’ services. However, the recent infrastructure logjam in West Texas has pushed multiples lower. Nonetheless, the market has been recognizing the value contributions of these companies. ConclusionTo be clear, nearly all of these companies had to shrink their balance sheets to get these multiples in line. This explains why some of the data is not as meaningful in 2016. However, it appears that’s what was necessary in light of the shift in the market.Overall rig counts have shifted downward since 2014 and are currently nowhere near prior levels, thereby forcing these companies to shed assets in recent years. That’s the price of market efficiency. However, with those challenges no longer weighing them down, some oilfield services companies may be finally arriving at the valuation party.Remember the initial question posed in this post: When it comes to valuations, are oilfield servicers late to the proverbial oil patch valuation gala or just in time to enjoy the recovery? Maybe the question to ask is: How much time is left before the celebration ends?Originally appeared on Forbes.com.

Why Scale Doesn’t Always Resolve Succession Issues

Recent challenges at Och-Ziff and Hightower highlight the struggles RIAs face in transitioning the business to the next generation of management. Size doesn’t alleviate this problem and may actually exacerbate it for some asset managers. In this week’s post, we explore what went wrong in these instances and what you can do to avoid a similar fate.Public MiscuesAs one of the few publicly traded hedge funds, it appeared that Och-Ziff figured out its ownership succession issue. Legacy shareholders could liquidate their holdings in the IPO or any time thereafter at the market price. Unfortunately, though, it did not resolve the firm’s management succession question. In December of last year, founder Dan Och informed the firm’s clients that his protégé and current co-CIO Jimmy Levin, age 34, would not be assuming the reins as CEO when Och decided to step down. Many believed Levin was the heir apparent after being promoted and receiving a huge incentive package earlier that year (worth nearly $280 million). Levin’s rapid rise reportedly irked other members of management, a few of which left the firm in recent years. OZM’s shares are off nearly 30% since this announcement despite eventually finding Mr. Och’s replacement a few months ago.Then, just last week, RIA acquisition firm HighTower Advisors announced that co-founder Elliot Weissbluth would be stepping down as CEO and HighTower would be seeking a new president and head of field services. Such turnover at the top means HT will likely have to look outside the firm for new leadership, which can be a long and expensive process when you don’t have a successor lined up.Certainly, OZM and HighTower are not the only RIAs with succession issues, and this is certainly not an exhaustive list.Last year, billionaire Ray Dalio, who started Bridgewater Associates in 1975, announced the second shakeup within a year at the top ranks of his $160 billion firm.Israel Englander, CEO of Millennium Management, was caught off guard in January when his potential successor abruptly resigned with plans to start a competing firm.George Soros and Seth Klarman have also struggled to prepare the next generation of leadership at their firms. All of these businesses are industry leaders with tens (or hundreds) of billions under management. The fact that they struggle with management succession shows just how hard it is to actually pull off in practice. Firm size and longevity do not guarantee a smooth transition to the next generation of leadership. In fact, the success of these firms may have fueled complacency and impeded their succession planning – why look for new management when everything’s going so well? The problem is no one lives forever, and (most) people get tired of working.How to Transition WellSo what can you do now to avert succession issues down the road? It may sound like a cliché, but it’s never too early to think about the next generation of leadership. Most RIA principals are baby boomers that are approaching retirement age, and we suspect (mostly from firsthand experience) a fairly high percentage of them don’t have a formal (or even informal) succession plan. If you intend to evolve your practice into a sustainable enterprise and have something to sell when you retire, you need to be thinking about your likely successors and how to retain them.A logical starting point for accomplishing this goal is tying management succession to ownership succession. Many of our clients’ principals sell a portion of their ownership to junior partners every year (or two) at fair market value. This process ensures that selling shareholders are incentivized to continue operating the business at peak levels while allowing rising partners to accrue ownership over time. Many buy-sell agreements also call for departing partners to sell their shares at a discount to FMV if they are terminated or leave within a pre-specified period to ensure they stick around after the initial buy-in. Basically, you want your interests aligned with the next generation of management, and gradually transitioning ownership to them at a reasonable price is one way of accomplishing this goal.It’s also important to relinquish your day-to-day responsibilities with ownership. This can’t (and shouldn’t) happen overnight. After you’ve identified a capable successor(s), make sure he or she is assuming more of your responsibilities and not just your share count. Your work hours should go down over this transition period. When advising clients on management and ownership succession, we often tell principals that are approaching retirement to ask themselves where they want to be in five or ten years (depending on their age and other factors) and work towards that goal. We rarely hear that they want to maintain their current work levels for the rest of their career. Have a goal in mind and steadily work towards it as others assume your responsibilities and ownership. It should pay off in retirement.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Bryce Erickson is a Contributor to Forbes.com

Based upon the content in this blog, representatives from Forbes.com reached out to Bryce Erickson, ASA, MRICS with an invitation to become a contributor to Forbes.com in their Energy section.Read Bryce’s first contribution: "Oilfield Service Valuations: Missing the Party or Just Fashionably Late?"Bryce leads Mercer Capital’s Oil & Gas Industry team. He has more than 20 years of oil & gas industry and valuation experience both in the U.S. and internationally.On Forbes.com, Bryce will focus on industry developments, economic trends, and the impact on valuation for companies operating in the Permian, Eagle Ford, Bakken, and Marcellus & Utica regions, in addition to topics related to mineral rights and royalty owners.Bryce provides oil & gas companies, midstream operators, and oilfield servicers, as well as mineral & royalty owners with corporate valuation, asset valuation, litigation support, transaction & due diligence advisory, and other related services.

2Q18 Call Reports

After reaching record highs in late January, volatility in the equity markets picked up and has remained elevated through the second quarter. While volatile equity markets and normalizing monetary policy offer opportunity for asset managers, the industry continues to face fee pressure and increasing costs. At the same time, many asset managers are considering M&A as a means to gain distribution and operational leverage, reflecting the persistence of consolidation rationales in the industry.As we do every quarter, we take a look at some of the earnings commentary of pacesetters in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Normalizing monetary policy and continued equity market volatility through the second quarter suggest opportunities for active managers. We continue to believe that the uptick in volatility and the gradual trend toward normalization of monetary policy on the part of global central banks will provide a more favorable backdrop for active management over time. – Philip Sanders, CEO & CIO, Waddell & Reed Financial, Inc. [A]t a time of change and transition in the debt markets, we're especially proud of our positioning in fixed income in what is the largest asset class in the world … And I'm quite sure that [our fixed income managers] would tell you that they welcome higher rates and are confident in their ability to find wonderful investment opportunities in such an environment. – Joseph A. Sullivan, Chairman, CEO & President, Legg Mason, Inc.After a strong start to 2018, markets reversed mid-first quarter as escalating trade tensions, inflationary concerns and a flattening yield curve caused investors to pull back. Market uncertainty continued throughout the second quarter, reflecting ongoing global trade tensions, a slowdown in emerging markets, increased volatility and widening credit spreads. In the face of an uncertain and evolving investment landscape, clients have paused, deferring their investment decisions until they have greater clarity on the future. – Gary Shedlin, Senior MD & CFO, BlackRock, Inc.I think in a rising rate environment, a different kind of market, the value growth cycle, the 30-year spread of where we are of value versus growth, the strength of the dollar, all of these things can mitigate some of the pressures that we're seeing on the current flows. So I think that, that's – we don't think that's forever. – Gregory Johnson, Chairman & CEO, Franklin Resources, Inc.Theme 2: Fee pressure, distribution leverage, an aging owner base, and increasing regulatory compliance costs continue to be key drivers of sector M&A.Our [M&A] approach is very attractive to our target universe, which is prospective Affiliates that are looking for a permanent institutional partner and I would underline the word permanent there. [A]t the highest level, we're helping solve a demographically driven kind of management ownership and succession problem for these firms, and we have a solution that preserves and protects their unique entrepreneurial cultures across successive generations of management. That's why that kind of permanent underline is so important … Now in terms of the current environment – absolutely, this has been an elevated period of M&A activity in the industry and you should assume alongside our proprietary calling effort, we're looking at all of the opportunities in the market. – Nathaniel Dalton, President and Chief Executive Officer, Affiliated Managers Group, Inc.I think with the increase, the regulatory increase and the increase in expectations around due diligence, suitability and all of these things, it played – the distribution platforms just can't do it. Nobody can do it. And so I think again these trends towards greater regulation, greater exposure, greater need to diligence managers and all that kind of stuff, greater suitability, all these things are driving towards doing business with fewer managers, larger managers, more diversified managers, and then what I said earlier in my remarks, managers that can also work with them to create vehicles and unique structures to serve what they're trying to do for their clients in their region and then also potentially have the distribution support, the sales support, marketing support, all that kind of stuff to support the product and their salespeople, their bankers in the field. – Joseph A. Sullivan, Chairman, CEO & President, Legg Mason, Inc. [W]hen you look at capital, M&A is still the priority for the use of that capital on the balance sheet. And I think the challenges that you mentioned, and we all know, whether it's fee pressure, passive or just the move to advisory from brokerage, will continue to put pressure on organic growth rates. So we are, as we said on past calls, very active in looking. – Gregory Eugene Johnson, Chairman & CEO, Franklin Resources, Inc. [W]e also believe that you do need scale to be competitive in this marketplace. If you asked me about the level of scale you needed 5 years ago, I would not have thought that was such a hugely important factor for success going forward. It is, because of the demands on money managers going forward, to do more than just manage money for clients and not just invest in investment capabilities, but also in operational capabilities, largely around technology. So scale becomes really an important factor as you look to success going forward, so you can make these investments all been talking about. – Martin L. Flanagan, President, CEO, & Director, Invesco, Ltd.Theme 3: The industry is continuing to evolve in response to ongoing fee pressure. The way I think about it is in the core strategies, core fixed income, core equity, we're no different than anybody else. There's pressure within the industry on fee rates. That's clear … We're going to get some wins in core strategies, and they're going to be at lower fee rates than they were 10 years ago or they were 5 years ago or they were 3 years ago. But we're also winning business and we have the opportunity to win business in [alternative] strategies that we didn't have 10 years ago or 5 years ago or 3 years ago that are in higher fee rate. – Joseph A. Sullivan, Chairman, CEO & President, Legg Mason, Inc.I generally think, consistent with the overall industry, as scale becomes more important and fees come under pressure … I think you'll see an increase in the amount of support provided by the model of a multi-boutique as opposed to each individual boutique doing everything themselves because again, it's generally always been a distraction and it's always been a little bit expensive. But I think now, with some of the competitiveness and the fee pressures, it's just makes more and more sense for that model … to provide support to grow the business, support to distribute the business and to do all those back office and operational things. – George R. Aylward, President, CEO & Director, Virtus Investment Partners, Inc.I don't know that anybody has really true pricing power in this business. Obviously, the better performance, you have a little bit of flexibility. But at the end of the day … there are always going to be strong competitive products that have good performance. And if you don't have competitive pricing structure, it's going to be really tough to grow those assets. – Philip James Sanders, CEO, CIO, & Director, Waddell & Reed Financial, Inc.

WHITEPAPER | How to Value an Early-Stage FinTech Company

Valuing a FinTech company can be a very complicated and difficult task; however, it carries significance for employees, investors, and stakeholders of the company. While FinTech companies have large differences, including niche (payments, solutions, technologies, etc.) and stage of development, understanding the value of a FinTech company is crucial to everyone with an interest in the company.

Public Royalty Trusts (Part II)

Can Revenue Interests Still Benefit from Capital Appreciation?

In a recent post, we explored the ins and outs of MV Oil Trust. We analyzed the underlying net profit interests it holds, the underlying properties of the trust, and the rights of unitholders including their rights during termination of the trust. This week, we will look into how these play into the composition of the MV Oil Trust’s stock price, and the balance struck between investor’s current return in the form of dividends and potential for returns from capital appreciation.Tradeoff Between Current and Future ReturnsThere is a natural friction between distributions of earnings versus reinvestment for growth. Young and growing companies tend to reinvest their earnings to fund future growth opportunities. Investors in such companies, therefore, have to be willing to forego upfront returns in hope of realizing greater returns down the road. Investors in mature companies, however, generally expect to receive dividends as a return on their investment because these companies typically have fewer opportunities for growth.Composition of Stock PriceWhile public royalty trusts are equity securities by name, they have unique characteristics that differentiate them from many equity securities. Investors typically take on exposure to equity securities for two basic reasons: receipt of cash dividends and anticipation of capital appreciation. Cash dividends are residual earnings of the Company paid to the investor at the discretion of management, and these are current returns. Capital appreciation occurs through the sale of shares at a price higher than what the investor paid, and this is a future return.Investors in public royalty trusts are typically seeking dividends. Because the investment is ultimately in a depleting asset (oil or gas reserves), capital (and therefore stock price) is expected to depreciate to zero in the long run. Many public royalty trusts, including MV Oil Trust, are restricted from acquiring more assets or interests, and most earnings are required to be paid out. These restrictions are similar to another type of trust: Real Estate Investment Trusts (REITs). Because most earnings must be distributed, dividends paid to investors would not appear to be constrained by the discretion of management, and therefore some investors consider investments in trusts to be less risky. This is not necessarily the case for royalty trusts, however, because the source of income is less stable and the ultimate level of cash distributions is dependent on the level of production set by the operator (who is not always associated with the management of the trust). Thus, investments in royalty trusts may be viewed to be riskier than investments in REITs due to this unique control structure.Let’s Get TheoreticalAccording to the dividend discount model, the intrinsic value of a stock is the expected value of future dividends, discounted back to the present at an appropriate discount rate. Forecasts of dividends are typically estimated for anywhere between 3-15 years, or until a time where future dividends will grow/decline at a stable rate. At this point, a terminal value is added, which accounts for all remaining value after earnings have stabilized, which is discounted back to the present. In the case of public royalty trusts, units of the trusts tend to hold declining intrinsic value. That is, their intrinsic value will drop to zero upon expiration of the trust agreement. This would imply no terminal value, save for the potential liquidation of assets. In the case of MV Oil, the trust will distribute the net proceeds from the sale of assets upon dissolution of the trust, so there will be a terminal value that accounts for future production remaining from the underlying properties. When a dividend is paid, the market value of the trust should decrease by the amount of the dividend. As an example, imagine a public royalty trust paying quarterly distributions of about 50¢ per share for the next two years prior to termination with a terminal value of zero. If the stock price is a little under $4.00, after accounting for the present value of these distributions, the stock price should decline by 50¢ upon receipt of the first dividend, because the stock at that point will only be worth the remaining seven distributions. Capital Expenditures ConstraintsMV Oil Trust is restricted from acquiring other properties or interests, but it will still spend money on drilling new wells on their established sites, as well as covering maintenance of currently producing wells. These maintenance expenditures may affect the quantity of proved reserves that can be economically produced. Because MV Partners has agreed to limit the amount of capital expenditures in a given year, they may choose to delay certain capital projects into the next year when the budget allows. If operators do not implement required maintenance projects when warranted, the future rate of production decline of proved reserves may be higher than the rate currently expected. So, the capital expenditure limit, implemented as a protection for unitholders, could actually have a deleterious effect.Is There Any Room for Capital Appreciation?The question then becomes, can revenue interests in an oil and gas royalty experience capital appreciation? With the requirement to pay out substantially all of its earnings as distributions and restriction on acquiring new properties or interests, it would appear that capital appreciation is unlikely. However, as we have seen in the public market, commodity price expectations can vary and change significantly in a relatively short time period. In the case of MV Oil Trust, the rebound in commodity prices and subsequent return to distributions caused the significant increase in unit price over the past two years. Even though investors are purchasing the right to obtain future distributions, buying low and selling high on the units is possible, as with any investment. For public royalty trusts, investors would need to be able to anticipate shifts in either production or price.Drill Baby Drill?Capital appreciation for royalties is not limited to the potential upside from increasing crude and natural gas prices. MV Oil Trust has drilled new wells in each of the past three years, providing investors with an upside not seen in all royalty trusts. Additional wells increase capacity which will increase royalty revenue and therefore increase future dividends, thus raising the value of the trust. Proved undeveloped reserves (PUDs) present an upside to unitholders, and drilling wells is the next step in developing these reserves, so they can eventually be produced and sold.Many royalty trusts either have not recently drilled any new wells or they do not have any proved reserves that are left undeveloped. This includes Permian Basin Royalty Trust, Mesa Royalty Trust, Sabine Royalty Trust, VOC Energy Trust, San Juan Basin Royalty Trust, and Pacific Oil Trust.Some trusts originally had upside from wells that they were contractually obligated to drill in an “Area of Mutual Interest (AMI)” when the trust was started. This includes the three SandRidge trusts, which we discussed in a recent post. Chesapeake Granite Wash Trust and ECA Marcellus Trust I also agreed to drill wells in an AMI, neither have drilled any further wells after fulfilling this requirement. Thus investors in these trusts will likely only realize capital appreciation if crude prices unexpectedly increase and stabilize at this higher price.Hugoton Royalty Trust and Cross Timbers Royalty Trust have had little to no drilling in recent years, but both benefit from having XTO Energy as an operator, who has indicated plans to drill new wells that will benefit each of these trusts.Enduro Royalty Trust, MV Oil Trust, BP Prudhoe Bay Royalty Trust, and Whiting USA Trust II have all had drilling in recent years. MV Oil Trust’s undeveloped reserves represent 14% of proved reserves, representing potential upside from future drilling. Prudhoe Bay has drilled over 100 wells in the past three years, and it has experienced the third highest 2-year return. Whiting USA Trust II has significant undeveloped acreage in the Permian, which likely plays a role in its superior 2-year return for investors.The remaining four mineral partnerships are either C Corporations or MLPs. As discussed recently, they are designed to gather assets and grow through acquisitions. Because they are not structured as trusts, they are not required to distribute a substantial amount of their earnings.ConclusionEven when royalty trusts are prohibited from acquiring more assets, investors can realize capital appreciation if oil price expectations change, the operator of the underlying assets drill more wells and/ or increase their operating efficiency, or if management expedites distributions.While the value of the underlying asset of royalty trusts (royalty interests) are expected to decline over time, there is still an opportunity for capital appreciation with commodity price changes or additional drilling. Ultimately, declining revenue distributions for private owners of royalty interests typically do not benefit from capital appreciation, but selling at the opportune time can effectively function as capital appreciation.We have assisted many clients with various valuation and cash flow questions regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.

The Haves and Have-Nots of the RIA Industry

Despite the old maxim of a rising tide lifting all boats, the current markets are clearly more buoyant for wealth management firms than asset management firms. Many asset managers are trading at or near all-time lows from a valuation perspective, while financial advisory shops continue to accumulate client assets. For this week’s post, we’ll take a closer look at this trend, and what it means for the broader industry.The Story for Asset ManagersDon’t interpret this as our being bearish on asset management. Almost every asset management firm, public or private, is more valuable today than it was in 2009. The explanation for that is simple: rising markets lead to higher AUM, management fees, and earnings, so many of these businesses are worth 2-3x (or more) what they were a decade ago because profitability has (easily) tripled in the last nine years. As appraisers, we’re more concerned with the multiple (i.e. valuation) applied to these earnings since that’s what we take from the market and relate to our client company’s performance to derive value. Here’s how the market is currently pricing some of these businesses:Notwithstanding the run-up in their market caps since the last financial crisis, earnings multiples for asset management firms have mostly contracted, particularly recently. There are a number of rational explanations for this – fee compression, flight to passive strategies, ETFs, fund outflows, maturing industry, etc. This seems quite overdone for a business with a strong recurring revenue model and high margin potential through continued gains in AUM (like we’ve seen).So what gives? You’ll recall from your corporate finance classes in college that this multiple is a function of risk and growth. While there are certainly risks facing this business today, we don’t necessarily think the business’s cost of capital has increased much (if at all) over the last year as the sector’s risk dynamics haven’t changed much over the last year. Lower valuations must, therefore, be indicative of sliding growth prospects. Clearly, the market is telling us that the industry’s current headwinds (regarding fees and outflows) are likely to persist and may even be questioning the longevity of the bull market.Different Story for Wealth ManagersWealth managers chart another path. There’s not a whole lot of public market perspective on these businesses due to the lack of publicly traded wealth management firms, but there is some. Silvercrest Asset Management (ticker: SAMG), which provides family office and financial advisory services, is up more than 30% over the last year and currently trades at just over 21x trailing twelve months earnings.Then there are all the recent headlines surrounding Focus Financial Group, a serial acquirer of wealth management firms. Admittedly, we’ve contributed to some of this. As a result, you probably didn’t even know about the Victory Capital (multi-boutique asset manager) IPO that happened earlier this year. The market currently values Focus at nearly 5x revenue and Victory at well under 2x revenue even though VCTR is profitable and FOCS is not. Arbitrage opportunity?To be fair, these businesses have always been priced differently. Wealth managers often elicit a higher multiple because of their lower risk profile. Their clients (mostly individuals) are typically less concentrated and more likely to stick around when performance suffers. Asset managers on the other hand, typically enjoy higher margins since it’s less costly to service fewer relationships. This trade-off is nothing new and likely to persist.The Overarching NarrativeThe recent widening of the multiple gap and disparate performance over the last year suggests the two businesses are riding completely different trajectories. Again, the market seems to think that the fee compression and flight to passive movements are here to stay, and wealth management firms may be the indirect beneficiary of these trends. We don’t disagree with this but think there will always be a place for active management, especially for those firms with solid long-term performance and steady inflows. Still, this bull market seems to have forgotten about a sector that typically thrives in a bull market.Moving forward, we expect some mean reversion but aren’t ignoring what the market is telling us about the outlook for asset managers – it’s probably going to get worse before it gets better. Solid performance can buck this trend for any RIA, but consistently delivering alpha is a tall order. Since most firms underperform the market after fees, perhaps it’s not surprising that sector has struggled so much recently. Still, this has almost always been the case, so the industry’s current woes are more likely attributable to fee compression (or fear of fee compression) and surging demand for passive products. A bear market might actually help (relative) performance as many asset managers outperform during times of financial stress, but that would also strain revenue and profit margins. Attractive valuations could spur deal-making and consolidation, which could alleviate some of these pressures. We’ve seen some of this, but suspect more is on the way. Either way, we’ll continue to monitor these pricing trends and let you know how this all shakes out.

A Review of M&A Activity in the Downstream Oil & Gas Space

Nesting Dolls of Refinery Acquisitions

On April 30, 2018, Marathon Petroleum announced its acquisition of the newly formed Andeavor making Marathon the largest refiner in the U.S. (by capacity) and one of the top five refiners in the world. The merger is moving into its final stages, and Marathon’s CEO is positive about the combination of the two well situated companies.In this post, we analyze the recent acquisition history of Western Refining, Tesoro, and Marathon, which has started to look somewhat like nesting dolls of acquisitions. For an industry that has had sluggish M&A activity in the last couple years, this line of acquisitions seems to hint to a possible trend of consolidation. Domestic oil production has increased significantly over the last couple years. Even though export bans on crude oil were lifted a couple years ago, overall, there is more crude oil in the U.S. that needs to be refined. According to the EIA, U.S. refining capacity is “virtually unchanged from 2017 to 2018.” Domestic refineries are now running at average utilization figures of 90%, as compared to the IEA’s global average of 70%. Building a new refinery takes time and money and has significant regulatory hurdles; thus U.S. refiners appear to be combining in order to increase efficiencies and meet the higher demand for their services as a result of the recent increase in domestic crude oil production. Recent Acquisition HistoryThe table below shows metrics from the line of acquisitions leading up to Marathon’s acquisition of Andeavor, along with other recent transactions in the downstream space for comparison.Western Refining’s Acquisition of Northern Tier for $1.6 BillionIn late 2015, Western Refining bought all remaining shares of Northern Tier Refining, not already owned by Western Refining and its subsidiaries, for $1.6 billon. (Western Refining previously bought a controlling interest in Northern Tier for $775 million in 2013.) The resulting company had three refineries in Gallup, NM; St Paul, MN; and El Paso, TX.Western Refining paid 5.3x EBITDA for the remaining minority position in Northern Tier. Some analysts such as Albert Alfonso, originally believed that the deal was undervalued. While the deal multiples were quite a bit lower than the multiples observed in the downstream space at the time, it is important to consider the premiums paid for acquisitions of control versus the price paid in this acquisition of a minority position by a company that previously paid for control. For comparison purposes, this transaction is more similar to Delek’s 2017 acquisition of the remaining shares of Alon at 5.9x EBITDA for a minority stake.Tesoro’s Acquisition of Western Refining for $6.4 BillionIn November 2016, Western Refining and Tesoro Corporation merged to form Andeavor. Tesoro bought Western Refining for 10.6x EBITDA and 80% of revenues, which at the time was in line with the earnings multiples observed in Delek’s acquisition of shares of Alon U.S. Energy for 11.0x EBITDA. (Through this transaction, Delek gained control of the entity of which they originally owned 48%.) The newly formed Andeavor was the fourth largest independent refiner in the U.S.Tesoro had refineries in California, Washington, Alaska, Utah, and North Dakota. The addition of Western Frontier expanded their presence by adding refining locations in Texas, New Mexico, and Minnesota.Western Refining shareholders received either 0.4350 Tesoro shares, or $37.30 in cash per share. As compared to the previous day’s closing price of Western Refining, the shareholders received a 22.3% premium, according to a Fortune article about the transaction. In order to prevent dilution from the offering of additional shares, Tesoro announced it would increase its buyback program by $1 billion. The deal was expected to create between $350 and $425 million in synergies to be realized in the first two years of their combination.In addition to expanded refining capacity, the combined companies had over 3,000 retail stations.Marathon’s Acquisition of Andeavor for $23.3 Billion (Enterprise Value of $35.6 Billion)Marathon Petroleum is expected to close on its acquisition, newly formed Andeavor for 12.7x EBITDA, which shows a slight premium to the few transactions observed in the refining space lately. Andeavor shareholders will have the option to choose 1.87 shares of MPC stock, or $152.27 in cash per share. This represents a 25% premium to the closing price the day before the transaction was announced. In order to prevent dilution from the issuance of additional MPC shares, Marathon’s Board approved $5 billion repurchase authorization.The two companies were largely located in different parts of the country as shown in the map below. Andeavor Chairman and CEO Greg Goff (who will become Executive Vice Chairman at MPC) explained,“Look at the map of the two companies and the way they are positioned geographically in the United States and you come to the conclusion that this is a great opportunity to be able to bring the companies together.”The map below shows the locations of both Marathon and Andeavor’s refineries. Marathon had six refineries in the eastern half of the U.S. and Andeavor had 10 refineries in the western U.S. and Alaska. The combined company will have approximately 15% of total fuel making ability in the U.S. Additionally, the combined companies have over 7,800 branded fuel stations. Immediately Accretive DealAccretive deals add more value than they cost, either over time or immediately. The Marathon and Andeavor deal is expected to be immediately accretive to earnings per share; meaning the price paid by Marathon is lower than the immediate expected boost in earnings per share post-acquisition.The deal is expected to create significant synergies resulting in around $1 billion over the first three years. These synergies will come as a result of stronger purchasing power, system optimizations, procurement efficiencies, leveraging of assets, and retail network efficiencies. Additionally, according to Marathon’s Chairman and CEO, Gary Heminger, thinks that the potential synergies could be even greater than the estimated $1 billion. However, that remains to be seen. Many analysts are sometimes skeptical of synergies due to their somewhat abstract nature.Did Marathon Pay Too Much?Marathon’s acquisition of Andeavor comes at a time when U.S. refineries are positioned to benefit from the increase in domestic production of oil and gas. Many refineries that purchase WTI crude are currently benefitting from the discount of WTI to Brent, which has lowered their costs of sales as refined product prices are still increasing. Refineries margins have increased 8% worldwide and almost 25% in the U.S. Midwest year over year according to British Petroleum’s Refiner Marker Margins and crack spreads have increased as shown in the graph below. Management of both companies seem positive regarding the deal and there seems to be little reason to believe that the deal would face any resistance from regulators as there was is little overlap in the locations of the refiners. However, investors of MPC could ask if MPC paid too much? Stock buybacks are generally a signal to investors that the Company views its own stock as a good investment. Additionally, management will generally not buy back shares if they think the stock is currently overpriced. Marathon’s announcement of a buyback should somewhat ease investors’ concerns. ConclusionIt is hard to pinpoint the root cause of the recent consolidation activity in the downstream oil and gas space. The pressure of RIN expenses on smaller refineries that do not have the capacity to blend their renewable fuels could be one cause of consolidation. The immediate need for more operating capacity as U.S. oil production has increased might be pressuring larger refiners to purchase rather than build additional capacity. Additionally, the recent tumult of the global trade environment adds an additional layer of uncertainty for U.S. refineries whose main export market is Mexico.In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.Whether you are selling your business, acquiring another business or division, or have needs related to mergers, valuations, fairness opinions, and other transaction advisory needs, we can help. Contact a Mercer Capital professional to discuss your needs in confidence.

Does the Money Management Industry Need Consolidation?

As World War II drew to a close, a military aircraft manufacturer in Sweden saw the post-war consumer economy as an opportunity to expand into cars, and the Saab automobile was born. For about 45 years thereafter, Saab established itself as a scrappy automaker known for innovation. Saab was the first automaker to introduce seatbelts as standard equipment, ignition systems that wouldn’t crush a driver’s knees in a collision, headlamp wipers and washers, heated seats, direct ignition, asbestos-free brake pads, and CFC-free air-conditioning. Saabs were distinctive, substantial hatchbacks with strong but efficient motors and enjoyed a devoted following. Unfortunately, Saab’s fan base was too small, and as the company struggled to build the scale necessary for global distribution, financial troubles drove them into the gaping maw of General Motors.In the late 1980s both GM and Ford were attempting to consolidate global automotive capacity and bring as many brands under their corporate hierarchy as possible. With consolidation came homogenization, as global behemoths looked for ways to cut manufacturing costs. Under Ford’s ownership, Jaguar and Aston Martin starting sharing parts with each other and their Dearborn parent. Ford, arguably, saved both marques and orphaned them before they were ruined. Jaguar is thriving today, and Aston Martin is planning its first public offering. Saab wasn’t so fortunate, with GM blending Saab’s mystique with Subaru (sushi with meatballs?) and Saturn (a space oddity if there ever was one). Saab struggled for about twenty years in GM’s dysfunctional family, but eventually the brand was wrecked and Saab was no more.Divergent Industry TensionsLike the automotive industry in late 1940s and 50s, the investment management industry is characterized by scores of independent firms who have found success in idiosyncrasy, providing clients a limitless variety of paths and approaches to common investment dilemmas. Some would suggest that this is the source of the industry’s strength, but not everyone agrees, as evidenced by the Focus Financial IPO two weeks ago.A key element of the Focus market opportunity is “fixing” the fragmented nature of the RIA industry, providing an ownership structure, exit opportunity, and transition mechanism for the thousands of independent advisory practices with a stream of profitability threatened by aging founders. This opportunity exists in an industry that is far from declining – in fact it is growing in clients, assets, and advisors. Focus can provide ownership transition capital to bring some order to this creative process and share in the profits along the way.The RIA industry is growing, but it is doing so because it is largely in a stage of de-consolidation, rather than consolidation. Most of our clients set up their own shops – whether in wealth management or asset management – because they were exiting larger firms they felt restricted their thinking, their business development, and their incomes. Investment managers are characteristically independently minded and entrepreneurially motivated. In many ways, the increase in investment advisory practices is an effort to recapture the careers available to what were once called stockbrokers forty years ago. One client of ours who escaped his wire house environment earlier this year decried how his former firm had been taken over by lawyers and accountants who were conspiring to restrict opportunities for both him and his clients.So many wire houses are now losing advisors to the RIA industry, broker protocol is splintering, and the only BDs reporting growth in advisors are doing so at great recruiting costs, which may or may not be recoverable. The alternative would be to acquire practices outright, but great entrepreneurs make miserable employees. Focus aims to thread this needle by acquiring a preferred interest in the profitability of partner firms (defined as Earnings Before Partner Compensation, or EBPC) that assures Focus a basic rate of return on investment but leaves the leadership of partner firms the opportunity for upside. Further, while the Focus holding company will provide programs in products, marketing, and compliance to partner firms, opting-in to those programs is treated like coaching, rather than being compulsory.Will the Focus “preferred stake in EBPC” work? Will selling partners be motivated enough to continue to grow their practices profitably? Will subsequent generations of partner firm leadership have enough upside to stick around or will they seek out other opportunities? Is coaching through encouragement enough to manage the activity of boutique investment advisory practices? Can subsidiary firm margins been grown enough to offset the corporate overhead of the parent?The Prevailing RhythmWe are obviously skeptical, but we’re not cynical. We’ve been around long enough (and have been wrong enough), so we are intently watching and listening to the drumbeat of the consolidators. Focus has put more thinking and garnered more capital to try to build critical mass in the wealth management industry than anybody else. They are not the only group trying to do this, but they’ve gone farther than anybody else. We don’t buy the idea that Focus is the public company barometer of the RIA industry, but it is the barometer of RIA consolidation. The question for the investment management industry remains: is consolidation the answer?

Now That Focus Has Priced – Is It Pricey?

After Focus Financial filed their S-1 in May, I drew some analogies to Ferrari’s public offering two years ago (NYSE: RACE), as both companies faced considerable skepticism at advent of their IPO. Last week, the two stories intersected once again, as the man who steered Ferrari to its public offering, Sergio Marchionne, died unexpectedly at 66, and two days later Focus Financial went public (Nasdaq: FOCS).Marchionne leaves behind an indelible imprint on the automobile industry. He almost single-handedly rebuilt the automotive landscape from its most unlikely corner, Italy, by squeezing $2 billion out of GM to recapitalize Fiat in 2005. With Fiat rescued from oblivion, Marchionne rebuilt Alfa Romeo, Maserati, and Ferrari under the Fiat umbrella. He took advantage of the credit crisis to bring Chrysler under Fiat’s control, and then took advantage of the subsequent bull market in luxury goods to take Ferrari public. He was trained as a lawyer, practiced as an accountant, and fueled by expresso and cigarettes. Above all, though, Signore Marchionne seemed to really love cars – something lacking in too many automotive executives these days.I won’t go so far as to compare Focus Financial’s founder, Rudy Adolf, to Marchionne, but it’s worth noting that, like Marchionne, Adolf pulled off what many others have tried, and failed, to do. Now that Focus is public, we have a new channel with which to study and benchmark the industry. We have lots of questions, but for this post, we’ll just look at the implications of the Focus valuation that is consequent from the IPO.Focus Is Richly PricedAfter a predicted pricing range of $35-39 per share, FOCS went public at $33. Of the $490 million raised in the offering (after underwriting fees), Focus is going to use a bit less than $400 million to pay down debt, about $35 million to settle equity compensation and other obligations to existing owners, and the remaining $60 plus million they’ll hold in cash for opportunities as they come along. If the underwriters exercise their greenshoe, Focus picks up another $75 million or so.We heard plenty of chatter about the implications of Focus pricing below the originally suggested range, but we don’t make too much of it. The $35-39 range was very high (as we’ll get into later in this post), and in any event, the trading activity immediately raised Focus shares up to the range (no doubt guided by the invisible hands of market makers associated with the book runners). The IPO was a success.Focus Didn’t Sell CheapOne thing we don’t have a question about is the magnitude of Focus’s valuation at IPO – it was expensive by any measure. In the quarter ending March 31, 2018, Focus reported a net loss of nearly $37 million on $196 million in revenue. In the prospectus, management provides a series of adjustments to redeem the quarterly loss to a net profit of almost $30 million and EBITDA of over $44 million. We don’t take issue with many of management’s normalizing adjustments, as there are several non-recurring expenses associated with taking a company like Focus public. We are curious, though, about adding back non-cash equity compensation and the change in fair value of contingent consideration made for acquisitions. From the perspective of a shareholder, equity compensation is still a drain on earnings, because it dilutes existing shareholders’ claim on profitability. Since Focus is an acquisition company, it seems that any increased earn-out or other contingent payment expense increases the cost to Focus – whether in the form of cash or stock – such that these aren’t truly extraordinary items that a shareholder would disregard when calculating Focus’s profitability. Any argument with these adjustments takes an already lofty IPO valuation for Focus to nosebleed levels. At the IPO price of $33 per share, Focus has an equity market cap (absent special allotments for the underwriters) of about $2.3 billion, and a total market capitalization inclusive of net debt of $2.8 billion. If we look at the most recent reported quarter, annualize it to develop a measure of ongoing performance and further look at a year forward assuming a 20% annualized growth rate (10% to the mid-year), we show strong multiples of revenue and earnings (compared to industry standards), and higher-than-usual multiples of EBITDA. However, that’s only if you accept all of management’s adjustments. If instead, you don’t give Focus the benefit of adding back non-cash (but nonetheless dilutive) equity compensation expense, the resulting multiples of profitability are other-worldly. The big issue that most analysts seem to have with Focus is that they want to be given credit for inorganic growth on their multiple while adjusting earnings to eliminate the cost of that inorganic growth. The Focus prospectus and roadshow presentation made much of their 20% growth historical and prospective topline growth, and everyone knows that growth is because of acquisitions. The prospectus doesn’t actually offer any estimate of organic growth, or same-store sales growth, because they credit organic growth for subsidiary-level acquisitions by partner firms. It seems to us that the costs of that growth are, indeed, relevant to earnings. So either we judge Focus as an acquisition company or an operating company, rather than give them credit for the topline performance of an acquisition company and the bottom line performance of an operating company. Peer Comparisons Are DifficultFocus isn’t really an RIA, it holds preferred interests in profit sharing units in RIAs. Nonetheless, most analysts will lump them into the RIA space. The question is where?Earlier this year a small RIA called Victory Capital went public (Nasdaq: VCTR). Victory is an amalgamation of wealth management firms and an ETF offering. It’s about half the size of Focus, and it hasn’t fared too well since the offering. Another possible comp is Silvercrest, which probably feels forgotten by the public markets in the wake of attention given to Focus. Since neither Victory nor Silvercrest are really RIA consolidators, Focus management probably wouldn’t appreciate the comparison to them. Neither Victory nor Silvercrest have shown the topline growth of Focus Financial, although Silvercrest’s growth isn’t that out of line with what Focus has produced organically – maybe even better.While it’s difficult to find peers to compare Focus to, their valuation prices them more richly than even AMG. Is it reasonable to compare Focus to Blackrock? We don’t think so.Pricing ImplicationsMost CEOs appreciate the market validating their strategy with high multiples, but high multiples are a double-edged sword. In the 1990s, I had a number of clients at Mercer Capital involved in roll-up corporations of one kind or other that went public. Some worked, and some didn’t. While Focus isn’t directly comparable to many consolidators, some of what has been observed in other industries holds true here as well.High valuation multiples must be justified, and are often tested stringently with newer public companies. Focus promises high topline growth, with the implication that the profit margins will sort themselves out with scale over time. This is a common story for public companies in consolidating industries. The trouble comes when acquisitions are unavailable at reasonable terms or even accretive pricing, profits are uninspiring, and management feels pressured to do deals that don’t make sense just to demonstrate growth.Based on their own disclosures, Focus will have to continue an aggressive acquisition strategy to achieve the 20% plus growth expectations that it has set for itself. If that growth is accomplished with new share issuances (as they have employed in the past), the market may not appreciate the dilution. Focus could, of course, pay cash, as they have a fair amount of it on hand following the IPO; but cash isn’t free either. What the market will eventually want to see – and several commentators have already mentioned this – is organic growth. If the firms that sold Focus some participation in their profitability grow their AUM from either existing or new clients, the fees should translate into profit growth that will accrue to Focus. The S-1 is curiously vague about Focus’s historical organic growth – defining it as inclusive of subsidiary-level acquisitions by partner firms. We question whether or not this is a true metric of organic growth, and in any event, the numbers Focus has posted with regard to this aren’t terribly impressive: 13.4% in 2017 and mid-single digit growth in the two years prior to that. We’ve written elsewhere that Focus will eventually have to prove itself as an operating model, and not just as an acquisition model. Their success or failure in this regard will be judged, at least in part, by demonstrated organic growth.As for inorganic growth, Focus has interests, either directly or indirectly, in 140 plus firms. This leaves lots of room to grow in an industry with 15 thousand or so firms and a solid growth trajectory. If Focus stays priced at elevated multiples, it may raise expectations of sellers – especially in the circumstances where Focus is paying with stock. If, on the other hand, Focus shares settle to more normal multiples of profitability, sellers may be wary of selling into a downward trending share price. In some ways, it may be easier to attract acquisition candidates as a public company, but in others, it may be more challenging.Margins are another matter. Most investment management firms benefit from operating leverage as they grow, and Focus has suggested the same opportunity exists for them as well. Our concern here is that Focus is not a small startup asset manager, they are a $126 billion manager with over 2,000 employees in their affiliated firms and fourteen years of history – yet their EBITDA margin (even on a highly-adjusted basis) hasn’t crested 25%. It’s possible that additional scale will improve this metric, but being a public company is labor intensive, as is tracking the activities of 140 plus partner firms, seeking out more, and seeking ways to improve the performance of existing firms. It may be difficult to assess the Focus margin against that of more typical RIAs, but as the Focus story unfolds, management will have to explain how to evaluate the effectiveness of the 70 or so employees at the holding company, what a reasonable cost of operations is, and how much profitability can be expected.Nevertheless, They Did ItSetting all of my armchair quarterbacking aside, though, the fact remains that Rudy Adolf and his team pulled off what many have thought about but failed to do. The investing public now has a way to be involved in the profitability of the RIA phenomenon, and the RIA industry has a new funding source for transaction activity. Lots of questions remain, but if Sergio Marchionne could use the public markets to remake a moribund industry from a nation that isn’t terribly investor friendly, executing on the Focus business model should be an easy lap.

Public Royalty Trusts (Part I)

Can Revenue Interests Benefit from Capital Appreciation?

In previous posts, we have discussed the relationship between public royalty trusts and their market pricing implications to royalty owners. Many publicly traded trusts have a fixed number of wells, so the value comes from declining distributions. Some of the trusts have wells that have not been drilled, which represent upside potential for investors. The future growth and outlook potential for each type of publicly traded trust is significantly different and a potential investor would want to know the details. The same is true for a privately held royalty interest.In this post, we will explore the subject characteristics of MV Oil Trust. This will serve as a primer for a subsequent post in which we will look further into the composition of its stock price in order to better understand investors’ ability to achieve returns through distributions and capital appreciation.Market Observations1Over the previous two years, the performance of the 21 publicly traded royalty trusts has varied widely. The table below shows the performance and other key metrics of the 21 main oil and gas-focused partnerships that are publicly traded, as of July 12, 2018. Clearly, there were some winners and losers, with more winners than losers. Of the winners, Whiting USA Trust II (WHZT) (+243%), discussed in a recent blog post, has had the highest price return. The focus of this blog post will be MV Oil Trust (MVO) (+99%), whose market value has nearly doubled in the past two years. For comparison, the chart below shows the two-year returns from MV Oil Trust, Crude Oil, Natural Gas, and the S&P 500. Over the last five years, there has been significant correlation between MVO’s share price and the price of crude oil (93.3%) and less correlation with the price natural gas (74.6%). MV Oil TrustOn January 24, 2007, MV Partners and MV Oil Trust completed an IPO. MV Oil Trust holds net profits interests, which represents the right to receive 80% of the net proceeds from all of MV Partners’ interests in oil and natural gas properties located in the Mid-Continent region in the states of Kansas and Colorado. As of December 31, 2017, the underlying properties produced predominantly oil (99% of production) from approximately 900 wells.MV Partners is the designated operator for these properties, but they are currently being operated on a contract basis by two affiliated companies, Vess Oil Corporation and Murfin Drilling Company, Inc. MV Partners pays an overhead fee to operate the underlying properties, which is based on a monthly charge per active operated well ($3.1 million average in the past three years).It is important to note that a majority (76% in the past two years) of the oil produced from the underlying properties was sold to a related entity, “MV Purchasing.” The price received is based on a recent NYMEX price, reduced for differentials based on location and oil quality. In 2017, the average differential between the benchmark and the price realized by MV Oil Trust was just under $5 per barrel. MV Oil Trust is extremely dependent on MV Partners and its related entities. Where this private company experiences difficulties, the trust would undoubtedly suffer, both in terms of production level and the amount it could sell.What is a Net Profit Interest?Trust unitholders receive 80% of the NET proceeds. “Gross proceeds” are the aggregate amount received by MV Partners from sales of crude oil, natural gas, and NGLs produced from the underlying properties. This does not include consideration for sale of any underlying properties by MV Partners, nor does it include any of the oil or gas lost in the production or marketing process. “Net proceeds” represents gross proceeds, less:Payments to mineral owners or landowners, such as royalties and expenses for renewals or extensions of leases;Any taxes paid by the owner of an underlying property;Costs paid by an owner of the underlying properties under any joint operating agreement;All exploration and drilling expenses;Costs or charges associated with gathering, treating and processing oil, natural gas and natural gas liquids;Any overhead charges, including the overhead fee payable by MV Partners to Vess Oil and Murfin Drilling; andAmounts reserved for approved capital expenditure projects (up to $1 million per 12 months), including well drilling, recompletion and workover costs. Unitholders are entitled to quarterly cash distributions of substantially all of the trusts quarterly cash receipts, less the trust’s expenses and any cash the trustee decides to hold as a reserve against future expenses. As noted above, the trust’s share price is highly correlated with the price of oil because the trust is ultimately as valuable as the distributions it makes.Termination of the TrustUnlike a traditional royalty interest that continues into perpetuity, a net profit interest in MV Oil Trust will terminate on the later of:June 30, 2026, orThe time when 14.4 MMBoe have been produced and sold (equivalent to 11.5 MMBoe in respect of the trust’s right to receive 80% of the net proceeds from the underlying properties) As of December 31, 2017, the trust had received payment for approximately 8.0 MMBoe of the 11.5 MMBoe interest, or about 70% of the termination threshold. The trust will dissolve prior to its termination if it sells the net profit interest or if annual gross proceeds attributable to the net profits interest are less than $1 million for each of two consecutive years. Upon dissolution, the trustee would then sell all of the trust’s assets and distribute the net proceeds of the sale to the trust unitholders.Underlying PropertiesThe underlying properties are in Kansas and Colorado, or the Mid-Continent region, which is a mature producing region. Most of the production consists of desirable light crude oil. Most of the producing wells are relatively shallow, ranging from 600 to 4,500 feet, and many are completed to multiple producing zones. In general, the producing wells have stable production profiles with total projected economic lives over 50 years and an estimated average annual decline rate of 8.6% over the next 20 years. This extended shelf life is attractive for unitholders of the trust because even though the trust is expected to terminate, the unharvested production capacity can still be sold.As seen in the tables below, the majority of proved reserves are developed, oil reserves. Also, the majority of acreage is in either the El Dorado or Northwest Kansas area. The majority of the net operated wells are oil wells; however, there are also some non-operated oil wells. In the past three years, each Trust has added to its well count by drilling additional development wells. Most of these occurred in 2016 when 7.6 net wells were drilled. These additional wells increase production capacity and thus potential for future distributions. Other Rights of Trust Unit HoldersNet proceeds received by unitholders exclude the sale of underlying properties, but this does not prevent the sale of assets. Unitholders will be compensated if a sale occurs. Further, the trust is only able to release the net profits interest associated with a lease that accounts for up to 0.25% of total production for the past 12 months without consent of unitholders. This sale also cannot exceed a fair market value of $500,000. This protects unitholders from having significant assets sold in any given year, which would decrease the level of future production.As mentioned earlier, capital expenditures are currently limited to $1 million per 12 months. These expenditures are further limited after the “Capital Expenditure Limitation Date.” This is defined as the later of:June 30, 2023, orThe time when 13.2 MMBoe have been produced and sold (equivalent to 10.6 MMBoe in respect of the trust’s right to receive 80% of the net proceeds from the underlying properties) On this date, capital expenditures are further limited to the average of the prior three years of capital expenditures, which will likely drop it considerably below its current limit of $1 million per year.ConclusionIn our next post, we will use MV Oil Trust as a basis for examining how investor returns are affected by a royalty trust’s distribution of proceeds, volatility in the price of crude oil, the timing of entrance and exit, and other unique features of the royalty trust such as limits on capital expenditures. We will do this by looking into what goes into the stock price of royalty trusts and the tradeoff between current and future returns.When investing in a public royalty trust or using it as a pricing benchmark for private royalty interests, there are many items to consider that are unique to each royalty trust. The source of income, region, operator, termination, and other key aspects make each trust unique.We have assisted many clients with various valuation and cash flow questions regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.1 Capital IQ

M&A Update: Good Gets Better

After a slow start, M&A activity among U.S. commercial banks and thrifts picked up to the point where 2018 should look like recent years. Historically, approximately 2% to 4% of the industry is absorbed each year via M&A. Since 2014, the pace has been at or slightly above 4% as a well performing economy, readily available financing, rising stock prices for bank acquirers, and strong asset quality and earnings of would be sellers have supported activity.There were 140 announced transactions according to S&P Global Market Intelligence through early July, which equates to 2.4% of 5,913 FDIC-insured institutions that existed as of year-end 2017. The average assets per transaction based upon YTD activity was $656 million, which is below the 28 year average of $1.1 billion. Pricing has trended higher as measured by the average price/tangible book value (P/TBV) multiple, which increased to 172% in 2018 from 164% in 2017 and about 140% in 2014-2016 before the sector was revalued after the national election on November 8, 2016. The median P/E based upon trailing 12 month earnings increased to 26x in 2018 from 23x in 2017 and 21x in 2016; however, the 2018 P/E based upon trailing 12 month earnings does not reflect a full year impact of the reduction in the top marginal federal tax rate to 21% from 35% that occurred on January 1. The adjusted P/E assuming the lower tax rate was in effect for 2017, too, is around 20-22x. Lower tax rates notwithstanding, it appears that buyers are still paying roughly 9-13x pro forma earnings assuming all expense savings are fully realized, a level of pricing that we believe has existed for many years excluding periods when industry fundamentals are stressed. For example, Fifth Third Bancorp (FITB) estimates the $4.6 billion consideration to be paid to MB Financial (MBFI) shareholders equates to 16.4x consensus 2019 earnings and 9.6x assuming all expense savings realized in 2019 (which will not be the case due to the phase-in lag). Cash Deals vs. Mix/Stock DealsDig deeper and, of course, there is more to the pricing story. The reduction in tax rates has had a material impact on profitability. Depending upon the index bank stocks rose 25-30% in the three months after the national election on November 8, 2016, on the expectation of what has mostly played out: a reduction in corporate tax rates, less regulation, higher short rates and faster economic growth. The improvement in public market multiples has supported expansion of M&A multiples when the majority of the consideration consists of the buyer’s common shares. As shown in Table 1, the median P/TBV and P/E ratios for transactions announced in the 20 months since the election were 173% and 23.0x compared to 147% and 20.3x for the 20 months ended November 8, 2016. Multiple expansion is even more pronounced when only 2018 deals are considered because the YTD median P/TBV and P/E multiples are 193% and 25.4x. Not surprisingly (to us), the median multiples for cash deals did not rise as much, increasing to 141% after the election compared to the 20 month pre-election median of 123%. Cash did not inflate in value over this period like public market bank stock valuations; hence, the only meaningful factor that drove the limited improvement in cash acquisition multiples was the increase in ROE. In addition, cash activity slowed post-election because buyers and sellers waited to see if would be sellers’ earning power would increase from a reduction in corporate tax rates, which was not confirmed until late 2017. Transactions in which the primary form of consideration consisted of the buyer’s common shares did not have to wait for the tax issue to be resolved because buyer and seller both faced the issue. Small Deals, Larger Deals, and Perhaps Big DealsM&A is largely a story of the consolidation of the small banks by large community and small regional banks. Two decades ago the theme was the same, but overlaid was the formation of the nationwide and multi-region franchises through mega-mergers such as NCNB/Bank of America and Wells Fargo/Norwest.Since the financial crisis, activity has mostly been confined to small deals with deal values a fraction of the pre-crisis and especially pre-2000 amounts. Annualized year-to-date deal value is $33 billion, which compares to approximately $26 billion annually during 2015-2017. By comparison, the value of announced transactions in 1997 and 1998 were many multiples greater at $97 billion and $289 billion, respectively.During the past five years, there only have been 10 deals that exceeded $2 billion of consideration and 22 deals in which the consideration exceeded $1 billion. As shown in Table 2, the two largest transactions involved Canadian banks, while three involved the large Ohio-based banks. Change may be afoot, however. Fifth Third’s $4.6 billion pending acquisition of MB Financial is its first bank acquisition since 2008, and it was announced a couple of days before President Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act. Among other things, the financial deregulation law moved the SIFI asset threshold from $50 billion to $100 billion and provided significant relief for institutions such as Fifth Third that fall within the $100 billion to $250 billion asset bucket. Notably, during the past five years only CIT Group crossed the prior $50 billion SIFI threshold via acquisition, and apparently did so at the urging of regulators who wanted CIT to shore up its deposit funding. We look for more activity among mid-sized regional banks that are near or over $50 billion of assets; however, deal activity among the very largest banks is off the table given the $250 billion asset threshold for the global SIFI designation and the 10% nationwide deposit market share cap if pierced via acquisition. The potential fly in the ointment to the robust bank M&A environment is the flattening yield curve and the attendant underperformance of bank stocks this year. If bank stocks lag and valuations compress further, then it may be difficult for buyers to meet inflated seller expectations that rarely take into account downward moves in buyers’ share prices. How We Can HelpThe adage banks are sold rather than bought is largely true, meaning most banks transact when the sellers are ready to do so. Sometimes that occurs after years of planning; sometimes it occurs unexpectedly when another institution makes a casual inquiry.Mercer Capital has over three decades of experience as a financial advisor helping institutions navigate the process as buyer and seller. Even if your board has no interest in selling (or buying) we would be happy to present an overview to your board about the lay of the land as it relates to the public market, M&A market and what actions your board might consider to enhance value. Please call if we can be of assistance.Originally published in Bank Watch, July 2018.

Wealth Management Industry: Opportunities Abound Despite Headwinds

Wealth management firms have fared well in recent years on the back of rising markets, but the underlying drivers suggest an industry in flux; global investible assets are at all time highs, intergenerational wealth transfer is accelerating, and FinTech products are poised to disrupt. Yet, many analysts are skeptical about the industry’s prospects. Rising global wealth means that there are more assets for wealth managers to manage, and intergenerational wealth transfer means that there are also more opportunities to gain (and lose) clients. FinTech products threaten competition, but also offer efficiencies for agile firms. Depending on your point of view, the industry is either poised to grow or on the verge of massive disruption.The Next GenerationOne thing is clear: the wealth management industry has benefited from the fact that global wealth (and demand for wealth management services) has reached all-time highs. According to Capgemini’s 2018 World Wealth Report, global wealth held by high net worth (HNW) individuals grew 10.6% to more than $70 trillion in 2017. More wealth means, well, more wealth to manage, and revenue at wealth management firms has generally increased with the market. However, for wealth managers, business is also a function of who holds that wealth – and that is changing. As baby boomers continue to retire over the next decade, trillions of dollars of wealth will be transferred to a younger generation. This massive wealth churn is an opportunity for wealth management firms to attract a new, younger client base, but wealth managers face several challenges in appealing to that new demographic.One such challenge is the industry’s aging advisor base. According to data from EY, the average advisor is now 50 years old, and only 5% of advisors are under 30. As assets move from one generation to the next, a weak pipeline of new advisors is a looming threat for the industry. The age gap between clients and their advisors is poised to create real difficulties in attracting and retaining an evolving client demographic, particularly given the increasing prominence of FinTech-based competition. A lack of succession planning at many wealth management firms will only exacerbate these problems.FinTech's ImpactWith a changing client demographic, also comes changing expectations. As a result, wealth management firms face pressure to adapt their service and product offerings, most notably through changing the way that they utilize technology. On its face, FinTech-based wealth management products appear to be a threat to traditional human advisors, less agile firms will likely find this to be true. For other firms, FinTech-based solutions offer an opportunity to increase advisor efficiency and meet regulatory requirements by utilizing hybrid advice models. By utilizing FinTech solutions, wealth management firms can free up advisors from routine tasks and allow advisors to offer a greater breadth of client services and improve client relationships.Despite its potential benefits, technology is also partly responsible for the continued fee-pressure wealth managers face. According to data from McKinsey & Company, pricing on fee-based accounts dropped by five basis points to 1.08% in 2017. Establishing a personal connection with clients is one way wealth management firms can differentiate themselves to help maintain pricing power. According to a 2018 study by Capgemini, only 56% of HNW individuals said they connected strongly with their advisor. Despite the strong market returns over the last two years, this low satisfaction suggests that performance is not the only concern of wealth management clients.ConclusionThe current fee-conscious environment favors advisors that offer a value proposition that software cannot replicate at lower cost. Ultimately, such a value proposition will likely need to be based on establishing real relationships with clients. Growing revenue on the back of strong markets may have masked the changes in the business for many wealth management firms, and the party may end if equity markets normalize going forward. One thing the industry has going for it is that the demand for wealth management services is clearly there, and increasingly so. The performance of wealth management firms will depend in large part on how well individual firms are able to adapt to an evolving landscape to capture growing demand.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Details and Analysis of Kimbell Royalty Partners’ Acquisition of Haymaker Minerals & Royalties, LLC

As we have discussed in previous posts, there are 21 main oil and gas-focused partnerships that are publicly traded, as of June 30, 2018. Publicly traded royalty partnerships have been slowly regaining the value lost when crude oil prices fell below $30 per barrel in early 2016. In the two years since June 2016, 16 of the 21 royalty partnerships have had positive returns with an average return of 48%. Over the past two years, the remaining five partnerships experienced a negative 31% average return. In those two years, natural gas prices have experienced an insignificant increase of just 5%, while oil prices have risen more than 50%. The underperformance of natural gas prices is due to the surge in production of shale gas since 2006 and the more recent rise of natural gas production as a result of increased oil production.Kimbell Royalty Partners, LP (KRP)The youngest of the 21 partnerships, Kimbell Royalty Partners, LP (“Kimbell,” “KRP,” or the “Company”), went public in February 2017. The Company’s IPO opened at $18.00 per share, initially offering 5 million shares. Since going public, KRP’s price struggled in its infancy and fell under $16 per share in mid-August 2017. This year has been much kinder to Kimbell due to the high crude price with its share price peaking at $23. Approximately 70% of Kimbell’s revenues are from oil and natural gas liquids. Of the 21 mineral partnerships, Kimbell, Dorchester Minerals LP, Black Stone Minerals LP, and Viper Energy Partners LP are the only non-trust royalty partnerships and are either C Corporations or MLPs. These MLPs and C Corps are designed to gather assets and grow through acquisitions, focusing on both dividend payments and the growth of shareholder value. On the other hand, the other 17 are royalty trusts, which have a limited pool of assets and must return most of the cash flow earned from the royalties to the shareholders through dividends. Trusts’ capital structures limit opportunities for reinvestment, making it difficult to grow their asset base through acquisitions. Of the MLPs/C Corps, Kimbell has the highest dividend yield at 7.63%, with Dorchester, Black Stone, and Viper at 6.23%, 6.76%, and 6.02%, respectively. KRP is the smallest of the four partnerships with a market capitalization of $370 million, while Black Stone and Viper each have market capitalizations near $3.7 billion. 1Acquisition OverviewPrior to its acquisition of Haymaker Minerals & Royalties, LLC and Haymaker Resources, LP (collectively, “Haymaker”), Kimbell had nearly 5.7 million gross acres in nearly every major oil and gas basin across 20 states with a primary focus in the Permian Basin and the Mid-Continent. Kimbell solely invested in mineral and royalty interests with the largest portion of its production concentrated in the Permian Basin, where it had 1.75 million gross acres of mineral interests and ~200,000 acres of overriding royalty interests (ORRIs). Currently, KRP has 25 active drilling rigs on its acreage and mineral and ORRIs on 50,000 wells. Kimbell’s holdings in the Permian Basin alone account for 26% of its net royalty acres, 60% of its gross acreage, and 60% of active wells on its total acreage.In comparison, Haymaker had ~5.4 million gross acres and ~43,000 net royalty acres primarily focused in the Mid-Continent. Haymaker had royalty interests in 33,800 wells and had more than double the number of active drilling rigs than Kimbell with 51. Kimbell acquired Haymaker for $404 million with $210 million of cash and 10 million newly issued common units going to Haymaker’s sponsors. The acquired company’s private equity sponsors are KKR & Co. LP (“KKR”) and Kanye Anderson Capital Advisors, LP (“Kayne Anderson”). Alongside the acquisition, Kimbell converted its tax status from an MLP to a C Corp. Kimbell believes that this conversion will give the company access to a much broader base of investors and access to a more “liquid and attractive currency.” Kayne Anderson’s and KKR’s willingness to take the newly issued shares, which will account for ~37% of Kimbell’s outstanding common units, shows the potential for investment growth that is achievable for Kimbell but not necessarily for Haymaker. Kimbell estimates that the acquisition will not only be accretive due to the quality of the assets, the acquisition will also be highly scalable and reduce the G&A costs on a per Boe basis. After the acquisition, Kimbell will have more than 11 million gross acres spanning 28 states, with 38,000 of its 84,000 wells in the Permian Basin. As of April 27, 2018, Kimbell’s 73 rigs account for 7% of the total rigs in the United States. To calculate price per acre, Haymaker’s 42,759 net royalty acres must be converted to the industry standard 1/8 conversion since Kimbell uses a non-standard method of calculating net royalty acres. The conversion, which assumes eight royalty acres for every mineral acre, results with Kimbell acquiring 342,072 net royalty acres for $404 million. This results in an implied price of $1,181 per net royalty acre. At the time of the transaction, Kimbell’s market capitalization was approximately $327 million with an 8.7% yield. Post-transaction, KRP’s FCF yield rose to 12%, implying a 15% yield for Haymaker prior to the transaction. Much of Haymaker’s acreage is congruent to Kimbell’s existing acreage and is an evenly split oil and natural gas mix. Haymaker’s acres enhance the Company’s position in the Permian and Mid-Continent and also increase its exposure in the Appalachian Basin and the Marcellus and Utica Shales. After the transaction, Kimbell’s production will be approximately 2/3 liquids and 1/3 gas. KRP believes that through the consolidation of costs, their pro-forma G&A expense can decrease by as much as 50% to $3.22 per Boe. This decrease is due to the increased scalability of Kimbell after the transaction. The transaction is also projected to increase the net production per unit by 56%. The Company estimates the increased production and the cutting of costs alone could lead to a 20% increase in distributable cash flow per unit. AnalysisWhy would two companies with relatively comparable assets have such drastically different yields? Is it due to the fact that Kimbell is publicly traded while Haymaker is private? Perhaps the solution lies between the vast differences in public and private mineral market share sizes.Kimbell estimates that the total mineral buying market is close to $500 billion, excluding ORRIs. Public companies only make up 2.5% of the total market with a combined enterprise value of ~$12.3 billion. The two largest public, Black Stone Minerals and Viper Energy Partners, make up a combined $8.3 billion of that total value. While the public minerals market is only made up of a handful of companies giving public investors a limited number of investment options, the private minerals market is highly fragmented.Small mineral aggregators can operate with a higher attention to acreage details. These aggregators have the ability to negotiate directly with the landowners and handpick the acreage of their choosing. As a result, they expect higher yields than the public companies. While these yields are higher, the acreage is typically much more focused on certain areas. Combined with their small size, these investments are inherently riskier than a larger, more diverse pool of assets, such as those held by public royalty trusts.Kimbell’s acquisition of Haymaker demonstrates the disconnect between the public and private markets and the discounts at which private LPs are valued. It seems that private royalty LPs simply do not have the same access to capital as the public MLPs or C Corps. This lack of access is potentially why KRP and Haymaker have distinctly different yields, 8.7% and 15%, respectively, and why KRP was able to successfully negotiate such a highly accretive deal. Private equity investors/sponsors seem to recognize this–Haymaker’s sponsors for example. Haymaker’s sponsors, a well-respected private equity firm (KKR) and one of the leading energy investors (Kayne Anderson), most likely saw the potential behind the accretive mix of the two companies, which is why they were willing to accept roughly 50% of the purchase price in Kimbell shares. Not only was Kimbell public, its transition to a corporation opened itself up to a broad array of inexpensive capital, far less expensive than what Haymaker could find. This access to cheaper capital makes it easier for Kimbell to grow through acquisitions and continue to increase its returns and shareholder value. Kimbell has the potential for growth as a public corporation far beyond what a private company like Haymaker could achieve.Public investors are looking for opportunities to invest in mineral plays; however, many of these investors’ only opportunity to do so is through public companies. Following the rise of crude oil prices, the increased demand from public investors has driven up the prices of the royalty trusts and MLPs and, in turn, lowered the yields. More and more investors, including institutional investors, are looking towards the mineral market to find investment growth. The emerging field of mineral aggregators has the potential to provide this growth through accretive acquisitions, as well as steady dividend payments, that public investors crave.We have assisted many clients with various valuation and cash flow issues regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.[1] Capital IQOur thanks to Daniel Murchison who drafted and did much of the research for this post in collaboration with our Energy Group.

RIA Stocks Post Mixed Performance During 2Q18

Over the last several years, asset managers have benefited from global increases in financial wealth driven by a bull market in asset prices. However, favorable trends in asset prices have masked some of the headwinds the industry faces, including increasing consumer skepticism of high-fee active products and regulatory overhang.Traditional active managers have felt these pressures most acutely, as undifferentiated active products have struggled to withstand downward fee pressure and at the same time, have been a major target of regulatory developments. To combat fee pressure, traditional asset managers have had to either pursue scale (e.g. BlackRock) or offer products that are truly differentiated (something that is difficult to do with scale). Consumers have been more receptive to the value proposition of alternative asset managers and wealth managers, and these businesses are better positioned to withstand fee pressure as a result.Second Quarter PerformancePerhaps reflective of the headwinds that the industry faces, asset managers generally underperformed broad market indices during the second quarter. While major indices regained traction during the second quarter, the returns for asset managers were generally more muted even though these businesses generally benefit from rising markets. The operating leverage inherent in the business model of most asset managers suggests that market movements tend to have an amplified effect on the profitability (and stock prices) of these businesses, and in recent quarters that has been the case. The reversal of that trend last quarter may be indicative of investors’ increasing focus on the headwinds the industry faces and the general uncertainty that arises late in the economic cycle. Taking a closer look at recent pricing reveals that traditional asset managers, which are perhaps the most affected by fee compression trends, ended the quarter down 3.7%, while other categories of asset managers generally saw positive returns. Trust banks were up 2.4% during the quarter, buoyed by a steadily rising yield curve which portends higher NIM spreads and reinvestment income. Alternative asset managers were up 2.8% during the quarter as this product segment is less impacted by fee pressure than traditional active products. Wealth managers were up 3.8% during the quarter, buoyed by market-driven increases in AUM, although these businesses face challenges with new client acquisition and maintaining pricing power. The RIA size graph below shows a similar trend for most of its categories. The smallest category of publicly traded RIAs (those with less than $10 billion AUM) was down nearly 15% during the quarter, although this is the least diversified category of RIAs with only two components. Due to the lack of diversification, the smallest category of RIAs is subject to a high degree of volatility due to company-specific developments. Most of our clients fall under this size category, and we can definitively say that these businesses (in aggregate) have not lost nearly 15% of their value since April as suggested by this graph. Market OutlookThe outlook for these businesses is market driven - though it does vary by sector. Trust banks are more susceptible to changes in interest rates and yield curve positioning. Alternative asset managers tend to be more idiosyncratic but still influenced by investor sentiment regarding their hard-to-value assets. Wealth managers and traditional asset managers are more vulnerable to trends in active and passive investing. The outlook for the industry during the rest of 2018 ultimately depends on how the industry headwinds continue to evolve and (as always) what the market does on the back half of the year.

Takeaways from FinXTech 2018: The Rise of Bank and FinTech Partnerships

I recently attended FinXTech, an industry event where the hosts at Bank Director bring together FinTech founders and bank directors and executives for productive conversations about the road ahead as partners (and competitors).Those discussions occurred against a backdrop in which FinTech, as a concept to enhance the customer experience and to drive operating efficiencies, is widely accepted by bank management, shareholders, and regulators. How “FinTech” is implemented varies depending upon resources. As shown in the Table 1, there has been no surge of M&A in which banks buy FinTech companies. Only nine of 276 transactions announced since year-end 2016 entailed a bank or bank holding company acquirer. KeyCorp, which has been one of the nine active FinTech acquirers, announced in June 2018 that it would acquire digital lending technology for small businesses built by Chicago based FinTech company Bolstr. At best, activity can be described as episodic as it relates to bank acquisitions, which appears to be designed to supplement internal development.The very largest banks such as JPMorgan Chase & Co. are spending billions of dollars annually to upgrade technology—a level of spending that even super regional banks cannot match. In contrast, community and regional banks have been left scratching their heads about how to address FinTech-related issues when money is a constraining factor.During the FinXTech 2018, the focus shifted from the potential disruption of a bank’s franchise by FinTech to the potential to partner with FinTech companies, which stood out to me as a marked change from prior years.Both banks and FinTech companies realize that they need each other to some degree. For banks, FinTech offers the potential to leverage innovation and new technologies to meet customer expectations, enhance efficiency, and compete more effectively against the biggest banks. For FinTech companies, the benefits from bank partnerships can include the potential to leverage the bank’s customer relationships to scale more quickly, access to funding, and regulatory/compliance expertise. Several examples of successful partnerships between banks and FinTech companies were highlighted at the FinXTech event. (You can read more about some of them here.)The FinTech/Bank partnership theme also was evident in GreenSky’s recent IPO, a FinTech company based in Atlanta. GreenSky arranges loans primarily for home improvement projects. Bank partners pay GreenSky to generate and service the loans while the bank funds and holds the loans on their balance sheet. As more partnerships emerge, it will be interesting to see if FinTech impacts the valuation of banks that effectively leverage technology to achieve strategic objectives such as growing low-cost core deposits, opening new lending venues, and improving efficiency. One would think the answer will be “yes” if the impact can be measured and is meaningful.Another trend to look for will be whether smaller banks become more active as investors in FinTech companies. For the most part, investments by community and regional banks in FinTech companies remains sporadic at best even though FinTech companies raised nearly $16 billion of equity capital between year-end 2016 and June 2018 in both private and public offerings. An interesting transaction we observed was a $16 million Series A financing by Greenlight Financial Technology, Inc., a creator of smart debit cards, in which the investors included SunTrust Bank, Amazon Alexa Fund, and $619 million asset NBKC Bank, among others.FinXTech 2018 included several sessions related to due diligence for FinTech partnerships; however, with limited M&A and investing activity by banks there was little discussion about valuation issues, which can be challenging for FinTech companies and differs markedly from methods employed to value a bank.Not surprisingly, we have lots of thoughts on the subject.With the emerging partnership theme from FinXTech 2018 in mind, view our complimentary webinar “How to Value an Early-Stage FinTech Company.” Additionally, if you have questions, reach out to one of our professionals to discuss your needs in confidence.Originally published in Bank Watch, June 2018.

Growing Pains Curb Valuation Gains in the Permian

2Q18 Review

[caption id="" align="aligncenter" width="337"]Too much to swallow?[/caption] The story of the Permian Basin in 2018 so far has been developing as one of the finest proverbial "fishing holes" in the world. However, as the year has progressed, it appears many industry players have found their reputed "catch" too big to process and are scrambling to deal with it before it begins to stink. Translation: the year began with a flurry of developmental drilling activity followed by an emerging bottleneck. The unintended consequence of this has been that some operators have been growing oil production too fast for pipeline and infrastructure to keep up. A pricing differential has arisen due to the supply glut and there has been concurrent stagnation in valuations. Here’s how some of it has transpired through the timeline of the first half of 2018. Q1: Flocking to the PermianThe Permian's 2018 journey began on the same trajectory that 2017 ended with growth, investment, and more growth. This has been for a good triumvirate of key reasons too:Estimates vary by county, producer, and information source, but according to Bloomberg Intelligence, recent break-even prices in the Permian were as low as $38 in both the Delaware and Midland Basins.3Some of the best shale stacked geology in the world, andLong-standing pre-existing infrastructure to get petroleum to market (the play has been active since the 1920's). It's no wonder the Permian continued to attract operators and capital. Capex budgets were not only growing for operators as a general matter, but increasingly higher percentages of those budgets were geared towards being spent in West Texas. The chart below demonstrates this trend: Transactions in other basins were driven by motivations to re-deploy cash in the Delaware Basin, Midland Basin, or both. We discussed this in a recent post. Operators and mineral holders in other basins watched as activity and capital flocked to the Permian Basin. Q2: Hydrocarbon Traffic Jam However, plans, forecasts, and reality clashed around the end of the first quarter of 2018. Although the takeaway capacity and infrastructure were present, it wasn't enough to keep up with growth, and it has burst at the seams. This first began to be hinted at back in 2017, in regards to the growth and when new pipelines were coming online; it was discussed as a real problem issue in April with a few foreboding articles.This has led to capacity issues on a meaningful scale and there's too much of a good thing as a result. Goldman Sachs' research team put together an interesting infographic that was referenced by HFI Research that characterizes it well:Local Permian Oil & Gas Prices: Falling FastThis has led to a rapid change in local wellhead prices in the Permian. As early as January 2018, wellhead prices in the Permian were trading at a premium to markets at Cushing, OK. However, as seen below in this Bloomberg chart, the gap skyrocketed over the course of the next 45 days and is currently hovering around $12 per barrel. The primary driver of this differential is nested in alternative transportation costs as shown above. This glut of production has rendered local natural gas to an almost forgotten status. In the Permian, natural gas at the wellhead is almost worthless in some cases. There's nowhere for it to go, and many producers have little choice but to burn (or flare) its' gas at the wellhead. It's not bad news for all in the oil patch. Some players are embracing the turn of events. Refiners are welcoming the low prices as they are able to arbitrage price differences at the gasoline pump and midstream producers are getting top dollar to transport more crude out of West Texas. However, for many E&P producers (and royalty & mineral holders) this presents not only a problem from a pricing standpoint but from a future drilling standpoint as well. Plans made as recently as a few months ago are undoubtedly being reconsidered by many producers. The ones who have secured takeaway capacity are letting the market know about it. Q3 and Beyond: Valuation Stagnation and what about Backwardation?Valuations for Permian focused producers have stagnated this year. Since January 1st only a handful of companies stock prices are up, while the majority have actually declined. This would appear counterintuitive in light of the overall optimism in the space. Doesn't that bottleneck restriction push prices higher? Isn't that a good thing? The answer is true in many respects, and producers worldwide and in other basins are reaping the benefits of this. However, as far as Permian focused producers are concerned, they don’t get these benefits. They are getting around $60 per barrel, instead of $70+ right now. Also, remember that valuations are a function not only of reserves (which are just as robust and optimistic as they have been recently), but of ultimately the production, cash flow, and timing that result from the development of those reserves. This development has impacted all three: Production is anticipated to be curbed (at least until the bottleneck is dealt with – which might not be until late 2019 at this point);Cash flow is impacted by both production limitations AND pricing differentials; andTiming of when those cash flows will be received has been delayed. Speakers at a recent ASA Energy Conference in Houston, mentioned that certain upstream management teams have expressed elements of frustration that investors have not rewarded valuations with the oncoming of robust Q1 earnings, particularly out of the Permian Basin. We're not so sure that's the case. Acreage grabbing has slowed and earnings are expected to follow with all of the favorable aspects of the Permian. Perhaps trepidations about this bottleneck and pricing differentials have fueled concerns and hampered values. Additionally, if futures curves are any indication, there is an expectation that prices will return from the current $70+ environment back down into the low $50s per barrel in a few years.However, the good news from a longer run perspective is that most producers make capital expenditure decisions from a longer-term perspective (several years out) due to the time it takes to deploy that capital and when it begins to make a return. With break evens so low, this disruption – even if it lasts through 2019, does not change the longer term outlook in the Permian. It mostly delays it, which is a good reason why stock values are on hold right now.Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, biofuels and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Third Quarter 2018 | Segment Focus: Roads, Bridges, and Highways

U.S. roads, bridges, and highways require attention and may receive it with an anticipated large increase in transportation infrastructure projects.

E&P Third Quarter 2018

Region Focus: Bakken Shale

Region Focus: Bakken Shale // Oil and gas prices in 2018 have been steadily increasing in the midst of strong demand and constrained supply, and the U.S. energy sector is at the center of this focus.

Transportation & Logistics Newsletter

Third Quarter 2018

Demand for services in the logistics industry is tied to the level of domestic industrial production.

Thinking About Going Exclusive?

Five Considerations for RIA/BD Hybrids Looking to Drop Their BD Status

With the Advisor Rule looming and commissions dwindling, it may be time for some RIA/BD hybrids to take it to the next level: drop the broker-dealer license and register exclusively with the SEC as an investment advisor. This week’s post focuses on what’s driving the downward trend in BD-only registrants and when it makes sense to abandon the hybrid model. We’ve not included many images of hybrid vehicles on this blog, and for good reason. They’re usually not the most aesthetically pleasing cars and therefore unlikely to generate good click bait for our readers. They can, however, be extremely (fuel) efficient and practical in certain contexts. The same could probably be said of hybrid RIA/BD firms, as the traditional broker-dealer model continues to lose ground to hybrids and fee-only RIAs. According to the Financial Industry Regulation Authority (FINRA), the number of broker-dealers has dropped 24% over the last decade, from 4,891 in 2008 to just over 3,700 today. The Credit Crisis is partially responsible as the entire industry’s reputation and financial viability suffered a huge blow, forcing many BDs to consolidate or go out of business. The rise of online DIY trading platforms and low fee ETF products exacerbated this trend as commission income spiraled downward to stay competitive. The rising expenses and nuisances associated with FINRA registration also pressured firms down the RIA path, and the recent overhang of the Fiduciary (now Advisor) Rule hastened this transition for many industry participants. Many hybrids are considering dropping their BDs. Should you follow their lead? That really depends on a number of factors.1. BD Income’s Overall Contribution to Your Total RevenueIf commissions and/or trading income represent less than 10% of your total revenue, then you should seriously consider dropping the BD license. Your compliance and FA/broker expenses alone may well exceed what you’re taking in from the FINRA registration. This seems simple and obvious, but many hybrids originally operated as a broker-dealer, and the transition to (RIA) exclusivity can be daunting and sometimes difficult to implement in practice. The good news is that transition costs are one-time; whereas, the forgone compliance expense associated with dual registration is an ongoing benefit.2. Top Line Exposure to Bear MarketsIt’s been over nine years since we had a sustained market downturn. We’re probably overdue. Many hybrids have been transitioning toward the RIA model for quite some time but are reluctant to drop the BD license because it offers some cushion against falling advisory fees when AUM plummets with the market. The asset-based revenue model has been great for FAs largely invested in equities since the Financial Crisis, but that won’t always be the case. Commissions and trading income aren’t completely market proof but do offer some hedge against revenue declines from down markets. If your firm manages mostly equities and primarily charges asset-based fees, you may not want to totally abandon your BD status just yet.3. Emphasis Clients Place on the Fiduciary Standard Over the Suitability StandardMany years ago most your clients probably didn’t know or care about the distinction. Now your best clients, and particularly your best prospective clients, likely are not only familiar with these terms but understand the implications. If your hybrid is not technically a fiduciary, you may want to change that before ditching your BD license.4. The Costs (and Headaches) Associated with Dual RegistrationI think most industry participants would agree that less is more when it comes to regulatory oversight, and several clients have told us that FINRA compliance is more burdensome than the SEC’s. Devoting capital and resources to compliance matters can be a huge distraction. Abandoning the BD license could be a quick fix if it’s not doing much for you in the first place.5. Your Firm’s IdentityDo your clients and other stakeholders see the company as an advisory firm or broker-dealer? Are you operating as a fiduciary for clients or selling proprietary products and/or executing trades on their behalf? Either route may have served you well in the past, but it may be time to choose a path. Acting as a fiduciary to some (but not all) clients could lead to conflicts of interest and confuse your role to prospective clients. Picking a side would clarify this message and potentially land more business from investors looking for an RIA or BD firm but not necessarily both. If, on the other hand, a hybrid culture has been instilled across the firm for quite some time, it may not be worth the hassle or cost to go the exclusive route.Undoubtedly, there are other things to keep in mind if you’re thinking about going exclusive. You can take some comfort in knowing that you’re not alone. Industry consultants Cerulli Associates estimates that hybrids have grown to roughly 15% of the industry, up from 7% in 2004 as BD-only firms have declined in number while fee-only RIAs have grown more modestly in recent years. Still, this trend is probably not sustainable with a looming Advisory Rule, so you need to be thinking about your options if you haven’t already done so.

Take What You Can and Get Out

When oil prices crashed in mid-2014, companies were forced to become more efficient in order to survive. It became clear that location meant more than ever and companies could no longer justify operating in regions such as the Bakken and the Eagle Ford, where break-even prices were higher than they were in the Permian. Thus in order to stay in business, companies flocked to the Permian. This week, we look at how the increased appeal of the Permian Basin has affected M&A activity in the oil and gas sector.The trend towards the Permian Basin was somewhat slow to begin as the uncertainty that accompanied the price collapse led to a standstill in activity. While some investors were quick to move to the Permian when acreage was still relatively inexpensive, most were slow to sell their acreage in other basins as the low oil price environment pushed down the price of acreage. Now that the Permian has become the clear leader in production, M&A activity in the region has picked up and multiples for Permian acreage have increased due to high demand. Although it was three to four years ago that the Permian emerged as the cost leader, companies are still moving to the Permian with haste.This trend is especially apparent as it relates to Pioneer Natural Resources’ recent acquisition activity. Pioneer announced earlier this year that it would shift its focus to become a pure-play Permian producer, with plans to spend its entire $2.9 billion capex budget in the Permian Basin.Since the announcement, Pioneer sold Eagle Ford assets for $102 million and southeastern Colorado assets for $79 million, as summarized below. It appears that Pioneer was willing to take a loss in order to re-deploy capital to the Permian Basin. In March 2018, Pioneer sold its assets in the Eagle Ford for $10,000/acre and $92,727 per flowing barrel. The price Pioneer received was in line, or even above, industry averages which are more along the line of $4,200/acre and $98,000 per flowing barrel. However, this month Pioneer announced the sale of its Raton assets for only $79 million, a multiple of $5,600 per flowing barrel. Meanwhile, multiples for acreage in southeastern Colorado are not expected to be at the same level as multiples seen in the Eagle Ford. BusinessWire reported that this sale “is expected to result in a pretax noncash loss of $65 million to $75 million.” Pioneer seems to have shifted its strategy from a planned liquidation to a "take what you can and get out" approach.While Pioneer just exited its current position at multiples lower than what might be otherwise expected for the region, they are looking to buy acreage in a region where multiples have flown through the roof. Recent acreage transactions in the Permian Basin are closing at median multiples of $16,000 per acre and over $180,000 per flowing barrel as summarized below, according to Shale Experts.Pioneer’s recent transaction activity shows the urgency with which companies are now shifting their focus to the Permian. Pioneer’s acceptance of a large loss for its Raton assets is symptomatic of the recent dominance of the Permian to all other U.S. shale plays. And while Pioneer accepted a loss in order to sell its acreage at meager multiples of $5,600 per flowing barrel, it will now likely use that cash to pay for Permian acreage at multiples of over $100,000 per flowing barrel.Part of the reason for paying the premium multiple can be explained by the existence of more proved undeveloped (PUD) reserves in the Permian Basin as compared to other regions. Many transactions in the Permian are motivated by the existence of future drilling potential over current production. Thus multiples of current production in the Permian are inflated when compared to transactions in regions that have more current production but less potential for the development of PUD reserves. However, the difference is mainly due to the obvious benefits of operating in the Permian Basin as compared to other unconventional shale plays, including low break-even prices, efficiencies generated multiple stacked plays, and lower costs from shorter transportation distances to refineries. However, it is worth noting that increased drilling activity in the Permian Basin is beginning to strain the existing infrastructure in the Permian, creating transportation bottlenecks (or as Bryce Erickson likes to call it, a hydrocarbon traffic jam).Javier Blas with Bloomberg recently pointed out the logistical difficulties in getting Permian oil and gas to market and the growing price differentials as a result. This could be a cause of short to intermediate term revenue and valuation disruptions for some producers.With such wide range of observed transaction multiples, it is especially important to understand each transaction and the main drivers of value before using a transaction as a benchmark of value. We have assisted many clients with various valuation needs in the upstream oil and gas space in the Permian Basin, other conventional and unconventional plays in North America and around the world. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.

Piping Hot Permian

Production in the Permian is as hot as the summers in West Texas. Despite being discovered in the 1920s, it was not until 2007 that the region’s true potential was realized when hydraulic fracturing techniques were used to access the play's tight sand layers. Given its low-cost economics and large well potential, in recent years, the Permian has been in the limelight with operators and investors alike prioritizing the region.According to Baker Hughes, there are virtually no active gas-directed rigs, but significant gas production is still occurring in the region because natural gas is coming as a by-product from the oil rigs. As we discussed in a previous post, this is having a negative effect on natural gas prices and producers outside of the Permian. Companies in the Permian have an advantage because they do not have to choose between oil and gas, and production is more efficient. As such, the Permian is the largest producer of oil and the second largest producer of gas, after the Marcellus.Rig Counts and ProductionWith many producers clamoring for a piece of the action, the number of rigs in the Permian has consistently grown at a faster rate than total rig counts in the country. As a result, the Permian has increased its share of total rig counts, as seen in the graph below. In June 2015, the Permian accounted for 27% of all rigs, but that number steadily increased to 45% as of June 2018. The number of rigs in the Permian has grown 32% in the past year, compared to 16% nationally; these figures were 156% and 125% for the year before that. According to the EIA, production of oil and natural gas in the Permian Basin has increased at a compound annual rate of 25.0% and 21.1%, respectively over the last five years. In the past year alone, oil production increased 35.6% and gas production increased 26.5%, with over 45% of the U.S.’ crude oil and 15% of the country’s natural gas currently coming from the Permian Basin.1 A concerted effort has been made to increase efficiency, which has led to a rise in production per well. Oil production per rig in the Permian increased more than 36% in the last year, which, when combined with the rise in rig count, further emphasizes the focus on the region. Economic ImpactWith this rush to West Texas, Midland and Odessa are in the middle of the action. The boom has had a large impact on their economies as a whole. Population growth from 2016 to 2017 was estimated at 4.2% for Midland and 4.8% for Odessa, compared to 2.0% for Texas and 0.8% for the country. Unemployment was also extremely low at 2.1% and 2.8%, respectively, compared to 3.8% for the state and 3.7% for the country. The national unemployment rate is already at its lowest of this millennium, emphasizing how razor-thin the margin is in Midland. This has caused significant labor shortages in other sectors of the economy as they cannot compete with $28/hour wages offered after minimal training requirements for workers in the oil sector.Valuation ImplicationsWe can understand the valuation implications for companies in the Permian Basin by looking at 1) royalty trusts and mineral rights aggregators and 2) E&P companies.Royalty TrustsPositive market sentiment for the Permian region can be viewed in the performance of both operators in the region and publicly traded royalty trusts with exposure to the Permian. As seen in the following tables, royalty trusts in the Permian have seen far superior two year returns. Also of note is the average size measured by market cap. Viper Energy Partners, Black Stone Minerals, and Kimbell Royalty Partners are all aggregators of mineral interests and are not restricted from acquiring new interests like many other royalty trusts. This causes them to be larger, and it also allows them to gain exposure to new, advantageous regions, which may play a role in all of them having exposure to the Permian. Royalty Trusts typically decline in both production and level of reserves. For the trusts with properties outside of the Permian, they have averaged decline rates of 14% for production and 21% for reserves over the past three years.2 However, trusts in the Permian are increasing at average rates of 13% for production and 7% for reserves. This indicates the increased activity in the region, though again, it should be noted that some of the trusts that are not restricted from acquiring new properties are likely to be categorized in the Permian group as they would have sought exposure to the region. E&P CompaniesAs seen in the graph below, E&P companies valuation multiples on average remain highest in the Permian, but they have declined 21% in 2018. Multiples in the Bakken and Eagle Ford meanwhile have cut into the gap, increasing 34% and 25%, respectively since the beginning of the year. The Marcellus and Utica continue to see the lowest valuation multiples and have declined by 2% in 2018. Companies in the Permian are generally more profitable than companies in other regions as explained by their lower break-even prices. According to Bloomberg Intelligence, recent break-even prices in the Permian were $38 in both the Delaware and Midland Basins.3 This represents a 6% decline for the Delaware Basin since June 2017, compared to a 28% decline in break-even price for the Midland Basin. These break-even prices compare favorably to $40 in the Bakken and about $44 in the Eagle Ford. Production in the Permian appears to be full steam ahead. And as they say, if you can’t stand the heat, stay out of the Permian. We have assisted many clients with various valuation needs in the oil and gas space in the Permian region, other conventional and unconventional plays in North America, and around the world. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed. End Notes1 EIA; Calculations based on monthly crude oil and gas production and EIA drilling report by region 2 Capital IQ; Calculations based on production and reserve figures reported in royalty trust 10-K’s 3 Bloomberg Intelligence; County Level Estimate

3 Things All Mineral Owners Should Know

Minerals Workshop at the DUG Permian Basin Conference

On May 21, Mercer Capital attended the Minerals Workshop at the DUG Permian Basin Conference in Fort Worth, Texas. The agenda included five presentations and eleven speakers, including royalty brokers, royalty aggregators, and royalty managers. Speakers included: Leslie Haines, Hart EnergyGeorge Soulis, Oil & Gas Asset ClearinghouseDarren Barbee, Oil and Gas InvestorC.H. Scott Rees III, NSAIJames R. Elder, Momentum Minerals LLCNick Varel, Wing Resources LLCWill Cullen, LongPoint Minerals LLCJames Wallis, NGP Energy Capital ManagementJames S. Crain, EnCap Investments LPJohn M. Greer, Latham & Watkins LLPHenry S. May III, Post Oak Energy CapitalMike Allen, Providence Energy Corporation We learned about changes in the royalty market, mineral investor required returns, private equity strategies and due diligence musts for buyers. In light of the information, three themes emerged that mineral owners should know about the royalty market.Growing Universe of Mineral BuyersWith the interest rate environment near all-time lows, many investors are looking for alternative investments to provide higher yields. This has driven private equity money into oil and gas. While part of private equity is targeting returns in operating exploration and production companies, mid-stream assets and refineries, significant money has found its way into the mineral and royalty market. Over the past four years, the mineral business has changed due to a surge in popularity. Minerals provide higher yield investment opportunities in a low yield environment. As a result of the surge, buying minerals is getting more and more competitive. Many of the speakers mentioned the prices for mineral buyers are increasing, and the market is attracting larger and more efficient mineral buyers. One speaker mentioned that prices on the ground have increased 40% to 50% in the last several years. In effect, increased competition is making it tough for the “small guys” to compete. A low yield investment environment is driving more money into the industry, increasing the number of buyers, increasing competition, and driving up prices of mineral interests. The chart below demonstrates the upward trend of the three most discussed mineral "aggregators" at the Minerals Workshop.Target Double-Digit ReturnsInvestments are graded based on the returns of alternatives and their prospective risk. For example, debt issued by the United States Treasury Department is considered “risk-free” (we can discuss the merits of that assumption later). Therefore, the yields for U.S. Treasury bonds and bills provide a measure of risk-free required returns. As of June 11, 2018, the 20 year Treasury bond yields approximately 3.10%, which means nothing without a comparison. For comparison, buyers of mineral rights have target returns upwards of 50% in some cases. While bonds produce low 3% returns, large capitalization equities in the public market return 5% to 8%. An asset class that can produce 50% returns is a significant difference! While part of the delta is due to the incremental risk assumed by the buyer, a significant reason for the delta is due to the negotiating power many mineral buyers have flexed in the industry over the last few years.To put it simply, demand for mineral rights was low in the last quarter of 2014. This is understandable as oil prices collapsed from $100+ to $20’s. Interest was low, oil and gas operators were going bankrupt, and the outlook was uncertain. As a result, the activity level for selling mineral rights was low to non-existent. Therefore, when one of the private equity speakers mentions “in 2015 there were many mineral interests to purchase,” it should come as no surprise. They were buying when there was “blood in the street.” Since that period of time, many operators have recovered, the Permian Basin has become the hottest shale play in North America, and oil prices have reached $60+. Investment capital has taken notice of the higher return opportunity and has created more demand for mineral rights. The interest has been spurred on by the promise of high rates of return.Of the 11 presenters, more than half shared their targeted internal rates of return for their investments. The interesting part of this discussion was not the high double-digit returns, but the range of returns each was targeting. For mineral and royalty interests, target rates of returns were 10% to 50%. It was clear that broad range was based on several factors including: (1) use of leverage; (2) time horizon; and (3) information. One might wonder how mineral buyers are able to create this type of return in an increasingly competitive market. The reason for this: actual and perceived information asymmetry between buyers and sellers.Asset Knowledge & Due DiligenceWhen a mineral buyer approaches a mineral owner, there is a real chance the buyer knows more about the minerals than the owner.Increasingly sophisticated buyers perform the following due diligence on mineral and royalty interests: (1) Analysis of the lease historical production; (2) well spacing analysis; (3) infrastructure analysis; (4) reserve and geological analysis; (5) decline curve analysis; (6) “closeology” analysis which is using public data from operators to assess the activity within an area; and (7) lease detail analysis. All of which, is done before offers are made to the mineral owner. However, buyers don’t stop there. After an offer is made, more due diligence is performed which requires mineral ownership approval. These due diligence steps are focused on cash flow and pricing differential analysis which can be understood from check stubs that royalty owners received each month.Since many mineral rights and royalty rights are passed down from generation to generation, it is not uncommon for the 2nd, 3rd, or 4th generation owners to negotiate from a disadvantaged position, due to lack of information sometimes not transferred from one generation to the other. All of the above due diligence items are available to the mineral owner; however, it takes time and experience to know where to find the information and to understand the data. Information asymmetry is one of the biggest reasons the market for royalty sellers is inefficient. Large, very highly capitalized buyers have invested the time and energy to understand the opportunities in minerals and utilize this advantage in negotiations.We have assisted many clients with various valuation needs in the upstream oil and gas space in the Marcellus and Utica areas, other conventional and unconventional plays in North America and around the world. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.

Tax Reform and Purchase Price Allocations for Oil & Gas Companies

On December 22, 2017, President Trump signed The Tax Cuts and Jobs Act, which resulted in sweeping changes to the U.S. tax code.The Act decreased the corporate tax rate to 21% from 35%, in addition to modifying specific provisions around interest, depreciation, carrybacks, and repatriation taxes.The change in tax rate will have the biggest impact on purchase accounting. In the energy industry, this will manifest itself in several ways. This blog post explores some of the impacts to valuations performed under fair value accounting in ASC 805 and ASC 820.Cash Flows and ReturnsWhen we evaluate prospective financial information, a lower tax rate will result in higher after-tax earnings.The value of the tax shield created by depreciation and deductions will be influenced by both the lower corporate tax rate (which reduces the tax shield’s value) and accelerated depreciation of qualifying capital equipment purchases (which increases the tax shield’s value). This could mean incentives for energy-oriented companies to (i) create a more modernized drilling rig fleet sooner that are best suited for today’s multi-frac lateral wells and (ii) accelerated plans to create more infrastructure and pipelines in active basins such as the Permian, Bakken and Eagle Ford. In addition, it also could drive more refinery and LNG liquefaction plant development. In most cases, a lower tax rate will increase cash flows, increasing the internal rate of return on acquisitions for a given purchase price.On the other hand, if lower tax rates drive higher purchase prices, internal rates of return may be unchanged.In terms of the weighted average cost of capital (WACC), the lower tax rate actually increases the after-tax cost of debt.Keeping other inputs constant, this modestly increases WACCs.Relief from RoyaltyUnder the relief from royalty method, after-tax royalties avoided increase as the tax rate falls.However, the tax amortization benefit (TAB) component of the intangible value also declines as a result of the lower tax rate, which serves to partially offset the increase in after-tax cash flows.Scenario AnalysisIn a scenario analysis used to value a noncompete agreement, a lower tax rate will again decrease the tax amortization benefit.Since both scenarios under the with and without approach will reflect the same tax rate, the impact of the new lower rate will be muted.As a result, the fair value of noncompete agreements may well be somewhat lower under the new tax rate.Cost ApproachThe cost approach, which is often used to value assets such as the assembled workforce or some technologies, the impact depends on whether a pre-tax or after-tax measurement basis is used.If fair value is measured on a pre-tax basis, the fair value of such assets is unaffected.If measured on an after-tax basis, costs avoided net of tax will be higher under lower tax rates, although this gain will be offset somewhat by the decrease in the TAB. Multi-Period Excess Earnings Method The impact of the tax rate on assets valued under the Multi-Period Excess Earnings Method (MPEEM) is more ambiguous since two key elements will be affected – the contributory asset charges and the tax rate used to derive after-tax cash flows.On the cash flow side of things, the lower tax rate will result in higher cash flow but a lower TAB.As far as contributory assets are concerned:Relief from royalty asset charges will increase under a lower tax rateWith and without scenario analysis with level payments charges will potentially decrease due to the lower base valueCost approach asset charges may increase or decrease depending on the net effect of taxes and TAB calculationsReserves & Goodwill The net impact of a lower tax rate on goodwill will vary by transaction. Since reserves are typically viewed through a pre-tax lens, the value of reserves could be muted (all else held constant). However, we note that if tax incentives increase CapEx and drilling plans, then more reserves could move up the category chain (P2 to P1 for example) and thus increase the fair value of reserves. If the lower tax rate results in a higher transaction price, the aggregate increase in fair value will likely result in a larger allocation to goodwill. This would apply more to intangible based energy companies. Upstream companies typically do not book goodwill. If, instead, the lower tax rate increases the projected IRR on a transaction, the impact on residual goodwill is harder to predict and will depend on the composition of the assets acquired.The changes to corporate taxes under the new bill are wide-ranging.In addition to the effect of lower rates discussed in this post, fair value specialists need to be alert to how other specific provisions of the bill may influence individual energy companies.Impact of Tax Rate Decrease on Valuation MethodCash Flows/Returns Higher after-tax cash flows/impact on returns depends on transaction priceTax Amortization Benefits DecreaseRelief from Royalty Method Increase (potential offset by decrease in TAB)Cost Approach (pre-tax) No ChangeCost Approach (post-tax) Increase (potential offset by decrease in TAB)With and Without Scenario Potentially lower (potential offset by decrease in TAB)MPEEM May Increase or Decrease (depends on magnitude of other changes)

Summer Reading for the RIA Community

Focus Financial’s IPO Filings

Money, being what it is, never sleeps. It also never goes on vacation. I was, however, about to spend ten days away from the office with my older daughter in Scotland and England when Focus Financial (finally) filed for a public offering. One of the most anticipated events in the wealth management industry, the pendency of the Focus IPO didn’t cancel my trip, but I knew that my vacation was going to be at least punctuated by reading the S-1 along with my peers’ commentaries. I’ve now read the 275-page document a few times, and while it’s not your typical beach novel, the Focus prospectus is required summer reading for anyone in the RIA community.The First Question to Ask of Any IPO is “Why?”Initial public offerings are sacramental in the church of capitalism. At one time, IPOs represented a coming-of-age when growing asset-needy businesses could finally have the financing they required to expand into leading, mature organizations. Today, public offerings may just represent the day when private equity backers decide they would rather someone else own a business instead of them. IPOs can, in many cases, be read as a sell-signal.In spite of this, public offerings still generate a surprising amount of enthusiasm. My daughter and I started our trip at the Aston Martin dealership in Edinburgh, and the characteristically friendly Scots there chatted excitedly about Aston Martin’s upcoming IPO whilst making sure my daughter learned the ins and outs of at least a million pounds worth of stainless-steel, aluminum, and carbon fiber. Aston Martin’s IPO not only represents permanent equity backing for a uniquely capital-intensive business, it is also the triumph of a marque bought out of obscurity by a wealthy English industrialist, Sir David Brown. Brown not only manufactured and sold tractors by the thousands, he also understood the halo effect of auto racing to underscore a nation’s industrial competitiveness, and he was tired of seeing English cars lose to the Italians. Sir David was also savvy enough to take a page out of Enzo Ferrari’s business model and financed his passion for auto racing by selling expensive road cars. It was a prescient decision for Brown, as his eponymous series of “DB” cars were adopted by a mythological British figure, James Bond, and the combination sustained the brand’s identity for fifty years. It is highly unlikely that the DB11 would exist today if Sean Connery hadn’t been assigned a DB5 as his company car in the 1960s.Today, Aston Martin is once again following in the hoof-steps of the prancing horse, as Ferrari’s 2016 public listing was a huge success (NYSE: RACE). Ferrari is much more than an automaker, of course; it is a brand. Despite devotees like yours truly, Aston Martin’s intellectual property is no match for Ferrari, which boasts an adjectival name, a primary color, and a mascot that are instantly recognizable and merchantable. For Aston Martin’s listing to be successful, it will have to make it as an automaker instead of a fashion label – no doubt a much tougher slough.What Exactly is Focus Financial?All of this brings me back to Focus Financial, whose business model is a little difficult to, well, focus. The IPO is being hailed as a validation of the RIA industry, but the RIA industry doesn’t really need validation (it is proven and profitable) and Focus isn’t really an RIA.The Focus brand, for example, doesn’t really extend to the investors with their partner firms. If you review many of their partner firm websites, for example, you don’t see much mention of Focus, and any mention certainly isn’t prominent. Focus’s brand is directed at the acquired firm, a back-of-the-house system. The storefront is still the individual tradename and people of the partner RIA. In much the same way, the Focus financial statements aren’t really the consolidated statements of their affiliate firms, but rather a specifically defined interest in the cash flows of the affiliate firms. In mathematical terms, you might say that the calculus of the Focus financial statement is the first derivative of an RIA income statement rather than the RIA income statement itself.Focus acquisition model (adapted from pages 120-121 of the prospectus) Focus Financial is an aggregation of RIA cash flow streams, contingent rights, and responsibilities. The Focus model is to acquire between 40% and 60% of an existing RIA’s earnings before partner compensation, or EBPC, which post-acquisition is referred to as “target” earnings (Focus also has a program for wirehouse broker groups who want to go independent). The remaining EBPC is retained by a management company formed by the affiliate firm as a wage pool for selling partners. Focus takes a preferred position in the affiliate firms’ EBPC; the selling partners are responsible for delivering at least the dollar portion of EBPC sold to Focus (termed the “base” earnings). Any excess above target earnings is split pro rata. This asymmetric payoff dampens the downside volatility for Focus, but obviously also raises it for selling partners. Focus has a handy chart in their S-1 that illustrates the potential repercussions of this on partner firms. As shown in the example above, assume Focus acquires 60% of a selling firm’s earnings before partner compensation and EBPC is $3 million. If revenue grows by 10%, EBPC grows to $3.5 million. In the upside scenario, selling partners and Focus share in this 40%/60%, and selling partners see their management fees increase from $1.2 million (40% of EBPC established at time of sale) to $1.4 million (the $200 thousand increase representing 40% of the overall $500 thousand increase in EBPC). One can see how enough growth in AUM enables selling partners to recover their pre-acquisition compensation level, in addition to receiving proceeds from selling rights to part of their EBPC to Focus. The downside scenario is fairly dramatic, however. In the example, a 10% drop in revenue causes the selling partner compensation pool to drop by almost half, from $1.2 million to $700 thousand, which is less than a quarter of pre-transaction partner compensation. Because we haven’t experienced a sustained bear market since Focus completed most of their acquisitions, the downside implications of this arrangement on selling partner groups (and, in turn, on Focus) aren’t yet fully known. The disproportionate risk borne by the partners of affiliate firms is, presumably, known to them – although knowledge and experience sometimes yield different outcomes. We wonder how selling partner groups would behave in a market environment in which their compensation was severely restricted, remembering that retained EBPC is effectively wages for the continuing efforts of affiliate firm leadership.How Does Focus Pay for This?As anyone who reads this blog is fully aware, RIA transactions are typically a mixture of upfront payments and contingent consideration. Focus is no different, and while the prospectus doesn’t describe a sample transaction, it is clear that Focus uses both cash and equity to provide fixed payments and earn-outs. The equity consideration is valued by Focus, apparently with the assistance of third-party appraisers (not us!). More than one commentator has suggested that a downside to Focus Financial going public is that they can no longer “assign” a value to their stock, as it will now be determined by market. I’m sure that my peers who provide valuation services to Focus don’t appreciate the slight.The valuation of Focus is, at this point, somewhat complicated, and we are very interested to see how the market treats them. In 2017, Focus reported a loss of nearly $50 million on total revenues of $663 million. Last year was a good year for most RIAs, and to explain their loss, Focus management suggests a lengthy list of adjustments to get to a pro-forma EBITDA margin of about 22%. Market pundits so far are suggesting an enterprise valuation of $2.0 to $2.5 billion for Focus, which works out to about 8x to 10x pro-forma EBITDA.The question becomes whether or not you agree with all of management’s adjustments to travel from reported to pro forma EBITDA. Some off these add-backs are not controversial (eliminating non-recurring items such as delayed offering cost expenses), but over a third of management’s adjusted EBITDA for 2017 comes from eliminating non-cash equity compensation expense and adding back the change in fair value of contingent consideration.The analyst community remains divided on how to treat equity compensation, but we quote Warren Buffett’s old saying –“If stock options aren’t compensation, then what are they? If compensation isn’t an expense, then what is it? If expenses don’t belong on the income statement, then where do they belong?”For a shareholder in an acquisition platform like Focus Financial, equity compensation and contingent consideration are dilutive to earnings per share, and one would expect them to be recurring in nature. Further, a 22% EBITDA margin is low for a large RIA – even on a reported basis. Then again, Focus isn’t really an RIA.So we don’t have a good sense of what Focus’s profit margins will be once it matures to a steady-state enterprise. The financial history shown in the S-1 doesn’t really demonstrate the kind of operating leverage we might expect, but, to be fair, I think it’s still too early to tell.What Does Focus Do After an Acquisition?While the 55 Focus partner firms employ over 2,000 people, the holding company itself has about 70 staff members, most of whom are charged with growing cash flows through acquisition or by improving affiliate firm profitability. To enhance organic growth, Focus has staff assigned to affiliate RIAs to provide them with ideas to improve operations and marketing, much as broker-dealers do for their network affiliate RIAs. Eventually, Focus will have to transition from an acquisition platform to an operating platform, and these services will become more critical to fueling the growth engine.It’s worth pointing out that there is a cost to the staff and their activities at the holding company that is borne under the Focus model but not by an otherwise independent RIA. Further, the Focus prospectus doesn’t suggest that this cost is mitigated by explicit post-acquisition synergies such as personnel redundancies, although this probably happens from time to time. In addition, the prospectus is explicit that holding company staff is there to assist partner firms with growth and operations, rather than to impose rubrics and expectations. The idea is to maintain the entrepreneurial spirit of the partner firms and to avoid “turning entrepreneurs into employees.” Can thousands of people be directed with only carrots and no sticks? Probably not, and I’ve no doubt that Focus management realizes that.One test of the Focus model is whether or not the staff at the holding company can pay for themselves. Can they improve partner firm cash flows to more than offset the cost of the aggregation? If so, this will be a big success.Does the Focus Model Work?Focus has been in operation for a dozen years now, but it’s still very much a development stage company. Focus has proven itself as an acquisition platform. RIA transactions are difficult, and Focus has managed to attract and retain 55 direct partner firms. Several of these firms have themselves engaged in acquisitions after they became part of the Focus network, bringing the total number of firms under one umbrella to 140. Indeed, one major asset Focus can boast is its knowledge of the RIA firm landscape and how to successfully acquire and integrate wealth management firms.That said, acquisitions either consume distributable cash flow (the prospectus is clear that the company does not plan to pay dividends, which is very different from typical RIAs) or result in equity issuance (which can be dilutive of existing shareholder returns). Focus can build shareholder value by arbitraging returns if it can acquire firms at a lower multiple than it trades for, but this requires the market giving it a premium multiple on a sustained basis. Since acquisition multiples in the RIA community don’t usually happen at substantial discounts to publicly traded asset managers, it may prove difficult to enhance shareholder returns through acquisition – at least on a sustained basis.No doubt Focus has plenty of room to run as an acquisition platform, but longer term shareholder returns will require Focus to develop an operating platform that widens partner firm margins and speeds revenue growth to a greater degree than those same firms would do on their own. One test is easy to measure, and the other is not. Together, they form a major part of the holding company’s “alpha.”Analysts can look at Focus’s profitability and determine whether the model enhances RIA cash flow or not; as I mentioned earlier, current margins suggest they still have room for improvement. Determining whether or not an affiliate firm is growing faster in association with Focus is more difficult – there are many variables that would have to be isolated to do that. Since management teams share in profit increases, they theoretically have incentive to help the organization grow. Post-acquisition, of course, Focus takes a pro rata piece of that increase in profitability, and while the selling generation of partners gets compensated for this in the form of earn-out payments, successive generations will not. It will be interesting to see how second-generation partner firm leadership behaves.The Focus S-1 reports organic revenue growth – essentially same store sales growth – of 13.4% for 2017 versus 2016. Organic growth for the prior two years was reported in the mid-single digits. Whether or not those organic growth rates best industry averages depends on whom you ask. We think this will be a closely studied metric for Focus as it matures.Further, because Focus is an amalgamation of RIAs which still report independently, it is possible to review ADVs and track their partner firm AUM over time. We’ve done this, and the study predictably shows a wide variety of growth patterns across these businesses which are still run as independent entities. Some appear to have grown more rapidly after being acquired by Focus, and others not so much. It would take a good bit of work to track these growth patterns relative to financial market behavior, industry trends, and to segment out partner firms that are growing at least in part because of their own acquisitions. For now, Focus’s report on organic growth may be the favored big-picture performance measure.What Questions Remain?The most significant remaining queries for Focus Financial revolve around the theme of sustainability. In the near term, can Focus continue to attract enough sellers to monetize their know-how and identity as an acquirer? In the longer term, can Focus transition into an operating brand and grow organically in such a way that it proves the value they add as an organizing force in the RIA space? Will they show growth rates and margins that prove the value-add of the holding company?Focus is organized as more of a quilt (independent businesses) than a blanket (think wirehouse). Given that, can Focus direct their partner firm employees’ and principals’ zeal while avoiding the behavioral risks that come with independence? Will Focus ultimately have to become more regimented in the investment products it offers, the marketing approaches its advisors employ, the training and compliance procedures they require, etc.? There is a natural tension in all investment management firms between development and risk management, and as firms grow, the latter usually overtakes the former.Will succeeding generation leadership at partner firms be sufficiently incented to continue the growth that first made them attractive as acquisition candidates to Focus? The selling partners of affiliate firms have a relationship with Focus that younger members do not share.Why Does All This Matter?Most of the questions I’m throwing out in this blog post apply to the broader RIA universe, and not just to Focus Financial. The Focus IPO is significant because it represents the single-most direct response to major industry issues, while at the same time leveraging industry trends. With managed assets increasingly leaving bank-controlled brokers, the retirement era of the baby-boomers leading more and more assets to independent firms, and a transition planning crisis among RIA ownership groups, someone had to develop a model to organize, if not consolidate, this highly fragmented industry. Fourteen years ago, Focus’s founder Rudy Adolf sat at his kitchen table and decided to do just that.The Focus prospectus makes it clear that engineering a profitable solution to the RIA industries primary conundrums is not, however, as easy as defining the situation itself. As a conglomeration of independent businesses, the Focus financial statements are themselves gerrymandered in a way that takes some getting used to, and we don’t think their results will track the RIA industry as closely as some have suggested.None of this detracts from what Focus has accomplished. They have developed a business model to address very difficult acquisition and integration issues and have steadily grown their brand as an acquirer in the parentage of several prominent PE sponsors. In going to market, Focus management is committing to prove viability in public filings, conference calls, and daily trading. It is a major undertaking for any company, but even more so for the one who goes first. If Focus Financial is, like Ferrari, successful as a public company, no doubt Hightower and United will, like Aston Martin, consider following their lead.We look forward to seeing more.“Dad, which button controls the ejector seat?”

Issue No. 2 | Data as of Mid-Year 2018

Feature Articles: Six Different Ways to Look at a Dealership and Value Drivers of a Store Valuation

The Permian Boom Causing a Natural Gas Bust

The oil industry is cruising. Producers are flocking to many oil rich plays, most notably the Permian Basin, Bakken, and Eagle Ford. Producers in these areas are all looking to exploit multi-zone payouts and gain significant efficiencies with new deep lateral and horizontal wells.While this strategy is working very well for oil producers, often lost in the oil excitement is the byproduct, additional dry and natural gas liquids. For producers targeting natural gas, this is not good news. The U.S. has significant natural gas. While export demand is approximately 10% to 12% of all domestically produced natural gas, high supply and demand factors have kept prices relatively flat.The Economics of the Current Price EnvironmentThe articles below address the economics of the current price environment:Thank Goodness for Natural Gas Exports (Forbes)Demand for Natural Gas is Surging, but Glut Remains (US News and World Report)Why U.S. Natural Gas Prices Will Remain Low (Forbes) While the low prices are favorable for consumers of natural gas, E&P companies are struggling. Producers of natural gas, specifically those operating in areas where crude oil is minimal, such as the Marcellus and Utica, are getting stretched thin, some beyond their ability to recover. Rex Energy Corporation (Rex) is the latest natural gas producer to file for a Chapter 11 orderly reorganization beginning with the sale of assets. Rex Energy CorporationRex Energy Corporation is an independent E&P company that produces condensate, natural gas liquid (NGL), and natural gas in the Marcellus, Utica, and Burkett Shale. On May 18th, Rex announced that, following its previously announced strategic review, it has decided to begin an orderly sale process for its remaining assets in order to maximize their long-term value and prospects. To facilitate the sale and address its debt obligations, the Company initiated voluntary proceedings under Chapter 11 of the U.S. Bankruptcy Code with support outlined in a Restructuring Support Agreement signed by 100% of its first lien lenders and approximately 72% of its second lien noteholders.A review of their financial performance over the previous five years indicates declining revenues from lower natural gas prices. Revenue increased from 2013 to 2014, then declined during 2015-2017. This behavior is consistent with commodity price fluctuations. Operating income followed a similar trend which put pressure on the company to use debt to fill the gap. Debt doubled from 2013 through March 2018 and interest expense increased during all years and peaked at $62 million during the LTM March 2018 period. All of this was done hoping natural gas prices would increase to the point Rex could reach profitability. However, Rex ran out of time.Other Marcellus and Utica OperatorsRex is not the only Marcellus and Utica operator with this trend. CNX Resources, Eclipse Resources and EV Energy Partners all have stock charts with similar trends. Diversified Gas and Oil is the only publicly traded Marcellus and Utica focused producer with a stock price trend bucking the macro environment. They are also relatively new to the publicly traded scene, having been publicly traded for less than two year.CNX Resources, Eclipse Resources and EV Energy Partners have seen price declines on the order of 50% to 100% since mid-2014. Eclipse Resources, for example, experienced a rapid fall in its stock price after raising $818 million in a U.S. initial public offering. Its stock price has fallen by nearly 100% and last month Eclipse announced that they were evaluating different options to maximize company value such as engaging in accretive acquisitions or sale of the company.The performance of all the E&P companies named above is shown below. Descriptions of each company are included below per their respective 10Ks. CNX Resources Corporation, an independent oil and natural gas company, explores for, develops, and produces natural gas in the Appalachian Basin. As of December 31, 2017, it had 7.6 trillion cubic feet equivalent of proved natural gas reserves. The company also owns, operates, and develops natural gas gathering and other midstream energy assets in the Marcellus Shale in Pennsylvania and West Virginia. The company was formerly known as CONSOL Energy Inc. and changed its name to CNX Resources Corporation in November 2017.Eclipse Resources Corporation, an independent exploration and production company, acquires and develops oil and natural gas properties in the Appalachian Basin. The company holds interests in the Utica Shale and Marcellus Shale areas.EV Energy Partners, L.P., through its subsidiaries, engages in the acquisition, development, and production of oil and natural gas properties in the United States. Its properties are located in the Barnett Shale; the San Juan Basin; the Appalachian Basin; Michigan; Central Texas; the Monroe Field in Northern Louisiana; the Mid–Continent areas in Oklahoma, Texas, Arkansas, Kansas, and Louisiana; and the Permian Basin.Diversified Gas & Oil PLC engages in the production of natural gas and crude oil in the Appalachian Basin of the United States. It has interests in the oil and gas properties in Pennsylvania, Ohio, and West Virginia. As shown below, it has not experienced the same declines in price as many of the other producers in the region.ConclusionWhile these macro issues have been impacting the industry for years, many investors have expected supply to fall to the point of creating higher prices. As this Wall Street Journal article points out, many investors had to adjust their investment time horizon. Investments made during 2014 and 2015 have not been exited by hedge funds like Fir Tree due to lower than expected public demand. Fir Tree’s energy investment strategy included purchasing the debt of failing companies only to flip it into a controlling equity position in the “emerged from bankruptcy” company. While they have been somewhat successful in this strategy, their holding periods are longer than originally planned. It appears investor’s are salivating for more companies like Amazon and less for companies like Sandridge Energy. While the headlines are focused on Permian Basin winners, the rest of the oil and gas market is not as cheery. The mixed bag of winners and losers makes the industry tricky to operate within.We have assisted many clients with various valuation needs in the upstream oil and gas space in the Marcellus and Utica areas, other conventional and unconventional plays in North America and around the world. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.

1Q18 Call Reports

After a strong start to the year driven by tax reform and global economic growth, markets reversed in February and March and volatility picked up significantly. While most publicly-traded asset managers posted negative returns for the quarter, the return of market volatility may be an opportunity for certain active managers. The first quarter also saw notable changes on the regulatory front, with the DOL Rule being struck down and the SEC proposing the new “best interest” standard for brokers. On the fixed income side, the yield curve continued to flatten during the first quarter, and higher short-term rates may pull cash off of the sideline and into fixed income products.As we do every quarter, we take a look at some of the earnings commentary of pacesetters in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: The return of volatility to the markets offers opportunity for active managers.[W]hile we have started with the equity markets generally moving upward in January, the trend broke down in February and March as volatility increased as a dispersion across and within those markets. In this environment, the best active managers were able to outperform, and many of our Affiliates generated meaningful alpha. – Nathaniel Dalton, President & COO, Affiliated Mangers Group, Inc.Over the last year or so, we have seen correlations declining, and more recently, we have seen increased volatility and rising interest rates. We may be returning to a world in which investment returns are not overwhelmed by central bank policy. We believe that's an environment in which asset allocators will place greater importance on high value-added investing and an environment in which value-added should be more apparent. – Eric Richard Colson, Chairman, President, & CEO, Artisan Partners Asset ManagementWe are optimistic that this higher level of volatility, combined with a gradual trend toward the normalization of monetary policy on the part of global central banks will continue to improve the investment backdrop for active managers. – Philip James Sanders, CEO, Chief Investment Officer & Director, Waddell & ReedTheme 2: The regulatory environment continues to evolve with the DOL Rule recently being vacated and the SEC’s recent “best interest rule” proposal.Obviously, we're at the very early beginning of [the SEC proposal], which will have a longer road ahead of it before it likely moves forward into any type of finalization of becoming a rule. But the early indications are based on it being more of a disclosure-based rule. It does provide for the additional flexibility with regard to the broker/dealer, not causing significant cost increase associated with the broker/dealer and the financial advisers that we support. So we're going to continue to monitor that. I don't expect at least in the initial stages that to hamper our ability to increase our advisers' overall annual productivity ranges, but we're going to continue to monitor what happens in this space with regard to the SEC rule proposal. – Shawn Michael Mihal, President, COO & Director, Waddell & Reed With the changes in the DOL rules, a lot of the financial advisers have been using index-like and ETF products to create model portfolios and build those model portfolios with the least expensive products. But as the cycles start to change, they will start to incorporate more active products in that both active fixed income and active equities. – Robert Steven Kapito, President & Director, Blackrock[T]he new … higher standard of conduct or new best interest standard that is under comment period with increasing the suitability requirements and disclosure. I think what's important in the proposal is that certainly, brokerage as it exists today, can survive and doesn't have to be modified to a level where you can't have differentiated commissions … And so I think it would slow down the acceleration of movement from brokerage to advisory accounts, and the urgency to do that would not be there. – Gregory Eugene Johnson, Chairman & CEO, Franklin ResourcesTheme 3: Rising yield curve may pull cash from the sidelines and into fixed income products.We see at least three broad opportunities for our fixed income business in a higher rate environment. First, higher rates are attractive for the retail investor and should increase flows. Second, higher rates create the need to rebalance into fixed income for many institutional investors. And third, regardless of the rate environment, the opportunity always exists with strong investment performance to take share. – Joseph A. Sullivan, Chairman, CEO & President, Legg Mason[W]e estimate there's over $50 trillion of cash that's sitting in bank accounts earning less than 1%, in some places, negative. So as rates go up, especially in the short end, that is going to attract a lot of this cash into the fixed income markets, of which we can manage that money rather directly into the normal fixed income products or into ETF fixed income products, which seem to be getting a lot of the new flows from rises in rates. – Robert Steven Kapito, President & Director, BlackrockWhile the prospects of rising rates tends to push investors away from long-dated fixed income, the flat curve is creating strong relative risk-return opportunities in short duration funds and cash management strategies, which we saw clients take advantage of in the first quarter. – Laurence Douglas Fink, Chairman & CEO, BlackrockMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Potential for Platooning

Would you follow another truck at less than 50 feet if it could create marginal improvements in fuel efficiency? Under normal circumstances, that would be dangerously reckless. However, platooning technology might make this realistic – and safe – option for truck drivers in the near future.

Royalty Interests and the Importance of the Operator

In previous posts, we have discussed the market pricing implications of publicly traded royalty trusts to royalty and mineral owners. We have explained the importance of understanding the specifics underlying those trusts before using them as a pricing benchmark. In this post, we will delve further into market prices of royalty and mineral interests and the important role of operators. We will look into the three publicly traded royalty trusts operated by SandRidge Energy: SandRidge Mississippian Trust I, SandRidge Mississippian Trust II, and SandRidge Permian Trust.Market Observations1Over the previous two years, the performance of the 21 publicly traded royalty trusts has varied widely. Thirteen have experienced positive market value returns with an average of positive 57% and eight have returned market value losses during the previous two years with an average market value return of negative 39%.Clearly, there are some winners and losers, with more winners than losers. The royalty trust with the highest market value return was Whiting USA Trust II (WHZT) (+330%), which was discussed in a recent blog post. Mesa Royalty Trust (MRT) (47%) was another big winner covered in a previous blog post. However, the focus of this blog post will be on some of the underachievers: SandRidge Mississippian Trust I (SDT) (-76%), SandRidge Mississippian Trust II (SDR) (-61%), and the SandRidge Permian Trust (PER) (-21%).For comparison, the chart below shows the returns from PER, SDR, SDT, crude oil, natural gas, and the S&P 500. Why has the value of these SandRidge Trusts depreciated so much over the past two years despite increasing commodity prices? Also, why has the Permian trust fared better than the Mississippian Trusts? Below is a discussion of the assets, underlying properties, and agreements of each Trust. SandRidge Mississippian Trust IThe only asset of the Trust is the conveyance of the Royalty Interests by SandRidge Energy, Inc. The Royalty Interest entitles the Trust to receive:90% of the proceeds from the sale of oil, natural gas, and natural gas liquids ("NGL") production attributable to SandRidge’s net revenue interests in 36 wells producing at December 31, 2010, and one additional well undergoing completion operations at that time (together, the “Initial Wells”).50% of such proceeds from 123 “Trust Development Wells” drilled within an area of mutual interest (“AMI”) Pursuant to a development agreement entered into between the Trust and SandRidge, SandRidge was obligated to drill, or cause to be drilled, the Trust Development Wells by December 31, 2015. SandRidge fulfilled this obligation in April 2013. SDT’s Royalty Interests are in specified oil and natural gas properties located in the Mississippian formation in Alfalfa, Garfield, Grant, and Woods counties in northern Oklahoma.SandRidge Mississippian Trust IIThe only asset of the Trust is the conveyance of the Royalty Interests by SandRidge Energy, Inc. The Royalty Interest entitles the Trust to receive:80% of the proceeds from the sale of oil, natural gas, and natural gas liquids ("NGL") production attributable to SandRidge’s net revenue interests in 54 wells producing at December 31, 2011, and 13 additional wells awaiting completion at that time70% of such proceeds from 206 horizontal “Trust Development Wells” drilled within an area of mutual interest (“AMI”) Pursuant to a development agreement entered into between the Trust and SandRidge, SandRidge was obligated to drill the Trust Development Wells by December 31, 2016. SandRidge fulfilled this obligation in March 2015. SDR’s Royalty Interests are in specified oil and natural gas properties also located in the Mississippian formation in Alfalfa, Grant, Kay, Noble and Woods counties in northern Oklahoma, as well as Barber, Comanche, Harper, and Sumner counties in southern Kansas.SandRidge Permian TrustThe only asset of the Trust is the conveyance of the Royalty Interests by SandRidge Energy, Inc. The Royalty Interest entitles the Trust to receive:80% of the proceeds from the sale of oil, natural gas, and natural gas liquids ("NGL") production attributable to SandRidge’s net revenue interests in 517 wells producing at April 1, 2011, and 21 additional wells awaiting completion at that time70% of such proceeds from 888 horizontal “Trust Development Wells” drilled within an area of mutual interest (“AMI”) Pursuant to a development agreement entered into between the Trust and SandRidge, SandRidge was obligated to drill the Trust Development Wells by March 31, 2016. SandRidge fulfilled this obligation in November 2014. PER’s Royalty Interests are in specified oil and natural gas properties in the Fuhrman-Mascho field in Andrews County, Texas, which is a part of the prolific Permian Basin. It should be noted that this is outside the two main Permian sub-basins (the Delaware Basin and the Midland Basin). Nevertheless, the Permian's attractive location and increased well count likely explains why the Permian Trust outperformed the Mississippian Trusts. The following table shows important production and reserve data for the underlying properties, as well as SandRidge’s ownership in the Trusts’ units and other pertinent data. The Trusts no longer have any hedging derivatives contracts, so they are exposed to oil and natural gas price volatility. Analysis of TrustsDevelopment Wells and Area of Mutual InterestEach of the Trusts receives 80-90% of the proceeds from the sale of oil, natural gas, and NGLs (after deducting post-production costs and any applicable taxes). This is fairly common for publicly traded royalty trusts, but the Trust Development Wells are unique. At the IPO date for each Trust, well counts were relatively low. In fact, the initial wells made up less than 25% of the total well counts for the Mississippian Trusts and about 38% of the Permian Trust. This agreement allowed the Trusts to make distributions from currently producing wells in addition to offering growth opportunities with the future development wells.The “development” aspect of the wells would seem to cast doubt upon the production of each Trust if it did not end up developing the total number of wells required or in a timely manner. The development agreement offered protection to investors. It is important to note that SandRidge fulfilled its development obligation in plenty of time in each case. Investors were further protected with the clause ensuring wells would be drilled in an area of mutual interest (AMI). This means SandRidge could not drill wells in random locations to fulfill its obligation.DistributionsThe Trusts make quarterly cash distributions of substantially all of its cash receipts, after deducting amounts for the Trusts’ administrative expenses and cash reserves withheld by the Trustee. The price for oil peaked in 2014 near $108 per barrel and close to $8 for natural gas before declining sharply in the latter half of the year. The low point was seen in late 2015, early 2016, with prices of approximately $28 and $1.64, for oil and gas. Prices currently stand around $68 per barrel and $2.80 per MCF, respectively. The steep decline in oil and gas prices in mid-2014 had a crippling effect on distributions. The following chart tracks the quarterly distributions per share for the Trusts since 2012.Termination of the Trusts The Trusts will dissolve and begin to liquidate on the “Termination Date” (noted in the table above). At the Termination Date, 50% of the Royalty Interests will revert automatically to SandRidge. The remaining 50% of the Royalty Interests will be sold at that time, and the net proceeds of the sale, as well as any remaining Trust cash reserves, will be distributed to the unitholders on a pro rata basis. SandRidge has a right of first refusal to purchase the Royalty Interests retained by the Trust at the Termination Date. There are certain provisions protecting investors in the case the Trust were to dissolve prior to the Termination Date, such as a requirement that cash available for distributions be above a certain threshold, as noted in the table above. The Trusts are highly dependent on its Trustor, SandRidge, for multiple services including the operation of the Trust wells, remittance of net proceeds from the sale of associated production to the Trusts, administrative services such as accounting, tax preparation, bookkeeping, and informational services performed on behalf of the Trusts. For these administrative services, the Trusts pay SandRidge an annual fee (noted in the table above) which is payable in equal quarterly installments and will remain fixed for the life of the Trusts. SandRidge is also entitled to receive reimbursement for its out-of-pocket fees, costs, and expenses incurred in connection with the provision of any of the services under this agreement. SandRidge Energy and the Importance of the OperatorSandRidge Energy (SD) is an oil and natural gas exploration and production company headquartered in Oklahoma City. According to SD's website, its principal focus is on developing high-return, growth-oriented projects in the US Mid-Continent and Niobrara Shale.SandRidge filed for Chapter 11 bankruptcy in May 2016 and emerged from bankruptcy in October 2016, as we discussed in a blog post around that time. SandRidge was relisted on the NYSE around $19.50 per share. Its performance has been volatile and generally negative since, as seen in the chart below. Activist investor Carl Icahn spent $82 million in October and November 2017 to acquire about 13.5% of SandRidge stock. Since he became a shareholder, Icahn has had a large impact, causing directors to cancel their planned $746 million purchase of Bonanza Creek Energy and lay off 80 employees including their CEO and CFO. He also played a role in the rejection of an acquisition attempt by Tulsa-based Midstates Petroleum Inc. in February. Icahn recently expressed "grave concerns" with the board, claiming it had “a history of making poor decisions on behalf of stockholders.” Market confidence for SandRidge Energy is very low, after having gone through a bankruptcy-related restructuring recently as well. These concerns are significant to the SandRidge Trusts because operators play a vital role for royalty interests. They are responsible for production, without which, there are no distributions. If an operator is unable to produce or becomes less focused on a particular well or region, the royalty interests attached to them are worth significantly less. In the case of the SandRidge Trusts, turmoil with the operator has put future production into question. The lack of control for the royalty interests means they are tied to the fortunes of the operator. Even for securities with yields above 20%, the unsustainability of these distributions does not inspire confidence in investors. ConclusionThe operator is a key consideration for owners of royalty interests, particularly those interested in selling. As outlined in our post last week, offers received for royalty interests can be heavily dependent on operators and the uncertainty related to a change in operator.Owners of mineral interests typically receive offers as multiples of average monthly revenue received. These multiples are typically determined by commodity prices, quality of operators, growth opportunities, and market sentiment. While owners of royalty interests do not have much control over these factors, they provide important starting points when considering selling.We have assisted many clients with various valuation and cash flow questions regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.[1] Capital IQ

What’s the Latest on Broker Protocol?

It’s been several months since Morgan Stanley and UBS departed from the Protocol for Broker Recruiting, and the industry is continuing to feel the ripple effects of their maneuver. Much remains to be seen, but many analysts expect more firms to abandon the protocol despite Wells Fargo’s and Merrill Lynch’s recent announcements to stick with it for now. All of these firms were early adopters of the protocol, which has grown to include nearly 1,800 firms today.A Changing TideHistorically, firms have joined the protocol with the expectation that they could maintain a lock on their advisors due to their distinct advantages in trading capabilities and investment offerings over the independent model. However, recent technological advancements make it easier for advisors to become registered and serve clients on their own. Advisors also now have the option of the consolidator route through which firms like Dynasty Financial Partners, HighTower Advisors, Focus Financial Partners, and United Capital provide them with liquidity options and greater autonomy to serve clients and recruit other advisors.There’s also the issue of vesting schedules and expiring contracts that were signed at the peak of the last financial crisis. Many of the brokers who signed retention deals at Merrill Lynch or UBS in 2009 are now fully vested and more incentivized to jump ship. Meanwhile, the FAs at Morgan Stanley who received retention deals as a result of the JV with Smith Barney in 2009 will become free agents at the end of this year.Another side effect of the protocol is the increasing consolidation of the IBD space. Many wirehouse FAs are turning to the IBD model to gain access to an RIA platform with the continued support and resources that a broker-dealer can provide. According to an InvestmentNews report, the three largest IBDs (Ameriprise, LPL Financial, and Raymond James) saw a 42% increase in FA recruitment during 2017. Simply put, the RIA/IBD hybrid model is a more appealing alternative over the wirehouse model in the eyes of many FAs looking for a change.The UndercurrentStill, firms like Raymond James that have used the protocol to successfully poach advisors from their competitors will likely stick around. The few net winners in the wirehouse recruitment saga over the last ten years have little or no reason to abandon protocol. Many have lost more advisors than they’ve recruited; therefore, it’s hard to stay with a program that clearly hasn’t helped them. One could certainly view the departure of Morgan Stanley and UBS as a concession of their own inability to effectively recruit and retain during the protocol era.Many FAs may find it more difficult to sell their book of business (or at least realize full value) in a post-protocol world. If it’s riskier and more expensive to join another broker-dealer, then current employers could use these circumstances to reduce payouts to their advisors. It could also be more challenging to transfer clients to another platform, thereby limiting the number of prospective buyers. In short, FA economics are not likely to improve when their employers decide to break protocol.Impact on RIA Valuations & DealsWhat about RIA valuations? Abandoning protocol should make it easier to retain FAs but also makes it harder to recruit from other firms that have done the same. We’ll call that a tie. If RIAs can use this to gain leverage over their advisors and offer lower payouts, then margins and profitability should improve. Valuations should improve on higher earnings, so, on balance, this could be bullish for RIAs and the wealth management industry (at least from the employer’s perspective). Still, not everyone will abandon protocol. Many RIAs do not recruit experienced hires and will likely be unaffected by recent events.The effect on sector deal making will likely be more nuanced. Matt Sonnen and his team at PFI Advisors see this as a major opportunity for RIAs to recruit from the wirehouses before the door shuts and more firms abandon protocol. It appears that we’ve already seen some of this take place: This trend should continue until the dust settles at which point it will make the transition process riskier and more expensive. When this happens we could see a curtailment of the recent momentum though it seems unlikely that we would revert back to 2013-14 levels in the absence of another bear market. We’ll keep you apprised of how all this shakes out in future posts. Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

WHITEPAPER | Valuing and Transacting Your Wholesale Beverage Distributorship

In Valuation and Transaction Advisory Considerations for Wholesale Beverage Distributors, Tim Lee offers important insights for principals of distributorships, their legal advisors, as well as wholesaler CFOs, board members, and lenders. This paper includes an in-depth discussion of industry rules of thumb, helps you understand basic valuation theory and how the realities of the industry reconcile to the fundamentals of financial valuation and M&A strategy. The paper also includes examples of differing transaction scenarios and tools for assessing how transaction values and deal financing translate to investment return.The author, Tim Lee, is an expert on valuation and transaction issues in the beverage industry. This comprehensive paper (45 pages) equips the reader with the knowledge to understand how valuation relates to big-picture decision making.

Royalty Trusts: I’m a Revenue Partner… No, Wait… That Looks Like Equity

In previous posts, we have discussed the existence of publicly traded royalty trusts & partnerships and their market pricing implications to royalty owners. Before using publicly traded royalty trusts as a pricing reference for your royalty interest, it is important to understand the economic rights and restrictions within those royalty trusts. Many publicly traded trusts have a set number of wells generating royalty income at declining rates for multiple years to come. In contrast, some trusts participate in a number of wells that have not been drilled, which represent upside potential for investors. Future growth and outlook potential for these publicly traded trusts are significantly different. A potential investor would want to know the details. The same is true for a privately held royalty interest.Market Observations1As of April 25, 2018, there are approximately 21 publicly traded oil and gas-focused royalty trusts and partnerships.Figure 1Over the previous two years, the performance of the 21 publicly traded royalty trusts has been a mixed bag. Eight have returned market value losses during the previous two years with an average market value return of negative 39%. Thirteen have experienced positive market value returns with an average of positive 57%.Contrast this wide return with the price of crude oil and natural gas which have both increased over the same period (Figure 2). Oil has consistently marched from $45 to $68, while dry gas has climbed from $1.88 to $2.79.Figure 2Clearly, there are some winners and losers among the 21 royalty trusts over the previous two years and, noticeably, more winners than losers. As seen in Figure 1, the royalty trust with the highest market value return was Whiting USA Trust II (WHZT) (+330%) over the previous two years, with MV Oil Trust (+69%) and VOC Energy Trust (+59%) coming in second and third, respectively.Why did Whiting USA Trust II outperform all other royalty trusts over the previous two years and what is the nature of its economic rights and restrictions?Whiting USA Trust II (WHZT)Recent Pricing ActivityOver the previous two years, WHZT's stock price has increased from $0.50 to $2.15, an increase of 330% (Figure 3). Much of this increase was a steady climb from $0.50 to $1.50 as of April 5, 2018, which represents an increase of 200%. The last movement of $0.65 occurred in the previous 20 days. WHZT released their most recent 8K and 10K on March 23 and March 22, respectively. It appears it took the market a few weeks to get around to reading it. Additionally, the pricing activity is functioning much more like a working interest versus a royalty interest. Digging deeper will help us learn why.Figure 3Description of Assets Owned by WHZTWHZT assets include “term net profits interest in the oil and gas producing properties located in the Permian Basin, Rocky Mountains, Gulf Coast, and Mid-Continent regions” as described in their latest 10K filing:[The term net profits interest (NPI)] represents the right for the Trust to receive 90% of the net proceeds from Whiting’s interests in certain existing oil, natural gas and natural gas liquid producing properties which are referred to as “the underlying properties”. The underlying properties are located in the Permian Basin, Rocky Mountains, Gulf Coast and Mid- Continent regions of the United States. The underlying properties include interests in 1,312 gross (376.7 net) producing oil and gas wells as of December 31, 2017.Overall, these positions look positive as the Permian Basin is the most popular North American play currently and the Rocky Mountains, Gulf Coast, and Mid-Continent have positive characteristics too.Is an NPI Closer to a Royalty or Working Interest?The NPI represents a 28.7% profits interest in the producing oil and gas wells of Whiting. Net proceeds are calculated in the following manner: (1) Quantity of oil, gas and natural gas liquids times the price of oil, natural gas or natural gas liquids; minus (2) lease operating costs and workover costs; minus (3) production and property taxes; minus (4) development costs, hedge payments and all such production and development costs; minus (5) a maximum reserve of $2 million for future development. If the result of this formula is positive, 90% is distributed to the unitholders of WHZT. If the result is negative, the unitholders of WHZT are not liable currently. Unitholders are quasi-liable with any future net profits as accumulated losses will be zeroed out with future gains until there is a gain greater than zero.It appears an NPI is a fancy term for working interest. If not for the protection of direct capital calls, there is not a significant difference between an NPI and working interest, or any material difference from what we read. Indirectly, the unitholders are making capital calls, in the form of the promise to pay off any accumulated losses with future income before receiving any distributions.On the positive side, the 10K does appear to communicate relief in the form of limited and capital expenditures deducted from the NPI calculation. As of January 2018, capital expenditures included in the net profits calculations were limited. The annual limitation, effective January 1, 2018, is the average annual capital expenditure amount for the previous three years. Therefore, the capital expenditure limitation for 2018 is approximately $4.0 million. This limitation is new for 2018.Based upon the NPI calculation, make whole provision for accumulated losses, and the limited capital expenditure protection, the unitholders of WHZT appear to own a working interest in the oil and gas properties versus a royalty interest.Distributions to UnitholderPerhaps part of the publicly traded price activity can be explained by considering the historical distribution pattern to unitholders (Figure 4). Distributions are based upon the NPI formula discussed above. Since its inception in 2012, distributions have been consistent during Q2 2012 through Q3 2014, at which point distributions decline for the remainder of 2014, 2016 and are non-existent for much of 2016. Based on the data available, future distributions appear to be uncertain, erratic and dependent on oil prices, operating expenses and capital expenditures, to name the large items.Figure 4Specific Time HorizonWHZT also has a specific time horizon before the trust will be terminated and shutdown. WHZT will be shut down when the first occurs:(a) the NPI termination date, which is the later to occur of (1) December 31, 2021, or (2) the time when 11.79 MMBOE have been produced from the underlying properties and sold (which amount is the equivalent of 10.61 MMBOE in respect of the Trust’s right to receive 90% of the net proceeds from such reserves pursuant to the NPI), or;(b) the sale of the net profits interest. The Trust is required to sell the NPI and liquidate if cash proceeds to the Trust from the net profits interest are less than $2.0 million for each of any two consecutive years. During the years ended December 31, 2017 and 2016, the Trust received cash proceeds of $6.7 million and $1.9 million, respectively, from the net profits interest. As of the end of 2017, WHZT has received approximately 75% of the MMBOE attributable to the NPI. As of the latest reserve report (year-end 2017) the NPI is projected to receive 10.61 MMBOE prior to the December 31, 2021 date. A liquidation and termination of the trust appears to be within a four-year horizon.Underlying Property Description2The underlying properties consist of certain oil and natural gas producing properties located in the Permian Basin, Rocky Mountains, Gulf Coast, and Mid-Continent areas. The underlying properties include interests in 1,312 gross (376.7 net) producing oil and natural gas wells located in 47 mature fields with established production profiles.As of December 31, 2017, approximately 98.9% of estimated proved reserves attributable to the trust were classified as proved developed producing reserves and 1.1% were classified as proved developed non-producing reserves. For the year ended December 31, 2017, the net production attributable to the underlying properties was 1,168 MBOE or 3,199 BOE/d. Whiting operates approximately 65% of the underlying properties based on the December 31, 2017 reserve report standardized measure of discounted future net cash flows.Figure 5 summarizes estimated proved reserves and the standardized measure of discounted future net cash flows as of December 31, 2017 attributable to (i) the Trust based on the term of its NPI, and (ii) the underlying properties on a full economic life basis (dollars in thousands):Figure 5Trust Rights and RestrictionsSurprisingly, a unitholder within this trust can have significant power, compared to other comparable entities. The Trustee or a Trust unitholder, holding at least 10%, may call meetings of the unitholders. Each Trust unitholder is entitled to one vote for each unit owned and the majority of unitholders can:Dissolve the trustRemove the trustee or the Delaware trusteeAmend the trust agreementMerge or consolidate with another entityApprove the sale of assets in certain circumstances;Agree to amend or terminate the conveyance;AnalysisAccording to the IPO price on March 28, 2012, the net profits interest was given a market value of $418 million. The same properties are given a current market value of $39.6 million six years later. This change represents a decline of 90%. Furthermore, the current market value is approximately $10 million more than the most recent reserve report present value measures ($29.1 million).It is clear the market anticipates positive factors to push the underlying property cash flows higher compared to the 2017 reserve report. Based upon the latest 10K, we know the additional future cash flow will not come from new wells, as all wells within the property are classified as PDP or PDNP. No PUD’s or other classification of reserves has been identified. Therefore, the increase in cash flows is coming from higher commodity prices, lower operating costs or lower development costs.Either way, with over six years of production history, it appears optimistic that operations will become more efficient in years seven, eight and nine than they have been in years one through six. This leaves future commodity prices as the only logical lever left to base an increase. Additionally, with the market value holding close to $40 million dollars, an investment of approximately 51% or nearly $20 million, would allow for significant powers within the Trust. Given that the market value appears to be higher than the underlying asset value, a strong strategic case would need to be presented for that action to be logical.ConclusionThis discussion is an example of the importance of understanding the details about your royalty interest or in the case of WHZT, your net profits/working interest. Consideration must be given to the underlying assets, current and future wells, outlook for oil and gas prices, rights and restrictions of the mineral rights owner, lease terms, distributions, etc. WHZT is also an example of why some publicly traded royalty trusts are not appropriate to use for comparison. WHZT may best be used for a working interest comparable but definitely not a royalty interest comparable.Mercer Capital is an employee-owned independent financial advisory firm with significant experience (both nationally and internationally) valuing assets and companies in the energy industry (primarily oil and gas, bio fuels and other minerals). Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. As a disinterested party, we can help you understand the fair market value of your royalty interest and provide confidence that you get a fair price for your interest. Contact anyone on Mercer Capital’s Oil & Gas team to discuss your royalty interest valuation questions in confidence.1 Capital IQ2 WHZT 2017 10K

Purchase Accounting Considerations for Banks Acquiring Asset Managers

As banks of all sizes seek new ways to differentiate themselves in a competitive market, we see many banks contemplating the acquisition of an existing asset management firm as a way to expand and diversify the range of services they can offer to clients. Following a transaction, the bank is required under accounting standards to allocate the purchase price to the various tangible and intangible assets acquired. As noted in the following figure, the acquired assets are measured at fair value. Transaction structures between banks and asset managers can be complicated, often including deal term nuances and clauses that have significant impact on fair value. Purchase agreements may include balance sheet adjustments, client consent thresholds, earnouts, and specific requirements regarding the treatment of other existing documents like buy-sell agreements. Asset management firms are unique entities with value attributed to a number of different metrics (assets under management, management fee revenue, realized fee margin, etc.). It is important to understand how the characteristics of the asset management industry, in general, and those attributable to a specific firm, influence the values of the assets acquired in these transactions. Common intangible assets acquired in the purchase of a private asset manager include the trade name, existing customer relationships, non-competition agreements with executives, and the assembled workforce. Trade NameThe deal terms we see employ a wide range of possible treatments for the trade name acquired in the transaction. The bank will need to make a decision about whether to continue using the asset manager’s name into perpetuity or only use it during a transition period as the asset manager’s services are brought under the bank’s name. This decision can depend on a number of factors, including the asset manager’s reputation within a specific market, the bank’s desire to bring its services under a single name, and the ease of transitioning the asset manager’s existing client base. However, if the bank plans immediately to take asset management services under its own name and discontinue use of the firm’s name, then the only value allocable to the tradename would be defensive.In general, the value of a trade name can be derived with reference to the royalty costs avoided through ownership of the name. A royalty rate is often estimated through comparison with comparable transactions and an analysis of the characteristics of the individual firm name. The present value of cost savings achieved by owning rather than licensing the name over the future period of use is a measure of the value of the trade name.Customer RelationshipsThe nature of relationships between clients and portfolio managers often gives rise an allocation to the existing customer relationships transferred in a transaction. Generally, the value of existing customer relationships is based on the revenue and profitability expected to be generated by the accounts, factoring in an expectation of annual account attrition. Attrition can be estimated using analysis of historical client data or prospective characteristics of the client base. Many of the agreements we see include a clause that requires a certain percentage of clients to consent to transfer their accounts in order for the deal to close at the stated price. If the asset manager secures less than the required amount of client consents, the purchase price may be adjusted downward or the deal may be terminated entirely. Due to their long-term nature and importance as a driver of revenue in the asset management industry, customer relationships may command a relatively high portion of the allocated value.Non-Competition AgreementsIn many asset management firms, a few top executives or portfolio managers account for a large portion of new client generation and are often being groomed for succession planning. Deals involving such firms will typically include non-competition and non-solicitation agreements that limit the potential damage to the company’s client and employee bases if such individuals were to leave.These agreements often prohibit the individuals from soliciting business from existing clients or recruiting current employees of the company. In certain situations, the agreement may also restrict the individuals from starting or working for a competing firm within the same market. The value attributable to a non-competition agreement is derived from the expected impact competition from the covered individuals would have on the firm’s cash flow and the likelihood of those individuals competing absent the agreement. In the agreements we’ve observed, a restricted period of two to five years is common.Assembled WorkforceIn general, the value of the assembled workforce is a function of the saved hiring and assembly costs associated with finding and training new talent. However, in a relationship-based industry like asset management, getting a new portfolio or investment manager up to speed can include months of networking and building a client base, in addition to learning the operations of the firm. Employees’ ability to establish and maintain these client networks can be a key factor in a firm’s ability to find, retain, and grow its business. An existing employee base with market knowledge, strong client relationships, and an existing network often may command a higher value allocation to the assembled workforce. Unlike the intangible assets previously discussed, the assembled workforce is valued as a component of valuing the other assets. It is not recognized or reported separately, but rather as an element of goodwill.GoodwillGoodwill arises in transactions as the difference between the price paid for a company and the value of its identifiable assets (tangible and intangible). Expectations of synergies, strategic market location, and access to a certain client group are common examples of goodwill value derived from the acquisition of an asset manager. The presence of these non-separable assets and characteristics in a transaction can contribute to the allocation of value to goodwill.EarnoutsIn the purchase price allocations we do for banks and asset managers, we frequently see an earnout structured into the deal as a mechanism for bridging the gap between the price the bank wants to pay and the price the asset manager wants to receive. Earnout payments can be based on asset retention, fee revenue growth, or generation of new revenue from additional product offerings. Structuring a portion of the total purchase consideration as an earnout provides some downside protection for the bank, while rewarding the asset management firm for continuity of performance or growth. Earnout arrangements represent a contingent liability that must be recorded at fair value on the acquisition date.ConclusionThe proper allocation of value to intangible assets and the calculation of asset fair values require both valuation expertise and knowledge of the subject industry. Mercer Capital brings these together in our extensive experience providing fair value and other valuation work for the asset management industry. If your company is involved in or is contemplating a transaction, call one of our professionals to discuss your valuation needs in confidence.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Eagle Ford – 2017/2018 Acquisition & Divestiture Commentary

Transaction activity in the Eagle Ford Shale has been fairly steady over the past 12 months, with the majority of transactions in the $100-300 million range. The seller’s rationale has most often been about balance sheet management and re-allocation to other plays, usually the Permian Basin. However, the Eagle Ford area has some quality economics of its own, which has been attractive to buyers. Many argue it has the best shale production economics in the U.S. next to the Permian Basin. These differing strategy based swaps have been at the heart of transaction flow. This has also led to consideration that Devon may sell its Eagle Ford division in search of returns elsewhere. The chart below, drawn from Mercer Capital’s newsletter, shows some details in regards to the transactions including some comparative valuation metrics.Magnolia – Blank Check Company forms a New South Texas ProducerThe largest transaction in the past year was the recent announcement of a special purpose acquisition entity (“SPAC”) coming to an agreement with certain Enervest controlled funds. The result of the merger is the creation of a pure play Eagle Ford and Austin Chalk company with 360,000 net acres in South Texas. The majority of that acreage is in what is known as the Giddings field which is an oil play in the Austin Chalk (mostly held by production).Break-evens are claimed to be in the low $30’s per barrel with one year (or less) paybacks in Karnes and Giddings field. Magnolia1 is led by a former Occidental Petroleum executive, Steve Chazen, who has both short and long-term optimism for the opportunity. Estimated EBITDA for 2018 is projected at $513 million including approximately $240 million of cash flow after capital expenditures.Highest and Best EconomicsDenver-based Sundance Energy Australia Ltd. struck a deal with Pioneer Natural Resource Co. to buy almost 22,000 acres and 1,800 boe/d of production in the Eagle Ford Shale, bolting on to an existing leasehold in South Texas.The pure-play Eagle Ford player agreed to pay $221.5 million for the leasehold, which runs through McMullen, Atascosa, LaSalle and Live Oak counties. The transaction would give Sundance 56,600 total acres in the play, with an inventory of 716 gross undrilled locations.Meanwhile, Pioneer was exiting to focus on the Permian Basin. Pioneer announced in February it would put most of its resources going forward into the Permian and planned to sell nearly all “non-Permian” projects, including in the Eagle Ford, Raton Basin, and West Texas Panhandle. The table below demonstrates why its desire to focus on the Permian was warranted. However, one thing to note is that purchasing acreage in the Permian is much more expensive than the Eagle Ford, so drilling most likely needs to be based on existing acreage positions. Overall, the Eagle Ford’s economics are improving (Venado – a KKR backed Austin firm, made a $765 million purchase from Cabot that was based on this optimism). About 61,500 net acres of the Venado position, which is located primarily in Frio and Atascosa counties in South Texas, is operated and about 9,400 net acres are non-operated. Production from the properties during third-quarter 2017 was 15,656 barrels of oil equivalent per day. An interesting discussion on this acquisition can be found in this video: ?? Have a great week! Endnote1 In case one was wondering - Chip and Joanna Gaines are not involved.

RIA Stocks off to a Rough Start in 2018

A rocky first quarter was particularly volatile for publicly traded RIAs. After reaching record highs in late January, most categories of publicly traded RIAs ended the quarter with negative returns.First Quarter PerformanceThe weak performance of publicly traded RIAs during the first quarter comes on the heels of significant outperformance during 2017. Market gains apparently trumped fee compression, fund outflows, regulatory overhang, rising costs, and a host of other industry headwinds that have dominated the headlines in recent years. There is a simple explanation for the industry’s performance in recent years: the combination of market appreciation and operating leverage have precipitated significant improvements in profitability since the Financial Crisis, eliciting a favorable response from investors, despite everything we’ve been reading about the industry. However, the return of market volatility and the reintroduction of the idea that markets can, in fact, go down, have brought back into focus the industry headwinds, and investors have reacted accordingly. As illustrated in the chart above, upward or downward trends in the broader market tend to have a magnified effect on the stock prices of asset managers. Market swings will have a magnified impact on earnings (and stock prices) for asset managers because top-line volatility is tied to AUM movements and some costs are fixed. While 2017 was a great year for the S&P and an even better year for most categories of RIAs, 2018 has been the complete opposite thus far. This reversal is no surprise, as historically corrections and bear markets have led to more precipitous declines in profitability, due to the presence of fixed expenses in most RIA’s capital structure, a fact illustrated by the significant underperformance of RIAs during 2008 and early 2009. Taking a closer look at recent pricing reveals that traditional asset managers and trust banks have outperformed the S&P and other classes of asset managers throughout the first quarter. Traditional asset managers ended the quarter up 4.5% and were the only category of asset managers to post positive returns. Trust banks were down just 0.3% during the quarter, buoyed by a steadily rising yield curve, which portends higher NIM spreads and reinvestment income. Alternative asset managers were down 5.0% during the quarter as these businesses continue to find delivery on their value proposition (alpha net of fees) elusive. Mutual funds, which have been battered by active outflows and fee compression, were down 7.1% on the quarter. The RIA size graph below shows that larger RIAs generally performed better than smaller RIAs during the first quarter. Asset managers with more than $500 billion in AUM were the only category to outperform the S&P, and asset managers with less than $100 billion in AUM had the worst performance. This is to be expected during periods in which the market declines, as smaller RIAs generally have narrower margins and profitability can shift wildly with small changes in AUM. Market OutlookThe outlook for these businesses is similarly market driven - though it does vary by sector. Trust banks are more susceptible to changes in interest rates and yield curve positioning. Alternative asset managers tend to be more idiosyncratic but still influenced by investor sentiment regarding their hard-to-value assets. Mutual funds and traditional asset managers are more vulnerable to trends in active and passive investing. The outlook for the industry during the rest of 2018 ultimately depends on how the industry headwinds continue to evolve and (as always) what the market does over the next few months.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Capital Structure in 30 Minutes Whitepaper

In this post, we share a recent whitepaper: "Capital Structure in 30 Minutes." Capital structure decisions have long-term consequences for shareholders. Directors evaluate capital structure with an eye toward identifying the financing mix that minimizes the weighted average cost of capital. This decision is complicated by the iterative nature of capital costs: the financing mix influences the cost of the different financing sources. While the nominal cost of debt is always less than the nominal cost of equity, the relevant consideration for directors is the marginal cost of debt and equity, which measures the impact of a given financing decision on the overall cost of capital. The purpose of this whitepaper is to equip directors and shareholders to contribute to capital structure decisions that promote the financial health and sustainability of the company. This whitepaper is the second in the "Corporate Finance in 30 Minutes Series." Learn more about the whitepaper series below. Corporate Finance in 30 MinutesIn this whitepaper, we distill the fundamental principles of corporate finance into an accessible and non-technical primer.Capital Structure in 30 MinutesThrough this whitepaper, we equip directors and shareholders to contribute to capital structure decisions that promote the financial health and sustainability of their companies.Capital Budgeting in 30 MinutesCapital Budgeting in 30 Minutes assists directors and shareholders evaluate proposed capital projects and contribute to capital budgeting decisions that enhance value.Distribution Policy in 30 MinutesOf the three primary corporate finance decisions, distribution policy is the most transparent to shareholders. This whitepaper helps directors formulate and communicate a distribution policy that contributes to shareholder wealth and satisfaction.

Asset Manager M&A Activity Accelerates in 2018

Asset manager M&A was robust through the first quarter of 2018 against a backdrop of volatile market conditions. Total deal count during the first quarter was up 32% versus the first quarter of 2017, though total disclosed deal value was down 25%. In terms of deal count, M&A is on pace to reach the highest levels since 2014, although we note that the quarterly data can be lumpy. Several trends which have driven the uptick in sector M&A have continued into 2018, including revenue and cost pressures and an increasing interest from bank acquirers.Notable TrendsThe underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, and slowing organic growth for many active managers. While these pressures have been compressing margins for years, sector M&A has historically been muted. This is due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation. Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure for certain firms."Since I've been in the industry, there's been declarations of massive consolidation. I do think though, this time there are a set of factors in place that weren't in place before, where scale does matter, largely driven by the cost coming out of the regulatory environments and the low rate environments in cyber and alike. And, you have to be, as a firm, you have to be able to invest in the future. And I think a number of smaller-sized firms are finding that hard." Martin Flanagan - President and CEO, Invesco Ltd. 1Q17 Earnings Call"You need to have, of course, the right product set. But you need especially to have underlying firms, which are positioned as best they can in terms of alignment and focus to sustain alpha generation. And in that respect, scale is the enemy, not the friend." Sean Healey - 1Q17 Earnings Call, Affiliated Managers Group IncConsolidation pressures in the industry are largely the result of secular trends. On the revenue side, realized fees continue to decrease as funds flow from active to passive. On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs. Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to gain scale in order to realize cost efficiencies, increase product offerings, and gain distribution leverage.Acquisition activity in the sector has been led primarily by RIA consolidators, with Focus Financial Partners (which itself was acquired by Stone Point Capital and KKR in a $2 billion deal last year), Mercer Advisors (no relation), and United Capital Financial Advisers each acquiring multiple RIAs over the last year. While these serial acquirers account for the majority of M&A activity in the sector, banks have also been increasingly active acquirers of RIAs in their hunt for returns not tied to interest rate movements. Despite a rising yield curve and the negative impact of goodwill on tangible book value, we suspect that RIAs will remain attractive targets for bank acquirers due to the high margins (relative to many other financial services businesses), low capital requirements, and substantial cross-selling opportunities.The Market's ImpactRecent increases in M&A activity come against a backdrop of a bull market that continued unabated through 2017 but faltered during the first quarter of 2018. Steady market gains have continued throughout 2017 and have more than offset the consistent and significant negative AUM outflows that many active managers have seen over the past several years.In 2016, for example, active mutual funds’ assets grew to $11 trillion from $10.7 trillion, despite $400 billion in net outflows according to data from Bloomberg. While the first quarter of 2018 saw negative returns for most major indices, the gains seen during 2017 have yet to be eroded. At the end of the first quarter, the S&P was down nearly 10% from its peak in late January 2018, but the index is still only 2% below year-end 2017. As a result of increasing AUM and concomitant revenue growth (perhaps notwithstanding this last quarter), profitability has been trended upwards despite industry headwinds that seem to rationalize consolidation.ConclusionWith no end in sight for the consolidation pressures facing the industry, asset manager M&A appears positioned for continued strength or potential acceleration regardless of which way the markets move during the remainder of 2018. Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back-office efficiencies. Expanding distribution and product offerings will also continue to be a key acquisition rationale as firms have struggled with organic growth.With over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. An aging ownership base is another impetus, and recent market gains might induce prospective sellers to finally pull the trigger. More broadly, the recent tax reform bill is expected to free up foreign-held cash and increase earnings, which could further facilitate M&A’s upward trend during the rest of 2018.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Was 2014 a Lesson Learned?

Overview of the Macro Oil and Gas Environment at the End of 1Q 2018The oil and gas market continued to show improvement in the first quarter of 2018. Positive momentum in production growth in the U.S. continued and prices increased from an average of $55 in Q4 2017 to an average of $63 in Q1 2018. Mercer Capital’s Senior VP, Grant Farrell, at the beginning of the quarter said, “a repeat of 2017 would be a welcomed event” and it appears we are on track. Oil prices are ticking up, domestic production has increased to a 50 year high, and the U.S. is exporting more crude oil than ever before.Too Good to be TrueIf you are like me, you can’t ignore the wary feeling in your gut that makes you ask, “Is it too good to be true?”According to Reuters, global inventories could increase due to the rapid increase in production in the U.S. which “could well outweigh any pick-up in demand.” Rig counts in 2018 were expected to increase to 945 active rigs. [1] However, Baker Hughes reports that we have already met this target and currently have 993 active rigs versus 824 a year ago. Have we already forgotten the lesson we learned in 2014: too much supply, too fast leads to a decline in prices? Additionally, what will happen to demand as transportation becomes more fuel efficient and we shift further away from oil in favor of renewable energy resources? Easing ConcernsThankfully, I am not the only one asking these questions. A survey of oil and gas professionals in the February 2018 Issue of the Oil and Gas Journal showed that 63% of oil and gas senior professionals are optimistic about 2018. However, this optimism does not stem from a forecasted favorable price environment. Rather, their confidence is supported by the knowledge that they can now operate profitably in a $55 per barrel price environment.[2] Oil and gas exploration companies today are more cost-efficient than ever. The collapse in prices in mid-2014 gave companies two options: adapt to the new price environment or go away. Today we are left with a more cost-aware sector that has used technology to reduce risks and cut costs.Further, domestic E&P companies today have the ability to quickly adjust their operations in response to price changes. Jude Clemente, a recent contributor for Forbes recently wrote, “The U.S. has now become the world's swing oil producer and is the main factor that will limit how high prices can go.”BP Chief Economist Spencer Dale recently responded to similar questions asked across the energy industry: “Will oil and gas lose dominance to renewable fuels in the future?” BP argues that crude oil demand will continue to increase in the foreseeable future but will begin to reach a plateau in the next twenty years. While renewable energy is the fastest growing energy source, developing nations across the world will drive energy demand in the future. The mix of crude oil and renewable energy will shift, and crude oil will likely meet 85% of oil demand in 2040 instead of 94% of demand today. This does not, however, mean demand for crude oil will disappear.OverviewThe forecast for the oil and gas industry in 2018 was positive and we seem to be meeting or even exceeding investor expectations. The U.S. is expected to give up its title of the largest crude oil importer and exports are expected to continue growing as new pipelines and export terminals allow for increased capacity.The positive momentum in the industry is being reflected in private company valuations both as a result of improved earnings forecasts and reductions in risk. Growth in production and increases in price are increasing revenue, and more of the top line is flowing down to net income as companies have cut costs. Earnings improvement is being magnified by the recent tax cuts which have significantly increased net income. Further, the risk profiles of E&P companies have improved as companies are better equipped to handle price volatility and E&P companies are generally taking on projects with shorter payback periods.Mercer Capital has significant experience valuing assets and companies in the energy industry. Because drilling economics vary by region it is imperative that your valuation specialist understands the local economics faced by your oilfield service company. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.Endnote[1] US oil, gas industry capital spending to increase in 2018. US Oil and Gas Journal.March 2018. [2] Survey: Oil, gas professionals express optimism for 2018 challenges. Oil and Gas Journal. February 2018

Volatile First Quarter Brings Asset Management Industry Headwinds Back Into Focus

Publicly traded asset managers had a rough first quarter, as volatility returned to the market and major indices posted negative quarterly returns for the first time in over two years. While the overall drop in the market was relatively modest, stock price declines of publicly traded asset managers were generally more significant. It is not surprising that most asset managers have underperformed during periods of declining markets, since the reverse was true during 2017, when most asset managers outperformed the major indices. To the extent top-line volatility is tied to AUM movements and costs are fixed, market swings will have a magnified impact on earnings (and stock prices) for asset managers. The return of market volatility and the reintroduction to the idea that markets can, in fact, go down, have brought back into focus the industry headwinds which, at least for the last several years, have been allayed by a favorable market backdrop. Notably, outflows from higher cost funds have continued to increase, as shown in the following chart from Morningstar. During 2017, the chart shows accelerating outflows from the most expensive active funds and record inflows into the cheapest ones. These dynamics are problematic for many mutual fund companies and other asset managers that rely on active equity products, which are necessarily more expensive to implement than their passive counterparts. There was one positive development related to asset flows for active managers during 2017: aggregate outflows for active funds in 2017 were stemmed considerably (in fact were nearly zero). Relative to the significant net outflows active funds have seen the last several years, 2017's low level of outflows seems like a win for the sector (if you count less of a bad thing as a good thing). Still, if stemming the outflows comes at the cost of lowering fees, the result will be lower revenue yields and profitability. It appears that stemming outflows without significant fee cuts will be an uphill battle. Active fund outflows are not only attributable to the rise in popularity of low-cost ETF strategies but also sector-wide underperformance against their applicable benchmarks. Both individual and institutional investors are now more inclined to shun active managers for cheaper, more readily available products, particularly when performance suffers. Active manager performance was better in 2017, although still, less than half managed to beat their passive peers on a net-of-fee basis. According to data from Morningstar, 43% of active managers outperformed passive peers in 2017 versus 26% in 2016. It appears that as long as active managers are missing the mark on their value proposition (alpha net of fees), ETFs and other passive strategies will continue to gain substantial inflows from active managers, resulting in higher and higher allocations to index products. With improved performance relative to passive funds in 2017 and a volatile market so far in 2018, the opportunity is there to reverse this trend. However, it will take a sustained alpha generation before things start to go the other way, and in the interim, funds with a low active share and high fees are not likely to fare well. We’ve all read that consistently beating the market is nearly impossible, even for the savviest of stock pickers, but none of that research was compiled when passive strategies dominated the investment landscape. We don’t foresee a huge shift back to active management any time soon, but we realize that we were probably overdue for some mean reversion. It is conceivable that the current market environment could be more conducive to stock picking, but we’ll need more time to judge whether this is truly the case. Regardless, it is hard to imagine that passive investing will completely replace active management. Such a scenario could lead to significant mispricing in the securities markets, which would be fertile ground for enterprising investors and mutual funds. This is why we say that active management may be down but is not out. Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Before Selling Your Oil and Gas Royalty Interest Read This

There are many reasons that you may want to sell your oil and gas royalty interest, but a lack of knowledge regarding the worth of your royalty interest could be very costly. Whether an inflow of cash would help you make ends meet or finance a large purchase; you no longer want to deal with the administrative paperwork or accounting cost of reconciling monthly revenue payments; or you would prefer to diversify your portfolio or move your investments to a less volatile industry, understanding how royalty interests are valued will ensure that you maximize the value.There is a market for royalty interests, making them fairly liquid; therefore, most of the time, the difficulty is not finding a buyer, but determining whether the buyer’s offer is appropriate.Given that many royalty owners have little connection with the oil and gas industry aside from the monthly payments they receive, buyers may bid substantially below a royalty’s fair market value hoping to earn a profit at the expense of an uninformed seller. As such, it is critical that royalty owners looking to liquidate their interest understand its value to ensure that they can identify legitimate bids.Before attempting to sell your mineral interest, understand these issues.Understand What You Are SellingA royalty interest represents a percent ownership in the revenue of an E&P company. Royalty interest owners have no control over the drilling activity of the operator and do not bear any costs of production. Royalty interest owners only receive revenue checks when their operator is producing minerals but see no monthly payments when production is suspended.1Recognize Production and Price as Value DriversThe value of a royalty interest is based on the present value of expected future cash flows, which are a percentage of an operator’s revenue.An operator’s revenue is dependent upon production and price. Thus, when determining the value of a royalty interest, it is critical to understand a well’s future potential for production and the market forces that affect price.Production: The Decline Curve’s ImpactAs oil and gas is extracted from a well, its production declines over time. Every well has a unique decline curve which dictates production. A decline curve graphs crude oil and natural gas production and allows us to determine a well’s Estimated Ultimate Recovery (EUR). A variety of factors can affect the shape of a well’s decline curve. For example, decline curves are generally much steeper if the well is drilled using unconventional techniques, like horizontal drilling, or hydraulic fracturing. When determining the value of an oil and gas royalty interest, it is critical to understand a well’s EUR because the value of your royalty interest is dependent upon future production.Price: Local and Global Market ForcesOil and gas prices are affected by both global and local supply and demand factors. The oil and gas industry is characterized by high price volatility. The size and global nature of this market mean that these prices are influenced by countless economic – and sometimes political – factors affecting individual producers, consumers, and other entities that comprise the global market. Most operators, however, sell their oil and gas at a slight discount or premium to the NYMEX because of local surpluses or shortfalls. Thus, it is important to understand the local market as well.Understand Location’s ImpactDrilling economics vary by region. There are geological differences between oilfields and reserves that make it harder to drill in some places than others. Whereas some wells can be drilled using traditional, conventional techniques like vertical drilling, less permeable shale wells must be drilled using unconventional methods, like horizontal drilling or hydraulic fracturing. These unconventional methods tend to bear higher operating costs. Location also tends to influence drilling and transportation costs, ultimately making breakeven prices and profits vary across and within regions. Although a royalty interest owner is paid before any operating expenses are accrued, an operator considers break-even pricing when determining whether to continue operating a well or suspending operations. Accordingly, the value of any royalty interest is strongly influenced by its location, and it is important to consider geological differences when valuing any mineral interest.Proceed with CautionWhile there are legitimate online brokers who will buy your royalty interest for a fair price, it is important to be on the lookout for those who aim to profit at your expense.Beware of online royalty brokers who only consider rules of thumb such as 4x to 6x annual revenue. While industry benchmarks can be a helpful aid, they should not be relied upon solely to determine value, as they do not consider specific well economics.If the entity valuing your interest is also an interested party, it is critical to remember that they have an incentive to quote a low value.Mercer Capital is an employee-owned independent financial advisory firm with significant experience (both nationally and internationally) valuing assets and companies in the energy industry (primarily oil and gas, bio fuels and other minerals). Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors.As a disinterested party, we can help you understand the fair market value of your royalty interest and ensure that you get a fair price for your interest. Contact anyone on Mercer Capital’s Oil & Gas team to discuss your royalty interest valuation questions in confidence.End Note1 For more information on mineral interests see our post, Three Types of Mineral Interests.

Three Takeaways from the CFA Institute’s Wealth Management Conference in Los Angeles

Last week, Taryn Burgess, Matt Crow, and I exhibited at CFAI’s Wealth Management Conference in Los Angeles. The conference was well attended and lauded by most everyone there (most of whom were wealth management professionals at RIAs in the major metropolitan areas along the East and West Coast, unlike us). A lot of topics were discussed, most of which centered around financial planning, practice management, and servicing private clients with evolving needs and return requirements. Though we weren’t able to attend all the sessions, we did pick up on a few themes from our discussions with the attendees and other exhibitors:CFAI appears to be placing more emphasis on wealth management strategies and private clients. When I was studying for the CFA exam (2006-08), the curriculum seemed to be more geared towards portfolio managers and research analysts. On the buy-side, the emphasis was on the asset management sector and investment strategies for institutional clients. While there was some focus on wealth management and private clients, more of the curriculum seemed to be devoted to portfolio management for pension funds, insurance companies, endowments, and the like. One of the conference speakers noted that this was likely due to the rising demand for wealth management services and the corresponding decline in active management (and those serving the industry). We’ve seen a fair amount of asset managers jump ship for the private client side to take advantage of this trend. It will be interesting to see how their transition shakes out since, in our experience, the cultures and skill sets of asset management firms versus private client RIAs often seem completely incompatible with one another. In any event, many of the CFAI folks we talked to at the conference noted that the institute is starting to place more emphasis on the wealth management side, and conference attendance continues to rise with the industry’s popularity.Understanding behavioral finance is a key competitive advantage for wealth managers over their robo-advisory rivals. Many of the sessions were devoted to understanding private client’s behavioral tendencies and the proliferation of robo-advisors competing for their business. It appears that most wealth managers are acknowledging the emerging competitive threat of robo-advisory firms, especially with millennials and younger clients. Touting the ability to hand hold and have face-to-face meetings with clients is no longer sufficient to ward of the robo-advisory threat, and many wealth managers are turning to behavioral finance to better understand their client’s needs in ways that AI falls short. It’s not inconceivable that, moving forward, many financial advisors will have degrees in personal psychology to better their understanding of client behavior and cognitive tendencies. Several speakers discussed new research and developments in the study of behavioral finance and how their firms were using these advancements to communicate with their clients more effectively and help them realize their financial goals. Once rejected by many industry participants, behavioral finance is increasingly becoming a point of emphasis for continuing education at wealth management firms across the country. We would not be surprised if CFAI made this a higher priority in future curriculums.Everybody’s asking about sector M&A (or lack thereof). We’ve blogged about this before and don’t think any of these dynamics have changed (though there has been somewhat of an uptick in recent years). While there weren’t any conference sessions devoted to this topic, most of the questions we got at our booth were about RIA dealmaking and sector consolidation. Since it was a wealth management conference, there was a lot of interest in what Focus Financial was up to and we can only surmise as to what’s going on there since it remains closely held. What we do know is that it’s never too early to be thinking about how to maximize your firm’s value even if it’s not for sale. This means cleaning up your P&L (and possibly balance sheet), making the necessary investments in technology, transitioning client relationships to the next generation, and having succession planning discussions with junior partners. We can help with the value part (and potential sale), but there may not be much to transact if you haven’t started thinking about some of these topics. The conference was informative and productive. Hopefully, we’ll see you at next year’s event in Fort Lauderdale.

Second Quarter 2018 | Segment Focus: Building Materials

Favorable macroeconomic environment is driving increased construction on all fronts – residential, nonresidential, public. In addition, U.S. tax overhaul already boosting nonresidential construction through 2Q18.

E&P Second Quarter 2018

Region Focus: Permian Basin

Region Focus: Permian Basin // Domestic oil production has increased significantly over the last few years primarily due to the shale boom in the Permian Basin.

Transportation & Logistics Newsletter

Second Quarter 2018

Eagle Ford Q1 2018

Lower Breakevens Yet Some Plan Fewer Wells

A milestone worth noting: The EIA recently announced that 2017 marked the first time since 1957 that U.S. natural gas exports exceeded imports. The economics of the Eagle Ford Shale have been steadily improving for the past year. While the Permian has been receiving the most attention given its low-cost economics and large well potential, the Eagle Ford (particularly its oil window) has increased well production whilst dropping its costs. However, based on recent announcements, many companies will be reducing the number of wells drilled in 2018 as compared to 2017.Breakeven PricesAs recently as a year ago, several companies and outlets reported breakeven oil price estimates in the low-to-mid $40s. Recently, several operators in the Eagle Ford are estimating breakeven as low as $28 and many around $35. This is a significant drop and points to anticipated efficiencies in drilling and completion costs. This is positive, but the trend is generally moving away from the Eagle Ford relative to other plays. According to IHS Markit, “only 1,415 new wells were brought online in 2016 compared to 2,717 in 2015 and 4,040 in 2014". IHS also noted "the play’s overall annual base has been decreasing year-over-year as a result of production coming from older wells. The annual base decline in the Eagle Ford in 2016 was 46% compared to 49% and 50% in 2015 and 2014, respectively.” IHS Markit also reported that a key reason for the decline in activity in the Eagle Ford is due to the rising interest in the Permian Basin and STACK/SCOOP plays, which have attracted the interest of key Eagle Ford players, including Pioneer Resources, Devon Energy, and Marathon Oil. TPG AcquisitionIt is notable, and probably not a coincidence, that TPG, the most optimistic company per the Figure above, last week made one of the largest acquisitions in the Eagle Ford in the past few years (we will discuss this acquisition and other recent ones in more detail in a few weeks. Stay tuned.).2018 PlansTis the season for 2018 guidance and several of the major Eagle Ford shale operators have given theirs. As mentioned, several companies (Sanchez, Chesapeake, and Carrizo) are decreasing their estimates for new well compared to last year, but are increasing their capex budgets. Overall, EOG and Sanchez have increased their rig presence as of last week, but those figures fluctuate even week-to-week. EOG is leading the way in its activity from well count to acreage. In terms of new activity planned in 2018, it is the most aggressive of the four companies we follow (see Figure below). It’s also notable that EOG continues to test its position in the Austin Chalk formation – completing four wells in 4Q2017.Bill Thomas, the company's chairman and CEO, said last year was a success, considering lingering weakness in crude oil prices and headwinds from the series of hurricanes that hammered southern U.S. shale basins in late 2017."EOG emerged from the industry downturn in 2017 with unprecedented levels of efficiency and productivity, driving oil production volumes to record levels with capital expenditures approximately one half the prior peak," he said in a statement. Carrizo’s strategy revolves around “multipads” wherever possible in the Eagle Ford. In 2018, Carrizo is completing a 16-well multipad utilizing three completion crews. In addition, Carrizo sees more than 700 remaining PUDs in the core of its Eagle Ford position at a 330-500 foot spacing profile (depending on the geology of the project area). Chesapeake, meanwhile, continues to manage its balance sheet with asset sales and tempered activity which makes its activity profile a little harder to discern. PerformanceWhat does this mean for performance? Well, the past week has been good to a number of producers, but it comes after a subpar stock price performance for everyone on this list not named EOG.However, if efficiencies compound for Eagle Ford players, this chart could look very different a year from now. Time will tell.Have a great week!

The Impact of the 2017 Tax Cuts & Jobs Act on the Investment Management Industry

The Tax Cuts and Jobs Act (TCJA) that was signed into law in December 2017 has already had, and will continue to have, a tremendous impact on the investment management community that warrants considerable attention from partners at RIAs. We won’t mince words – this tax bill is a blockbuster for the investment management industry.Taken as a whole, TCJA has already been especially beneficial to the RIA sector, as lower corporate tax rates have had a positive impact on equity markets, boosting AUM and earnings, which are now taxed at lower rates. Although most firms are still assessing the full impact of tax reform, the TCJA will likely impact capital management, M&A activity, and investments in technology.This whitepaper is a compilation of thoughts we have gathered at Mercer Capital in the early days of this new tax regime. We expect to learn more as the year rolls on, as the compliance and tax planning opportunities presented by the TCJA materialize and work through the system. We don’t suggest that this text is an exhaustive list of all of the implications of the tax bill on the investment management industry, but herein, we present what we think are the major issues that RIA partners should consider. Specifically:The tax bill has made investment management firms worth more by:Driving up AUMImproving RIA economicsMaking RIA pre-tax cash flows worth moreHowever, the tax bill has less of an impact on tax pass-through entities because:The tax advantage of S-corps and LLCs, relative to C corporation, is now mutedMany RIAs will not benefit from the QBI deductionYour RIA’s shareholder agreement probably needs to be revised because:Most buy-sell agreements value the business via formulaTCJA renders many RIA valuation rules of thumb obsoleteThe change in RIA valuations is potentially so significant that it calls into question the use of formula agreements entirelyThe tax bill may have a mixed impact on asset manager M&A because:Higher valuations will bring more sellers to the table, and buyers will feel more pressure to complete transactionsInternal succession, however, may be more difficult because individuals won’t enjoy the same increase in after-tax cash flows as corporate buyers Download your copy of the whitepaper below and let us know if you have any questions on how these implications affect your firm. WHITEPAPERThe Impact of the 2017 Tax Cuts & Jobs Act on the Investment Management CommunityDownload Whitepaper

How to Value an Oil and Gas Refinery

Because of the historical popularity of this post, we revisit it this week. Originally published last summer, this post helps you, the reader, understand the issues to consider when valuing an oil and gas refinery, as well as the appropriate valuation approaches. When valuing a business, it is critical to understand the subject company’s position in the market, its operations, and its financial condition. A thorough understanding of the oil and gas industry and the role of refineries is important in establishing a credible value for a business operating in the oil and gas refining space.Oil and Gas Supply ChainThe oil and gas industry is divided into three main sectors:Upstream (Exploration and Production)Midstream (Pipelines)Downstream (Refineries) Exploration and production (E&P) companies search for reserves of hydrocarbons where they can drill wells in order to retrieve crude oil, natural gas, and natural gas liquids. E&P companies then sell the commodities to midstream companies who use gathering pipelines to transport the oil and gas to refineries. Refiners convert raw crude and natural gas into products of value, such as transportation fuels.Oil and Gas Refinery OperationsCrude oil itself has little end use. Refiners create value by converting crude oil into various usable products. Transportation fuels, such as gasoline, diesel, and jet fuel, are some of the most commonly produced refined products. Other refined products include heating and lighting fluid, such as kerosene, lubricating oil and waxes, and asphalt. Refineries are capital intensive and their configuration depends largely on their physical location, available crude oils, product requirements, and environmental standards.Valuing an oil and gas refinery requires the consideration of a wide range of issues (far too many to list in full here), with primary considerations as outlined below.The price of inputs. The price of crude oil fluctuates due to changes in world demand and supply. Many refiners hold large volumes of crude inventory, but as the price of crude oil fluctuates, refiners face risk associated with the falling value of their inventory. Thus, in order to reduce risk refiners should shorten their timeline from purchasing crude oil to selling the finished product and/or use derivatives to hedge the risk associated with volatile oil prices.The price of refined products. There are four main components to refined product prices: (1) Crude Oil Prices, (2) Wholesale Margins, (3) Retail Distribution Costs, and (4) Taxes. Generally, input prices and wholesale margins drive fluctuations in product prices as the last two are relatively stable. However, President Trump has indicated that he hopes to lower corporate taxes.Crack spread. A refiner’s margins are generally determined by the crack spread, which measures the prices of refined products compared to the cost of crude oil. The price of transportation fuels generally moves in sync with the prices of crude oil, but the price of some refined products such as asphalt and lubricating oils is not as closely correlated with crude oil price changes.Environmental regulation. The refining industry has historically been heavily regulated. Regulations such as the RTR & NSPS aim to control air pollution from refineries and provide the public with information about refineries’ air pollution. President Trump is working to establish a more energy friendly environment and has signaled his intention to sign the repeal of many methane emission regulations if the repeal is passed through both Houses of Congress.Heavy vs. light crude. Most U.S. refineries were built to process heavy crude. However, the onset of U.S. shale drilling has led to a surplus of light sweet crude that U.S. refineries were not originally built to process. While the refining process of heavy and light crude is generally the same, the refining of light crude is less costly.Oil and Gas Refinery Financial AnalysisWhen valuing a business, it is critical to understand the subject company’s financial condition. A financial analyst has certain diagnostic markers that tell much about the condition of a business.Balance Sheet. The balance sheet of a refinery is dominated by inventory and fixed assets. According to RMA’s annual statement studies, 16.3% and 32.2% of petroleum refineries’ assets are inventory and fixed assets, respectively.1 Because refining is a capital intensive business, it is important to consider the current operating capacity of a company’s fixed assets in order to determine if future growth will require significant capital expenditures. If a refinery hopes to expand refinery throughput beyond the current refining capacity, it will have to invest in more equipment.Income Statement. The development of ongoing earning power is one of the most critical steps in the valuation process, especially for businesses operating in a volatile industry environment. Cost of goods sold account for approximately 75% of sales according to the RMA data. Thus it is important to consider possible supplier concentrations when analyzing the income statement because disruptions in the supply chain can have significant income statement impacts to oil refineries.How Does Valuation Work?There are fundamentally three commonly accepted approaches to value: asset-based, market, and income. Each approach incorporates procedures that may enhance awareness about specific business attributes that may be relevant to determining the final value. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value for the subject interest under consideration.The Asset-Based ApproachThe asset-based approach can be applied in different ways, but in general, it represents the market value of a company’s assets minus the market value of its liabilities. Investors make investments based on perceived required rates of return, and only look at assets as a source of rate of return. Oil and gas refineries are asset intensive businesses. They have distillers, crackers, cokers, and more. While an asset value consideration can be a meaningful component of the overall valuation of an oil and gas refinery, it is essentially the income generated by these assets that typically drives the value of a business. For this reason, the asset-based approach is typically not the sole (or even primary) indicator of value.The Market ApproachThe market approach utilizes market data from comparable public companies or transactions of similar companies in developing an indication of value. In many ways, this approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.In the downstream oil and gas sector, there are ample comparable public companies that can be relied on to provide meaningful market-based indications of value. Such options are Alon US Energy Inc., CVR Refining, LP, Valero Refining, and Western Refining. Acquisition data from industry acquisitions (typically a median from a group of transactions) can be utilized to calculate a valuation multiple on the subject company’s performance measure(s). This will often provide a meaningful indication of value as it typically takes into account industry factors (or at least the market participants’ perception of these factors) far more directly than the asset-based approach or income-based approach. Additionally earnings multiples such as EV/ EBITDA can be used to calculate indication of values.The market-based approach is not a perfect method by any means. For example, industry transaction data may not provide for a direct consideration of specific company characteristics. Say a company is a market leader and operates in a prime geographic market. Since the market and the specific company are relatively more attractive than the average transaction, the appropriate pricing multiple for this company is likely above any median taken from a group of industry transactions. Additionally, many companies in the oil and gas industry are vertically integrated and have significant midstream or marketing operations in addition to their refining operations. For example, Marathon Petroleum Company is a leading refiner in the US, but is also a marketer of refined products and has significant midstream operations. Clearly, the more comparable the companies and the transactions are, the more meaningful the indication of value will be. When comparable companies are available, the market approach can provide a helpful indication of value and should be used in determining the value of a refinery.The Income ApproachThe income approach can be applied in several different ways. Generally, such an approach is applied through the development of an ongoing earnings or cash flow figure and the application of a multiple to those earnings based on market returns. An estimate of ongoing earnings can be capitalized in order to calculate the net present value of an enterprise. When determining ongoing earnings historical earnings should be analyzed for non-recurring and non-normal income and expenses which will not affect future earnings. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market through the use of a capitalization rate.Income is the main driver of value of a business; thus, the income approach should be considered when determining the value of your business.Synthesis of Valuation ApproachesA proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations. This is why industry “rules-of-thumb” (be they some multiple of revenue, earnings, or other) are dangerous to rely on in any meaningful transaction. Such “rules-of-thumb” fail to consider the specific characteristics of the business and, as such, often fail to deliver insightful indications of value.An owner who is contemplating any kind of transaction or agreement based on value needs to know what their business is worth. Whether you are selling out or selling in, knowing the fair market value of your business will let you evaluate whether or not an offer for your company is reasonable. Additionally, many business owners fail to understand the valuation implications of buy-sell agreements. If you have other shareholders in your business who are non-family, and maybe some who are, you probably have some kind of buy-sell agreement between the shareholders that describes how the business (or business interests) will be valued in the event of a shareholder dispute, death, or departure from the business (even on friendly terms). A business owner executing or planning a transition of ownership can enhance confidence in the decisions being made only through reliance on a complete and accurate valuation of the business.Mercer Capital has long promoted the concept of managing your business as if it were being prepared to sell. In this fashion you promote the efficiencies, goals and disciplines that will maximize your value. Despite attempts to homogenize value through the use of simplistic rules of thumb, our experience is that each valuation is truly unique given the purpose for the valuation and the circumstances of the business.Mercer Capital has experience valuing businesses in the oil and gas industry. We hope this information, which admittedly only scratches the surface, helps you better shop for business valuation services and understand valuation mechanics. We encourage you to extend your business planning dialogue to include valuation, because sooner or later, a valuation is going to happen. Proactive planning and valuation services can alleviate the potential for a negative surprise that could complicate an already stressful time in your personal and business life.For more information or to discuss a valuation or transaction issue in confidence, do not hesitate to contact us at 901.685.2120.End Note1 2016-2017 RMA Statement Studies. NAICS #324110. Companies with greater than $25 million in sales

Two Perspectives on RIA Transactions in the Wake of the Tax Bill

Mercer Capital’s marketing staff is trained to market valuation services, not perform valuations. Nevertheless, these folks have to read a lot about the practice in reviewing our articles, presentations, blogposts, books, and whitepapers, and I’ve wondered how much they absorb of what we write. I think I got my answer last week, when I showed our marketing director a photograph of an early-1960s Aston Martin DB4 and asked if she knew what kind of car it was.“Is it a Porsche?”Incredulously, I had to remind her that Porsche didn’t make GT cars in the 1960s, only rear-engine models like the 911, 356, and 912. The first Porsche with a front engine, grand-touring configuration was the 928, first produced in 1975. The 928 was supposed to be the replacement for the 911, which was expensive to build and difficult to drive (rear engine cars have an unrivaled penchant for oversteer). Porsche enthusiasts (a fandom like none other) balked, and the marque decided to build both the GT and their traditional rear-engine models until giving up on the 928 in 1995.The 928 was a brilliant car, but it wasn’t a game changer for Porsche. I suspect the jury is still out on the tax bill’s long-term impact on the investment management industry as well. One of the more interesting aspects of the 2017 Tax Cut and Jobs Act (TCJA) that is the bill’s potential impact on mergers & acquisitions. Most of the press assumes that the TCJA is going to be positive for M&A, although it cuts differently across different sectors. For the investment management community, the change in tax law is a mixed bag, and we’ve yet to see a compelling case to suggest that, overall, it will tend to encourage or to discourage transaction activity in RIAs on a net basis.Keep in mind that much of the TCJA did not apply to investment management firms. The new rules on expensing capital expenditures don’t matter for the asset manager that spends a few hundred thousand dollars (at most) per year on information technology equipment and licenses, plus a conference room table or two. Incentives to re-shore foreign capital doesn’t apply to most RIAs, and the limitations on interest deductibility won’t matter except for the most highly leveraged transactions. There is an argument to be made that the TCJA is bullish for RIA M&A, but there is a counter-argument as well.Point: New Tax Legislation Encourages RIA TransactionsMost commentators only see positives in the tax bill for M&A activity, and at least some of that extends to investment management firm transactions. We joined in this chorus, noting that rising asset prices have brought many RIAs a surge in AUM, which grows revenues similarly and profits even more, thanks to the magic of operating leverage.For RIAs structured as C corporations, the TCJA significantly improved after-tax cash flows since most firms pay high effective tax rates. And those higher after-tax cash flows are potentially even more richly rewarded by a market willing to pay higher multiples in a time of mostly bullish sentiment.All else equal, higher valuations usually encourage sellers to take advantage – which is important fuel to the RIA transaction community in which buyers usually outnumber sellers by a wide margin. And conglomerates with investment management firm divisions may be encouraged to make divestitures in a time when valuations are high and the taxes on gains they make in the sale would be relatively low.All in all, there are many reasons to believe that the tax act will spur more transaction activity for RIAs. However, there is another side to this story.Counterpoint: New Tax Legislation Does Nothing for RIA transactions, and Might Even Discourage ThemOne drawback of the TCJA is that it does little, if anything, for internal RIA transactions, the most common style of investment management firm transactions. While tax rates for C corporations were slashed, the top tax rate for individuals only declined modestly, from 39.6% to 37%. Most RIAs are structured as some kind of tax pass-through entity, either as an LLC or an S corporation. So taxes on investment management firm earnings are taxed as personal rates rather than corporate rates.Buyers in internal transactions at RIAs pay for their stock with after-tax cash flow (distributions), and purchasing capacity will be little improved by the TCJA (with a few exceptions). Without an improvement in after-tax distributions, internal buyers can’t pay more for their stock. So the tax bill isn’t really bullish for internal ownership transition. Further, to the extent that sellers now have expectations for higher prices, we may witness a widening of the bid-ask spread, which will discourage ownership transition altogether.Risky BusinessBack to my feature car – the 928 could have wound up on the engineering design floor had Porsche not decided to go ahead and produce it alongside the now (if not then) iconic 911. The legacy of the 928 – always a great GT – was eventually cemented onscreen by Tom Cruise in the 1983 film Risky Business. In the alternative, Porsche could have thumbed their nose at rear-engine aficionados and moved ahead with replacing the 911, but by being non-committal, they hedged their bet and ended up extending the brand. We recommend similar caution in assuming the TCJA is only good for RIA transaction activity. It might be, or it might not be. Risky business indeed.“…never driven in the rain.”

2018 Trends to Watch in the Banking Industry: Acquire or Be Acquired Conference Recap

For those readers unable to escape the cold to attend Bank Director’s Acquire or Be Acquired (AOBA) conference in Scottsdale, AZ, we reflect on the major themes: bank M&A and scarcity, tax reform and valuation, and FinTech. For those unfamiliar with the three-day event, over 1,000 bankers, directors, and advisors gather to discuss pertinent industry issues.Bank M&A and ScarcityThere are fewer than 5,500 banks today, which is roughly half from only 10 years ago when we first attended AOBA. This scarcity was top-of-mind for several panelists who noted variations on the same theme: Scarcity matters to both buyers and sellers as the number of banks dwindles at a rate of 3-4% per annum.Unlike the 1990s and even the pre-crisis years when a seller could expect multiple offers, banks that sell today often have just one or two legitimate suitors. In our view, this means that sellers need to think more strategically about their valuation today and prospectively if their most logical suitor(s) is acquired. Even if the logical acquirer is unlikely to be acquired, board planning for some institutions should consider the potential to strike a (cash) deal with a credit union. For buyers, scarcity may translate into less desirable banks in targeted markets. If so, scarcity may mean greater emphasis on expansion through lift-outs from other banks, or even a push into non-traditional bank acquisitions/investments such as wealth management that could serve as a nucleus around which traditional banking services are bolted. One key question to watch: Will scarcity impact the pace of consolidation and the valuation of transactions? The short answer is seemingly “yes,” but rising acquisition valuations over the past couple of years correspond to the rising value of acquirers’ publicly traded shares.Tax Reform and ValuationThe banking sector was revalued higher in the public markets following the November 2016 elections, reflecting four attributes that would favor banks: regulatory reform, tax reform, faster GDP growth, and therefore, higher interest rates. While the impact (thus far) of regulatory reform and higher interest rates is limited, passage of the Tax Cuts and Jobs Act of 2017 is a highly tangible benefit for banks and customers. With the stroke of a pen, ROE for many banks will rise to or above the institution’s cost of capital, returning to pre-financial crisis levels. However, tax reform is not a cure for strategic issues such as whether FinTech may radically disrupt the “core” in the deposit relationship between customers and their banks.One panelist summed up the debate by noting that management teams who achieve a 10-15% increase in earnings and ROE in 2018 from tax reform are not geniuses; rather, they are around to cash the check. The real winners, as it relates to tax reform, will be banks that leverage the enhanced cash flows to make optimal capital budgeting and strategic decisions. Bankers will have to allocate the additional earnings before some of it is competed away among investments in staff, technology and/or higher dividends, share repurchases and acquisitions. Perhaps in the ideal world, the incremental capital to be created would be used to support faster loan growth, but few at the conference indicated their institution had seen an increase in loan growth as a result of tax reform.A related theme that emerged in several sessions was the dichotomy in valuations between the “haves” and “have-nots” along key metrics such as size, profitability, core deposits, location, management team, and operating strategy/niche. This divergence could widen further following tax reform as the “haves” effectively take their higher cash flows and reinvest/deploy them more profitably than the “have-nots.” Ultimately, these strategic decisions and the trajectory of the bank’s performance will drive whether tax reform leads to sustainably higher bank valuations, likely varying case-by-case. For those interested, we discuss implications of tax reform for banks in greater detail here.FinTechWhile FinTech wasn’t even on the agenda when we first made the trip to Scottsdale for AOBA in the mid-2000s, it was all over this year’s schedule. One panelist humorously compared bankers’ reactions to FinTech with the “Seven Stages of Grief” noting that bankers seemed to have finally progressed beyond the early-stages of anger and denial toward the latter-stage of acceptance. Bankers are considering practical solutions to incorporate FinTech into their strategic plans. Sessions included panel discussions on the nuts and bolts of structuring FinTech partnerships and creating value through leveraging FinTech to enhance profitability. (For those interested in FinTech, learn more about our book on the topic.) Niches of FinTech that garnered particular attention included digital lending, payments (both consumer and business), blockchain, and artificial intelligence. AI in particular was top-of-mind, and one panel noted it as an area of FinTech offering strong potential for banks in the next few years.We look forward to discussing these three themes with clients in 2018 and monitoring how they evolve within the banking industry over the next few years. As always, Mercer Capital is available to discuss these trends as they relate to your bank – feel free to call or email.Originally published in Bank Watch, February 2018.

The 2018 Outlook for the Refining Industry

Over the last six months of fiscal 2017, changes in the oil & gas market led to increasing refinery revenues and the expansion of margins. Earnings in the refining industry increased in fiscal 2017 as refined product prices increased, the crack spread widened, and volumes sold increased as demand rose. With recent gains in the industry and the effect of the Tax Cuts and Jobs Act of 2017, refiners should sail steadily through 2018. However, the future impact of many regulations surrounding the oil & gas industry is still uncertain.Factors Providing Positive Momentum in 2018Tax Cuts and Jobs Act of 2017We start with the obvious. The Tax Cuts and Jobs Act of 2017 will increase net earnings. Many clients have called to ask, “What is the impact of the tax cuts on my company? If taxes decrease, will the value of my company increase?”As Travis Harms, Senior VP at Mercer Capital, said in his recent presentation on the tax reform.“Simply put, we can say, yes a lower corporate tax rate will make corporations more valuable, all else equal. Will all else always be equal? No. Appraisers will need to carefully consider the effect of the new tax law not just on rates, but on growth expectations, reinvestment decisions, use of leverage, operating margins, and the like for individual companies.”As noted by George Damiris, CEO and President of Holly Frontier, on HFC’s fourth quarter earnings call, “The reforms to the U.S. tax code encourage capital investments and lower the corporate rate to better enable manufacturers to compete in the global market.”Price of Crude OilEven if OPEC maintains production cuts, rising U.S. shale oil output is thought to temper the results of OPEC’s reduction in supply. This will likely result in falling or stable oil prices. Because refined product prices often lag crude oil, the crack spread should widen or at least remain steady in 2018.Gregory Goff, CEO of Andeavor explains, “Last year, primarily because of rising crude prices throughout the year, we didn't have any periods of time where the market was impacted by having a declining crude price and the lag effect of that. So, organically, the growth was muted a little bit by the weaker margin environment.”Analysts polled by Reuters believe that oil prices will not continue to rise past the first quarter of 2019, because U.S. production will offset production declines by OPEC. We believe that oil price decreases could lead to higher margins in the refining industry over 2018. Holly Frontier, in their fourth quarter earnings call, provides an outlook of crude spread and product crack improvements in 2018.Friendly Environment for Oil & Gas CompaniesPresident Trump is positioning the U.S. to offer a more energy-friendly environment. The deregulation of the oil & gas industry was generally applauded on earnings calls at the beginning of 2018 and industry executives believe it will provide a more efficient marketplace for refiners.Factors Providing Negative Momentum in 2018The Future of the RFS is Still UncertainThe final Renewable Fuel Standards (RFS) for 2018 were released on November 30, 2017 and contained a slight reduction in volume requirements. This will provide some relief for refiners. However, refiners have made it clear that a long term solution regarding the RFS is needed. While large integrated refiners have the capability to blend their own petroleum products with renewable fuels, small and medium sized merchant refiners do not have this capability and are required to purchase RINS, which have significantly increased in price. The cost of RINs has hurt the profits of merchant refiners over the last few years and will continue to do so unless the standards are reworked or repealed.Potential Tariffs Could Hamper Exports and Increase CostsAs noted in the EIA’s Annual Energy Outlook 2018, domestic consumption of petroleum products is expected to decline due to increases in fuel efficiency. However, refinery utilization is expected to remain stable due to expected increases in petroleum product exports in the future. The imposition of tariffs on steel and aluminum imports does not directly affect U.S. oil refineries. However, steel is one of the most wildly used metals in the oil & gas industry. If the impacts of tariffs are passed onto the consumer, then the oil & gas industry could realize higher costs of steel.Further, there is concern of retaliation and trade wars which could hamper growth in the industry if tariffs on U.S. products are imposed by retaliating countries. Over 33% of U.S. exports of refined products are sent to Mexico and Canada, who are currently except from the tariffs. However, growth in demand from other countries could be dampened by the soon-to-be enforced tariff.What Does This Mean for Refinery Valuations?Consistent with the view that markets are generally efficient, the new lower corporate tax rates seem to have been priced into the market shortly after election day. Thus when the tax plan passed, the expected increase in after-tax earnings did not come as a surprise to the market. Additionally, there has been talk of crude price decreases since U.S. production broke a production record 10 million bpd in November 2017. This was the first time the U.S. broke this record in 48 years. Since then it has been thought that the U.S. is on track to surpass Saudi Arabia and Russia in crude oil production, making OPEC’s production cuts less impactful.Much of the positive momentum in the refining industry was expected by industry analysts. Valuation multiples have remained relatively stable over the last six months. EV multiples are trending between 7.5x to 8.5x EBITDA. According to Moody’s, “Outlook for the refining and marketing sector is stable, with earnings likely to increase 5-7% in 2018.” As earnings increase, company valuations will likely increase. However, refiner’s profit margins are highly dependent on management decisions. The degree of the effects of the new tax plan on your business depends on many company-specific decisions, such as the use of operating leverage. Further, management decisions regarding inventory management and price hedging can be the “make or break” in unexpected downturns. In order to understand the impact of these factors on the value of your refinery, you should contact an industry valuation specialist.A Plug for Mercer CapitalMercer Capital has significant experience valuing assets and companies in the energy industry. Our oil & gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil & gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil & gas valuations and associated oil & gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Your RIA May Qualify for the QBI Deduction, But Don’t Get Your Hopes Up

The Tax Cuts and Jobs Act (TCJA) introduces the Qualified Business Income (QBI) deduction as a partial offset to the bill’s reduction in the relative tax efficiency of pass-through entities (S corporations, limited liability companies, and partnerships) versus C corporations. Still, many RIAs will not be eligible for the deduction, and those that do will have a lot to keep in mind as it pertains to reasonable compensation levels and investment income. We’ll try to sort it all out for you in this week’s post. On balance, the TCJA has been very bullish for the RIA industry. A significant reduction in C corporation tax rates has helped precipitate a steady rise in the stock market over the last several months, so AUM balances are on the rise. Operating leverage in the business model compounds this effect, expanding margins as earnings growth outpaces gains in AUM and fee income. RIA market caps have responded accordingly: However, not all aspects of the bill are favorable to the industry. The relative tax efficiency of the pass-through structure has been reduced by the bill as personal tax rates have not declined nearly as much as rates for C corporations, and most RIAs are LLCs or S corps (therefore, taxed only at the shareholder/personal level). For RIAs with low dividend payouts (which is somewhat rare in our experience), it may actually make more economic sense to be structured as a C corp in the wake of the tax bill. At least one alt manager has already done so already. RIA’s ExclusionTo compensate for the narrowing S corp tax advantage, the TCJA introduced the Qualified Business Income (QBI) deduction that allows certain S shareholders to deduct 20% of their pass-through income. Oddly enough, the QBI deduction is not available to RIAs (above a certain income limit, discussed later). Congress decided to exclude certain “specified service trade or business,” defined as “any trade business which involves the performance of services that consist of investing and investment management, trading, or dealing in securities.”It’s not abundantly clear to us why the investment management exclusion (and the limitation on the deductibility of financial planning fees) was specifically included in the bill. Perhaps this exclusion was an offset for carried interest miraculously avoiding a tax hike from the TCJA. Maybe Congress didn’t feel any sympathy for an industry that has performed so well since the Financial Crisis and enjoys relatively high levels of compensation. Whatever the reason, it’s in there, but like many features of the TCJA, it includes a loophole.QBI EligibilityDespite the exclusion, the QBI deduction remains available to RIA shareholders for whom total income is less than $315,000 for married couples or $157,500 for individuals and is partially available for married couples and individuals up to $415,000 and $207,500, respectively. Industry consultant Michael Kitces helps us keep this all straight: If you’re the owner of an investment management firm and make over $207,500 as an individual or $415,000 if you’re married, the QBI deduction is not for you. While a good problem to have, it means many RIA owners will not be eligible for the deduction. If you find yourself in this category and do not distribute a high percentage of your earnings (that would still be subject to double taxation for C corporations), you might want to consider a C election. Otherwise, the S or LLC status probably makes the most economic sense even with the relative reduction in tax efficiency. Nuances to ConsiderEven if you’re at or below the income threshold, there are still a few nuances you need to consider in determining eligibility. One potential hurdle is the prohibition of “reasonable compensation” being classified as QBI, so certain RIA owners will now be incentivized to pay (or at least determine) a market rate for his or her salary and bonuses. We know firsthand that this is easier said than done and could require consultation with an industry advisor (like ourselves) or compensation expert to make such a determination. It’s also important to keep in mind that the income must also be domestic and not attributable to securities investments to qualify as QBI (even though REIT income not attributable to capital gains or qualified dividends is allowable).Regardless of eligibility, the QBI and its random countenances are not likely to be a game changer for your RIA. It is, however, worth understanding these features if you can take advantage of (one of the few) benefits from the TCJA on pass-through entities like S Corps and LLCs. Otherwise, you can take comfort in not having to keep track of all this.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

What Is a Reserve Report? (Part II)

This is the second of multiple posts discussing the most important information contained in a reserve report, the assumptions used to create it, and what factors should be changed to arrive at Fair Value[1] or Fair Market Value[2].In our first post, we discussed the purpose of a reserve report, why they are important, how they are prepared and what is contained in the report. In this post, we discuss two of the most important inputs that go into every reserve report: production and pricing and why it may be appropriate to make adjustments to these inputs for purposes of Fair Value or Fair Market Value.What Is a Reserve Report?To recap, a reserve report is a reporting of remaining quantities of minerals which can be recoverable over a period of time. The current rules define these remaining quantities of mineral as reserves. The calculation of reserves can be very subjective, therefore the SEC has provided, among these rules, the following definitions, rules and guidance for estimating oil and gas reserves:Reserves are “the estimated remaining quantities of oil and gas and related substances anticipated to be economically producible.The estimate is “as of a given date.”The reserve “is formed by application of development projects to known accumulations.” In other words, production must exist in or around the current project.“In addition, there must exist, or there must be a reasonable expectation that there will exist, the legal right to produce or a revenue interest in the production of oil and gas.”There must also be “installed means of delivering oil and gas or related substances to market, and all permits and financing required to implement the project.”Therefore, a reserve report details the information and assumptions used to calculate a company’s cash flow from specific projects which extract minerals from the ground and deliver to the market in a legal manner. In short, for an E&P company, a reserve report is a project-specific forecast. If the project is large enough, it can, for all intents and purposes, become a company forecast.ProductionIn our first post, we summarized 12 significant assumptions made in a reserve report. Production is an important input that goes into every reserve report. Production revolves around the estimate of current and future oil and gas removed from the resource play. To organize the certainty of future production forecasts, the SEC requires the use of three categories: (1) Proved, (2) Probable, and (3) Possible. These categories have the following definition:Proved: An estimate that is reasonably certain. There must be at least a 90% probability that the actual quantities recovered will equal or exceed the estimate. Therefore, economic producibility: proved oil and gas reserves are those quantities which can be estimated with reasonable certainty to be economically producible from a given date forward from known reservoirs and under existing economic conditions, operating methods and government regulations. Economic producibility must be based on existing economic conditions.Probable: An estimate that is as likely as not to be achieved and when using a probabilistic method, there must be at least a 50% probability that the actual quantities recovered will equal or exceed the estimate.Possible: An estimate that might be achieved, but only under more favorable circumstances than are likely and, when using a probabilistic method, there must be at least a 10% probability that the actual quantities recovered will equal or exceed the estimate. The production assumptions might be the most important assumption within the reserve calculation. Careful attention should be utilized in the estimation of future production. Use of a certified reserve engineer is highly encouraged for this assumption. If the production and decline curves are prepared in an appropriate manner, no adjustment to this input is needed for Fair Value or Fair Market Value, unless hypothetical conditions are to be applied. In which case, adjustments need to be made for matching the valuation date with the production forecast date.PricingReserve reports allow for two types of pricing assumptions for the future estimate at which the minerals are assumed to be sold in the market place. The first SEC rule states (1) companies should use the average of the first day of the month price for the previous 12 months; therefore, an average of the previous year (historical pricing); and (2) the SEC also allows for use of contract prices if future production is contractually guaranteed at certain pricing. This type is forward-looking.For the most part, reserve reports use historical prices in their analysis. This assumption should be challenged for possible replacement in Fair Value or Fair Market Value analysis.In these types of situations, future expectation is appropriate to utilize in the reserve calculation. Therefore, a forward-looking price assumption, frequently called a “price deck,” should be considered.Forward-looking price assumptions come in the form of futures contracts which are based on certain amounts of crude oil/natural gas delivered in certain future months. These types of futures contracts are traded daily on various exchanges[3] and include contracts for delivery as far out as 60 months or longer in some instances.Therefore, with the available information and forward-looking purpose of Fair Value and Fair Market Value analyses, strong consideration should be made to replace a historical price deck with a forward-contract price deck. Additionally, incorporation of differentials and local pricing should also be considered when using a price deck based on futures contracts.A Plug for Mercer CapitalMercer Capital has significant experience valuing assets and companies in the energy industry. Because drilling economics vary by region it is imperative that your valuation specialist understands the local economics faced by your E&P company. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.Endnotes[1] “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” – FASB Glossary[2] “The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts” – U.S. Treasury regulations 26 C.F.R. sec. 20.2031-1(b)[3] Chicago Mercantile Exchange, New York Mercantile Exchange, Intercontinental Exchange

Valuing Oil & Gas Reserves (Part II)

Don Erickson, Managing Director of Mercer Capital, educates the public on valuation methodologies and trends impacting various industries. One such industry is Oil & Gas. In the second part of this two-part slide deck, he discusses the basics of how to value oil & gas reserves. Structured in two parts, this slide deck was originally presented to notable professionals in the valuation industry and is designed as a high level overview of the technological and production method changes currently employed by the oil and gas industry. Mercer Capital’s goal with this slide deck is to give the public a vocabulary and conceptual framework for thinking about valuation issues and challenges within the industry given it is prone to volatile swings in commodity prices. Mercer Capital has significant experience valuing assets and companies in the oil and gas industry, primarily oil and gas, bio fuels and other minerals. We also provide financial education services to family businesses. We help family ownership groups, boards, and management teams align their perspectives on the financial realities, needs, and opportunities of the business. Contact a Mercer Capital professional today to discuss your needs in confidence.

Valuing Oil & Gas Reserves (Part I)

Don Erickson, Managing Director of Mercer Capital, educates the public on valuation methodologies and trends impacting various industries. One such industry is Oil & Gas. In this slide deck, he discusses the main drivers impacting the oil and gas pricing environment over the previous decade and the implications to valuing reserves. Structured in two parts, this slide deck was originally presented to notable professionals in the valuation industry and is designed as a high level overview of the technological and production method changes currently employed by the oil and gas industry. Mercer Capital’s goal with this slide deck is to give the public a vocabulary and conceptual framework for thinking about valuation issues and challenges within the industry given it is prone to volatile swings in commodity prices. Mercer Capital has significant experience valuing assets and companies in the oil and gas industry, primarily oil and gas, bio fuels and other minerals. We also provide financial education services to family businesses. We help family ownership groups, boards, and management teams align their perspectives on the financial realities, needs, and opportunities of the business. Contact a Mercer Capital professional today to discuss your needs in confidence.

Q4 Call Reports

Triadic Effects of the New Tax Law

Publicly traded asset managers were up nearly 13% last quarter, driven by tax reform and strong equity markets. The Tax Cuts and Jobs Act has been especially beneficial to the RIA sector, as lower corporate tax rates have had a positive impact on equity markets, boosting AUM and earnings, which are now taxed at lower rates. Many firms are still assessing the full impact of tax reform, but what is clear is that lower corporate tax rates in 2018 will give asset managers increased flexibility in capital management, M&A activity, and technology investment. On the fee side, tailwinds for low-fee passive products remain strong, but recent strength in equity markets has shifted the asset mix for many firms towards higher-fee equity products, which may increase realized fees in the short term.As we do every quarter, we take a look at some of the earnings commentary of pacesetters in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Recent corporate tax reform could spur M&A and other investing activity as firms have increased flexibility in capital management and strategic investment decisions.We're excited by the options created by corporate tax reform and are currently discussing how we can best serve all stakeholders. These options include committing resources to further develop our financial technologies and investment data science expertise; obviously, M&A activity; investing to optimize our global distribution efforts; and introducing and seeding new products and services. We also plan to make investments that directly benefit employees and the communities where they do business. – Greg Johnson, Chairman and CEO, Franklin ResourcesI think the difference [post tax reform] is that everything's fairly equal as we look at the world. [I]n the past, if it was captive offshore cash, and before any tax reform, you may have had a bias to try to do something outside of the U.S. I think, today, the U.S., it's all fungible cash around the world. So we would look openly to opportunities as much here in the U.S. as abroad. I think that the net-net would be you have an opportunity to do a larger acquisition in the U.S. than you did in the past. That would be the only real change, I think, as far as how we look at the M&A landscape. – Greg Johnson, Chairman and CEO, Franklin ResourcesClearly, an increase in incremental cash flow from tax reform could impact likely favorably our capital management decisions, and that reflects both potential dividends and buybacks. And our plan is to – I mean, given the tax reform is basically three weeks old – our plan is to effectively reassess our latest capital management recommendations probably around mid-year once we kind of finalize the impact the tax reform is going to have on BlackRock. And there's going to be lots of additional guidance that's going to be forthcoming as well as making sure that we are looking at all of the balance sheet, if you will, opportunities that we have over the next several months, including more aggressively seeding and co-investing in new products. – Gary Shedlin, CFO, BlackRockTheme 2: Technology investment and acquisitions will continue to play a key role in expanding product breadth and enhancing client experience; BlackRock makes several FinTech acquisitions.We accelerated the expansion of our technology portfolio during 2017 with the acquisition of Cachematrix and minority investments in iCapital and Scalable Capital. Our investments in technology and data will enhance our ability to generate alpha and more efficiently serve clients, resulting in growth in both base fees and technology revenue. – Greg Shedlin, CFO, BlackRockTechnology is enabling more productive engagements with more financial advisers than ever before, driving accelerated asset and base fee growth across our platform. BlackRock is using better data and technology to scale our own wealth advisory sales teams and equipping them with a better insight about our clients, about their portfolios, and giving a much better texture about markets. – Laurence Fink, CEO, BlackRockIn the area of technology, we expect approximately $1 million of additional run-rate costs in 2018 and an extra $4 million of onetime upfront expenses related to the implementation costs for risk management and regulatory initiatives, mostly to further support expanding degrees of investment freedom. We also plan to implement a new client reporting system, which will enhance the client experience. – Charles Daley, CFO, Artisan Partners Asset ManagementTheme 3: Tailwinds for passive products remain strong, and significant net inflows into low-fee passive products have continued in both the retail and institutional channels. Despite ongoing fee pressure from passive products, some firms have seen modest fee increases due to market-driven shifts in AUM composition towards higher-fee equity products.Global iShares generated a record $245 billion of new business for the year, representing full year organic growth of 19% with flows split nearly evenly between core and higher-fee noncore exposures. Since BlackRock launched the iShares core funds 5 years ago, we have seen over $275 billion of net inflows, including $122 billion of net inflows in 2017 alone. Three of the industry's top five ETFs, in terms of net new assets globally this year, were iShares core ETFs; IBV, our S&P 500 Fund; IEFA for developed international market exposure; and IEMG, our core emerging markets fund. – Gary Shedlin, CFO, BlackRockThe rotation from active to passive has accelerated. Risk-based asset allocations continue to gain popularity at the expense of the style box approach, and the demand for ETFs and other efficient investment vehicles has grown. – Eric Colson, CEO, Artisan Partners Asset ManagementThe fourth quarter open-end fund fee rate increased to 50 basis points from 48 in the prior quarter due to the impact of lower fund expense reimbursements as a result of the consolidation of service providers and an increase in average assets and higher fee equity products due to market appreciation. – Michael Angerthal, CEO, Virtus Investment Partners, Inc.

Electronic Logging Devices

Gone are the days of paper logbooks, because the future is here for truckers in the form of Electronic Logging Devices, or ELDs. But what are they, what do they do, and what will they be replacing?

What RIA Owners Need to Know About the New Tax Law

For this week’s post, we’re offering the slides and recording from our recent webinar on the tax bill’s impact on the investment management community. On balance, we believe most RIAs are better off as a consequence of the legislation, but there are nuances to the “win.” Specifically, the webinar covers the following observations on the recent bill:U.S. equities have, overall, benefited from the tax billHigher valuations have driven ongoing revenues higher at investment management firmsMany RIA margins will expand as a consequence of improved economicsInvestment management firm valuations will grow in many cases because of stronger cash flowRIAs structured as tax pass-through entities (S corps, LLCs, Partnerships) may want to consider reorganizing as C corporations So feel free to tune in or scroll through if any of these topics are pertinent to you or your firm. Download Slides???

2018 NAPE Expo Observations & Thoughts

Mercer Capital again attended the NAPE Expo in Houston this past week. People, information, and ideas abounded with over 11,000 participants and 800 exhibitors.We met and had numerous discussions with company representatives, dealmakers, and service providers alike. The marketplace remains excited about the potential for 2018.A recurring theme of the Wednesday conference was restructuring and bankruptcy in light of the continuing bankruptcy activity in 2017. The ramp up in M&A activity in 2017 was also discussed. We summarize that information here.Restructuring & BankruptciesSuccess stories were presented, such as Samson Resources’ CEO Joseph Mills discussing their successful emergence from Chapter 11 bankruptcy whereby approximately $4 billion of debt and $300 million in interest expense was discharged.A panel discussion on navigating the distressed oil and gas world was thought-provoking. The panel participants provided an overview of the 2017 bankruptcy environment as well as where we are headed in 2018 (including statistics and commentary). From 2015 through October 2017, there were a total of 116 U.S. producer bankruptcies representing $80 billion of secured and unsecured debt. Because some of these bankruptcies were very large and complicated, the panel discussed the cost/benefit factors of various restructuring and bankruptcy scenarios. Cautionary commentary acknowledged that it’s expensive to file bankruptcy (sort of an oxymoron) and that even the best laid plans can fall apart when various creditors and equity holders come into contact in a bankruptcy court. One panelist (Jason Binford) noted that it’s also expensive and potentially fatal to wait to file bankruptcy. Many times there’s a lot at stake as the table below demonstrates. Strategies to avoid bankruptcy were categorized between internal & external options. Internal options included (i) operational improvements, (ii) portfolio management, and (iii) liquidity management. External solutions included (i) capital markets/M&A, and (ii) liability management – including Chapter 11 bankruptcy, in which the audience was reminded that a company does not have to be insolvent to enter into Chapter 11. 3rd Party Valuations Can Be Critically Important in BankruptciesThe importance and contentiousness of valuations was emphasized, particularly when equity committees believe that there is more value to the company than what other participants may think. In those situations, a quality and persuasive valuation can be critical and be the difference between the court wiping out prior equity holders and replacing them with new equity holders.The panel also advised not letting short-term price movements overly dictate strategy in this volatile priced industry.Increasing M&A Activity Pace in 2017Upstream M&A activity accelerated quickly in 2017; however, deal activity declined as commodity prices increased during the year. There were 224 deals in 2017 (a 13% increase over 2016) totaling $181.97 billion (a 10% decrease).Of the 224 deals, 106 were shale deals valued at $66.55 billion. The most active basins were the Permian (unsurprisingly), followed by the Marcellus and then Eagle Ford.From our standpoint, it was notable that on the Expo floor, away from the conference where shale plays took precedence, there was an incredible array of conventional, offshore, and international prospects that were still attractive and receiving attention.Our Takeaways from 2018 NAPE ExpoAgain, the marketplace remains excited about the potential for 2018. The rise in commodity prices will likely not last through the year given the potential supply that is available to come online – whether through OPEC policy changes, reduction of DUC well inventory, or another means of changing supply and demand dynamics.The U.S. upstream segment is well-positioned to continue to have positive economics due to increasingly efficient operations, technology, and innovation.Thanks again to everyone we connected with this week. The conversations were terrific, and we enjoyed getting to know all of you. If you were there, let us know your thoughts and comments about NAPE. We would love to hear them. Have a great Valentine’s Day!

The Oilfield Services Industry Is Still Struggling and What This Means to Valuation

Lately, talk of the domestic oil and gas market has been especially positive. But the oilfield services industry is still struggling to recover from the collapse of oil prices in mid-2014 and the subsequent reduction in capital spending by upstream companies.We look at how the downturn in crude prices in 2014 still affects the oilfield service industry and consider the impact on company valuations.What Happens to Oilfield Services Companies When Oil Prices Are LowOilfield service companies provide support services to oil and gas production companies – leasing drilling rigs, repairing wells, manufacturing drilling equipment, processing seismic data, and more.When oilfield production companies cut capital expenditures and delayed drilling projects after oil prices fell in mid-2014, demand for oilfield service companies plummeted. They were no longer needed to drill new wells because new drilling activity essentially stopped when prices fell, and they were not needed to perform routine maintenance as many companies delayed repairs in order to cut costs.When oil prices fell, some regions were deemed uneconomical by many players, while other regions, such as the Permian Basin, experienced a rush to grab land while it was still available. While oilfield service companies operating in the Permian were better off than others, even these companies struggled as oil producers played the game of survival of the fittest where only those who could cut costs and increase efficiency could win.In order for drilling to remain economical in the new low oil price environment of 2015 and 2016, production companies invested in cost savings measures. Technological advancements, like multiwell pad drilling, reduced costs for the oil producers which in turn decreased revenue for oilfield service companies. As Dan Eberhart, contributor to Forbes wrote recently in “Revenge Of The Oil Services Sector in 2018”:"Make no mistake, when producers boast of 'efficiency gains' made to outlast low prices, they are primarily referring to cost-cutting achieved by squeezing contractors for lower day rates on services like drilling and well completions, providing fracking sand and connecting new wells to pipeline systems."Where Do Oilfield Companies Stand Today?Although earnings in the E&P sector have improved over the last year, earnings in the oilfield service industry have taken a beating over the last few years. Three of the top four players had negative LTM EBITDAs until mid-year 2017.Per the chart below, EBITDA has varied as compared to 4Q12. Of the four companies that released 2017 year-end financials (most oilfield service companies have not yet released 4Q17 data), EBITDA for two is significantly down from the previous quarter, one is stable, and one is up. EBITDA at 4Q17 has stabilized around 80% to 100% lower than EBITDA in 4Q12. Making matters worse, the oilfield service industry is highly capital intensive. The RMA average capital intensity ratios for companies that drill oil and gas wells (NAICS 213111) and companies that support activities for oil and gas operations (NAICS 213112) are $1.67 and $0.91, respectively.[1] To fund the massive amounts of capital needed, oilfield service companies can either use debt or cash. After the downturn in price, over 150 oilfield service companies filed for bankruptcy. The high number of bankruptcies in the industry has demonstrated that oilfield service companies may not be able to rely on debt as heavily as they have in the past in order to fund future capital expenditures. While bankruptcies in the E&P sector slowed in 2017, bankruptcies continued in the oilfield service industry. What Are the Appropriate Approaches to Value Oilfield Service Companies Today?In down cycles such as this, valuations are hard to understand because earnings alone cease to become particularly reliable indicators of value.Public multiples provide less insight as negative earnings multiples make little sense. Reliance on the multiples of companies that are currently profitable is questionable because the low profitability can artificially inflate the multiples and not provide a holistic view of value.Instead of using current earnings as indicators of value, the use of forward earnings and their associated forward multiples is considered. This is consistent with a forward-looking discounted cash flow method, but the valuation is then heavily dependent upon the reasonableness of the projections. The oilfield service industry is not expected to see a full recovery in 2018 so forward multiples may appear inflated even for fiscal 2018.During down cycles of asset intensive industries, such as oilfield services, investors often rely on an asset-based approaches. The net asset value method is an asset-based approach that develops a valuation indication in the context of a going concern by adjusting the reported book values of a subject company’s assets to their market values and subtracting its liabilities (adjusted to market value, if appropriate).Valuations Remain Challenging to InterpretUnderstanding the value of your oilfield services company in the context of the broader oil and gas marketplace can be difficult during times like these.Many think that the industry has recovered, or at least is on the way, but the oilfield service sector still appears to have a ways further to go.Until rates and/or utilization for services companies begin increasing and E&P companies begin sharing the gains they have made since oil prices have recovered, valuations could remain challenging to interpret.Mercer Capital has significant experience valuing assets and companies in the energy industry. Because drilling economics vary by region it is imperative that your valuation specialist understands the local economics faced by your oilfield service company. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.Endnote[1] Ratios provided for companies with over $25 million in Sales per RMA 2017-2018 Annual Statement Studies

S Corp RIAs Disadvantaged by the Tax Bill

New but Unimproved

In 1973 Ford Motor Company committed brand espionage by replacing its reigning muscle car, the Mustang, with a slow and cramped economy box as an alleged successor: the Mustang II. Whereas earlier versions of the Mustang were fitted with a reasonably powerful V-6 and much more powerful V-8 motors, the best the “II” could boast was a smallish V-6 from the Capri. With all of 105 horsepower, the V-6 enabled Mustang II could meander to 60 miles per hour in about 13 seconds (given level pavement and favorable winds).We covered much of what we think the new tax bill will mean to RIA valuations in last week’s blogpost – and it’s mostly good news. The “rest of the story” involves the bill’s impact on shareholder returns for RIAs structured as tax pass-thru entities (S corporations, LLCs, Partnerships), for which the news is not so buoyant.As with the Mustang II, the Tax Cuts and Jobs Act took a good thing and made it not so good. The S corporation was a fairly brilliant innovation from the 1950s, allowing certain small businesses to benefit from the limited liability of a being a corporation yet file their taxes as partnerships. S corporations (and LLCs) “pass-through” the tax liability on profits to their shareholders rather than pay one layer of tax at the corporate level on company profits and another at the shareholder level on dividends.Why Many RIAs are Structured as Tax Pass-Through EntitiesBefore the Trump Tax Bill, it often made sense to structure investment management firms as tax pass through entities – usually S corporations or LLCs. As shown in the table below, given taxable income of, say, $1 million, a C corporation would only have $650 thousand to distribute after paying federal corporate taxes at a rate of 35%. Even though the same $1 million of taxable income would be taxed at a higher personal rate for S corporation shareholders, the after-tax distribution of $604 thousand would have a higher economic value when you consider S corp shareholders skip the dividend tax (paid at 23.8%) that would accrue to the C corporation shareholder. After grossing up the after-tax dividend to the S corp shareholder at the C corporation dividend tax rate, the S corporation shareholder earns a C corporation equivalent dividend of nearly $800 thousand. Assuming the RIA in this example is valued at 8x pre-tax income, the S corp shareholder experiences a distribution yield that is 180 basis points higher than if his or her RIA were structured as a C (all else equal). The example above assumes a fully distributing RIA, since many if not most RIA clients we’ve encountered over the years dividend out something close to 100% of their net income. But the S corporation yield advantage also exists if, say, an RIA only distributes half of the C corp equivalent after-tax income (or, conversely, retains half of net income). Tax Cuts and Jobs Act Mutes S Corp AdvantageThe new tax legislation has a big impact on C corporation taxes, a more modest impact on personal income taxes, and no effect on capital gains taxes. As a consequence, the economic advantage of organizing as an S corporation or LLC has been whittled away to almost nothing in some cases, and is arguably disadvantageous in other cases.The table below depicts the comparative consequences of the new tax bill on RIAs organized as C corporations and S corporations. For C corporations, the fourteen percentage point drop in corporate tax rates improves the after tax income available for distribution considerably. In our example, a fully distributing C corporation with $1 million in pre-tax income would have $790 thousand in after-tax income to distribute to shareholders – a substantial improvement over the $650 thousand available under the old tax rates. For S corporations and LLCs, however, the taxes on pass-through income are still substantial, as the after-tax distribution only improves from $604 thousand to $630 thousand (yes, it still improves). If you gross this up for taxes that would be owed on the C corporation dividend, you arrive at a C corporation equivalent dividend of $827 thousand, or not much more than the $790 thousand dividend available for the C corporation. The dividend yield advantage narrows from 180 basis points before the tax legislation to 40 basis points after the tax legislation (assuming some improvement in the valuation multiple – as discussed in last week’s blogpost). The comparison is even worse for investment management firms structured as tax pass-through entities but don’t distribute all of their net income. Going back to the example of the firms that distribute half of their after tax earnings (on a C corp equivalent basis), the dividend yield for the C corporation improves under the new legislation from 4.1% to 4.5%, even with a higher valuation. The S corp yield drops, however, assuming the same earnings retention as the C, from 4.6% to 3.5%, notably lower than the dollar amount and percentage distribution yield for the C corporation. (Probably) No QBI Deduction for YouKnowing that they were trimming back the S corporation advantage, the tax bill introduced a new concept, the Qualified Business Income deduction, that allows certain S shareholders to deduct 20% of their pass-through income and, therefore, maintain more of the S corporation differential in tax rates. However, in a very interesting and possibly more revealing move, the QBI deduction is NOT available for investment management firms.Congress decided to exclude certain “specified service trade or business” income from qualifying for the deduction. One excluded business is investment management: “The term ‘specified trade or business’ means any trade or business – (B) which involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).” Of note, Congress had never, to our knowledge, previously singled out investment management for specific treatment as a “specified service trade or business.” Like the limitation on the deductibility of financial planning fees mentioned last week, it appears this administration is taking aim at the RIA community (while inexplicably allowing QBI deductions for architects and engineers).Despite the exclusion, the QBI deduction remains available to RIA shareholders for whom total income is less than $315 thousand; the deduction phases out until it is completely unavailable at incomes greater than $415 thousand. As a result, many RIA shareholders will not get the benefit of the Qualified Business Income deduction.Final Thoughts and Parting ShotsSo, like the Mustang II, the tax bill is new but not necessarily improved for owners of RIAs structured as S corporations or LLCs (excluding the impact of generally higher AUM balances discussed in last week’s post). The Trump administration didn’t aim its product at the investment management community any more than Ford was looking after driving enthusiasts in the early 1970s. It could be worse, though. In the mid-1980s Ford tried to ruin the Mustang’s reputation again with a version that was also underpowered and, this time, front wheel drive. Mustang fans balked, and Ford released the car as an entirely separate product: the Probe, a name that may suggest how some RIA partners feel about the new tax law after they file their 2018 return.1988 Ford Probe: You know the marketing folks in Dearborn loved working with that name (photo: favcars.com)

It’s Tax Time: Implications of Tax Reform for Banks

A Memphis establishment long has used the slogan, “It’s Tax Time (… Baby),” in their low budget television advertising. After listening to early fourth quarter earnings calls, banks – and especially their investors – appear to be embracing this slogan as well. Four investment theses undergirded the revaluation of bank stocks after the 2016 presidential election: regulatory reform, higher interest rates, faster economic growth, and tax reform. One year later, regulatory reform is stymied in Congress, and legislative efforts appear likely to yield limited benefits. Short-term rates have risen, but the benefit for many banks has been squashed by a flatter yield curve and competition for deposits. Economic growth has not yet translated into rising loan demand.Fortunately for bank stock valuations, the tax reform plank materialized in the Tax Cuts and Jobs Act of 2017 (the “Act”).1 The Act has sweeping implications for banks, influencing more than their effective tax rates. This article explores these lesser known ramifications of the Act.2C Corporations & The ActIn 2017, the total effective tax rate on C corporation earnings – at the corporate level and, assuming a 100% dividend payout ratio, at the shareholder level – was 50.5%. Under the Act, this rate will decline to 39.8%, reflecting the new 21% corporate rate and no change in individual taxes on dividends. For a hypothetical bank currently facing the highest corporate tax rate, the Act will cause a 40% reduction in tax expense, a 22% increase in after-tax earnings, and a 269bp enhancement to return on equity (Table 1). The benefit reduces, however, for banks with lower effective tax rates resulting from, among other items, tax-exempt interest income. Continuing the example in Table 1, which assumed a 35% effective tax rate, Table 2 illustrates the effect on banks with 30%, 25%, and 20% effective tax rates. Since investors in bank stocks value after-tax earnings, not surprisingly banks with the highest effective 2016 tax rates experienced the greatest share price appreciation in 2017. Table 3 analyzes share price changes for publicly-traded banks with assets between $1 and $10 billion. ImplicationsThe preceding tax examples distill a nuanced subject into one number, namely an effective tax rate. The implications of the Act for banks, though, spread far beyond mathematical tax calculations. We classify the broader implications of the Act into the following categories:“Allocation” of Tax SavingsLendingMiscellaneousImplication #1: “Allocation” of Tax SavingsWe know for certain that the tax savings resulting from the Act will be allocated among three stakeholder groups – customers, employees, and shareholders.3 The allocation between these groups remains unknown, though.CustomersJamie Dimon had a succinct explication of the effect of the Act on customers:And just on the tax side, so these people understand, generally, yes, if you reduce the tax rates, all things being equal, to 20% or something, eventually, that increased return will be competed away.4The logic is straightforward. The after-tax return on lending and deposit-taking now has increased; higher after-tax returns attract competition; the new competitors then eliminate the higher after-tax returns. Rinse and repeat. One assumption underlying Mr. Dimon’s statement, though, is that prospective after-tax returns will exceed banks’ theoretical cost of capital. If not, loan and deposit pricing may not budge, relative to the former tax rate regime. Supporting the expectation that customers will benefit from the Act is the level of capital in the banking industry searching for lending opportunities.Renasant Corporation has noted already potential pressure on its net interest margin.Not sure [net interest margin expansion is] going to hold. We’ll need a quarter or 2 to see what competitive reaction is to say that we’ll have margin expansion. But we do think that margin at a minimum will be flat and would be variable upon competitive pressures around what’s down with the tax increase.5EmployeesAn early winner of tax reform was employees of numerous banks, who received one-time bonuses, higher compensation, and upgraded benefits packages. With falling unemployment rates, economists will debate whether employers would have made such compensation adjustments absent the Act. Nevertheless, the public nature of these announcements, with local newspapers often covering such promises, will create pressure on other banks to follow suit.Generally, bank compensation adjustments have emphasized entry level positions. An open question is whether such benefits will spread to more highly compensated positions, thereby placing more pressure on bank earnings. For example, consider a relationship manager who in 2017 netted the bank $100 thousand after considering the employee’s compensation and the cost of funding, servicing, and provisioning her portfolio. Assuming that customers do not capture the benefit, the officer’s portfolio suddenly generates after-tax net income of $122 thousand. The loan officer could well expect to capture a share of this benefit, or take her services to a competitor more amenable to splitting the benefit of tax reform.ShareholdersMr. Market clearly views shareholders as the biggest winner of tax reform, and we have no reason to doubt this – at least in the short-run. Worth watching is the form this capital return to shareholders takes. With bank stocks trading at healthy P/Es, even adjusted for tax reform, banks may hesitate to be significant buyers of their own stock. Instead, some public banks have suggested higher dividends are in the offing. Meanwhile, Signature Bank (New York), which has not paid dividends historically, indicated it may initiate a dividend in 2018. In the two days after the CEO’s announcement, Signature’s stock price climbed 8%.Table 4 compiles announced expenditures by certain banks on employees, philanthropy, and capital investments. Click to view Table 4.Some public market analysts have “allocated” 60% to 80% of the tax savings to shareholders, with the remainder flowing to other stakeholders. Time will tell, but banks will face pressure from numerous constituencies to share the benefits.Implication #2: LendingThe Act potentially affects loan volume with future possible effects on credit quality.VolumeLooked at most favorably, higher economic growth resulting from the Act, as well as accelerated capital expenditures due to the Act’s depreciation provisions, may provide a tailwind to loan growth. However, some headwinds exist too. Businesses may use their tax savings to pay down debt or fund investments with internal resources. The Act eliminates the deductibility of interest on home equity loans and lines of credit, potentially impairing their attractiveness to consumers. Last, the Act disqualifies non-real estate assets from obtaining favorable like-kind exchange treatment, potentially affecting some types of equipment finance.QualityWhile we do not expect the Act to cause any immediate negative effects on credit quality, certain provisions “reallocate” a business’ cash flow between the Treasury and other stakeholders (e.g., creditors) in certain circumstances:Net Operating Loss (“NOL”) Limitations. Tax policy existing prior to the Act allowed businesses to carry back net operating losses two years, which provided an element of countercyclicality in periods of economic stress. The Act eliminates the carryback provision. Further, businesses can apply only 80% of future NOLs to reduce future taxable earnings, down from 100% in 2017, thereby potentially pressuring a business’ cash flow as it recovers from losses. As a result, less cash flow may be available to service debt.Interest Deductibility Limitations. The Act caps the interest a business may deduct to 30% of EBITDA (through 2021) and EBIT (thereafter) for entities with revenue exceeding $25 million.6 Assuming a 5% interest rate, a business’ debt must exceed 6x EBITDA before triggering this provision. Several issues arise from this new limitation. First, community banks may have clients that manage their expenses to achieve a specified tax result, which could face disallowed interest payments. Second, in a stressed economic scenario, cash flow may be diverted to cover taxes on nondeductible interest payments, rather than to service bank debt.Real Estate Entities. The Act appears to provide relatively favorable treatment of real estate managers and investors. However, banks should be aware that the intersection of (a) the interest deductibility limitations and (b) the Act’s depreciation provisions may affect borrower cash flow. Entities engaged in a “real property trade or business” may opt out of the 30% interest deductibility limitation. However, such entities (a) must depreciate their assets over a longer period and (b) cannot claim 100% bonus depreciation for improvements to the interior of a commercial property. Banks should also prepare for reorganizations among business borrowers currently taxed as pass-through entities, especially in certain service businesses not qualifying for the 20% deduction described subsequently. From a tax planning standpoint, it may be advisable for some business clients to reorganize with certain activities conducted under a C corporation and others under a pass-through structure.Implication #3: Miscellaneous ConsiderationsAdditional considerations include:Effect on Tangible Book ValueTable 5 presents, for publicly traded banks with assets between $1 billion and $5 billion, their net deferred tax asset or liability positions as a percentage of tangible common equity. Table 5 also presents the number of banks reporting net DTAs or DTLs. From a valuation standpoint, we do not expect DTA write-downs to cause significant consternation among investors. If Citigroup’s $22 billion DTA revaluation did not scare investors, we doubt other banks will experience a significant negative reaction. In Citigroup’s case, the impairment has the salutary effect of boosting its future ROE, as Citigroup’s regulatory capital excluded a large portion of the DTAs anyway. Regulatory Capital7The Basel III capital regulations limit the inclusion of DTAs related to temporary differences in regulatory capital, but DTAs that could be realized through using NOL carrybacks are not subject to exclusion from regulatory capital. As noted previously, though, the Act eliminates NOL carrybacks. Therefore, certain banks may face disallowances (or greater disallowances) of portions of their DTAs when computing common equity Tier 1 regulatory capital.8Business InvestmentsAn emerging issue facing community banks is their relevance among technology savvy consumers and businesses. Via its “bonus” depreciation provisions, the Act provides tax-advantaged options for banks to address technological weaknesses. For qualifying assets – generally, assets other than real estate and, under the Act, even used assets – are eligible for 100% bonus depreciation through 2022. The bonus depreciation phases out to 0% for assets placed in service after 2026.9Mergers & AcquisitionsOur understanding is that the Act will not materially change the existing motivations for structuring a transaction as non-taxable or taxable. With banks accumulating capital at a faster pace given a reduced tax rate, it will be interesting to observe whether cash increases as a proportion of the overall consideration mix offered to sellers.Permanence of Tax ReformOne parting thought concerns the longevity of the recent tax reforms. The Act passed via reconciliation with no bipartisan support, unlike the Tax Reform Act of 1986. As exhibited recently by the CFPB, the regulatory winds can shift suddenly. Like the CFPB, is tax reform built on a foundation of sand?S Corporations & The ActAt the risk of exhausting our readership, we will detour briefly through the Act’s provisions affecting S corporations (§199A). While the Act’s authors purportedly intended to simplify the Code, the smattering of “lesser of the greater of” tests throughout §199A suggests that this goal went unfulfilled.Briefly, the Act provides that shareholders of S corporations can deduct 20% of their pro rata share of the entity’s Qualified Business Income (“QBI”), assuming that the entity is a Qualified Trade or Business (“QTB”) but not a Specified Service Trade or Business (“SSTB”).10 That is, shareholders of QTBs that are not SSTBs can deduct 20% of their pro rata share of the entity’s QBI.11 Simple.The 20% QBI deduction causes an S corporation’s prospective tax rate to fall to 33.4%, versus the 44.6% total rate applicable in 2017, thereby remaining below the comparable total C corporation tax rate (Table 6). S corporations should review closely the impact of the Act on their tax structure. The 2013 increase in the top marginal personal rate to 39.6% and the imposition of the Net Investment Income Tax on passive shareholders previously diminished the benefit of S corporation status. The Act implements a $10 thousand limit on the deductibility of state and local taxes, which may further diminish the remaining benefit of S corporation status. While we understand this limitation will not affect the deductibility of taxes paid by the S corporation itself (such as real estate taxes on its properties), it may reduce shareholders’ ability to deduct state-level taxes paid by a shareholder on his or her pro rata share of the S corporation’s earnings. S corporations also should evaluate their projected shareholder distributions, as S corporations distributing only sufficient amounts to cover shareholders’ tax liability may see fewer benefits from maintaining an S corporation election.12ConclusionFor banks, the provisions of the Act intertwine throughout their activities. Calculating the effect of a lower tax rate on a bank’s corporate tax liability represents a math exercise; predicting its effect on other constituencies is fraught with uncertainty.13 We look forward to discussing with clients how the far reaching provisions of the Act will affect their banks, clients, and the economy at large. It will be Tax Time for quite some time. As always, Mercer Capital is available to discuss the valuation implications of the Act.This article originally appeared in Mercer Capital's Bank Watch, January 2018.End NotesLest we be accused of imprecision, the Act’s formal name is “An act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018.”Before proceeding, we include the de rigueur disclaimer for articles describing the Act that Mercer Capital does not provide tax advice and banks should consult with appropriate tax experts.We recognize that some of the tax savings may be invested in capital expenditures or community relations, but these expenditures ultimately are intended to benefit one of the three stakeholder groups identified previously.Transcript of J.P. Morgan Chase & Co.’s Fourth Quarter 2016 earnings call.Transcript of Renasant Corporation’s Fourth Quarter 2017 earnings call.Floor plan financing is exempt from this provision.See also Federal Reserve, Supervisory & Regulatory Letter 18-2, January 18, 2018.Generally, DTAs are includible in regulatory capital up to a fixed percentage of common equity Tier 1 capital.In addition, §179 allows entities to expense the cost of certain assets.The §179 limit increases from $500 thousand in 2017 to $1 million in 2018.The Act also expands the definition of assets subject to §179 to include all leasehold improvements and certain building improvements.We recognize that the risk of exploding heads is acute with reference to §199A.Therefore, we avoided discussion of the limits on the 20% deduction relating to W-2 and other compensation, “qualified” property, and overall taxable income, as well as the various income thresholds that exist.Suffice to say, §199A is considerably more complex than we have described.It does not appear that banks are SSTBs (and, thus, banks are eligible for the 20% deduction), although the explanation is mind numbing.An SSTB is defined in §199A by reference to §1202(e)(3)(A) but not §1202(e)(3)(B).Existing §1202 provides an exclusion from gain on sale to holders of “qualified small business stock.”However, §1202(e)(3)(A) and §1202(e)(3)(B) disqualify certain businesses from using the QSB stock exclusion.Banks are specifically disqualified from the QSB stock sale exclusion under §1202(e)(3)(B).Since §199A’s definition of an SSTB does not specifically cite the businesses listed in §1202(e)(3)(B), such as banks, §199A has been interpreted to provide that banks are not SSTBs.Interested in more SSTB arcana?Architects and engineers are excluded specifically from the list of businesses ineligible for the 20% deduction, apparently speaking to the lobbying prowess of their trade groups (or their ability to build tangible things).We are not aware that the Act limits the increase in an S corporation shareholder’s tax basis arising from earnings not distributed to shareholders.However, the tax basis advantage of S corporation status typically is secondary to the immediate effect of an S corporation election on a shareholder’s current tax liability.To be fair, we should limit the “math exercise” comment to C corporations; the S corporation provisions in §199A undeniably are abstruse.

It’s Tax Time: Implications of Tax Reform for Banks

Fortunately for bank stock valuations, the tax reform plank materialized in the Tax Cuts and Jobs Act of 2017 (the “Act”). The Act has sweeping implications for banks, influencing more than their effective tax rates. This article explores these lesser known ramifications of the Act.

What Is a Reserve Report?

This is the first of multiple posts discussing the most important information contained in a reserve report, the assumptions used to create it, and what factors should be changed to arrive at Fair Value[1] or Fair Market Value[2].Why Is a Reserve Report Important?A reserve report is a fascinating disclosure of information. This is, in part, because the disclosures reveal the strategies and financial confidence an E&P company believes about itself in the near future. Strategies include capital budgeting decisions, future investment decisions, and cash flow expectations.For investors, these disclosures assist in comparing projects across different reserve plays and perhaps where the economics are better for returns on investment than others.However, not all the information in a reserve report is forward-looking, nor is it representative of Fair Value or Fair Market Value. For a public company, disclosures are made under a certain set of reporting parameters to promote comparability across different reserve reports. Disclosures do not take into account certain important future expectations that many investors would consider to estimate Fair Value or Fair Market Value.What Is a Reserve Report?Simply put, a reserve report is a reporting of remaining quantities of minerals which can be recoverable over a period of time. The current rules define these remaining quantities of mineral as reserves. The calculation of reserves can be very subjective, therefore the SEC has provided, among these rules, the following definitions, rules and guidance for estimating oil and gas reserves:Reserves are “the estimated remaining quantities of oil and gas and related substances anticipated to be economically producible;The estimate is “as of a given date”; andThe reserve “is formed by application of development projects to known accumulations”. In other words, production must exist in or around the current project.“In addition, there must exist, or there must be a reasonable expectation that there will exist, the legal right to produce or a revenue interest in the production of oil and gas”There also must be “installed means of delivering oil and gas or related substances to market, and all permits and financing required to implement the project.”Therefore, a reserve report details the information and assumptions used to calculate a company’s cash flow from specific projects which extract minerals from the ground and deliver to the market in a legal manner. In short, for an E&P company, a reserve report is a project-specific forecast. If the project is large enough, it can, for all intents and purposes, become a company forecast.What Is the Purpose of a Reserve Report?Many companies create forecasts. Forecasts create an internal vision, a plan for the near future and a goal for employees to strive to obtain. Internal reserve reports are no different from forecasts in most respects, except they are focused on specific projects.Externally, reserve reports are primarily done to satisfy disclosure requirements related to financial transactions. These would include capital financing, due diligence requirements, public disclosure requirements, etc.Publicly traded companies generally hire an independent petroleum engineering firm to update their reserve reports each year and are generally included as part of an annual report. Like an audit report for GAAP financial statements, independent petroleum engineers provide certification reserve reports.Investors can learn much about the outlook for the future production and development plans based upon the details contained in reserve reports. Remember, these reserve reports are project-specific forecasts. Forecasts are used to plan and encourage a company goal.How Are Reserve Reports Prepared?Reserve reports can be prepared many different ways. However, for the reports to be deemed certified, they must be prepared in a certain manner. Similar to generally accepted accounting principles (GAAP) for financial statements, the SEC has prepared reporting guidance for reserve reports with the intended purpose of providing “investors with a more meaningful and comprehensive understanding of oil and gas reserves, which should help investors evaluate the relative value of oil and gas companies." Therefore, the purpose of SEC reporting guidelines is to assist with project comparability between oil and gas companies.What Is in a Reserve Report?Reserve reports contain the predictable and reasonably estimable revenue, expense, and capital investment factors that impact cash flow for a given project. This includes the following:Current well production: Wells currently producing reserves.Future well production: Wells that will be drilled and have a high degree of certainty that they will be producing within five years.Working interest assumption: The ownership percentage the Company has within each well and project.Royalty interest assumptions: The royalty interest paid to the land owner to produce on their property.Five-year production plan: All the wells the Company plans to drill and have the financial capacity to drill in the next five years.Production decline rates: The rate of decline in producing minerals as time passes. Minerals are a depleting asset when producing them and over time the production rate declines without reinvestment to stimulate more production. This is also known as a decline curve.Mineral price deck: The price at which the minerals are assumed to be sold in the market place. SEC rules state companies should use the average of the first day of the month price for the previous 12 months. Essentially, reserve reports use historical prices to project future revenue.Production taxes: Some states charge taxes for the production of minerals. The rates vary based on the state and county, as well as the type of mineral produced.Operating expenses for the wells: This includes all expenses anticipated to operate the project. This does not include corporate overhead expenses. Generally, this is asset-specific operating expenses.Capital expenditures: Cash that will be needed to fund new wells, stimulate or repair existing wells, infrastructure builds to move minerals to market and cost of plugging and abandoning wells that are not economical.Pre-tax cash flow: After calculating the projected revenues and subtracting the projected expenses and capital expenditures, the result is a pre-tax cash flow, by year, for the project.Present value factor: The annual pre-tax cash flows are then adjusted to present dollars through a present value calculation. The discount rate used in the calculation is 10%. This discount rate is an SEC rule, commonly known as PV 10. The overall assumption in preparing a reserve report is that the company has the financial ability to execute the plan presented in the reserve report. They have the approval of company executives, they have secured the talent and capabilities to operate the project, and have the financial capacity to complete it. Without the existence of these expectations, a reserve report could not be certified by an independent reserve engineer.A Plug for Mercer CapitalMercer Capital has significant experience valuing assets and companies in the energy industry. Because drilling economics vary by region it is imperative that your valuation specialist understands the local economics faced by your E&P company. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.Endnotes[1] “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” – FASB Glossary[2] “The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts” – U.S. Treasury regulations 26 C.F.R. sec. 20.2031-1(b)

Are RIAs Worth More Under the New Tax Bill?

Absolutely (Well…Probably)

My seventeen year old daughter is getting pretty deep into her college search; she’s narrowed it down to a handful of schools that are between 1,000 miles from home and 4,000 miles from home, if that tells you anything. A few weeks ago she told an admissions officer from a really fine school in California that she is “interested in politics,” but that she doesn’t want to be a politician; instead she’s interested in “economics as they relate to public policy, especially tax policy.” I learned this over dinner one night.I know I should have teared up with pride, but instead I lost my appetite.Having my creative, funny, yet also quantitatively astute daughter sell her soul not just to the dismal science of economics but in particular Washington’s never ending quest to pervert the dismal science...feels a little like an act of betrayal - like her telling me that her dream car is a Saturn. At least it hasn’t come to that.For Once, Taxes Are Not BoringBecause we like our readers, the RIA team at Mercer assiduously avoids talking about tax policy in this blog. The Trump tax bill, however, can’t go without mention. We won’t mince words – this tax bill is a blockbuster for the investment management industry. Whatever your politics, you can’t ignore the magnitude of the change that is afoot.Among the issues presented by the tax bill is that advisor fees are no longer a line-item deduction for clients, an interesting shot at investors by this administration that doesn’t line up very well with the tax treatment of other professional services. While this is peculiar, David Canter recently published an interview with industry leaders Brent Brodeski and Michael Nathanson that cautions against making too much of this.We’re staying focused on the implications of the tax bill for investment management firm valuations, and there’s much to consider.The Tax Bill Has Driven Up AUM (for Most)Investment management revenue is a function of AUM, and the impact of the tax bill on valuations across a spectrum of asset classes is significant. While the impact of this on anyone who derives fee income from managing equities (fixed income shops are a different story) is clear, we don’t think it’s sufficient to just take the increase in market valuations at face; it’s more useful to unpack the issue and consider why.One of our colleagues here at Mercer, Travis Harms, did some research on the impact of the tax bill on valuation multiples to consider not just the what but also the why. Notably, Travis looked at the impact on pre-tax multiples, such as EBITDA, to interrogate whether or not a dollar of pre-tax cash flow is indeed worth more if it is less burdened with tax liabilities. Travis is interested in the change in multiples because he works heavily in the portfolio valuation space. We saw broad implications to his modeling exercise for the investment management community.Travis pulled monthly forward EBITDA multiples for the S&P 1000 (ex financials). The S&P 1000 is a combined mid and small cap index, consisting of company #501 through #1500. As shown in the following chart, the median multiple for such firms was approximately 9.0x to 9.5x during the fall of 2016, when a Clinton administration, and tax status quo, seemed inevitable. By late 2017, the median multiple had expanded by almost a full turn, to about 10.3x.Forward EBITDA multiples for sample equity index (S&P 1000 ex financials) shows movement in multiples that appear to correlate with changes in the outlook for corporate tax reductions. Valuation multiples are, of course, a function of three factors: 1) cash flow, 2) risk, and 3) growth. To determine whether or not the change in multiples is indeed attributable to a change in tax rates, Travis investigated whether or not there had been an effective change in the cost of capital (risk) or an expectation of increased growth in earnings. Travis’s analysis inferred an aggregate cost of capital (supply side weighted average cost of capital, or WACC) for his equity basket in September of 2016 as an anchor point, and then looked at the change in the cost of capital over the same period that resulted from a change in interest rates (holding the assumed equity risk premium constant). The risk-free rate (the interest rate on long dated treasuries) gapped up from close to 2.0% in September of 2016 to something on the order of 2.8% in December of that year, pushing the implied supply side cost of capital up to about 9.2%. Doing some fancy footwork, Travis ran a DCF model on his equity basket, letting the tax rate float. His DCF model suggests that the market priced in effective tax rates of approximately 20% by the end of 2017. Significantly, the early expectations for rate reduction seem to have waned a bit over the summer months as the Trump administration experienced a series of legislative failures. Also significant is that the model assumes there are no changes in the expected growth outlook for the companies in the sample basket, consistent with statements from the Federal Reserve suggesting no material uptick in GDP growth consequent from the tax bill. Travis didn’t modify expected growth because there is no robust way to review earnings estimates for a broad array of companies on a month by month basis. Of note, Aswath Damodaran, a finance professor at NYU, thinks the tax bill may in fact increase the sustainable growth rate for U.S. companies. Using a DCF model framework to evaluate the impact of a change in tax expectations on valuation multiples, we can let the cost of capital float with interest rates and hold growth expectations constant, such that the change in valuation multiples can be attributed to the change in tax rates. The implication of Travis’s analysis is that the market repriced as a consequence of lower tax rates, and not because of changes in the cost of capital (which, with higher interest rates, would have caused multiples to fall), nor expectations of higher earnings growth (of which there is little evidence). Put another way, the tax bill appears to have, indeed, inflated equity valuation multiples by reducing the tax burden on corporate profits. On one level, this is obvious, but the implications of this are interesting if it also suggests that current equity valuations are more sustainable than some believe. Perhaps valuation multiples gapped higher, as they should have, and will remain higher than they would otherwise be, so long as corporate tax rates persist at these levels. That would certainly be good news for the asset management community. The Tax Bill Has Improved RIA Economics (for Many)Taking this one step further, the tax bill would seem to have improved returns for many subsectors of the investment management industry. If public market valuations gapped up 10% or so, would we expect to see nearly a 10% increase in assets under management across the equity space in the industry? More AUM means more revenue and more profitability? In short, yes, as we can show in the example below. This table is fairly self-explanatory. Assuming an RIA with $5 billion under management, of which 80% is managed equities and 20% is fixed income, a 10% increase in equity valuations would have a corresponding 8% increase in overall AUM, ceteris paribus. If the same investment management firm realized fees of 65 basis points on equities and 20 basis points on fixed income, the leverage on the higher AUM attributable to equities would increase revenue a bit more than total AUM, or 9.3%. One potential problem with this aspect of the model is the assumption that clients with higher AUM balances won’t pass through breakpoints that will lower overall realized fees. For purposes of this example, however, we have assumed that the fee schedule isn’t progressive with the increase in AUM. When we consider the leverage on operating expenses, however, things really get interesting. Higher AUM balances can lead to a correspondingly higher expense base if the increase comes from more accounts or assets that are more expensive to manage. In this instance, however, AUM is simply inflated because of market activity. We might not assume G&A costs would rise at all, nor would, necessarily, salaries. Incentive compensation, however, would probably increase. Assuming bonus compensation to be 30% of pre-bonus EBITDA, we see an almost 20% increase in incentive compensation resulting from higher assets under management. Even with higher bonuses, however, total expenses only increase about 4%. The consequence of this is an increase in earnings before interest, taxes, depreciation, and amortization of almost 20%, and a cash flow margin increase of three percentage points. If you’re an asset manager, your reality may (will) be different than our example. If interest rates continue to rise, our sample RIA might experience some diminution in income from managing fixed income portfolios. Clients may rebalance to maintain the same allocation between stocks and bonds. Clients are, on the whole, more fee sensitive than they once were, and may want some betterment of their fee schedule as a consequence of this moment of good fortune. And your staff will probably notice that there is more cash flow available for compensation. The market may bid up the cost of talent, or at least salaries and bonuses will increase more than we show here in an effort to “keep a good thing going.” In any event, if your AUM increases nearly 10% and margins don’t widen, it would be worth looking through your numbers some to assess why. The opportunity for a significant increase in profitability at many RIAs appears to be on offer. The Tax Bill Has Improved RIA valuations (for Some)Taking this one step further, RIAs may not only benefit from a repricing of market multiples of their clients’ assets, but also of the value of their own returns. In our example firm, EBITDA increases 18.6% as a direct consequence of the tax bill. Valuations of RIAs would be expected to increase similarly, if there were no change in the valuation multiples for the RIAs themselves. If, however, appropriate multiples for RIAs gap-up 10% like Travis Harms observed happened in the public equity market, then the combination of that plus improved profitability produces a 30% increase in enterprise values for RIAs, and a corresponding 20% expansion in the implied AUM multiple. The reason for the increase in RIA multiples is the same as the increase in the market basket of equities Travis studied: a dollar of pre-tax cash flow is worth more when the tax burden on that dollar is less (assuming no change in the cost of capital or earnings growth). Your Results May (Will) DifferWhatever you do, don’t run out of your office and tell your partners that I’ve just proven your firm is worth 30% more than it was two months ago. There are many variables that affect firm valuation – some discussed in this post, some I’ve left out, and some I probably haven’t thought of yet. One issue in comparing movement in the public market multiples and private RIAs is that public companies are C-corporations whereas many, if not most, private RIAs are some kind of tax pass-through entity like an S corporation or an LLC. I’ll be back next week to talk about how the tax bill treats tax pass through enterprises, and it’s not nearly as generous as conferred upon C corps.In any event, the tax bill is bullish for the RIA community. There may not be a Saturn in my driveway, but a friend of mine who, like me, was born under the astrological sign of Capricorn says that Saturn is in our house this year (cosmologically, a favorable thing). I don’t know what the “Saturn” effect is for the markets, but for now it appears that the stars are aligned for the RIA community, an augur of good things to come.If you have questions as you wrestle with the valuation implications of the new tax bill on your RIA, give us a call to discuss your situation in confidence and/or register for our upcoming webinar addressing the matter.

M&A in Appalachia: Moving Day in the Neighborhood

This week we look back at transaction activity and trends in the Marcellus & Utica plays in 2017. When I reflect about what happened, for whatever reason, images resembling something out of an episode of Desperate Housewives come to mind whereby the prying eyes of the marketplace peer out of their windows, surveilling old competitors that pack up and leave whilst new, and sometimes mysterious, neighbors move in.But first, we point out recent articles that forecast that the U.S. may challenge Saudi Arabia and Russia in total oil production sometime in the next two years. For someone who has followed and worked within energy markets for many years, including before the shale fracking revolution, this is something I wasn’t sure I’d ever read. Of course it is likely a temporary surge once the OPEC/non-OPEC agreement expires, but it's still fascinating to contemplate.The Appalachian BasinOK, now back to the subject at hand. Transaction activity in the Marcellus & Utica shale was generally steady throughout the year and individual transactions were typically smaller in size. Rationale for these deals were varied, from bankruptcy sales, to consolidation of acreage, strategy changes to more liquid rich plays, leverage reduction, and more. The chart below, drawn from Mercer Capital's forthcoming 4Q17 Marcellus & Utica-focused newsletter, provides transaction detail and comparative valuation metrics.Back Up the Truck, Dear! We're Moving onto Bigger and Better Things.In one of the few large transactions last year, Noble Energy exited the Marcellus in order to focus on more liquid rich regions with its $1.2 billion sale to HG Energy. David L. Stover, Noble Energy's Chairman, President and CEO, commented, "The Marcellus has been a strong performer for Noble Energy over the last few years, which is a direct result of the success of our employees' efforts. During the same time period, we have also significantly expanded the inventory of investment opportunities in our liquids-rich, higher-margin onshore assets, which has led us to now divest our Marcellus position."In a similar vein, Carrizo Energy, a Houston-based producer, exited the play, utilizing the familiar "non-core" term to describe its position in the Appalachia region. S.P. "Chip" Johnson, IV, Carrizo's President and CEO, commented, "With the announced sale of our Marcellus package, we have continued to execute on the divestiture program we outlined earlier this year. We expect to close the sale of both of our Appalachian packages during the fourth quarter and remain on track to reach our divestiture program goals." Carrizo has stated its desire to focus on liquid plays and reduce leverage which these sales went towards achieving.Look Honey, Those Folks Are Moving Out … and Their Wells Are Just Perfect for Us!Looking at the other end of the rationale spectrum, there were a number of buyers that were enthusiastic about the opportunities that companies like Noble & Carrizo left behind. Kalnin Ventures, a Thai-based coal and power generation company, made their 5th acquisition in the play in the past two years by buying positions from Carrizo's and Reliance Marcellus II, LLC. They also made a 6th in December by taking out Warren Resource's entire Northeast Marcellus position for $105 million. In strategic contrast to Carrizo's sentiment, Kalnin thinks these assets fit within their strategy of acquiring profitable, consolidated, low-risk assets that provide strong cash flow yields.Believe it or not, Kalnin's activity actually did not top the acquisition charts in 2017. That distinction belonged to EQT, beginning with EQT's $527 million bankruptcy auction bid of Stone Energy's Marcellus and Utica acreage in February 2017. EQT, who made nearly $9 billion of Marcellus & Utica acquisitions in 2017, went on to highlight the year by its merger with Rice Energy in June 2017. Steve Schlotterbeck, EQT's president and chief executive officer said, "This transaction complements our production and midstream businesses and will deliver significant operational synergies to help us maintain our status as one of the lowest-cost operators in the United States." For a more in-depth valuation oriented discussion on the Rice Energy transaction, a prior Mercer Capital blog post breaks down the deal.Are You Watching This, Sweetie? So, What Kind of Deal Did They Get?Valuations for these transactions were relatively spread out depending on the metric observed, but were within an observable range. Kalnin appeared to pay more than other buyers in a few deals from a $/Acre perspective (over $19,500/Acre), but it can be argued that they baked in economies of scale in light of their overlapping positions and infrastructure. EQT appeared to buy in a very tight range from a $/Mcfe/Day perspective ($6,300-$6,600). That said, due to the steady activity and universe of buyers and sellers, pricing and values appeared to be fairly consistent. We shall see if that continues in 2018, and speaking of that - we wish you all a happy 2018!A Plug for Mercer CapitalMercer Capital has significant experience valuing assets and companies in the energy industry. Because drilling economics vary by region it is imperative that your valuation specialist understands the local economics faced by your E&P company. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Trust Banks Underperform in 2017 Despite Rising Equity Markets & Yield Curve

All three publicly traded trust banks (BNY Mellon, State Street, and Northern Trust) underperformed other categories of asset managers during 2017, and only State Street outperformed the S&P 500. While all three benefited from growth in Assets Under Custody and Administration (AUCA) and Assets Under Management (AUM) due to strong equity markets in 2017, the trust banks performed more in line with U.S. banks generally during 2017. The exception is State Street, which performed comparably to the SNL Asset Manager Index due in part to its large ETF business (State Street is one of the three largest ETF providers globally). The other two trust banks have less significant ETF business (Northern Trust) or none at all (BNY Mellon). Due in part to its strong ETF inflows, State Street is on track to pass BNY Mellon as the largest trust bank in terms of AUCA. Throughout 2017, trust banks tended to underperform other classes of asset managers like alternative asset managers, mutual funds, and traditional asset managers. To put this in historical context, trust banks have lagged the broader indices since the financial crisis of 2008 and 2009, although in 2016 our trust bank index was the highest performing category of asset manager. With the exception of trust banks, all classes of asset managers outperformed the S&P 500, as rising equity markets and operating leverage combined to increase the profitability of these businesses. Despite the relative underperformance during 2017, trust banks saw increases in their two largest sources of fee revenue (servicing and investment management fees) due primarily to strengthening equity markets. Trust banks also saw improved net interest margins due to higher U.S. market interest rates. Trading services revenues, which are a less significant component of fee revenue than servicing and management fees, were generally down in 2017 due to low volatility in the equity markets. Trust bank trailing multiples have expanded in line with other categories of asset managers since last year, so their underperformance suggests that earnings haven’t kept pace. So have these securities gone from overbought to oversold? A quick glance at year end pricing shows the group valued at 14-16x (forward and trailing) earnings with the rest of the market closer to 25x, so that alone would suggest that they aren’t too aggressively priced. Still, the three companies are all trading near 52 week highs, so it’s hard to say they’re really all that cheap either. Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Industry Consolidation Drives Further Gains in RIA Dealmaking

Asset manager M&A remained robust in 2017 against a backdrop of rising markets and higher AUM balances for most industry participants. Total (disclosed) transaction value was up 6% from 2016 levels despite a 6% reduction in the number of deals. Several trends, which have driven the uptick in sector M&A, have continued into 2017, including revenue and cost pressures and an increasing interest from bank acquirers.The underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, and slowing organic growth for many active managers. While these pressures have been compressing margins for years, asset manager M&A has historically been muted, due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation. Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure for certain firms.Consolidation pressures in the industry are largely the result of secular trends. On the revenue side, realized fees continue to decrease as funds flow from active to passive. On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs. Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to gain scale in order to realize cost efficiencies, increase product offerings, and gain distribution leverage.Acquisition activity in the sector has been led primarily by RIA consolidators, with Focus Financial Partners, Mercer Advisors (no relation), and United Capital Financial Advisers each acquiring multiple RIAs during 2017. While these serial acquirers account for the majority of M&A activity in the sector, banks have also been increasingly active acquirers of RIAs in their hunt for returns not tied to interest rate movements. Despite a rising yield curve which should make banks a little more comfortable with their core business, we suspect that RIAs will remain attractive targets for bank acquirers due to the high margins (relative to many other financial services businesses), low capital requirements, and substantial cross-selling opportunities. Recent increases in M&A activity come against a backdrop of a now nine-year-old bull market. Steady market gains have continued throughout 2017 and have more than offset the consistent and significant negative AUM outflows that many active managers have seen over the past several years. In 2016, for example, active mutual funds’ assets grew to $11 trillion from $10.7 trillion, despite $400 billion in net outflows according to data from Bloomberg. As a result of increasing AUM and concomitant revenue growth, profitability has been steadily rising despite industry headwinds that seem to rationalize consolidation. It is unclear whether this positive market movement has been a boon or a bane to M&A activity. On one hand, many asset managers may see rapid AUM gains from market movement as a case of easy come, easy go. In that case, better to sell sooner rather than later (and vice versa from a buyer’s perspective). On the other hand, as long as markets trend upwards, margin and fee pressures are easy to ignore. In that case, a protracted market downturn could lead to a shakeout for firms with cost structures that are not sustainable without the aid of a bull market (as was the case in 2008 and 2009). With no end in sight for the consolidation pressures facing the industry, asset manager M&A appears positioned for continued strength or potential acceleration regardless of which way the markets move in 2018, although a protracted bear market, should it materialize, could highlight consolidation pressures and provide a catalyst for a larger wave of M&A activity. With over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. An aging ownership base is another impetus, and recent market gains might induce prospective sellers to finally pull the trigger. More broadly, the recent tax reform bill is expected to free up foreign-held cash, which could further facilitate M&A’s upward trend into 2018. Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Economics of Drilling in the Marcellus & Utica

What a Steady Oil and Gas Industry in 2017 Points to in 2018

“Steady as she goes.” At least that is what I think captains of most vessels say…except maybe a car. For captains navigating the 2018 oil and gas industry, a repeat of 2017’s relatively calm waters is vocal wish. 2017 in ReviewOil prices closed the year reaching $60 per barrel, WTI futures prices returned to backwardation, and oil price volatility was relatively calm as the price moved within an $18 band all year ($42 - $60). Natural gas, on the other hand, continued its woes of declining prices, transportation constraints, and oversupply. Hope remains that increased natural gas exports will change the narrative, but that is still undetermined. For the oil industry, a repeat of 2017 would be a welcomed event, making the theme for the year ahead – “Steady as she goes.” Before projecting trends of 2018, let’s review 2017, starting with oil and gas commodity prices.Oil and Gas Commodity PricesIf bottom needs to be found before rebound can happen, 2015 and 2016 provided a solid foundation for the oil and gas price gains in 2017. This past year brought about the feeling of stability for oil prices and continued woes for natural gas. For the year, WTI increased 11% and Henry Hub natural gas decreased 20%. This is the second consecutive year-over-year increase for WTI.Additional PerspectiveIn a commodity-focused industry, commodity prices set the overall framework. With last year’s oil and gas prices as the framework, here are a few posts that provide additional color to the 2017 oil and gas industry.Are S&P Energy Stock Valuations Really Crazy Right Now? The Wall Street Journal published an article discussing what the author described as “crazy” stock valuations, and in particular the inflated valuations of oil and gas stocks from the perspective of operating earnings ratios. While we certainly are believers that value is driven by future operating earnings, and that earnings in the energy sector have fallen precipitously since 2014, is this all that determines the market’s pricing of the S&P 500 energy sector? As we reflect on this for a moment, a few additional considerations came to mind that may explain these “crazy” valuations more fully.Are Oil and Gas Bankruptcies a Thing of the Past? The worst of bankruptcies are over. Since the start of the oil downturn, more than 120 upstream and oilfield service companies declared bankruptcy. However, the decision to file for bankruptcy did not always signal the demise of the business. Now more prepared, many E&P companies who reorganized are looking to grow.Oil and Gas Investors Note Move Away From Contango The movement in the future spread away from a contango environment and toward backwardation is positive from a supply and demand perspective. Expectations are a backwardation environment will move crude oil prices higher. However, the exact cause of this change is unknown. While this shift is good news for the industry, company specific risk and investor's fickle attitudes create volatile equity markets.Current Regulatory Environment Affecting the Oil and Gas Industry As business valuation experts, we have to consider the outlook for the economy, industry, and business in every valuation; therefore, we pay attention to the oil and gas regulatory environment to assess what it means for our clients. Given the new administration, there is much to consider.WTI Futures and Inventories U.S. oil inventories decline as oil exports surge. In this post we address why the shift in oil futures from contango pricing to backwardation is a bearish sign for those in crude oil storage.Outlook for 2018The positive momentum for the oil industry should continue as long as prices hold steady or increase. With the futures curve currently in backwardation and the backwardation spread getting stronger, the upward trend in price should continue. Other resource plays, like the Bakken, Eagle Ford, and Canadian Oil Sands will become more attractive and active as the price of oil inches higher. Natural gas, on the other hand, continues to sort out its oversupply and distribution constraints which have continued to push prices down. Reorganization, consolidation, and operational efficiency in the Marcellus and Utica players are anticipated going forward. This focus will continue until gas price relief is a reality, at which point the companies still operating will be well positioned to thrive.Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Five Things Bitcoin Tells Us About the RIA World in 2018

When’s the last time you thought about Esperanto? Not being an “esperantist” myself, it had been a while. Yet I was searching for some kind of metaphor for bitcoin: a fictional and entirely artificial currency without state backing and having a value tied strictly to facilitating global peer-to-peer transactions when I remembered the fictional and entirely artificial language without state backing and having a value tied strictly to facilitating global peer to peer conversations. Esperanto still exists, but today it is more known by teenage boys everywhere as a fictional car similar to a mid-70s Cadillac El Dorado in the video game Grand Theft Auto (or so Google tells me – this author loves cars but is no gamer).Esperanto was developed in the late 19th century to be a universal second language. The idea was simple and appealing: everyone would maintain their native language and learn Esperanto, such that wherever one traveled he or she could converse with the locals. There would be no need to learn the local language of where you were traveling, and an esperantist could, theoretically, travel anywhere and converse with anybody. Esperanto was based on an amalgamation of several romance languages with a rigid set of phonetic and grammatical rules that would be easy to learn. Esperanto’s algo, as they say, was robust. It sort of caught on, but mostly as a niche skillset. Today, Esperanto is spoken by between two million and ten million people worldwide – approximately the same number of people who have accounts holding cryptocurrency.We’ve put off writing about bitcoin in this blog, partly because we really don’t understand it, few of our clients invest in it, bitcoin’s performance has little to do with whether the RIA industry performs well or poorly, and we desperately wanted to avoid making allusions to tulips. The attention that cryptocurrencies received in late 2017 got our attention, though, as a barometer for trends that will buffet the investment management industry in 2018. Our cursory understanding of bitcoin suggests:1. This Market Craves VolatilityThe financial market experience of 2017 felt like standing in the Whitney Museum watching all eight hours of Andy Warhol’s film, “Empire.” We kept expecting something – anything – to happen, but it never did. Despite a raucous political landscape, global instability popping up everywhere, and pinched cultural nerves at home, the financial markets in the U.S. were very nearly sleepy. With little of interest going on, the market needed a narrative that only a fictive asset with an uncertain purpose could supply. We have, it seems, made it full circle from the credit crisis, when the only asset class in vogue was cash, to a market in which the only asset in vogue is fake cash.2. Traders Want Their Revenue Share BackIt’s difficult to overstate the degree to which trading revenues have been decimated by technology. I’m old enough to remember the “5% rule” being a topic on the Series 7 exam. The thought, today, that prime brokers could ethically charge commissions as high as 5% on each side of a trade is beyond laughable. Suffice it to say, though, that trading used to command a much higher share of investment management revenues. Trading was a valued skill. Technology has destroyed that, as have placid markets and pricing transparency. Bitcoin is a mysterious asset with an unproven market and substantial bid-ask spreads; traders can exploit it so they love it. Look for new products that have pricing inefficiency and arbitrage opportunities that can generate trading revenue.3. The Lines Between Asset Classes Are BlurringWe haven’t fully left the 60/40 world where asset allocation meant choosing capitalization brackets in domestic and foreign equities, mixing fixed income investments across different maturities and different ratings, and throwing in some cash for a rainy day. However, portfolio construction isn’t as simple as it once was, and it probably won’t be again anytime soon. Bitcoin wasn’t the first shot fired at this way of thinking about diversification, but over time the investment community has become littered with categories of investments and some blurring of lines (i.e. large cap domestic companies tend to generate material amounts of profit overseas – so are they “domestic” or “global”?). What bitcoin suggests is that investors have come a long way from having to be talked into investing in something other than treasuries and the S&P 500. “Buying what you know” seems to have lost favor in a world where speculative upside has, at least for some, become more sought after than returns which are measurable and knowable.4. Investors Are Becoming ComplacentAn old and true Wall Street maxim is “every bull market climbs a wall of worry.” Does it feel like we’ve run out of worry? From a practical perspective, it appears that the “wall of worry” is lower than normal. Short interest is in retreat, reserve cash is being depleted, the yield curve is flattening, and nobody cares. Bitcoin is interesting as a gauge of the market’s appetite for speculation. A short nine years ago we were in the throes of the credit crisis, interest rates were going negative throughout the world, investors were shunning equities, and my favorite metaphor for the chaos was uttered (I just don’t remember by whom): “We’ve lost the buoys that mark the deep channel.” Now we’ve swung to the other extreme. I haven’t wandered down to the office library to blow the dust off our copy of “Dow 36,000”, but I’m getting close.5. Finance Evolves Slowly, But It Also Evolves ConstantlyCryptocurrencies are less than a decade old, but the concept has gained ground rapidly. Yet the big banks have largely stayed out of the fray, with Jamie Dimon being openly dismissive of bitcoin in October, and Goldman Sachs only recently announcing that it would open a desk to trade cryptocurrencies; even that won’t be operable until the summer of 2018 (!). So if you feel like you’re being left out of the party, you have good company. What this all demonstrates is that the financial services community changes slowly, which explains the pushback against the fiduciary standard and the mixed response to large broker dealers leaving the protocol. Markets move more rapidly than the people and the firms that serve the markets.Final Thoughts on BitcoinAre cryptocurrencies an asset class? Is bitcoin speculation or a hedge? Will bitcoin have a permanent place in finance or will the magic fade? Is it going to $100,000 or zero? We have no idea.The idea of a universal second language should have worked. Esperanto still exists, but possibly because it doesn’t reflect the life and culture of any particular subset of humanity, it’s really just an effect for the erudite. This makes us wonder about the future of bitcoin. Because it is not state sponsored, it also does not reflect any particular segment of the global economy (except perhaps for that part of the economy that lurks in the shadows).125 years or so after the development of Esperanto, the universal second language is English. Eight years after the development of bitcoin, the universal reserve currency is the dollar.We don’t expect a revolution from cryptocurrencies in 2018, but the follow-through on the 2017 hype should make for a good show.As always, feel free to reach out to us if you’d like to talk further.

First Quarter 2018 | Segment Focus: Residential Construction

Favorable macroeconomic environment leads to increased residential construction activity and new home sales in the midst of existing home inventory shortages. 30-year mortgage rates and 10-year Treasury yields increased 24 and 36 BPS year-over-year.

E&P First Quarter 2018

Region Focus: Eagle Ford

Region Focus: Eagle Ford The oil and gas market has been steadily improving.e volatility was relatively calm as the price stayed within an $18 band all year ($42 – $60).

Transportation & Logistics Newsletter

First Quarter 2018

Gone are the days of paper logbooks, because the future is here for truckers in the form of Electronic Logging Devices, or ELDs. But what are they, what do they do, and what will they be replacing? Most operators of Commercial Motor Vehicles (CMVs) must keep a Record of Duty Service (RODS) to ensure that they are complying with federally mandated Hours of Service (HOS) guidelines. All this alphabet soup to say, the federal government regulates how many hours drivers can be on duty in a daily or weekly cycle. Drivers are required to keep records about their duty hours which can be audited by the Department of Transportation or checked by police officers at roadside inspections. In the past, drivers have kept pencil and paper logs, but these are prone to error and intentional tampering.

Mercer Capital Releases Whitepaper on Valuation Issues with Corporate Venture Capital

Our colleagues down the hall who focus on the portfolio valuation side of our services to the asset management community have an extensive new study on the Financial Accounting Standards Board’s guidance for recognizing the fair value of corporate venture capital, or Accounting Standards Update 2016-01. ASU 2016-01 doesn’t exactly roll off the tongue, but it does represent an important step in the continued trek toward financial statements based on the fair value of assets and liabilities, rather than cost. As more investment activity takes place on the private side, more needs seem to accumulate to assess the market value of investments. The placid market of the past few years has made this task relatively easy, but we all know that’s not going to last.In any event, enjoy the read. It goes especially well with eggnog.Read Whitepaper

A Tale of Two Bakkens: Cashing Out or Doubling Down

Transaction activity in the Bakken shale was both busy and revealing in the second half of 2017. Many of these deals marked the departure of a number of companies that were known to be active in the play, particularly Halcon Resources. Other companies, however, have remained. The table below, drawn from Mercer Capital’s 3Q17 Bakken-focused newsletter, shows some details in regards to recent transactions, including some comparative valuation metrics.Cashing OutThe first major transaction was Halcon’s $1.4 billion sale of the majority of its North Dakota operations to Bruin E&P Partners LLC (a private company). Through this sale, as expected while resurfacing from bankruptcy, Halcon shifted focus to the Permian Basin. In addition, the Company cited the possibility of an outright sale as well. Two months later, Halcon sold its remaining Bakken assets (about 2,300 boe/day of production) for $110 million.In addition Earthstone Energy, and more notably, Linn Energy exited the Bakken in the past several weeks. Linn entered the Bakken play in 2011 by buying out a position previously held primarily by Concho Energy for $434 million. They exited for $285 million which was approximately a 1.5x multiple of the PDP value of $186 million as of YE 2016. It appears that Linn struggled with maximizing its production profile in light of the major price shift in 2014. Earthstone Energy also left, with a small $27 million non-operating sale. They, too, are shifting their focus to the Permian Basin.Valuations for these transactions were relatively tight. The Linn and larger Halcon sales were priced around approximately $14,000 per acre. The Earthstone deal was much smaller, and its valuation on a per acre basis was much smaller as well at around $1,100 per acre.Doubling DownHowever, amid the struggles of these other operators, Whiting and Continental demonstrated signs of commitment and improvement in the Williston Basin. Whiting sold its acreage position in Dunn County, North Dakota for $500 million. This amounted to a pricing of around $17,000 per acre, a premium to the Linn and Halcon sales. This, of course, is a relative bargain on a per acre basis compared to the pricing in the Permian these days. Then again, the economics between the two basins at current pricing is also a far cry from each other, with the Permian having clearly superior characteristics. Nonetheless, this did not signal an exit for Whiting, but was a signal to reduce leverage and give it balance sheet flexibility for its remaining Bakken acreage. Whiting is optimistic that recent improvements in oil pricing differentials and improved enhanced completion techniques will press to its advantage going forward in the play.While Whiting has not yet been able to scale its optimism, Continental has surprised many in the past year with its recent performance. In light of the challenges of the play, Continental has continued to improve its drilling and completion techniques, while elements they can’t control (such as oil prices) begin to swing back in their favor. As such, they have dropped LOE's and G&A to the lower end of their peer range, while netbacks are rising. All of this has happened, while many peers (as demonstrated above) have struggled or are leaving the area. Not all is the same. Performance and valuations in the Bakken appear to be mixed and right now it appears that the operator’s skill and knowledge is as important a value driver as the acreage they drill on. Mercer Capital has significant experience valuing assets and companies in the oil and gas industry, primarily oil and gas, bio fuels, and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 auditors. These oil and gas-related valuations have been utilized to support valuations for IRS estate and gift tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Valuing an Offer for Your RIA

The Devil’s in the Details

When we value an asset management firm, we do so in cash equivalent terms, as if someone were to pay that amount, on a given date, for a given firm or interest therein. On many occasions, clients have asked us how our estimate of value compares with an offer they received for the same firm or an interest in the same firm. It isn’t unusual for the offer to be ostensibly higher than our valuation, but it is unusual for the offer to be made in cash equivalent terms. As a consequence, we often have to look beyond the face value of the offer to determine what the economic value of the offer is, which may be much less than the headline number.In this final blogpost on evaluating unsolicited offers for your RIA, we take on this issue of valuing an offer. Valuing the offer for your RIA can be more difficult than valuing the firm itself.Similar Assets, Priced DifferentlySometimes, things which look similar are actually worth very different amounts of money – so one has to be careful making comparisons. The headliner offering at RM Sotheby’s latest auto auction in New York was a 1959 Ferrari 250GT California Spider built in full racing spec for Bob Grossman. The car is, of course, beautiful, but the story behind it is even better. The apogee of sports car racing was the 1950s and early 1960s, when well-healed amateurs could enter major races against established professional teams and often do very well. Bob Grossman was a successful sports car dealer and amateur racer in New York. He ordered the Ferrari pictured above and had it delivered straight to the track to race in the highly competitive 24 hours of Le Mans in 1959. The car had an aluminum alloy body (one of only eight made that way by Ferrari) and a race tuned V-12 with external plugs. Grossman had never driven at Le Mans before, was unfamiliar with the car, and had a co-pilot for the race whom he’d never met and who didn’t speak English. Grossman entered with the 250GT anyway and took third in his class.The car went on to perform very well in subsequent competitions before Grossman sold it. It doesn’t have leather seats or a radio, but still sold for $18 million. A similar 1961 Ferrari 250GT convertible, freshly restored but lacking racing heritage, was available at the same auction. Despite a pre-auction estimate of less than one-tenth the sale price of the Grossman Ferrari, the ’61 failed to sell. Two very similar cars offered at the same time in the same market; two wildly different valuations.Comparing Offers for Your RIAIf all RIA offers were all cash, this wouldn’t make much of a blogpost. RIAs rarely sell on simple terms in all cash transactions, however, so converting offer pricing and terms to cash equivalents is critical to determining whether an offer is reasonable or not. Because investment management is often a relationship intensive business, transacting an RIA often involves performance based payments like earn-outs, compensation arrangements tied to client transition, non-compete agreements, and other terms which effect the value of the transaction to the seller. Oftentimes cash consideration may only constitute two-thirds or so of total consideration offered.A selling client of ours a few years ago was counseled by a friend to assume that the cash he was paid up front would be the only consideration he ever got for his company, and not to take the deal if that wasn’t enough for him. That’s a little extreme, but the maxim that “cash is cash and nothing else is cash” does establish a hierarchy to think about the value of other forms of consideration.Trading Your Stock…for StockTaking stock in another asset management firm in exchange for some of all of your shares isn’t necessarily a bad idea, but it does double the complexity of the transaction. In addition to having to determine an appropriate value for your firm, you have to think about what the buyer’s stock is worth. Sellers can take this issue for granted, but it has a huge impact on the value transacted.Think, for example, about the relative merits of two shares of stock. If the selling firm’s stock is valued at 8x earnings, and the acquirer values their own stock at 10x earnings, then essentially for every dollar of earnings being given up by the seller, it now has a claim on 80 cents. There may be reasons why the acquiring firm’s stock is worth more – higher quality earnings, lower risk profile, better growth opportunities, etc. The trouble for most sellers, though, is that they understand the potential upsides and downsides of their own company, while having much less visibility into the relative merits of the acquirer’s stock.Does a stock for stock transaction involve giving up control of the selling company and taking an illiquid, minority position in the acquiring company? What is the dividend policy of the buyer versus that of the seller? Is the acquiring company a C corporation and how does that affect shareholder returns if the seller is a tax pass through entity like an S corporation or an LLC?Rolling your interest into the stock of your acquirer may be a good way to stay in the game. The question becomes: whose game is it?Is Selling Your Firm Just an Advance on Your Salary?One thing that is very likely to change when you sell your investment management firm is your compensation package. This is probably something you want to happen – within limits. If you’re currently taking out, say, $1 million per year in total compensation and you could be replaced (at least in theory) for half of that, then your earnings are understated by $500 thousand. At a multiple of 8x, that’s a difference in value of $4 million. You would probably rather pay capital gains tax rates on $4 million today than receive an extra $500 thousand per year, taxed at ordinary income rates, for several years.That said, if there is no clear correlation between compensation give-ups and the value being received from the transaction, it may start to feel like the buyer is paying you for your stock with your money. In some cases, that may even be true. If post-transaction compensation is set too low, you and your partners may have little incentive to perform after the ink dries on the purchase agreement, which doesn’t lead to good outcomes for anyone.We usually counsel acquirers to agree to normal compensation levels with their seller as part of transaction negotiations. If you do that, you’re much more likely to have a common understanding of the profitability of your RIA, and, thus, the negotiation is really about the multiple being paid.Performance Compensation as Risk SharingMany larger and more sophisticated acquirers use bonus compensation as a way to manage their risk. The typical arrangement we’ve seen is for acquirers to take something equivalent to a preferred stake in an RIA – taking their pro rata piece of the upside and little, if any, of the downside, or holding a stake in which management gets more benefit from increases in earnings and more detriment from declines in earnings. RIA consolidators seem particularly fond of this arrangement, and while it’s difficult to “value” the offloading of risk from buyer to seller (or continuing minority partner), it isn’t difficult to see who’s getting the better side of the deal.Earn-out Consideration is Never a GivenEarlier this year we had a whole series of blogposts about earn-out consideration, so I won’t rehash that here (Why Earns-outs Matter, Five Considerations in Structuring Earn-outs, and An Example of Structuring Earn-outs). Suffice it to say that earn-outs are common in RIA transactions and often are necessary to ensure that the value of client relationships and investment products are effectively transferred from seller to buyer. But an earn-out is only worth as much as it is likely to be earned, and this has to do with the target performance and terms associated with the earn-out. The time value of money must also be considered, particularly in earn-out arrangements of three years or more.One thing to keep in mind, as a seller, is how likely you are to reach the targets set by the earn-out. If the minimum growth target is, say, 15%, and your historical growth is less than that, consider how far markets have run to date and how you expect them to perform over the term of the earn-out. Modest earn-out requirements after a lull in the equity markets are one thing, but robust expectations after a long bull run are quite another. This issue is particularly poignant given where markets stand today.Don’t Forget to Value the TermsNon-compete agreements, office buildings, life insurance policies, working capital, contingent liabilities – there are a few dozen other issues that can change the economics of your offer. We can’t cover everything in a blogpost, but I will end with a simple piece of advice that many of these issues should be isolated and dealt with on their own merits – as opposed to being interactive with the operating value of the company. Even if the buyer wants to treat the transaction as an “all-in” or prix fixe price, you should know the breakdown of the offer on an a la carte basis.It isn’t always easy to determine whether an offer is too good to pass up, or too good to be true. If you’re considering a proposal to buy your investment management firm – especially one that came in over the transom – let us take a look at it. Whether you need a sounding board or an advocate, we can help.

WTI Futures and Inventories

Back in August 2017, we discussed the significant and bullish shift in the oil futures market from contango pricing to backwardation. This shift marked the first time backwardation would enter the market since 2014 and oil and gas investors were taking note. This was a bullish sign for many, including producers and oil field services, but a bearish sign for those in crude oil storage. Possible reasons for this include the following.Crude Oil ExportsThe U.S. has never exported more crude oil than right now. Latest data from EIA indicates the export of 1.4 million barrels per day in the month of September; nearly double the August daily export figures. Since the unrefined crude oil export ban was lifted in early 2016, the total average daily export figures have exploded. The average number of barrels exported in 2015 was 465,000 while 2017's average is 960,000 barrels per day.The top five nations receiving U.S. crude oil include 1) Canada; 2) China; 3) Korea; 4) United Kingdom; and 5) India. This group represents 65% of total exports in the month of September, with Canada leading the way with 23% of all U.S. exports while China is a close second at 17%.Interestingly, South Korea has surged its imports of U.S. crude. For reference, the average daily oil exports to Korea between June 2000 and August 2016 was 6,200 barrels per day. In the last 12 months, that number has surged to 50,000 barrels per day (more than 8x the average for the 2000's).Crude Oil Exports Takeaway: With the export ban rescinded, crude oil exports are increasing overall and specifically to eastern Asia.2017 Hurricane Season ImpactAs we wrote in our September 25, 2017 post, Hurricane Harvey, which made landfall in Houston, Texas, shut down more than 20% of the oil production from the Gulf of Mexico with additional onshore volumes shut-in. Four terminals in Corpus Christi were closed to tanker traffic. Nearly 50% of the nation’s refining capacity is located along the Gulf Coast and at least 10 refineries were shut down before the storm’s arrival.In response to the impact of hurricanes during 2017, U.S. refineries have been processing record seasonal volumes of crude to rebuild stocks of gasoline and especially diesel which were depleted by hurricanes and strong consumption at home and in export markets.As a result, crude stocks along the East, West, and Gulf Coasts have all fallen since the summer and are well below last year's levels and appear tight. Hurricane Season Takeaway: Refiners are running hard trying to replenish the stock lost during demand surge and shutdowns caused by the 2017 hurricane season. This results in higher demand for crude oil in the current market. Much of this demand is immediately filled by crude oil in storage.US Oil Inventories – Weekly Petroleum Status Report, EIACrude storage inventories hit their highest level ever in March 2017 with 1.2 trillion barrels of crude oil. Since that time, inventories have declined by 117 million barrels, according to information available from the EIA. Storage levels play a significant role in futures prices. U.S. crude futures, such as West Texas Intermediate (WTI), are based on crude delivered into the tank and pipeline system around Cushing, Oklahoma.Futures prices are, therefore, very sensitive to anything that affects the regional supply-demand balance in the Midwest (PADD 2) as Cushing's falls under the Midwest reporting region.Overall, commercial crude oil storage inventory levels across the U.S. are down 8% year-over-year. The largest single storage facility of commercial crude in the U.S. is stored in Cushing, Oklahoma. Cushing's inventory is down (15%) year-over-year, while the largest PADD area for crude oil storage (the Gulf Coast – PADD 3) was down (12%) year-over-year.Crude Oil Inventory Takeaway: The inventory levels of crude oil are falling all across the nation in response to higher exports of crude oil, the impact from 2017 hurricane season, and the backwardation trend in WTI future prices which encourages selling rather than storage of crude oil.Trend in WTI Future CurveThe table shows the future contract spread for the previous 12 months. The most recent data (December 1, 2017) returns the third month in a row of backwardation spreads since 2014. In addition, the trend movement from contango to backwardation can be seen while watching the shrinking spread from August 2016, when the market had a wider contango spread of ($5.72), to backwardation in October 2017 to a significantly wider backwardation spread in December 2017. ConclusionThe movement in the future spread toward backwardation is positive from an economic supply and demand perspective. Expectations are a backwardation environment will move crude oil prices higher, leading to more exploration and production activity, more active selling to refiners and the broader market, and less demand for storage. While this shift is good news for the overall industry, company specific risk and investors' fickle growth and risk attitudes create volatile public equity markets.Mercer Capital has significant experience valuing assets and companies in the oil and gas industry, primarily oil and gas, bio fuels, and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 auditors. These oil and gas-related valuations have been utilized to support valuations for IRS estate and gift tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Should RIAs Care About Broker Protocol?

As noted last week, much has been written about some of the major wirehouse firms abandoning protocol these last few months. This week we explore what the implications are for RIAs and how it could impact their value in the marketplace. There was a time when broker protocol made a lot of sense to the wirehouse firms. In an effort to avoid countless hours and company funds on litigation, the major brokerage firms at the time, Smith Barney (now part of Morgan Stanley), Merrill Lynch, and UBS signed the Broker Protocol Agreement in August 2004 to avoid the threat of lawsuits for financial advisors switching firms or setting up their own shop. At the time, the logic was that talent poaching was happening anyway, and the only parties benefiting from fighting the poaching were litigators. Several attorneys we’ve spoken with about the potential demise of protocol echoed this sentiment. For years it appeared that broker protocol worked pretty well; today over 1,600 RIAs and broker-dealers voluntarily participate in the de facto cease fire over talent between the brokerage houses. All was quiet on this issue until late October when Morgan Stanley announced it was abandoning protocol, emphasizing its commitment to training and retaining brokers rather than poaching them from rival firms. One month later UBS followed suit, similarly citing the firm’s focus on retaining existing advisors over recruiting them from other shops. From a numbers perspective, these moves aren’t surprising as larger wirehouses have been net losers for several years as protocol made it easier for FAs to switch firms or start their own. Interestingly enough though, Bank of America Merrill Lynch recently announced that it would be sticking to protocol in favor of advisor flexibility in serving client needs. Merrill’s decision seems counterintuitive until you consider that it uses certain exclusions to the agreement to selectively poach other advisors while punishing those trying to leave; therefore, it is less incentivized to break protocol. ML allows advisors who generate their own business to be covered by the protocol while those that use firm referrals to do so are exempt. Similarly, JP Morgan’s commission-based brokers are under protocol while those who receive a salary and bonus to service clients are not. Smaller independent firms and RIAs have also gamed the system by joining protocol to recruit advisors before exiting the agreement to make it harder for them to leave. Moves by UBS and Morgan Stanley to abandon recruitment will make it much more risky and costly for RIAs to recruit their advisors. It also limits the market for whom these advisors can sell their book to if many of the prospective buyers are on a different platform, which could compress valuations for advisory firms built under broker-dealers. In fact, we’ve already seen a bit of a dampening effect on M&A activity as the last quarter tallied the lowest level of RIA dealmaking and advisor breakaways in three years – just 29 such transactions compared to 40 in Q2, according to a new report by DeVoe & Company. Devoe also attributes the decline to the prior surge created by the expiration of many forgivable loans to wirehouse advisors during the financial crisis and the potential passage of the fiduciary rule in late 2016 or early 2017:Source: Devoe & Company, wealthmanagement.com On balance, RIAs and financial advisors looking to add brokers or sell in the foreseeable future should care about broker protocol. Sector transaction activity has already taken a hit, and we may be on the brink of another wave of firms abandoning protocol. Experienced advisor recruitment will also become more challenging as firms continue to exit the agreement. If, on the other hand, the remaining wirehouses stand firm, we could see a stabilization in M&A and possible mean reversion for broker recruitment. Wells Fargo’s pending decision on broker protocol could have a major impact on the industry as a whole, so we’ll be watching that announcement very closely. The epitaph for wirehouse brokerage operations has been written repeatedly over the past twenty-five years or more, but Morgan Stanley’s move to exit protocol has opened a whole new chapter in the saga, suggesting that RIAs are indeed making more than a dent in brokerage firm revenues. We suspect this will remain a major topic in 2018 and will keep you posted on what we think the impact will be to investment management firms. In the interim, feel free to reach out to us if you’d like to talk further. Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

The Importance of Size, Profitability, and Asset Quality in Valuation

The question for most financial institutions is not if a valuation is necessary, but when it will be required. Valuation issues that may arise include merger and acquisition activity, an employee stock ownership plan, capital planning, litigation, or financial planning, among others. Thus, an understanding of some of drivers impacting your bank’s value is an important component in preparing for these eventualities.Data Analysis & Quantitative Factors Affecting Your Bank’s ValueDetermining the value of your bank is more complicated than simply taking a financial metric from one of your many financial reports and multiplying it by the relevant market multiple. However, examination of current and long term public pricing trends can shed some light on how certain quantitative factors may affect the value of your bank.To analyze trends, we focus our discussion on P/TBV ratios since this is one of the most commonly cited metrics for bankers. While all banks can be affected by overall macroeconomic trends like inflation rates, employment rates, the regulatory environment, and the like, we explore relative value in light of three factors we consider in all appraisals – size, profitability, and asset quality.SizeSize differentials generally encompass a range of underlying considerations regarding financial and market diversity. A larger asset base generally implies a broader economic reach and oftentimes a more diverse revenue stream which can help to mitigate harmful effects of unforeseen events that may adversely affect a certain geographic market or industry. Furthermore, larger banks tend to have access to more metropolitan markets which have better growth prospects relative to more rural markets. Figures 1 and 2 on the next page illustrate that, to a point, larger size typically plays a role in value, as measured by price / tangible book value multiples. The sweet spot for asset size seems to be between $5 and $10 billion in total assets. Banks in this category traded at the highest P/TBV multiple as of September 30, 2017 and have generally outperformed all other asset size groups over the long term.ProfitabilityTo examine how profitability affects the value of your bank, we compare median P/TBV multiples for four groups of banks segmented by return on average tangible equity (Figures 3 and 4 on the prior page). A bank’s return on equity can be measured as the product of the asset base’s profitability (or return on assets) and balance sheet leverage. Balancing these two inputs in order to maximize returns to shareholders is one goal of bank management. A bank’s return on equity measures how productively the bank invests its capital, and as one would expect, the banks with the highest returns on equity trade at the highest P/TBV multiple.Asset QualityInferior asset quality increases risk relative to companies with more stable asset quality and may limit future growth potential, both of which may negatively impact returns to shareholders. In addition, it makes sense that a bank with high levels of non-performing assets might trade below book value. Book value of the loans (or other non-performing assets) may not reflect the true market value of the assets given the potential for greater losses than those accounted for in the loan loss reserve and the negative impact on earning potential. Figure 5 illustrates how pricing is affected by higher levels of non-performing assets. As shown in Figure 6, P/TBV multiples plummeted at the start of the economic recession and have yet to recover to pre-crisis levels.ConclusionSize, profitability, and asset quality are factors to consider in your bank’s valuation. From an investor’s perspective, your bank’s worth is based on its potential for future shareholder returns. This, in turn, requires evaluating qualitative and quantitative factors bearing on the bank’s current performance, growth potential, and risk attributes.Mercer Capital offers comprehensive valuation services. Contact us to discuss your valuation needs in confidence.This article originally appeared in Mercer Capital's Bank Watch, November 2017.

Current Regulatory Environment Affecting the Oil and Gas Industry

The oil and gas industry is heavily regulated by the Environmental Protection Agency (EPA), the Federal Energy Regulatory Commission (FERC), Bureau of Land Management (BLM), and the Department of the Interior (DOI).As business valuation experts, we have to consider the outlook for the economy, industry, and business in every valuation; therefore, we pay attention to the regulatory environment to assess what it means for our clients. Given the new administration, there is much to consider.Review of Recent Regulatory ReformStreamlining Federal ReviewsOn August 15, President Trump signed an executive order which aims to speed up the process for federal environmental reviews of energy and other infrastructure projects and holds agencies accountable if they fail to do so. Jack Gerard, President of the American Petroleum Institute (API), praised the order for its focus on speeding up projects, saying “We also look forward to President Trump as he signs an executive order aimed at streamlining the permitting process for infrastructure projects.” The API had previously called for significant improvements to be made to the permitting process.Federal Energy Regulatory CommissionsIn August, the Senate confirmed two appointees to the Federal Energy Regulatory Commission, which is an independent agency that regulates the interstate transmission of electricity, natural gas, and oil, among other things. Prior to the appointments, the commission did not have quorum (the first time in its 40-year history), holding up projects worth $50 billion in private capital according to the Electric Reliability Coordinating Council. FECR is now ready to address the backlog of projects.North American Free Trade Agreement (NAFTA)Negotiations of NAFTA began in the third quarter of 2017 and remain unresolved. President Trump has indicated on multiple occasions that the U.S. could simply pull out of the agreement, which worries many in the oil and gas industry. The API, CAPP, and AMEXHI are the top trade groups in the United States, Canada, and Mexico, respectively, and they issued a joint position paper on August 2 hoping to keep current policies intact and “Do No Harm.” As early as 2020, North America could achieve energy self-sufficiency and has made significant strides since the agreement was signed 23 years ago. The paper goes on to claim that a change in trade that reduces investment protections or increases tariffs or trade barriers could have a significant negative impact on the industry and risk tens of millions of jobs that depend on trade in North America.Tax ReformTowards the end of the third quarter 2017, Congressional Republicans introduced the outlines of their plans for tax reform. On December 2, the Senate passed the tax reform bill. The next step is for the House and Senate to agree on the same version of the bill. In general the bill has the goal of reducing the corporate tax rate and simplifying the overall tax code. The energy industry will likely see aspects that are both good and bad. A corporate income tax rate decrease from 35% to 20% would be great news for the oil and gas industry. On the other hand simplifying the tax code will likely lead to a decrease in tax exemptions of over $4 billion for the industry. The biggest of these, “intangible drilling costs,” or IDCs, could actually be expanded, with a provision in the reform that allows for the immediate expensing of new investments.Renewable Fuels Standards Program (RFS)The Renewable Fuels Standards Program continues to have a significant impact on the refining industry. Each November, the EPA issues rules increasing Renewable Fuel Volume Targets for the next year. Renewable Identification Numbers (RINs) are used to implement the Renewable Fuel Standards. At the end of the year, producers and importers use RINs to demonstrate their compliance with the RFS. Refiners and producers without blending capabilities can either purchase renewable fuels with RINs attached or they can purchase RINs through the EPA's Moderated Transaction System. While large integrated refiners have the capability to blend their own petroleum products with renewable fuels, small and medium sized merchant refiners do not have this capability and are required to purchase RINS, which have significantly increased in price.The new RFS for 2018, which were released in mid-July, displayed a slight reduction in the volume requirements. A public hearing was held on August 1 and on October 17. The EPA provided a public notice and an opportunity to comment on potential reductions in the 2018/2019 biomass-based diesel, advanced biofuel, and total renewable fuel volumes. The final rule should be available in December. A coalition of independent refiners and marketers has urged President Trump to move forward with this review. According to the November issue of the Oil and Gas Journal, the Fueling American Jobs Coalition (FAJC) said, “The need for significant reform has only grown over the last year as the cost of purchasing Renewable Identification Numbers (RIN) to comply with the RFS has skyrocketed, threatening some refiners’ survival.”RTR & NSPSIn December of 2015 the Petroleum Refinery Sector Risk and Technology Review (RTR) and the New Source Performance Standards (NSPS) rule was passed in order to control air pollution from refineries and provide the public with information about refineries’ air pollution. These regulations ranged from fence line and storage tank monitoring to more complex requirements for key refinery processing units. The EIA estimates the rule will cost refineries a total of $40 million per year, while the American Petroleum Institute (API) argued that the annual cost would exceed $100 million. The rule was expected to be fully implemented in 2018 however President Trump’s attention to the needs of deregulation of the oil and gas sector makes us to question the future implementation of the rules.SummaryThese are just a few of the regulations that affect the day-to-day operations of companies in the oil and gas industry. Changes in the regulatory environment have led to increased uncertainty in the oil and gas sector. Overall, however, outlooks for the industry appear favorable. While this post mainly outlines domestic oil and gas policy, it is important to remember that the domestic oil and gas market is affected by global oil supply and demand. On Thursday November 30, OPEC decided to extend production cuts through December 2018. This decision came one year after OPEC originally decided to make across the board production cuts in order to realize more stable oil prices around $50 per barrel.Mercer Capital has significant experience valuing assets and companies in the energy and construction industries. Our valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

What We’re Reading About Broker Protocol

Most of the sector’s recent press has focused on broker protocol, so we’ve highlighted some of the more salient pieces as a preface to our take on the matter in next week’s post.UBS Exits Protocol, Creating “New World” for Advisors, Clientsby Janet Levaux ThinkAdvisor offers differing takes on UBS’s recent decision to leave the Protocol for Broker Recruiting. Many believe a wave of advisor departures from the wirehouse firms is imminent while some contend that the rule wasn’t sustainable in the first place.UBS Broker-Protocol Exit Shows Independent Channel is Bleeding Wirehouses of Advisersby Bruce Kelly Smaller RIAs and, to a lesser degree, independent broker-dealers, have been taking market share from the big four BDs for the last several years. UBS and Morgan Stanley have broken protocol to stymy this momentum and retain advisors that were previously given a pass on being sued if they jumped ship to another broker-dealer.How UBS Exited the Broker Protocol and Why the Aftereffects May Surpass Those of Morgan Stanley's Earlier Departureby Brooke Southall RIABiz predicts that Merrill Lynch will be the next to abandon protocol, leaving Wells Fargo with a big decision to make in the coming weeks.B/D Advisor Valuations to Compress as the Broker Protocol Unravelsby Michael Kitces The Nerd’s Eye View blog predicts a complete unraveling of broker protocol in the coming weeks as few incentives remain for Wells and Merrill to stay on board now that Morgan and UBS have left the agreement. Mr. Kitces also expects the break to compound the decline in broker-dealer valuations as their market will likely be limited to a more captive audience of other brokers on the same platform. Breakaway Broker Deals a Drag on M&A Activity in Third Quarterby Jeff Benjamin The impact on sector M&A is more unclear though many industry observers foresee a short-term spike in breakaway acquisitions but an overall reduction in deal-making over the long run.Broker Hiring Pact Hurt by Defections Expected to Surviveby Neil Weinberg and Katherine Chiglinsky Many analysts believe the protocol will endure for some firms due to the high cost of litigating and the need for guardrails in handling sensitive client data. Raymond James, for example, has vowed to remain a member if it were “the last firm standing.” In summary, there seems to be a general consensus that Merrill (and possibly Wells) will abandon protocol in the coming weeks. Less certain is the impact on sector deal-making and valuations though it doesn’t seem particularly bullish for either. Stay tuned to next week’s post for more perspective on how we think this will all shake out for the RIA community.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Issue No. 1 | Data as of Year-End 2017

Feature Article: Automobile Dealership Valuation 101

How to Value an Oil & Gas Mineral Royalty Interest

Well-informed buyers and sellers are critical to an efficient market for royalty interests because there is a specialized and relatively complex body of knowledge to consider in the transfer of these types of assets.Often called a net revenue interest (NRI), royalty interests do not bear the costs of production and only participate in the potential upside of a resource. The value of a royalty interest, however, is often difficult to observe because they are typically closely held. In addition, once discovered and drilled, the natural resources are physically depleted, resulting in a declining asset as opposed to a growing one.A lack of knowledge regarding the worth of a royalty interest can be very costly. A shrewd buyer may offer a bid far below the interest’s fair market value, opportunities for successful liquidity may be missed, or estate planning could be incorrectly implemented based on misunderstandings about value.Understanding how royalty interests are properly appraised will ensure that you maximize the value of your royalty, whenever and however you decide to transfer it.This blog post summarizes our whitepaper – providing an informative overview of the valuation of mineral royalty interests within the oil and gas industry. While there are a myriad of factors (mostly out of a royalty holder’s control) impacting the economics of a royalty interest, this blog post focuses on valuation methodology.What Does the Valuation Process Entail?Valuation approaches refer to the basis upon which value is measured.There are three commonly accepted approaches to determining value:Asset-based ApproachMarket ApproachIncome Approach In the realm of business valuation, each approach incorporates procedures that may enhance awareness about specific economic attributes that may be relevant to determining the final value of a given entity. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value for the subject interest under consideration. However, due to fundamental structural differences between businesses and assets, the available valuation methodologies tend to be utilized differently when valuing royalty interests. (1)The Asset-Based ApproachThe asset-based approach can be applied in different ways, but the general idea is that the enterprise value of a business is given by subtracting the market value of liabilities from the market value of assets. While the asset-based approach can be useful when valuing companies operating within the oil and gas industry, this approach is not typically employed to determine the value of a royalty interest.Oftentimes a mineral royalty owner purchased land which included the mineral rights and an allocation of surface vs mineral rights was not performed. Additionally, considerable time may have passed between the time the surface and mineral rights were purchased and the valuation date. Adding to the ambiguity of the cost basis of the asset, mineral royalty interests are often family assets that are handed down for generations. For this reason, the asset-approach is rarely used to determine the market value of mineral royalty interests unless the mineral rights were recently purchased.The Market ApproachThe market approach utilizes transaction pricing from guideline transaction data or valuation multiples from a group of publically held companies to determine the value of a privately held enterprise or asset. To develop an indication of mineral royalty interest value using the market approach, you can utilize data from market transactions of mineral interests in similar plays. This data can be derived from direct transactions of mineral royalty interests or from publically traded royalty trusts and partnerships.Direct comparable transactions of mineral royalty interests are often the best indication of fair market value. However, the data with which to benchmark a subject mineral royalty interest against is often unavailable. If it is available, a careful comparative analysis must be made. Royalty trusts and partnerships hold various mineral royalty interests in wells operated by large exploration and production companies. Royalty trusts and partnerships tend to have very low, if any, operating expenses and can be an investment to provide exposure to oil and gas prices.Acquisition data from these trusts can be utilized to calculate valuation multiples on the subject royalty’s performance measure(s). This will often provide a meaningful indication of value as it takes into account industry factors (or at least the market participants’ perception of these factors) far more directly than the asset-based approach or income-based approach.Traditional oil and gas earnings multiples, such as EV/ EBITDAX, should not be used to calculate indication of values because royalty trusts do not have high operating costs and operational earnings margins are not a necessarily meaningful indication of performance for a royalty owner. Rather, a royalty trust's performance can be better understood by its distribution yield and potential for future revenue streams from new, undrilled wells.In many ways, this approach goes straight to the heart of value: a mineral royalty is worth what someone is willing to pay for it. However, the market approach is not a perfect method by any means for businesses or for mineral royalties.Royalty trust transaction data may not provide for a direct consideration of specific mineral royalty characteristics; it is imperative that the value conclusion be adjusted for differences in value level and in well economics, potential future drilling locations, among other factors. In any valuation, the more comparable the transactions are, the more meaningful the indication of value will be.The Income ApproachThe income approach can be applied in several different ways. Generally, such an approach is applied through the development of a cash flow or ongoing earnings figure and the application of a multiple to those earnings based on market returns. For mineral royalty interests, however, we oftentimes perform a discounted cash flow analysis. This approach allows for the consideration of characteristics specific to the subject mineral royalty, such as its well economics making it the most commonly used approach for mineral royalty interest valuations.To perform a royalty’s DCF analysis, production levels must be projected over the well’s useful life. Given that well production decreases at a decreasing rate, these projections can be calculated through deriving a decline rate from historical production. Revenue is a function of both production and price; as such, after developing a legitimate prediction of production volumes, analysts must predict future price values. The stream of revenue is then discounted back to present value using a discount rate that accounts for risk in the industry.Because revenue cash flows are the main driver of mineral royalty values, the income approach is the most reasonable and supportable valuation approach when determining the value of a mineral royalty interest.ConclusionA proper valuation of a mineral royalty interest will factor, to varying degrees, the indications of value developed utilizing the market-based and income-based approaches outlined above. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of the mineral royalty and its unique characteristics that provide relevance and credibility to these calculations. This is why industry "rules-of-thumb" are dangerous to rely on in any meaningful transaction.Such "rules-of-thumb" fail to consider the specific characteristics of an interest and, as such, often fail to deliver insightful indications of value. A mineral royalty owner executing or planning a transition of ownership can enhance confidence in the decisions being made only through reliance on a complete and accurate valuation of the interest.Mercer Capital's Oil & Gas team has extensive experience valuing mineral royalty interests. Despite attempts to homogenize value through the use of simplistic rules of thumb, our experience is that each valuation is truly unique given the purpose for the valuation and the circumstances of the interest. We hope this information, which admittedly only scratches the surface, helps you better shop for royalty valuation services and understand valuation mechanics.We encourage you to extend your wealth planning dialogue to include valuation of any mineral interests because, sooner or later, a valuation is going to happen. Proactive planning and valuation services can alleviate the potential for a negative surprise that could complicate an already stressful time in your personal life.For more information or to discuss a valuation or transaction issue in confidence, do not hesitate to contact us at (901) 685-2120 or (214) 468-8400.End Note(1) Treasury Regulations 1.611-2(d) asserts that the income approach will not be used if the value of a mineral property can be determined using the cost-approach (under the asset approach) or the market approach. However, those circumstances are rare and not consistent with industry norms. The income approach is most often employed to estimate the fair market value of mineral properties such as this.Mercer Capital's Energy Valuation Insights BlogThe Energy Valuation Insights Blog presents a weekly update on issues important to the Energy Industry. Follow us on Twitter @MercerEnergy.

Culture is King, So Why Isn’t It Mentioned in the Purchase Agreement?

Mercer Capital is headquartered in Memphis, where Elvis Presley lived most of his life. It occurred to me recently that I’ve never written about Elvis's passion for cars, a pretty huge oversight for this blog. Elvis bought a lot of cars – estimates number his purchases in the hundreds – for himself, family, employees, friends, and occasionally strangers. A friend of mine who owns a few auto dealerships now was a young car salesman at the local Lincoln/Mercury dealer in the 1970s when he got a call in the middle of the night to "come on down to the dealership…Elvis wants to look at cars." He and the other salesmen took scores of cars to Elvis's home, Graceland. Elvis sat in a chair on the front porch while they drove the cars, one at a time, past him in the circular driveway. Elvis would either say "yes" or wave them off. By sunrise, he had agreed to buy a dozen cars – mostly as gifts.If you visit Graceland, you’ll get a strong sense of how the extravagant culture of Elvis Presley's entertainment enterprise was built around him: dozens of cars, customized jet aircraft, strings of horses, collections of firearms, fried peanut butter and banana sandwiches, all night jam sessions in a Hawaiian-themed den with carpet on the ceiling, and a racquetball house with a running track on the roof.Graceland is a perfect study in corporate culture at the extreme. On the Graceland tour, you’ll quickly understand that Elvis was a "package-deal"; you couldn't get the same entertainer from a person who lived a life of moderation. While most RIA founders aren't as "unique" as Elvis, investment management firms tend to be built around the peculiar interests and desires of their founders, and separating the firm from the founder is easier said than done.Culture Is KingCulture is the most glaring omission of any purchase agreement. We may not have any clients who show up to work at their RIA in white jumpsuits, but we have some who wear board shorts and flip-flops to the office, and others who dress so formally we suspect they wear neckties with their pajamas. Some keep rigid office hours and some are always someplace else. Some like a team approach to investment management and others act strictly on their own instinct. Some drive flashy sports cars and others prefer run-of-the-mill SUVs. None of them wants to change just because they're selling their firm, but what's not written in the purchase agreement is the difficulty in maintaining cultural identity for a seller after the transaction.Transitioning culture wouldn't be such a big deal if founding members of RIAs could just walk away after the transaction. As we all know, though, even when an asset manager transacts, there are relationships to hand off and successor managers to groom and earn-outs to earn – such that partners usually have to stick around for three to five years after selling. As a consequence, founders have to undergo a cultural change at the firm they founded, which can be galling.For folks who are considering offers for their investment management firm, we usually counsel them to remember a few things that aren't outlined in the LOI:You're not going to be the boss anymore. One seller was apoplectic when the bank that purchased his wealth management firm changed the color of his firm's logo to match that of the bank. It's going to happen.You're going to have a boss. Sellers often seem surprised that there is a reporting structure of which they are a part, in spite of being assured that the buyer will give them "maximum autonomy." Autonomy doesn't mean you get your own island.Your employees are going to have a new boss. And they might like that boss more than they like you. You think that you want that for them, but it won't do much for your ego.Your clients may question your commitment after the sale. If you start to enjoy your reduced responsibility and increased liquidity too much, your clients will assume you are "calling in rich" – and take their assets elsewhere. Best to keep the overt transition low key until the earn-out period is complete.The same “founder's syndrome” that helped you build the firm will now fuel your frustration. Founders are driven by senses of identity and autonomy that are completely undermined by selling. So when you get up from the closing table, head straight for the therapist's couch. Elvis Presley's posthumous hit single, "A Little Less Conversation," pleads for actions instead of words. On the contrary, we suggest that founders think about what makes their firm unique and what aspects of that uniqueness you are, and are not, willing to give up in a transaction. Then have a little more conversation with the buyer about their post-transaction expectations for your firm's culture. If you can agree to how you're going to work together before the deal closes, everyone will be more successful after the deal closes. As always, feel free to reach out to us if you'd like to talk further.

Underpayments, Overpayments, Lost Opportunities and Bankruptcies: Trends and Happenings in Energy Litigation

At recent conferences, dialogue on trends and notable cases in litigation were an integral part of several presentations and discussions. Although not typically a preferable option for litigants, these cases can bring light and insight to a number of areas. Our experiences as expert witnesses can attest that these cases can have a broad-reaching impact for the litigants involved as well as for interested observers and even the community at large.Over the last five years, or so, there has been an overall uptick in cases. New royalty disputes, while rising steadily overall since 2012 took a big jump in 2015 and then came back down somewhat in 2016 and this year. Cases having to do with land and lease rights have also risen overall in the past several years. A recent notable case in this area has been Escondido Resources II, LLC v. Justapor Ranch Company, LLC (Webb County Trial Court 2013-CV7-0011396-D1).Lastly, as we have written about in the past, bankruptcy cases also rose in 2015 and 2016, as the price of oil fell and many operators were unable to pay off large sums of debt. While the number of oil and gas bankruptcies has since dropped, there are a number of companies that could still be described as distressed that have been unable to solve their balance sheet issues.Three Main Royalty Dispute IssuesIn regards to royalty disputes, there are generally three kinds of issues: (i) failure to pay, (ii) underpayment, and (iii) overpayment.The trend in recent years has been centered mainly on underpayment issues. Underpayment issues have often times revolved around disputes with post production costs in various lease clauses. Historically, some notable cases here include Heritage Resources v. Nations Bank (939 S.W. 2nd), Hyder v. Chesapeake (04-12-0769-CV), and French v. Oxy (11-10-00282-CV).In addition, there have been lost opportunity cases that are of note.One such case is Spring Creek et al. v. Hess Bakken IV (14-CV-00134-PAB-KMT). Both underpayment and lost opportunity issues are present in that case. In that case Hess Bakken (and later Statoil) was required to pay ORRI’s to Spring Creek, but there were several disputes as to the Defendants’ requirements to pursue new leases and drill additional wells in the area (known as the “Tomahawk Prospect”) which would be subject to payments made to the Plaintiff. Plaintiffs claimed damages in two areas: (i) the discounted present value of overriding royalty interest on areas of mutual interest (damages ranging between $24.2 million and $59.3 million), and (ii) the potential working interest in the same area ($182-403 million). The court granted a partial summary judgment for the defense denying working interest damages.ConclusionRoyalty underpayment cases are anticipated to remain steady in the current pricing environment. There is an understandable tension between mineral owners' concern over shrinking payments and operators' concern over profitability and favorable drilling economics.Mercer Capital’s professionals have consulted and testified in a wide variety of energy litigation matters. We have extensive experience in damages and valuation-related litigation support and assist our clients through the entire dispute process by providing initial consultation and analysis, as well as testimony and trial support. To discuss a matter in confidence, please call one of our team members.

3Q17 Call Reports

Despite gaining 5% last quarter, publicly traded asset managers are still coping with a low fee, passive environment and challenges associated with a ramp up towards full implementation of the DOL fiduciary rule. The DOL rule prohibits compensation models that conflict with the client’s best interests and is expected to induce active managers to provide lower-cost or passive products and accelerate the shift from commission-based to fee-based accounts. While net inflows into passive products are a secular trend (particularly on the retail side), the passive inflows seen thus far during 2017 may be unnaturally high due to flows that have been pulled forward from next year by brokers in response to the DOL rule as an effort to avoid litigation. Still, against this backdrop, many industry participants see opportunity, and the market for these businesses seems to as well.As we do every quarter, we take a look at some of the earnings commentary of pacesetters in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Pricing pressure and the DOL fiduciary rule have continued to drive flows into low fee passive products, particularly in the US retail channel."Third quarter long-term net inflows of $76 billion, representing 6% annualized organic asset growth, were positive across client type, investment style and region. Global iShares generated quarterly net inflows of $52 billion, representing 14% annualized organic growth with strength across both core and non-core exposures." —Gary Shedlin – CFO, BlackRock"Total net flows were positive $0.2 billion in the quarter, an improvement from net outflows of $0.2 billion in the prior quarter, as positive flows in structured products, retail separate accounts and ETF more than offset net outflows in institutional." —George Aylward, CEO, Virtus Investment PartnersTheme 2: Changes in the regulatory environment and client expectations have prompted many traditional asset managers to consider expense caps or variable fees tied to performance."I think that our view [on fees is that] as the industry continues to evolve due to a variety of issues, not the least of which are both regulatory and changing client trends, there are a number of active managers thinking about new ways to evolve fee structure. So we've seen a bunch of announcements of intentions to introduce a new performance-based model. I think we saw one change more recently in the United States, including the fulcrum fee, which has actually been in use in the U.S. for some time." —Gary Shedlin"With regard to the FlexFee Fund Series … [c]onversations are ongoing with our major distributors; I think they're going well. We're sort of working up to beginning in earnest at the beginning of the first quarter to begin the process of marketing the [FlexFee Fund Series]. And it will be our focus for the first half of 2018. We think there's significant potential here to gather additional assets. We think it realigns client expectation of share of excess returns that managers are taking versus what they, our clients, are keeping. We think it's a credible alternative to those who are incredibly fee-conscious today." —Seth Bernstein - President, CEO, AllianceBernstein Corporation"We have opened to fulcrum fees with many of our clients, specifically in the separate account space, and [they are] open to it." —Eric Colson, CEO, Artisan Partners Asset ManagementTheme 3: The trend towards fee-based accounts (as opposed to commission-based) has been accelerated by the DOL rule, and product offerings are under pressure to adapt accordingly."I think what we do know is that as you transition from a brokerage to a fee-based account, it's—you may have 1 out of 3 of your products on that lineup instead of all of them, and that's a general statement. But one that it makes it difficult to capture the assets that you had. So anybody with multiple products, with one relationship, is going to be under pressure as those assets transition. But I do think the pressure of the transition could be alleviated somewhat if we have a standard that allows those 2 to coexist." —Gregory Johnson - CEO, Franklin Resources, Inc."[P]art of it is you have to adjust the product line and make sure that you have mandates and styles and sleeves that are cost-competitive that can fit into solutions. You have solutions that differentiate, whether it's target date funds or multi-asset funds, that we can build. And part of that is having now ETFs that we can use in a lower cost way as part of that solution and have open architecture solutions that we've done around the globe with other partners. Those are the, I think, things that we continue to try to adapt to, but we're certainly not sitting around waiting to get back to the old brokerage model because, I think, at the end of the day, we recognize that the fee-based side is going to continue to be the driver going forward." —Gregory Johnson"And as you point out, one of the things we did effectively concurrent with [the launch of the MAP Navigator product] was to add some sub-advised funds that are passive/smart beta-ish. Yes, the uptake of those has been pretty good, I think about $300 million in AUM to-date." —Thomas Butch, CMO, Waddell & Reed Financial"In the U.S., there are 2 major shifts converging in wealth management. First, in one of the largest asset movements, fee-based advisory assets are expected to double by 2020 in the shift from brokerage to fee-based accounts. The second, digital technologies are disrupting traditional wealth advisory practices, which create competition for client assets and provide leverage for fast-growing advisory practices." —Larry Fink, CEO, BlackRock"We spoke earlier in the year about having the strong balance sheet and the financial flexibility, to be patient as we acknowledge what the DOL rules will do for our company, and as we open up gradually, open up the architecture in the broker-dealer, I think we're getting a little better read on kind of where those things are settling out. Product development is something where it's an ongoing process for us internally." —Philip Sanders, CEO, Waddell & Reed FinancialMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Coping With Deal Fatigue?

Keep Your Eyes on the Prize

In this continuing series on RIA partners responding to unsolicited offers, we thought it would be worthwhile to spotlight the number one killer of worthwhile transactions: deal fatigue.Transaction negotiations frequently take longer than anyone expects and often start and stop multiple times. The process has a tendency to terminate negotiations on bad transactions, but it also takes down many that should happen.Watching deal-making reminds me of car chase scenes in movies: unnecessarily long, fast-paced, often suspenseful, and with the potential for multiple fatalities – or at least bruised egos.The car chase scene that set the standard for the past fifty years was Bullitt, in which Steve McQueen, playing the role of Frank Bullitt, drove a 1968 Ford Mustang GT Fastback equipped with a 390 cubic inch V-8 and a four-speed manual transmission through the streets of San Francisco in pursuit of some hitmen in a Dodge Charger. Fiction being what it is, Bullitt catches the bad guys in his Mustang, even though in reality the Charger was faster. The car scene took three weeks to film, destroyed two Dodge Chargers and one Mustang, and ultimately resulted in a chase sequence lasting almost ten minutes that won the film’s editor, Frank Keller, an Oscar.Three weeks of filming for a ten-minute scene is about the ratio of time it takes to negotiate and finalize an RIA transaction relative to how long people think it ought to take. Many sellers believe that once a term sheet is agreed to or an LOI is signed, the rest is just papering the deal. Not so. Transaction negotiations, even drafting the purchase agreement, take months and sometimes years – but never merely weeks. I’ll spare you dozens of war stories, but I do have a few things to keep in mind if you find yourself going through the process.Have a Real Reason to Sell Your RIAStrategy is often discussed as something belonging exclusively to buyers in a transaction. Not true.Sellers need a strategy as well: what’s in it for you? When deals involving asset management firms fall through, I often hear things like “they just wanted to use our money to buy our firm from us.” Translation: the seller gives up shareholder returns (distributions and maybe bonus compensation) and agrees to work through a transition period (often three to five years) while the buyer capitalizes those same returns and uses them to finance or at least justify the purchase price.Sellers often feel like all they are getting is an accelerated payout of what they would have earned anyway while giving up their ownership. In many cases, that’s exactly right! On top of that, most investment management firm transactions have substantial earn-out payments included as part of the deal, such that the sellers may go from being masters of their own universe to singing for their supper.RIAs are professional service firms and the cash flow that creates value transfers from seller to buyer when the ink dries on the purchase agreement. Sellers give up something equally valuable in exchange for purchase consideration – that’s how it works.As a consequence, sellers need a real reason – a non-financial strategic reason – to sell. Maybe they are selling because they want or need to retire. Maybe they are selling because they want to consolidate with a larger organization, or need to bring in a financial partner to diversify their own net worth and provide ownership transition to the next generation. Whatever the case, you need a real reason to sell other than trading future compensation for a check. The financial trade won’t be enough to sustain you through the twists and turns of a transaction.Be Aware of Your Own PsychologyOne reason why we enjoy working with investment managers is that they are the kind of client who is wired like we are: analysts who think they can reduce most everything in life to an excel spreadsheet. Finance and much of economic theory are grounded in a neoclassical approach that can be expressed in logarithmic equations in which decisions are based on some logical assessment of marginal benefits. The reality of evolutionary neurobiology and the recent development of behavioral economics suggests that real life is much messier than that. People reason out dilemmas to the best of their ability, and then make a decision largely based on emotion.Even earning your CFA charter doesn’t enable you to escape your own humanity. People don’t refer to their firms as their “baby” for no reason – you will be emotional while you contemplate things like handing your relationships with clients and colleagues to a stranger for adoption, so be ready for it. It’s a normal feeling, and if you have the right acquirer, it will subside to relief that someone can carry on these relationships on your behalf, and is willing to pay you for the right to do so.A good analyst can justify his emotional impulse using financial analysis; a great analyst can prove it.One way to manage this through the deal process is to have an impartial counselor be a sounding board while you’re negotiating. This might be a friend or business colleague, but keep in mind you’re going to need a lot of counseling. Ideally, this is the same person who is representing you in the sale, and thus who knows you and the setting for the transaction. Getting this from your advisor requires a financial arrangement in which you can feel comfortable that he or she is representing you and not the transaction.Remember That Money Is Fungible and Value Is RelativeGive up on the notion of absolutes in transaction valuations or deal terms. The eleventh commandment is not 10 times EBITDA nor 3% of AUM, and neither one is engraved on any stone tablets in human history.Everyone wants to sell at the top of the market, but the top of the market for RIAs is usually the top of the market for other assets as well, so if you sell at the top you’ll pay more taxes and your after-tax proceeds will be reinvested in a fully priced market. It’s highly unlikely that your investment management firm will fetch top dollar in a bear market; so in many regards, the purchase price you exact in transaction negotiations only has merit relative to your reinvestment opportunities.This, again, is an argument for looking at the sale of your RIA through a strategic lens rather than a financial lens. Maybe you can do better than the market in selling your firm, but if you’ve been in the business long enough to have built a successful advisory business, you know how difficult it is to beat the market.Conclusion: Keep Your Eyes on the PrizeSo, if you’re entering into negotiations to sell your RIA, buckle up, stay composed, and be mindful of your goals. Steve McQueen was notoriously focused on managing his own career, which enabled him to drive even faster cars in real life, like his Ferrari 250 GT Lusso, shown below.Steve McQueen’s car in real life, a Ferrari 250GT Lusso (gentlemensjournal.com)As always, if you'd like to continue the conversation before our next post, give us a call.

Do You Know What is in Your Royalty Trust?

In previous posts, we have discussed the existence of royalty trusts & partnerships and their market pricing implications to royalty owners. To summarize our previous posts, it is important to understand the economic rights and restrictions within the publicly traded royalty trust being used as a “benchmark” before using it as a pricing reference for a royalty interest.For example, many of these publicly traded trusts have a set number of wells generating royalty income at declining rates for multiple years to come. In contrast, some of these trusts participate in a number of wells that have not been drilled, which represent upside potential for investors. The future growth and outlook potential for each of these two example publicly traded trusts is significantly different and a potential investor would want to know the details. The same is true for a privately held royalty interest.Market Observations1There are approximately 21 oil and gas-focused royalty trusts and partnerships publicly traded, as of October 31, 2017. Over the previous two years, the performance of the 21 publicly traded royalty trusts has been a mixed bag. Fourteen have returned market value losses during the previous two years with an average market value return of negative 31%, six have experienced positive market value returns with an average of positive 33% and one has been flat. Contrast this wide return with the price of crude oil and natural gas which have both increased over the same period. Clearly, there were some winners and losers among the 21 royalty trusts over the previous two years and, noticeably, more losers than winners. Of the winners, the royalty trust with the highest market value return was Mesa Royalty Trust (MRT) (+49%) over the previous two years, with ECA Marcellus Trust I (+36%) and Permian Basin Royalty Trust (+33%) coming in second and third, respectively. Why did Mesa Royalty Trust outperform all other royalty trusts over the previous two years and what is the nature of its economic rights and restrictions? Mesa Royalty Trust (MRT)Description of Assets Owned by MRTThe only asset of MRT includes an overriding royalty interest (ORRI) as described in their latest 10K filing:[MRT owns] an overriding royalty interest (the "Royalty") equal to 90% of the Net Proceeds (as defined in the Conveyance and described below) attributable to the specified interests in properties conveyed by the assignor on that date (the "Subject Interests"). The Subject Interests consisted of interests in certain oil and gas properties located in the Hugoton field of Kansas, the San Juan Basin field of New Mexico and Colorado, and the Yellow Creek field of Wyoming (collectively, the "Royalty Properties")As the 10-K refers, MRT’s asset is an overriding royalty interest in three oil and gas fields within the United States. [For more information on overriding royalty interests, see our post]. These properties are primarily natural gas and natural gas liquid plays in the San Juan Basin2 of New Mexico/Colorado, and the Hugoton Field of Kansas, Oklahoma and Texas3. The Yellow Creek field in Wyoming is not described further in the documents and is assumed to be immaterial in comparison to the San Juan Basin and Hugoton Field assets.Commodity PricesThe price for oil peaked in 2014 near $108 per barrel and close to $8 for natural gas before the collapse of both commodity prices during the 2nd half of the year. The nadir of the decline was during 4Q2015 and 1Q2016 for both oil and gas. Prices currently stand around $53 per barrel and $3.60 per mcf.Asset ProductionThe following charts tracks the quarterly production for MRT since 2010, as well as a rolling latest twelve month (LTM) production figure. Each chart shows increasing production through 3Q2014 and subsequent decline in production from 4Q2014 through 1Q2016. Quarterly production increased 174% from 1Q2016 to 2Q2017. Much of the increase in market value could be due to the increase in MCFE volume produced by the properties over the previous five quarters. We note that the production decline in MRT followed the commodity price decline. Additionally, the subsequent ramp up in production during 2Q2016 through 2Q2017 followed the stability and increase in commodity prices. The combination of production and commodity price increases during the previous five quarters resulted in increases of distributions to unit holders in MRT by approximately 375% from 1Q2016 to 2Q2017. This type of activity is rare for an overriding royalty interest. While commodity prices can be very volatile, production is normally a steady decline except for improvements from existing well workovers. It is not normal to see ORRI’s impacted by the addition of new wells. Judging by the significant increase in production, more research is needed to understand exactly what is impacting the ORRI owned by MRT. To do that, first consider the details within 10K regarding the ORRI owned by MRT and the economic rights and restrictions afforded. Economic Rights and Restrictions for a Unit Holder in MRTThe following is excerpted from the 2016 Annual Report.The Trust was created on November 1, 1979. On that date, Mesa Petroleum Co., predecessor to Mesa Limited Partnership ("MLP"), which was the predecessor to MESA Inc., conveyed to the Trust an overriding royalty interest (the "Royalty") equal to 90% of the Net Proceeds (as defined in the Conveyance and described below) attributable to the specified interests in properties conveyed by the assignor on that date (the "Subject Interests"). …Under the Conveyance, the Trust is entitled to payment of 90% of the Net Proceeds (as defined in the Conveyance), realized from Subject Minerals (as defined in the Conveyance), if and when produced from the Royalty Properties…The Conveyance provides for a monthly computation of Net Proceeds. "Net Proceeds" is defined in the Conveyance as the excess of Gross Proceeds, received by the working interest owners during a particular period over operating and capital costs for such period. "Gross Proceeds" is defined in the Conveyance as the amount received by the working interest owners from the sale of Subject Minerals, subject to certain adjustments. Subject Minerals mean all oil, gas and other minerals, whether similar or dissimilar, in and under, and which may be produced, saved and sold from, and which accrue and are attributable to, the Subject Interests from and after November 1, 1979. Operating costs mean, generally, costs incurred on an accrual basis by the working interest owners in operating the Royalty Properties, including capital and non-capital costs. If operating and capital costs exceed Gross Proceeds for any month, the excess plus interest thereon at 120% of the prime rate of Bank of America is recovered out of future Gross Proceeds prior to the making of further payment to the Trust. The Trust, however, is generally not liable for any operating costs or other costs or liabilities attributable to the Royalty Properties or minerals produced therefrom. The Trust is not obligated to return any royalty income received in any period.To chart the above narrative, here is the “waterfall” from mineral production to MRT Income. In addition to the above “waterfall,” MRT is not obligated to return any royalty income received in any period for any purpose, including losses incurred in future periods. Based on the “waterfall” analysis and the limited liability of future losses, it appears the asset owned by MRT functions more closely with a “profits interest” and less like an ORRI. ORRI’s typically participate at the revenue level and take a percentage off the top. They function much like royalty interests except for certain restrictions on the length of time they can receive royalties and a defined set of wells to which they have rights to production. In contrast, a “profits interest” is defined thusly: The award consists of receiving a percentage of profits from a partnership without having to contribute capital to the partnership.As the revenues available to MRT must go through several layers of cost for operations, capital expenditures and adjustments for losses incurred in prior periods before flowing through to MRT, the similarities are more akin to a profits interest versus an interest in the revenues (i.e. ORRI).ConclusionThe discussion above is the first of several key differences to understand before using MRT as a comparable company for royalty interest holders. We will discuss the other differences related to MRT in a later blog post, most notably the full reason for the increase in production over the previous five quarters.We have assisted many clients with various valuation and cash flow issues regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.End Notes1 Capital IQ 2 http://durangoherald.com/articles/1773963 http://www.bizjournals.com/houston/print-edition/2014/08/08/linn-energy-snatches-up-hugoton-basin-assets-for.html

Unsolicited Offers for Your RIA

Is the First Bid the Best?

After a fifty-year film collaboration with the James Bond franchise that started with Sean Connery piloting a DB5, Aston Martin pulled out all the stops and created a special model, the DB10, for the 2015 Bond movie, Spectre. At the time, rumors abounded in the car community that the DB10 would go into production as shown in the movie, but it was not to be. Aston Martin only built ten copies of the DB10, made from a stretched wheelbase Vantage and lots of custom sheet metal. Like most concept cars, though, elements of the DB10 design eventually showed up in Aston Martin’s next production car, the DB11.As a rule, concept cars are marketing pieces as much as design studies, rendered to get attention and hold it until the production model (which may bear little resemblance to the concept) is available for purchase. In the case of the DB10, this method worked, as Aston Martin’s launch of the DB11 has been the marque's most successful in history ("success" is relative; Aston Martin has sold fewer cars in its 104-year history than Toyota typically sells in two days).When clients call us seeking advice after receiving an unsolicited offer for their RIA, the first questions they ask generally revolve around two issues:Is the price reasonable? andDo we think the buyer will be willing to improve the offer? "Price" is a sticky wicket that we'll cover in a later post, but whether or not the first offer is going to change in the negotiation and due diligence process is a certainty: yes. The only question is which direction (higher or lower) the offer will move before the transaction closes.Universal Truths on Unsolicited OffersIf you receive an unsolicited offer for your investment management firm, you’ll find it is usually difficult to immediately assess the sincerity of the offer. And while making generalizations about the M&A process can be more misleading than helpful, we will assert the following:An unsolicited offer is made based on limited information. Often the initial overture is based on information beyond what is publicly available on the seller’s website and in regulatory filings. Even with financial statements in hand, prospective buyers making their offer know very little about the seller. The due diligence process involves the review of hundreds of pieces of documentation that can and will shape the purchase agreement.An unsolicited offer may be a competitive bid, but it is not a bid made in a competitive market. Not every sale is best conducted in an auction process, but the prospective buyer making an unsolicited offer knows that it is, at least for the moment, the only bidder. The object of an unsolicited offer is to get the seller’s attention and cause them to enter into negotiations, often giving the bidder an exclusive right to negotiate for a fixed amount of time.Whether the offer is made at the high end or the low end of a reasonable range depends on the bidder’s perception of the seller. If a buyer thinks a seller is desperate, the initial offer may be at the low end of a reasonable range, in which the selling process should evolve to move pricing and terms more favorable to the seller. In many cases, though, the initial offer is above what the buyer ultimately wants to pay ("bid it to get it") and will use the due diligence process to beat the price down or insert terms that shift the burden of risk to the seller. If the initial offer seems too good to be true, consider the latter a distinct possibility.An LOI is NOT a purchase agreement. Many sellers think the deal is done if they receive an unsolicited offer with a strong price and favorable terms. We don't want to suggest that buyers never put their best foot forward on the first round, but an unsolicited offer should be viewed more as an overture than a commitment.Once the offer is accepted, the real work begins. Stop and think for a moment about what you would like your employment arrangement to be post-transaction. Do you want a substantial base, incentive compensation, a multi-year arrangement, roll-over ownership, administrative responsibilities or just client-facing work, protections in the event of termination without cause, an internal or external reporting requirement, and/or other arrangements? Imagine your situation as viewed by the buyer and what they would want. This is just one item which is rarely delineated in detail on the first offer. A legion of issues must be resolved in the process of negotiating a final purchase agreement, which is why “deal fatigue” is a prevalent cause of abandoned transactions.ConclusionBond’s DB10 wasn't what it seemed to be. It wasn't the prototype of a production car. It wasn't equipped with Aston Martin's most potent powertrain (what was Q thinking?). It wasn't even built on a "DB" series chassis. It was a movie car, and ultimately a design exercise for Aston Martin to whet the public's appetite for their next production release. That the concept was only a suggestion of the ultimate product is a reasonable metaphor for the relationship between an unsolicited offer and a closed transaction. The offer gets the process started, but it's the process that creates the deal.Transacting an investment management firm is complicated. Advisors to buyers and sellers have the delicate task of aggressively representing their clients and covering every bit of ground in the due diligence process without killing the deal by exhausting the buyer and seller and making them wonder why they ever started negotiations in the first place. The primary danger of an unsolicited offer is that it lures potential sellers into thinking the deal is done and the process will be easy. As with most things in life, if something looks too good to be true, it usually is.

Congratulations! Someone Wants to Buy Your RIA. Now What?

A few weeks ago, I spotted a red Alfa Romeo Duetto Spider and my mind immediately wandered to Dustin Hoffman driving a Duetto in the film that launched his career, The Graduate. Of all the small, four-cylinder convertible sports cars produced in the late 1960s, the Alfa Romeo stands out because of its prominence in the film. Fifty years after it was released, The Graduate is still relevant because the plot captures a common theme: life is full of moments of great accomplishment that summarily dissolve into concern over what follows.Hoffman plays Ben Braddock, a newly minted college graduate returning home to Los Angeles. In spite of his successes thus far in life, Ben is disillusioned and nervous about the future. In the midst of his uncertainty, Ben is propositioned by the wife of his father's business partner, Mrs. Robinson. The movie sorts out the ensuing affair between Ben and Mrs. Robinson, and Ben coming to terms with his romantic preference for the Robinsons' daughter, Elaine. About the time he realizes he's in love with Elaine, Ben finds out she's getting married to someone else. He races to the church (the Alfa characteristically runs out of gas before he gets there), interrupts the wedding, and escapes with Elaine on a city bus. In the closing scene, Ben and Elaine sink into their seats and relish their victory, until satisfaction gives way to dread: now what?Around the time I spotted the Duetto, we were working with a client who had received an unsolicited offer to acquire their wealth management firm from one of the many consolidators trying to build national scale in the RIA space. The offer was calibrated to get our client's attention, with language that focused on “unlocking” value and projections of other-worldly financial returns from agreeing to the transaction. Irrational buyers with capacity don’t come along every day, so when a suitor presents themselves as "the one," you better decide if they are genuine or not. If so, say “yes” before they change their mind. If the offer is too good to be true, take a pass. This case was more of the latter.I know this particular consolidator has managed to convince numerous RIAs to join them over the years, so I can’t argue with their approach. Indeed, some of our client's partners seemed more than intrigued by the overture, while others weren't convinced. We were asked to review the offer from a dispassionate perspective and make recommendations to the partners about how to proceed.This wasn't the first time we've been asked to review an unsolicited offer to buy an asset management firm, and it surely won't be the last. As such, we thought it would be worth taking a few blog posts to talk about unsolicited offers, how to approach them, evaluate them, and decide whether to pursue or reject them.Over the course of the next few weeks, we'll cover topics relevant to dealing with overtures from acquirers, including:Be mindful of your own psychology. Selling an asset management firm is an emotional episode disguised with numbers. Don't confuse your own fears and desires with what may be the largest financial decision you'll make in your career.Just because they want you doesn't mean you have to want them back. There is a strategic approach to selling an investment management firm just as there is a strategic approach to acquiring one. Are they solving your problem or are you just solving theirs?Know what you are selling. You will be expected to give things up in exchange for the acquirer's check – and some of the most significant items transacted aren't listed in the purchase agreement.Be ready to value the offer. RIA transactions often include contingent consideration and terms that affect the cash equivalent proceeds of a deal. It is almost unheard of for an RIA acquirer to make payment, take the keys, and be done with the deal.Think about using an intermediary. A third party, compensated to represent you instead of the transaction, can be a powerful way to achieve the best outcome in any transaction. Like young Ben Braddock, looking back on a successful life so far as a student but not knowing what adulthood will bring, partners in mature asset management firms can simultaneously feel both a sense of great accomplishment at what they've built and a great sense of discomfort at what lies ahead. An unsolicited offer is usually intriguing and sometimes presents a bona fide path forward, but it may also be a threat to everything you value. We'll be covering more on this next week, but feel free to give us a call if you'd like to talk sooner.

How to Value Overriding Royalty Interests

Given that our own Taryn Burgess is attending the 7th Annual National Association of Royalty Owners (NARO) Appalachia Conference in West Virginia today, we decided to revisit this post (originally published in April 2017). Enjoy!What is a Royalty Interest?Ownership of a percentage of production or production revenues, produced from leased acreage. The owner of this share of production does not bear any of the cost of exploration, drilling, producing, operating, marketing or any other expense associated with drilling and producing an oil and gas well.What is an Overriding Royalty Interest (ORRI)?A percentage share of production, or the value derived from production, which is free of all costs of drilling and producing, and is created by the lessee or working interest owner and paid by the lessee or working interest owner.ORRI’s typically do not own a perpetual interest in the mineral rights. Typically they are structured to have rights to royalties for the term of the lease period. Royalty interests, on the other hand, generally have mineral ownership into perpetuity, even after a lease expires. Thus the main difference between royalty interests and ORRI’s is that royalty interests are tied to the ownership of the mineral rights below the surface, and ORRI’s are tied to the lease agreement and ceases to exist once the lease expires.Some may find it surprising that the popular publicly traded Permian Basin Royalty Trust (PBT) only owns ORRI’s, not royalties, in various oil and gas properties in the United States. PBT owns a 75% net ORRI in the Waddell Ranch properties comprising Dune, Judkins, McKnight, Tubb, University-Waddell, and Waddell fields located in Crane County, Texas. As of December 31, 2016, its Waddell Ranch properties contained 349 net productive oil wells, 64 net productive gas wells, and 102 net injection wells.The company also holds a 95% net overriding royalty in the Texas Royalty properties that consist of various producing oil fields, such as Yates, Wasson, Sand Hills, East Texas, Kelly-Snyder, Panhandle Regular, N. Cowden, Todd, Keystone, Kermit, McElroy, Howard-Glasscock, Seminole, and others located in 33 counties in Texas. Its Texas Royalty properties consist of approximately 125 separate ORRI’s containing approximately 51,000 net producing acres.Over the past four years, crude oil and gas prices have fluctuated significantly. While this is creating significant volatility on the E&P side of the industry on both an operational and investment decision level, many look at royalty trusts as a way to bypass the complexities of an operating E&P and attempt to “pure play” the price of oil and gas. Based on this assumption, we will analyze the changes PBT has endured over the past four years.Production PBT derives revenue from ORRI’s which cover approximately 382,000 gross acres (85,205 net acres) in west Texas. Since the ORRI’s that PBT owns were not derived from a 100% working interest, their gross acreage differs from their net acreage. Net acreage is calculated as the company’s percentage interest multiplied by its gross acreage. Over the past four years, the amount of acreage has not changed. Production, on the other hand, has changed significantly as shown in the table below. Comparing the production levels to the price levels of oil and gas indicates that even after the decline in oil and gas prices during 2014, production increased during 2015. Oil production increased 3% while gas production increased 44%. The increased production was in part due to the 3 new wells drilled during 2014, 3 workovers completed during 2014 and 29 wells completed during 2014 and 2015. During 2016, investment activity was significantly different which resulted in a 28% decline in oil production and 33% decline in gas production. No wells were drilled and completed during 2016. Only 1 workover was performed. Clearly, the operators were holding back capital as they waited for more price certainty in the future. Reserves The change in reserves tells the same story. After investing in the drilling and completion of new wells, and workover wells, the proved reserves increased from 2014 to 2015 for both oil and gas. The increase is significant as reserves are impacted by (1) investment in new/existing wells and (2) future prices of oil and gas. The price utilized in the 2015 reserves was significantly lower than what was used in the 2014 reserves. Therefore, the increase in reserves is significant as the additional proved reserves more than countered the reduction in the commodity prices in the reserve model. For 2016, the reserves declined due to the lack of investment in current and future wells. And while pricing stayed relatively the same from 2015 to 2016, the loss in proved reserves was directly attributed to the lack of investment in new and existing wells. Distributions PBT is at its lowest yield in the last four years. While the price was lower at the end of 2015, the dividend as a percentage of price was higher in 2015 relative to 2016. The above chart shows the impact of (1) changes in oil and gas prices; as well as (2) changes in production levels. These two areas are directly related to the dividend per share. The price, however, is directly related to the movement of buyers and sellers of PBT securities. While the dividend is “trailing” information, because it is the result of the previous 12 months of activity, the price factors in forward-looking information. For example, as of 2013, buyers and sellers of PBT were expecting higher dividends in 2014 due to the high price of oil and gas, PBT’s investment in wells and increasing proved reserves1. When commodity prices declined during 2014, the price quickly reflected the new pricing environment, the impact on reserves, and the shift in management’s investment attitude for new and existing wells. All of these factors pressured prices downward while the trailing dividends showed strength, resulting in a higher than normal yield. During 2015 and 2016, the price, dividend, and yield settled to relatively tempered levels. All data points above have had enough time to reflect the current environment and as such, are communicating a similar story. Finishing ThoughtWhen valuing a royalty interest or ORRI, here are a few items to keep in mind:Understand the rights and restrictions of the subject royalty interest: Royalty interests may have value into perpetuity as it is a direct ownership in the minerals;ORRI’s typically only have value for the life of the lease;Understand the differences between the subject ORRI and a publicly traded security that owns ORRI’s and make adjustments for the differences;Understand the historical, current and future outlook for commodity prices relating to the subject ORRI;Understand the historical, current and future outlook for reserves;Utilize publicly traded yields to assess the market's attitude for investments in similar securities; andAdjust for the differences between a publicly traded security and a non-marketable security. When comparing a royalty interest to an ORRI, it is critical to understand the subtle nuances of the rights and restrictions between the two. Owners of royalty interests utilizing PBT as a valuation gauge should adjust for such differences as well as other differences between publicly traded and non-marketable securities. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed. End Note1 Although not shown in the above chart, proved reserves increased 32% between 2012 and 2013 for PBT

ASU 2016-01: Recognition and Measurement of Financial Assets and Liabilities

It’s Not CECL, But It Could Affect YouComplying with the revised disclosure requirements of ASU 2016-01 may necessitate that banks adopt new methodologies to determine the fair value of the bank’s loan portfolio. In listening to presenters at the recent AICPA National Conference on Banks & Savings Institutions, we gathered that some banks are taking their first fitful steps toward implementing the pending accounting rule governing credit impairment. Bankers should not lose sight, however, of another FASB pronouncement that becomes effective, for most banks, in the first quarter of 2018. Accounting Standards Update No. 2016-01 addresses the recognition and measurement of financial assets and liabilities.History of ASU 2016-01A long and winding history preceded the issuance of ASU 2016-01. In 2010, the FASB drafted a predecessor to ASU 2016-01, which required that financial statement issuers carry most financial instruments at fair value. As a result, assets and liabilities presently reported by banks at amortized cost, such as loans, would be marked periodically to fair value. This proposal was almost universally scorned, satisfying neither financial statement issuers nor investors. The FASB followed with a revised exposure draft in 2013, which maintained amortized cost as the measurement methodology for many financial instruments. Stakeholders objected, however, to a new framework in the 2013 exposure draft that linked the measurement method (fair value or amortized cost) to the nature of the investment and the issuer’s anticipated exit strategy. The FASB agreed with these concerns, eliminating this framework from the final rule on cost/benefit grounds.The final pronouncement issued in January 2016 generally maintains existing GAAP for debt instruments, including loans and debt securities. However, the standard modifies current GAAP for equity investments, generally requiring issuers to carry such investments at fair value. Restricted equity securities commonly held by banks, such as stock in the Federal Reserve or Federal Home Loan Bank, are excluded from the scope of ASU 2016-01; therefore, no change in accounting for these investments will occur. Excluding these restricted investments, community banks typically do not hold equity securities, and we do not discuss the accounting for equity investments in this article. Interested readers may wish to review a previous Mercer Capital article summarizing certain changes that ASU 2016-01 makes to equity investment accounting.Entry vs. Exit PricingWhile ASU 2016-01 maintains current accounting for debt instruments, it does contain several revisions to the fair value disclosures presented in financial statement footnotes. Originally issued via SFAS 107, these requirements were codified in ASC Topic 825, Financial Instruments. Although ASU 2016-01 makes several changes to the qualitative and quantitative disclosures that are beyond the scope of this article, the most significant revisions are as follows:“Public Business Entities” must report the fair value of financial instruments using an “exit” price concept, rather than an “entry” price notion.1Non-Public Business Entities are no longer required to present the fair value of financial instruments measured at amortized cost, such as loans, in their footnote disclosures. Current GAAP is ambiguous regarding whether the fair value of financial instruments measured at amortized cost should embrace an “entry” or “exit” price notion. According to the FASB, this has led to inconsistent disclosures between issuers holding otherwise similar financial instruments. Certain sections of ASC Topic 825, which carried over from SFAS 107, could be construed as permitting an “entry price” measurement. For example, existing GAAP provides an illustrative footnote disclosure describing an entity’s fair value estimate for loans receivable:The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. [ASC 825-10-55-3, which is superseded by ASU 2016-01]By referencing “current rates” on “similar loans,” the guidance implicitly suggests an “entry” price notion, which represents the price paid to acquire an asset. Instead, ASC Topic 820, Fair Value Measurement, which was issued subsequent to SFAS 107, clearly defines fair value as an exit price; that is, the price that would be received upon selling an asset.Limitations of ALCO ModelsIn our experience, banks often use fair value estimates derived from their asset/liability management models in completing the fair value footnote disclosures for loan portfolios. Reliance on ALCO models suffers from several weaknesses when viewed from the perspective of achieving an exit price measurement:The discount rates applied in the ALCO model to the loan portfolio’s projected cash flows utilize current issuance rates on comparable loans. In certain market environments, the entry price for a loan portfolio developed using this methodology may not differ materially from its exit value. However, this approach becomes problematic when economic or financial market conditions suddenly change or the bank ceases underwriting certain loan types.The treatment of credit losses is not directly observable. Instead, the ALCO model implicitly assumes that the discount rates applied to the portfolio’s projected cash flow capture the inherent credit risk. However, this process does not necessarily correlate the fair value measurement to underlying credit risk. For example, a bank’s automobile loans underwritten in 2015 may be underperforming expectations at origination and also performing poorly compared with 2016 and 2017 originations. The fair value measurement should not apply the same discount rate to each vintage, given the disparate credit performance.Compliance GuidanceComplying with the revised disclosure requirements of ASU 2016-01, therefore, may necessitate that banks adopt new methodologies to determine the fair value of the bank’s loan portfolio. Mercer Capital has significant experience in determining the fair value of loan portfolios from which we offer the following guidance:ASC 820 emphasizes the use of valuation inputs derived from market transactions, but such transactions seldom occur among loan portfolios similar in nature to those held by community banks. If available, market data should take precedence.Absent market transactions, banks will rely on a discounted cash flow analysis to determine an exit price. To a limited extent, this is consistent with current ALCO modeling, but achieving an exit price requires additional considerations. While valuation should be tailored to each portfolio’s characteristics, certain common elements are embedded in Mercer Capital’s determinations of a loan portfolio’s exit value:Contractual cash flows. Consistent with current ALCO forecasting models, contractual cash flow estimates should be projected using a loan’s balance, interest rate, repricing characteristics, maturity, and borrower payment amounts.Loan Segmentation. To create homogeneous groups of loans for valuation purposes, the portfolio should be segmented based on criteria such as loan type and credit risk. Credit risk, as measured by metrics such as delinquency status or loan grade, can be manifest in the fair value analysis either through the credit loss forecast or the discount rate derivation.Prepayments. The contractual cash flows should be adjusted for potential prepayments, based on market estimates, as available, or the bank’s recent experience.Credit Losses. If not considered in the discount rate derivation, the projected cash flows should be adjusted for potential defaulted loans. In a fair value measurement this is a dynamic, forward-looking concept. It also is consistent with the notion in the Current Expected Credit Loss model—which underlies the recent FASB pronouncement regarding credit losses—that credit losses should be measured over the life of the loan.Discount Rate. The discount rate should be viewed from the perspective of a market participant, given current financial conditions and the nature of the cash flow forecast. Mercer Capital often triangulates between different discount rate approaches, depending on the strength of available data. For example, we may consider (a) a weighted average cost of funding the loan, (b) market yields on traded instruments bearing similar risk, or (c) recent offering rates in the market for similar credit exposures. Mercer Capital has developed fair value estimates for a wide variety of loan portfolios, on an exit price basis, ranging in size from under $100 million to over $1 billion, covering numerous lending niches, and possessing insignificant to severe asset quality deterioration. We have the resources, expertise, and experience to assist banks in complying with the new requirements in ASU 2016-01. This article originally appeared in Mercer Capital's Bank Watch, September 2017.End Note1 The definition of a “public business entity” is broader than the term may suggest. A registrant with the SEC is clearly a PBE, but the definition also includes issuers with securities “traded, listed, or quoted on an exchange or an over-the-counter market” (emphasis added). A number of banks “trade” on an over-the-counter market and therefore would appear to be deemed PBEs, even if they are not an SEC registrant. The following entities are also deemed PBEs:Entities filing Securities Act compliant financial reports with a banking regulator, rather than the SEC.Entities subject to law or regulation requiring such institutions to make publicly available GAAP financial statements, if there are no contractual restrictions on transfer of its securities.

Trends in the Refining Industry Display Cautious Optimism

A general theme across refiners' earnings calls and updates over the last few months was a story of cautious optimism. In this blog post, we outline prevalent general themes in the downstream oil market that have given refiners hope for 2018 as well as those that cause skepticism about the future.Sweet & Sour DifferentialThe price differential between light, sweet crude and heavy, sour crude has been shrinking since the fall of oil prices in 2014. From a max differential of $42.50 in December 2012, the differential has fallen to an average of $11 over the last month."OPEC cuts have impacted the available supply of medium and heavy sour grades resulting in narrow feedstock differentials which is a challenge to our complex refining system." – Thomas J. Nimbley, Chairman and CEO at PBF Energy on Second Quarter Earnings Call The differential has been shrinking as the global supply of oil has remained high causing crude benchmark prices to converge. Since the price of light, sweet U.S. crude has fallen, the cost savings that companies used to realize when purchasing heavy feedstock cannot make up for the higher costs of cracking it.Retrofitting RefineriesAs explained by Canada Oil Sands Magazine, "Refineries typically blend different grades of crude with varying quality specifications. Depending on the configuration of the refinery, each facility has a limited ability to handle heavy grades of crude and Sulphur." U.S. refineries were traditionally retrofitted to handle heavy crude because it allowed for higher refining margins. The U.S. traditionally has more complex refineries than Europe and Canada, which allows them to better crack heavy molecules into light, value-add products, such as jet fuel.However, starting in mid-2014, US refiners began struggling to keep up with the amount of light sweet crude available for sale in the US markets since most refineries were not built to handle such light crude. It was thought that the initial relaxation and eventual elimination of the crude oil export ban would relieve US refiners from this pressure. But the over-supply of oil across the globe dampened this effect.Because the price of light, sweet crude and heavy, sour crude has started to converge, there is potential for higher margins from light crude. Even if refiners have to pay the upfront investment costs to retrofit their facilities to handle lighter crude, they can face lower operating expenses going forward as it is easier to refine light crude than heavy crude into higher margin products."We expect to see improved margin capture as we are now able to upgrade components of our gasoline pool into higher octane, low sulfur finished product." -Thomas J. Nimbley, Chairman and CEO at PBF Energy on Second Quarter Earnings CallWidened Crack SpreadThe crack spread is the price differential between crude oil and its refined oil products. The 3-2-1 crack spread approximates refinery yield using the industry average for refinery production. For every three barrels of crude oil the refinery processes, it makes two barrels of gasoline and one barrel of distillate fuel. The crack spread is a good indication of refiners' profit margins. As shown in the chart above, the WTI crack spread increased over the first half of the year giving the downstream markets optimism about the rest of the year to come. The crack spread peaked at the end of August as many refiners were forced to shut down due to damage caused by Hurricane Harvey and the price of refined products spiked. The spread has since fallen to approximately $17 per barrel of WTI. "The decrease to refining margin was primarily driven by the higher RINs cost, which were partially offset by the increase in the Group 3 2-1-1 crack spread." – Susan M. Ball, CFO & Treasure of CVR Refining GP LLC on CVRR’s Second Quarter Earnings CallHigher RIN CostsThe Renewable Fuels Standards (RFS) Program has continued to have a significant impact on the refining sector over the last year. The RFS were signed into law by President George W. Bush in order to reduce greenhouse gas emissions and boost rural farm economies. Each November, the EPA issues rules increasing Renewable Fuel Volume Targets for the next year. RINs (Renewable Identification Numbers) are used to implement the Renewable Fuel Standards. At the end of the year, producers and importers use RINs to demonstrate their compliance with the RFS. Refiners and producers without blending capabilities can either purchase renewable fuels with RINs attached or they can purchase RINs through the EPA’s Moderated Transaction System. While large, integrated refiners have the capability to blend their petroleum products with renewable fuels, small- and medium-sized merchant refiners do not have this capability and are required to purchase RINS, which have significantly increased in price.RIN expenses have remained high and although President Trump promised to help small- and medium-sized merchant refiners who were disadvantaged by RFS, he also spoke fondly of the RFS program during his campaign.On July 5, 2017, the EPA issued proposed volume requirements under the Renewable Fuel Standard program, which are summarized below. A public hearing was held on August 1, 2017, and on October 17, 2017, the EPA provided a public notice and an opportunity to comment on potential reductions in the 2018/ 2019 biomass-based diesel, advanced biofuel, and total renewable fuel volumes. The final rule should be available in December. ConclusionRefiners were generally optimistic about their performance over the first six months of 2017. Higher crack spreads have allowed margins to increase and many believe that the Trump administration will help relieve some of the pressure caused by the RFS. Additionally, it is possible that the RFS volume requirements could be reduced further which would relieve margin pressure for merchant refiners.The quote below from HollyFrontier’s second-quarter earnings call appropriately summarizes the current state of the industry."Our refining outlook for 2017 remains cautiously optimistic. We anticipate solid economic growth will continue to support refined product demand and sustained growth in domestic crude oil production will lead to improved crude differentials. We are also optimistic that a more favorable regulatory environment could provide a tailwind for both the refining industry and the economy as a whole. With a large portion of our scheduled maintenance behind us, we are poised for strong financial and operational performance for the remainder of the year." – George J. Damiris, CEO, President, & Director at HollyFrontier – on Second Quarter Earnings CallMercer Capital has significant experience valuing assets and companies in the energy industry, throughout the upstream, midstream, and downstream sectors. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Asset Manager Deal Activity Accelerates, Still Room to Run

RIAs have long faced structural headwinds and consolidation pressure from increasing compliance and technology costs, broadly declining fees, and slowing organic growth for many active managers. While these pressures have been compressing margins for years, asset manager M&A has historically been muted, due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation. Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure for certain firms.Current Consolidation ConsiderationsConsolidation pressures appear to have reached critical mass in the last several years, and M&A activity has picked up notably as a result. M&A activity in 2017, in particular, is on track to reach the highest level in terms of deal volume since 2009. For publicly traded asset managers, at least, the market seems to view recent M&A activity favorably. Amundi has returned 46% year-to-date (as of October 20) after announcing the acquisition of Pioneer Investments last December. Aberdeen was up 15% through May 31 after agreeing to be acquired by Standard Life in March. KKR shares have risen 20% since April 19, when an investor group led by Stone Point Capital and KKR agreed to buy a majority stake in RIA aggregator Focus Financial Partners. Recent increases in M&A activity come against a backdrop of a now eight-year-old bull market. Steady market gains, particularly in 2017, have more than offset the consistent and significant negative AUM outflows that many active managers have seen over the past several years. In 2016, for example, active mutual funds’ assets grew from $10.7 trillion to $11 trillion, despite $400 billion in net outflows according to data from Bloomberg. As a result, profitability has been steadily increasing despite industry headwinds that seem to rationalize consolidation. It's unclear whether this positive market movement has been a boon or a bane to M&A activity. On one hand, many asset managers may see rapid AUM gains from market movement as a case of easy come, easy go. In that case, better to sell sooner rather than later. And vice versa from a buyer’s perspective. On the other hand, as long as markets trend upwards, margin and fee pressures are easy to ignore. In that case, a protracted market downturn could lead to a shakeout for firms with cost structures that are not sustainable without the aid of a bull market. We saw the effect a market downturn can have on M&A activity during 2009 when deal volume reached record levels as many distressed firms were sold. The M&A activity spurred by the 2009 downturn was short-lived, however. Deal volume was largely subdued between 2010 and 2013. The fallow period ended in 2014, and deal activity has accelerated since then while broad market indices have marched higher. ConclusionIt seems likely that asset manager deal activity will continue to gain speed regardless of which way the markets are moving, although a market downturn could certainly expedite consolidation. Asset managers face secular trends that threaten lower revenue and higher costs. On the top line side, assets continue to flow into low fee passive funds at a good clip. On the cost side, an evolving regulatory environment threatens increasing compliance costs. Consolidation allows asset managers to spread compliance costs over a larger AUM base and increase distribution channels and product offerings, thereby combating revenue and cost pressure.But if a protracted bear market does materialize, margins will face pressure not only from the evolving industry dynamics but also from evaporating AUM. A significant market downturn may highlight the consolidation pressures in the industry and catalyze a larger wave of M&A activity.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

What's My RIA Worth?

It is important to know the current value of your investment management firm and understand valuation concepts in order to:Know how to build the value of your investment management firm;Know how to evaluate opportunities to sell your firm; and,Have a basis for discussing internal ownership transition issues.In this 60-minute webinar, Matt Crow and Brooks Hamner, who work with RIAs throughout the country on valuation-related issues, will address the following:How to normalize cash flow to determine the profitability of a RIAHow to compare different investment management firms to determine what risk-adjusted valuation multiples to applyHow to evaluate the growth potential of one firm relative to the industry or relative to other firmsWhat public company multiples say about how a private RIA is valuedAre industry transaction multiples a useful benchmark in valuing an investment management firm?

Held (or Held Up?) by Production

Oftentimes differences are a matter of perspective. Put another way – one person’s loss can be another person’s gain. One of the thematic differences between producers and mineral owners is their perspective on "Held By Production." It elicits very different reactions depending on what side of the term one is on, and has a leverageable impact on value. In this post, we decided to spend some time exploring this concept and its impact on the energy industry.What Is "Held By Production"?Held By Production ("HBP") is a mineral lease provision that extends the right to operate a lease as long as the property produces a minimum quantity of oil and gas. The definition of HBP varies contractually by every lease it governs which is often misunderstood. We have had discussions with a number people, including peers (as well as knowledgeable industry participants) who did not have a clear grasp of HBP and its exact meaning. Some people thought HBP was governed by state law, regulatory agencies, or even accounting rules. However, the truth is that the facts and circumstances that shape a lease as it pertains to HBP are all negotiable. Therefore, by extension, the outcome of lease negotiations can have a spectrum of results: from being deemed balanced, to favoring the lessor (i.e., the mineral owner) or the lessee (i.e., the producer). When we attended the NAPE Expo this summer, presenters from Wood Mackenzie pointed out that a trend on recent analyst calls was for management teams of operators to highlight the percentage of their leases that were HBP (they mentioned that the Permian Basin was about 95% HBP due to decades of prior drilling). Operators want investors to note this and (hopefully) be more attracted to their stock. Why might someone be more attracted to an operator’s stock that has a large percentage of leases HBP? Investopedia puts it this way:The "held by production" provision enables energy companies to avoid renegotiating leases upon expiry of the initial term. This results in considerable savings to them, particularly in geographical areas that have become "hot" due to prolific output from oil and gas wells. With property prices in such areas generally on an upward trend, leaseholders would demand significantly higher prices to renegotiate leases.What Does "Held By Production" Mean to Mineral Owners (Lessors)?Mineral owners should have an understanding of how their lease terms impact drilling activity (and by extension – royalty payments) on their properties (a thematic element of the summer NARO conference). Lessors are challenging operators’ decisions not to drill on their land, even if prospects appear to be good. As a result, mineral owners are more interested in how certain clauses and term structures function in their leases. A session at the NARO conference centered on how mineral owners could legally terminate their lease in order to re-lease their property to a more "motivated" or even "competent" operator.Therefore, it is important for mineral owners to understand two lynchpin concepts as they pertain to defining HBP: the Pugh Clause and the Implied Covenant to Develop.Pugh ClauseThe Pugh Clause is named after Lawrence Pugh, a Crowley, Louisiana attorney who developed the clause in 1947, apparently in response to the Hunter v. Shell Oil Co., 211 La. 893 (1947). In this case the Louisiana Supreme Court held that production from a unit, including a portion of a leased tract, will maintain the lease in force as to all lands covered by the lease even if they are not contiguous. This clause is most often cited in today in pooling for horizontal wells. There have been situations (depending on the clause’s language) whereby one well might maintain a large area (thousands of acres) defined as HBP. This is to an operator’s advantage and a mineral holder’s chagrin. However, this can be negotiated to the mineral holder’s favor – particularly in active markets and basins. For example, we had a client that had a large tract of land in the Eagle Ford shale and was being courted by a number of eager operators. Ultimately, they negotiated a lease with an operator who contractually obligated the company to drill three wells per year on the property for the duration of the lease. Not too long after the lease was negotiated, the price of oil dropped in half and the operator was much less enthusiastic about having to drill three wells per year. There are a number of nuances and factors to Pugh clauses (and similar lease clauses) that we won’t explore here, but suffice to say, it is a critical factor to defining a property as HBP or not.Implied Covenant to DevelopAnother aspect of lease law is centered around the concept called "Implied Covenant to Develop." Sometimes a lessors' alternative is to attempt to find remedy through the implied obligation that the lessee failed to develop and operate the property as a reasonably prudent operator. Forcing an implied obligation generally occurs through a lawsuit and is difficult to prove. However, implied covenants have been addressed by courts from all producing states as well as the Supreme Court of the United States.There are several potential examples One example is discussed on a Gas & Oil Law blog:Consider an oil and gas lease taken on 200 acres. Let’s say that thirty years ago one well was drilled on the 200 acre lease, and that this well unit only included 40 acres. Under the implied covenant to reasonably develop, a judge may very well cancel the lease to the remaining, unused 160 acres (200 acres – 40 acres = 160 acres). How could a judge do that? The basic question that needs to be answered is whether or not the oil and gas producer has behaved as a reasonable oil and gas producer would in similar circumstances. If any reasonable producer would have drilled more than one well on the 200-acre lease, then a reviewing judge might void the lease to the remaining 160 acres. However, if the existing well was not a very good well, then it might be that the producer did behave reasonably when they decided not to drill additional wells.ConclusionDepending on which side of the negotiation one is on, HBP can be a favorable (or unfavorable) contributor to value. As such, it's crucial to have an analyst who possesses knowledge from all sides of industry negotiations.Mercer Capital has over 20 years of experience valuing assets and companies in the oil and gas industry. We have valued companies and minority interests in companies servicing the E&P industry and assisted clients with various valuation and cash flow issues regarding royalty interests. Contact one of our oil and gas professionals today to discuss your needs in confidence.

Recent Trends in Asset Management

This week, we’re sharing some recent media on trends in asset management, including the breakaway broker phenomenon, M&A activity, and the ongoing shift towards passive products. Most industry observers foresee a continued flight from traditional wirehouses, an uptick in M&A activity spurred by increasing competitive pressures, and further fee pressure from passive products as we move towards a new equilibrium. Switching From Wirehouse to RIA – AUM And Revenue Requirements To Break AwayBy Michael Kitces We wrote last month about advisors shifting from traditional wirehouses to independent RIAs, and this post by industry consultant Michael Kitces offers a deep dive into the economics of the switch from an advisor’s perspective.RIAs Poised to Land Wirehouse RecruitsBy Dan Jamieson Going independent doesn’t have to mean starting from scratch: wirehouse advisors are increasingly a recruiting channel for existing independent RIAs, according to this piece by industry observer Dan Jamieson.Advisor Platform Comparison: Wirehouse vs RIA Aggregator vs Independent RIABy Aaron HattenbachIn this guest post which appeared on Michael Kitces’ blog, industry insider Aaron Hattenbach offers perspective gleaned from his own experience on the relative merits of wirehouses, RIA aggregators, and fully independent RIAs, each of which he has worked at.UBS is ‘Constantly Approached’ About Asset-Management UnitBy Patrick WintersThis article from Bloomberg underscores the potential for a new wave of deals in the asset management space: UBS Chief Financial Officer Kirt Gardner indicates that UBS is “constantly approached” regarding its asset management unit.Path to Growth: Why RIA firms leverage M&A as a growth strategyBy Christopher V. Gunderson Increasing operational and compliance costs combined with downward fee pressure may be forcing consolidation in an industry where historically M&A activity has been sparse: according to a survey by InvestmentNews, 44% of RIAs plan to pursue M&A deals over the next five years.Why Critics of Passive Investing Are WrongBy: Kent Smetters Somewhere there’s equilibrium between active and passive asset management, and wherever that equilibrium may be, we are not there yet according to this WSJ piece by University of Pennsylvania Wharton School Professor Kent Smetters.

How Do Post-Production Deductions Affect the Value of Your Oil and Gas Royalty Interest?

I recently attended the National Association of Royalty Owners (NARO) National Convention in Dallas, Texas. The seminars on lease negotiations, mineral management, shale drilling, and more were all interesting and informative, but there was one topic that was brought up in almost every session: Post-Production Deductions (PPDs).From the first Board Meeting to the last session of the conference, post-production deductions were discussed in great detail. Why were these deductions brought up time and time again? Because post-production deductions affect the value of a mineral owner’s interest yet the regulations surrounding them is somewhat unclear and exists mainly on a contractual basis.What are Post-Production Deductions?The Marcellus Shale Coalition defines post-production deductions (PPDs) as “the expenses incurred in order to get the gas from the wellhead to market.” These costs include gathering, compression, processing, marketing, dehydrating, transportation, and more. PPDs vary significantly between operators and between oil fields because the quality of the products and the distance to market differ.In its raw form, natural gas has little value. In order to make it more marketable, the gas has to be processed so that it is ready to be transported and sold. When an operator markets the product so that it can be sold at a higher price, the royalty owner also benefits if the new net price is greater than the price they would have received.Are PPDs legal?Royalty interests represent a share of net revenue, which means that royalty owners get their share of gross revenue and their share of appropriate expenses. “But,” you say, “I thought royalty owners don’t share in the costs of production!” That is true. Royalty owners are not responsible for costs associated with research, exploration, drilling, or any other aspects of production; but they can be liable for their share of expenses generated post-production.In December 2016, the West Virginia Supreme Court decided that EQT (and therefore other operators) can “not deduct from that (royalty) amount any expenses that have been incurred in gathering, transporting or treating the oil or gas after it has been initially extracted, any sums attributable to a loss or beneficial use of volume beyond that initially measured or any other costs that may be characterized as post-production”. However, in May of this year, the West Virginia Supreme Court reversed its previous decision from last year, allowing post-production deductions for gathering, transporting, or treating gas after extracted. As summarized in WV Supreme Court Reverses Itself, Post-Production Deductions OK, the court said that, “oil and gas companies may use “net-back” or “work-back” methods to calculate royalties owed but that the “reasonableness” of those expenses in specific instances may be decided by future court cases.”In general, the matter of post-production deductions is generally a contractual one between the lessee and lessor. The Louisiana law review says that in general there are three kinds of royalty clauses: (1) the proceeds clause, (2) the market value clause, and (3) the market price clause. The proceeds clause requires that royalty owners be paid a percentage of the actual amount of proceeds, net proceeds, or gross proceeds that the company received. Unless otherwise specified the owner should be paid proceeds determined at the well not at the place of sale. According to Louisiana state law the market value clause allows the owner to determine the hypothetical price that a willing buyer would pay a willing seller for the product while the market price clause requires the operator to pay the royalty owner the actual price received at market. Both, however, allow the royalty owner to be charged for transportation and marketing costs.Future court cases will likely better define the level of post-production deductions that are considered to be fair to both the royalty owner and the operator. But it is important that royalty owners familiarize themselves with the current laws surrounding mineral rights and post-production deductions in the states in which they own mineral rights.How Do PPDs Affect the Value of Your Royalty Interest?The effect that PPDs have on royalty interests can be explained by one of the fundamental concepts of business valuation: value is a factor of cash flow, growth, and risk. PPDs directly reduce cash flow which reduces the value of a royalty interest as shown by the equation above. Additionally, the lack of a “no-deducts” clause in a lease agreement increase the risk associated with an interest. Even if a royalty owner does not currently pay post-production deductions, there is the possibility that the operator could charge PPDs in the future which increases risk. In our white paper titled, “How to Value an Oil and Gas Royalty Interest,” we explain how market and the income approach together can give a complete picture of value. ConclusionThe National NARO convention had educated speakers who talked on a broad range of topics. The organization encourages royalty owners to ask questions and continue learning no matter how long they have worked in the industry. The convention reminded me why industry expertise is so important in the field of business valuation. In order to fully understand the operations of a business, an analyst must have knowledge of all aspects of the industry. Mercer Capital has over 20 years of experience valuing assets and companies in the oil and gas industry. We have valued companies and minority interests in companies servicing the E&P industry and assisted clients with various valuation and cash flow issues regarding royalty interests. Contact one of our oil and gas professionals today to discuss your needs in confidence.

E&P Fourth Quarter 2017

Region Focus: Marcellus & Utica

Region Focus: Marcellus & Utica Oil prices closed the year reaching $60 per barrel, WTI futures prices returned to backwardation, and oil price volatility was relatively calm as the price stayed within an $18 band all year ($42 – $60).

Impact and Perspective on Hurricane Harvey’s Aftermath: Transforming

Some friends and neighbors of ours drove down to Houston this past weekend to assist with the recovery and cleanup effort in the wake of Hurricane Harvey (we were left with the much easier job of watching one of their children for a few days).They used to live in Houston and were moved to go down and help in relief efforts. They, along with a group from their church, came back yesterday with stories and photos of mold from floor to ceiling, throwing housefuls of furniture to the curb, and dead fish that managed to find their way through the floodwaters into people’s living rooms. To add to the loss, the majority of people affected were not covered by flood insurance.However, one thing that was not lost was unyielding dignity, hope, and courage that pulsated throughout the city. This was the most uplifting news to emerge out of the wreckage. As our friends described it, the experience was “transforming” on many levels.The Immediate and Residual Impact of HarveyDon Stowers – Chief Editor of the Oil & Gas Financial Journal recently wrote an editorial on the impact of Hurricane Harvey from an industry perspective. It too was transforming.According to the editorial - companies now are only beginning to assess the damages. More than 20% of the oil production from the Gulf of Mexico was taken offline with additional onshore volumes shut-in. Four terminals in Corpus Christi were closed to tanker traffic. Nearly 50% of the nation’s refining capacity is located along the Gulf Coast and at least 10 refineries were shut down before the storm’s arrival. This was felt here in Dallas as long lines and gas shortages were common for some days after the storm. However, this is anticipated to be more widespread. NYMEX gasoline contracts spiked to their highest levels in two years. Analysts say this will continue for months following the storm.The good news is that the industry will recover in a matter of months. Terminals will re-open. Shipping will resume and gas prices will likely return to lower levels. However, it will take longer for a number of other people to recover.Yet we remain encouraged by the resilient spirit of the people affected and the scores of inspiring people who are continuing to demonstrate the transformative power of the golden rule: Do to others what you would wish for them to do to you. Have a great week.

Additional Considerations for Leaving a Wirehouse or Brokerage Firm

Piggybacking off of our post from last week, we discuss the various options one faces when leaving a wirehouse firm, including the various pros and cons to doing so. The advisory profession has evolved significantly over time, so we’re writing this post to keep you apprised of your options as you consider the big leap. The industry has come a long way over the last couple of decades if you think about it. The client visits we go on today thankfully bear no resemblance to The Wolf of Wall Street or Boiler Room depictions of life as an “advisor” at a brokerage firm in the 80s and 90s. While Hollywood undoubtedly dramatized this reality for entertainment purposes, these films reinforce the rationale for all the change that has taken place over the last twenty years. Ongoing technological and regulatory shifts suggest that the profession will continue to evolve. All these iterations and alterations to the profession mean that advisors now have a variety of different platforms and businesses models to choose from. The three primary options include RIA aggregators and their network platforms, traditional wirehouse firms / broker-dealers, and independent RIAs. Michael Kitces’s blog, Nerd’s Eye View, includes a recent guest post from Aaron Hattenbach, who worked as an advisor under all three of these models and provides valuable insight on which path makes the most sense.The Evolution of RIAsAs a recent two-year participant in Merrill Lynch’s Practice Management Division (PMD), Hattenbach estimates the program’s failure rate to be 99% (other industry observers have estimated 95%; the wirehouse firms do not publish these statistics for obvious reasons). This sad reality is something an aspiring financial advisor should keep in mind when considering employment at one of the major wirehouse or brokerage firms.It also explains why the industry has such a tough time recruiting millennials to the business. Those who do succeed tend to be aggressive networkers and champions of the wirehouse brand and the breadth of services it can offer clients.Even if you are part of the 1% (or 5%) who make it through the program, the independent or aggregator RIA routes can be enticing. As noted last week, the sheer economics justifies the move to the independent route if you can transition most of the clients and manage overhead efficiently.Independence also breeds creativity and customization as the wirehouse firms tend to be more bureaucratic while offering firm approved, templated solutions to clients on behalf of advisors across their entire network. Hattenbach noted that most of his advisor colleagues at Merrill placed more emphasis on “being compliant” than sharpening their craft, advising clients, or growing their book of business.But independence isn’t the only option. Fortunately, there’s a compromise or go-between for total independence and the wirehouse route.The Tenets of RIA IndependenceThe RIA aggregator model allows its advisors to maintain some degree of autonomy without having to manage an actual business. Aggregators will purchase books of business from advisors and offer an ongoing payout structure after the deal.Aggregators like LPL Financial and Focus Financial have gained popularity in recent years as these businesses did not suffer the reputational (and financial) fallout of their wirehouse counterparts during the last financial crisis. Also, like their wirehouse competitors, RIA aggregators can use their massive scale to negotiate better terms for things like custody fees and trading costs than independent RIAs.Still, a lot of advisors have left the RIA aggregator network, perhaps one of the reasons behind Focus’s delayed plans for an IPO. Perhaps once the advisors get a taste of freedom, they will want full independence and start their own RIA. Even after operating under an RIA aggregator, the transition to independence can be quite the leap, and Hattenrach advises that the following attributes are needed:Operating experience in the investment advisory channelNiche specialty that allows for differentiation from the competition to compensate for the lack of brand recognitionA client base large enough to sustain itself or the financial flexibility and patience to grow it from scratchEntrepreneurial attitude and willingness to put in the many hours necessary to succeedThe ability to effectively multi-task and prioritizeAn advisory study group or professional group of colleagues that can from your “unofficial advisory board” Anecdotally, we’ve heard (and generally observed) that it often takes $500 million in client assets to create an independent RIA that is consistently profitable, depending upon fee structure, location, and headcount, among other things. This may be a bit conservative, but could be what it takes to breakeven in an environment dominated by passive investing, fee compression, evolving regulatory requirements, and rising compliance and compensation costs. We’ve seen profitable RIAs at lower levels of AUM, but to build consistent profitability in the face of all the aforementioned industry headwinds and a potential market downturn, you’re probably going to need a few hundred million in client assets.ConclusionThis is a lot to think about as each route has its own risks and rewards. If the solution were obvious, it’d be the only option. We see the independent and aggregator RIA model continuing to gain client assets and advisors from wirehouse firms, but think the Wall Steet firms and other broker-dealers are too heavily entrenched (and dedicated to fee income) to be totally wiped out anytime soon. Whatever the outcome, as asset management models continue to evolve the relative merits of independence and affiliation will too.

How to Value an Oil & Gas Royalty Interest

How to Value Your Exploration and Production Company

A lack of knowledge regarding the value of your business could be very costly. Opportunities for successful liquidity may be missed or estate planning could be incorrectly implemented based on misunderstandings about value. In addition, understanding how exploration and production companies are valued may help you understand how to grow the value of your business and maximize your return when it comes time to sell.The purpose of this whitepaper is to provide an informative overview regarding the valuation of exploration and production (E&P) companies operating in the oil and gas industry.

WHITEPAPER | How to Value Your Exploration and Production Company

Options for Today's Financial Advisors

Should I Stay or Should I Go?

Ever since the Financial Crisis, wirehouse advisors have been pondering this question as the independent model continues to lure wealth managers from the big banks and brokerage firms. This post discusses the various options that financial advisors (FAs) are faced with today and when it makes sense for them to stick around or do their own thing. It seems unlikely that English punk rock artist Mick Jones could empathize with future financial advisors when he unleashed his hit single, "Should I stay or Should I go" in 1981. Rather, he was probably referring to his own pending departure from The Clash (though he would later deny that contention). Either way, it seems oddly applicable to many FAs' current predicament as they contemplate the pros and cons of staying with their current employer or forming their own RIA.Considerations for Financial AdvisorsPerhaps the most obvious consideration is compensation. Though it varies by firm and location, wirehouse firms generally pay out 35% to 55% of fee income to their FAs, with the larger producers typically taking home a bigger cut of the business, according to industry consultant, Michael Kitces. Larger RIA firms, on the other hand, tend to pay their FAs 40% to 50% of fee income, 20% to 30% in non-compensatory overhead costs with the residual 20% to 30% in profits, depending again on size and location and dozens of other factors. This means that a solo practitioner could earn as much as 80% of his or her fees by starting their own firm, collecting all the fee income net of overhead expenses.Based on this math alone, it's hard to comprehend why over 50,000 advisors and $7 trillion assets have remained at Bank of America Merrill Lynch, UBS, Morgan Stanley, and Wells Fargo alone, according to the InvestmentNews Advisers on the Move database. IN attributes this phenomenon to signing bonuses at the wirehouse firms, the security they offer, increasingly higher compensation packages for top producers, and appealing retirement deals for senior FAs looking to cash out. Or it may be that capturing that margin for oneself is easier said than done.Kitces contends that "end advisors are often able to keep 10% to 20% more of their gross revenue after making the switch" even after considering all the perquisites that the bulge bracket firms are offering. So from a sheer economics perspective, it appears that going independent makes more sense, but there are still other factors to keep in mind. For one, you have to get client consent, which is not always a given, especially if the client identifies more with the bank than the broker, which is often the case with elderly investors. You'll also have to invest time and money in technology, personnel, and other overhead charges that were previously provided by the brokerage firms. In addition, you'll be suddenly responsible for practice management unless you pay someone else to do that for you, which can also be costly. Indeed, if you go, there could be trouble, as Mick Jones warned us.Don't leave without first thinking about your employment agreements, non-compete agreements, non-solicitation agreements, etc. The only thing worse than starting a business with plenty of overhead and no clients is starting a business with plenty of overhead, a few clients, and a lawsuit from your former firm.The obvious advantage of staying with a wirehouse is the plug-and-play platform that allows financial advisors to concentrate on client service and selling, rather than running a business. We hear plenty of grumbling about the big firms being run by lawyers instead of business development staff, spending so much time on defense that there's no time left for offense.Compliance issues are rising in the independent RIA space as well, though, and when you're in charge of your RIA, you're also in charge of the compliance department. Oddly enough, at the same time brokers are weighing leaving big banks to go out on their own so they aren't constrained by back-office regulations, independent RIAs are consolidating to allow their top people to focus on clients instead of practice management.ConclusionThere are plenty of tradeoffs to being independent. But staying could be even more problematic. The independent model allows you to better take advantage of the inherent operating leverage of the asset manager business. Rather than earning a fixed percentage of the fee income from client assets, an independent RIA owner/operator can achieve significant levels of profitability to augment fee income by growing AUM with more modest increases to overhead expenses. We've seen larger wealth management firms (client assets over $500 million) achieve EBITDA margins of 25% or greater when overhead costs remain relatively contained. Potential returns do appear to be commensurate with the risk involved in most of these situations – which is, after all, kind of the theme of investment management.Mick Jones ultimately decided to go, and has enjoyed something of a post-Clash career (although you could be forgiven for not being able to name any songs by Big Audio Dynamite). If you're considering going independent, we just hope you keep this all in mind.

How to Use Reserve Reports When Determining Fair Market Value

Last week, Lucas Paris analyzed the SEC’s $6.2 million settlement with a Big 4 audit firm relating to auditing failures associated with Miller Energy Resources, an oil and gas company with activities in the Appalachian region of Tennessee and in Alaska. In late 2009, Miller acquired certain Alaskan oil and gas interests for an amount the company estimated at $4.5 million. The company subsequently assigned a value of $480 million to the acquired assets, resulting in a one-time after-tax bargain purchase gain of $277 million. Following the deal, the newly acquired assets comprised more than 95% of Miller’s total reported assets.The SEC order determines that the Big 4 audit firm did not properly use the reserve reports conclusion of PV-10 (present value at 10%).This post considers the proper use of reserve reports and risk adjustment factors when determining fair market value.What Is Fair Market Value?The American Society of Appraisers defines the fair market value as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.1Treasury Regulation Section 1.611-1(d)(2) provides guidance in determining the fair market value of oil and gas properties. It similarly provides that “the fair market value of an [oil and gas] property is the amount which would induce a willing seller to sell and a willing buyer to purchase.” Additionally, Section 1.611-2(g) outlines some considerations that a valuation of mineral properties must include for tax-oriented appraisals. A summary of these considerations is shown in the chart below.A review of Treasury Regulations 1.611-2(g) clearly demonstrates that an analyst must do more than rely on reserve reports when determining fair market value.What Is a Reserve Report?The SEC defines reserves as “estimated remaining quantities of oil and gas and related substances anticipated to be economically producible, as of a given date, by application of development projects to known accumulations.”A reserve report is prepared by a petroleum engineer who estimates the remaining quantities of oil and gas and categorizes them based on the likelihood that they will be produced. There are three main categories of proved reserves (P1) which are distinguished in a reserve report. Proven reserves are defined to have at least a 90% probability of being recovered.Proved Developed Producing (PDP) reserves are defined by the OJFG as “the estimated remaining quantities of oil and gas anticipated to be economically producible, as of a given date, by application of development projects to known accumulations under existing economic and operating conditions.”Proved Developed Non-Producing (PDNP) reserves are proven reserves “that can be expected to be recovered through existing wells and existing equipment and operating methods.”Proved Undeveloped (PUDs) reserves are proven reserves “that are expected to be recovered from new wells on undrilled acreage or from existing wells where a relatively major expenditure is required for completion.” Other reserve categories include probable (P2) and possible (P3) reserves, which must exceed 50% and 10% probability of recovery, respectively. Reserve reports estimate future production of all proved reserves. From this, they predict future revenue and future expenses and discount the net income using a 10% standard discount rate. PV-10 is the resulting estimate of the present value of the company’s cash flow from proved oil and gas reserves. It is standardized value which provides consistency across public companies filings. However, PV-10 is not necessarily an accurate representation of fair market value. PV-10 assumes that all categories or proved reserves are equally risky. In reality, a potential buyer would not pay as much for an interest in PUD acreage as they would for PDP acreage because there is substantially more risk associated with the PUD acreage. If a valuation expert had been hired to do a purchase price allocation for Miller Energy’s acquisition of oil and gas interest in Alaska, PV-10 would not have been used as the fair market value. Rather, a valuation specialist with industry expertise would have performed a discounted cash flow analysis and evaluated how certain risks that pertain to each asset affect the value.How to Use a Reserve ReportThe income approach is generally accepted among industry professionals as the most accurate representation of fair market value of oil and gas interests, and the reserve report can be used as one of the main sources of information for the inputs of the discounted cash flow. Treasury Reg 1.611-2(e)(4) provides a straightforward outline of how the approach should be used. In general, a discounted cash flow analysis is the method of choice.In practice, the income approach requires that:The appraiser project income, expense, and net income on an annual basisThus, revenue and expense projections used in the income approach can be directly harvested from this report.Each year’s net income is discounted for interest at the “going rate” to determine the present worth of the future income on an annual and total basisThis is where a reserve report and a calculation of fair market value differ. While a reserve report uses a standard 10% discount rate, when determining fair market value a discount rate which considers potential risk factors should be developed. An analyst could add a risk premium for each reserve category to adjust a baseline WACC or they could account for this risk in a separate adjustment. The total present worth of future income is then discounted further, a percentage based on market conditions, to determine the fair market value.PV-10 treats PDP, PDNP, and PUDs the same. However, there are uncertainties and opportunities associated with PUDs that are not captured in the discount rate used for all proved reserves. A risk adjustment factor could be used to the discounted present value of cash flows according to the category of the reserves being valued to account for PUDs upside and uncertainty by reducing expected returns from an industry weighted average cost of capital (WACC). What About Probable and Possible Reserves?Reserve reports only account for proven reserves; they do not estimate the value of possible and probably reserves which are less likely to be recovered. While less certain, there is still some potential upside of the Probable and Possible reserve categories. In order to estimate the value of probable and possible reserves the market approach can be used.The market approach is a general way of determining a value indication of an asset by using one or more methods that compare the subject to similar assets that have been sold. Because reserve values vary between oil and gas plays and even within a single play, finding comparable transactions is difficult. A comparable sale must have occurred at a similar time due to the volatile nature of oil and gas prices. A comparable sale should be for a property that is located within the same play and within a field of similar maturity.If transactions show premiums over the value of proven reserves, then the buyer likely was paying for something else in addition to the proved reserves; he was likely paying for the less certain upside potential of probable and possible reserves. Through these transactions, the value of these reserves can be understood as they vary by basin and between fields. In many basins probable and possible reserves may currently be worthless because the price of oil may not rebound to a point where it would be economical to explore for and drill these reserves; however, in fields such as the Delaware and Midland Basins in the Permian recent transactions tell a different story.The valuation implications of reserves and acreage rights can swing dramatically in resource plays. While a reserve report is helpful, it does not measure fair market value or fair value. Utilizing an experienced oil and gas reserve appraiser can help to understand how location impacts valuation issues in this current environment. Contact Mercer Capital to discuss your needs and learn more about how we can help you succeed.End Notes1 American Society of Appraisers, ASA Business Valuation Standards© (Revision published November 2009), “Definitions,” p. 27.

WHITEPAPER | How to Value an Oil & Gas Royalty Interest

Emerging Community Bank M&A Trends in 2017

As summer came to an end, the U.S. was treated with a historic event as the first total solar eclipse crossed the country since 1918. The timing of the event had social media and news outlets buzzing in a traditionally sleepy news month. For many, the event exceeded all expectations; for others, it was a dud that didn’t live up to the hype. My personal experience was a bit of both. The minutes of darkened skies were definitely memorable, but things returned to normal quickly as the sun shone brightly only minutes after.Traditional M&A TrendsCommunity bank M&A trends also seem mixed. Rising regulatory burdens, weak margins from a historically low interest rate environment and heightened competition have crimped ROEs for years. Many pundits have predicted a rapid wave of consolidation and the demise of community banks in the years since the financial crisis. However, the pace of consolidation the last few years is consistent with the past three decades in which roughly 3-4% of the industry’s banks are absorbed through M&A yearly. The result is many fewer banks—5,787 at June 30 compared to about 15,000 in the mid-1980s when meaningful industry consolidation got underway.Somewhat surprisingly, the spike in bank stock prices following the November 2016 national elections did not cause M&A to accelerate. As would be expected, acquisition multiples increased in 2017 because publicly traded acquirers could “pay-up” with appreciated shares. As seen in the table on the next page, the median P/E and P/TBV multiples and the median core deposit premium increased for the latest twelve months (LTM) ended July 31, 2017 compared to the year ago LTM period. The ability of buyers—at least the publicly traded ones—to more easily meet sellers’ price expectations seemingly would lead more banks to sell. However, that has not happened as the pace of consolidation declined slightly to 132 transactions in the most recent LTM period compared to 140 in the year ago LTM time frame.FinTech’s Impact on M&AAnother emerging M&A trend is the presence of non-traditional bank acquirers, which include private investor groups, non-bank specialty lenders, and credit unions. While a FinTech company has not yet announced an acquisition of a U.S. bank this year, several FinTechs have announced they are applying for a bank charter (SoFi, VaroMoney), and in the U.K., Tandem has agreed to acquire Harrods Bank.So far, FinTech acquisitions of banks have been limited to a few acquisitions by online brokers and Green Dot Corporation’s acquisition of a bank in 2011. While FinTech companies have yet to emerge as active buyers, there have been some predictions that could change if regulatory hurdles can be navigated. Some FinTech companies are well-funded or have access to additional funding that could be tapped for a bank acquisition. In addition, an overlay of enhancing financial inclusion for the under-banked could mean bank transactions may not be as far-fetched as some may think.Beyond serving as potential acquirers, FinTech continues to emerge as an important piece of the community banking puzzle of how to engage customers through digital channels as the costly branch banking model sees usage decline year-after-year. Many FinTechs are eager to partner with banks to scale their operations for greater profitability, thereby better positioning themselves for a successful exit down the road.Consistent with this trend, we have also seen some acquirers (and analysts) comment on FinTech as a benefit of a transaction, as opposed to (or at least in addition to) the historical focus on geographic location, credit quality, asset size, and profitability. We will be watching to see if FinTech initiatives, whether internally developed or acquired, become a bigger driving force in bank M&A. If so, acquisitions of FinTech companies by traditional banks may increase (as discussed more fully in this article).As these trends grow in importance, buyers and sellers will have to grapple with unique valuation and transaction issues that require each to fully understand the value of the seller and the buyer, assuming a portion of the consideration consists of the buyer’s shares. Whether that buyer includes a traditional bank whose stock is private or a non-bank buyer, such as a specialty lender or FinTech company, we have significant valuation and transaction expertise to help your bank understand the deal landscape and the strategic options available to it.If we can be of assistance, give us a call to discuss your needs in confidence.This article originally appeared in Mercer Capital's Bank Watch, August 2017.

$475 Million Bargain Purchase Leads to a SEC Settlement

Originally published on Mercer Capital's Financial Reporting Blog, Lucas Parris analyzed the SEC’s $6.2 million settlement with a Big 4 audit firm relating to auditing failures associated with Miller Energy Resources, an oil and gas company with activities in the Appalachian region of Tennessee and in Alaska.In late 2009, Miller acquired certain Alaskan oil and gas interests for an amount the company estimated at $4.5 million. The company subsequently assigned a value of $480 million to the acquired assets, resulting in a one-time after-tax bargain purchase gain of $277 million. Following the deal, the newly acquired assets comprised more than 95% of Miller’s total reported assets. Was it a bargain purchase or not?Paris’ post examines the particulars of the case and provides some observations on fair value accounting that can be gleaned from the SEC settlement order.Bargain Purchase BackgroundA bargain purchase results when the fair value of the assets acquired exceeds the purchase price. If a transaction is determined to be a bargain purchase, the acquirer must recognize a gain on its income statement. Bargain purchases can be the result of a distressed seller or the lack of recognition of a contingent liability. In practice, bargain purchases are uncommon, and typically require a reassessment of the identifiable assets acquired, liabilities assumed, and consideration transferred to confirm that such a transaction has occurred.Miller’s Acquisition of the AssetsAccording to the SEC Order, Miller went public via a reverse merger in 1996. Between 2002 and 2009, its stock price regularly traded below one dollar per share and the firm reported net losses in all years. In late 2009, Miller learned that certain oil and gas interests located in Alaska (the “Alaska Assets”) were in the process of being legally “abandoned” in connection with a bankruptcy proceeding. The Alaska Assets included leases covering 602,000 acres of mostly unproven exploratory oil and gas prospects, five operative oil and gas wells located mainly on two fields, two major facilities, and an offshore platform.The prior owner had marketed the assets for nearly a year, culminating in a court-sponsored auction that produced bids of $7.0 million and $8.1 million. However, neither bidder closed on the bids. A second competitive auction occurred, in which Miller outbid a competing entity whose parent company was, at the time, the largest land drilling contractor in the world. Miller’s winning bid was $2.25 million in cash plus the assumption of $2.2 million in liabilities. The transaction closed December 10, 2009.Accounting for the AcquisitionIn its quarterly SEC filing following the transaction, Miller assigned a fair value of $480 million to the acquired assets. The primary assets were the oil and gas properties ($368 million) and fixed assets ($110 million).Oil and Gas Properties – To establish the fair value of the oil and gas assets, Miller relied upon a reserve report prepared by a third-party petroleum engineering firm under the guidelines for supplemental oil and gas disclosures (ASC 932). The SEC Order stipulated that this was improper because the report itself expressly disclaimed that any of its estimates were estimates of fair value. In other words, the report was prepared for another purpose and with a different accounting/valuation premise than is required under the fair value guidance of ASC 820 and ASC 805. The SEC Order noted that the reserve report estimates were improper from a fair value perspective because the report failed to incorporate an appropriate discount rate and risk adjustments for certain speculative reserve categories. The report was also alleged to contain understated and unsubstantiated cost forecasts, which had been originally provided to the engineering firm by Miller.Fixed Assets – Miller valued the acquired fixed assets (facilities and ancillary pipelines) at $110 million. However, the SEC Order noted that the basis for the $110 million figure was an insurance report that actually contained no third-party analysis – the figure was actually provided to the insurance broker by Miller and then referenced as if it was independently derived by the broker. Furthermore, the SEC indicated that the recording of a separate $110 million fixed asset was double-counting, because these assets were necessary to produce the oil and gas reserves and were already included in the $368 million reserve report value.Role of the Audit FirmMiller Energy replaced its prior independent audit firm in February 2011 (about a year after the acquisition of the Alaska Assets). The new Big 4 firm provided audit reports for Miller, with unqualified opinions, for fiscal 2011 through 2014. The SEC Order states that the firm failed to comply with certain auditing standards, including the requirement to analyze the impact of Miller’s opening account balances (including the value of its oil and gas properties) on the current year financial statements.The SEC Order alleges that the auditors failed to obtain sufficient competent evidence regarding the impact of the opening balances on the current year financial statements, despite knowing that no proper fair value assessment had been performed by management in the prior year. While the audit firm did undertake some audit procedures, it failed to appropriately consider the facts leading up to the acquisition including the competitive bidding process and the “abandonment” of the assets by the prior owner. The SEC Order also noted that the auditor failed to detect the double-counting of fixed assets in the opening balances.Fair Value ObservationsThe SEC Order contains extensive discussion of the auditing and review process as it relates to Miller’s Alaska Assets, which we will not attempt to summarize here. Instead, we will discuss a few of the key themes that emerge from our reading.Bargain Purchases Should Require Additional Scrutiny – It should go without saying, but if a $4.5 million purchase results in a $472 million gain on the income statement (over 100x), there should be a healthy dose of professional skepticism from all sides (management, auditors, and valuation specialists). Every transaction is unique, and perhaps the facts and circumstances support it, but one should be wary if the magnitude of the bargain is large. As an aside, one would think that potential investors would be wary of such an accounting treatment as well, without adequate and supportable disclosures.Proper use of valuation reports – The reserve reports relied upon by Miller management did not contain fair value measurements. Perhaps they were entirely appropriate for the purpose for which they were prepared, but that purpose was not fair value for ASC 805 compliance.Industry Expertise – The partner-in-charge and senior manager on the Miller engagement had no prior experience with oil and gas companies, which the SEC Order indicates resulted in departures from professional standards during the audit process. The SEC Order, citing an AICPA Auditing & Accounting Guide, states that when a client’s business involves unique and complex accounting, as in the case of the oil and gas industry, the need for the engagement partner to understand the client’s industry is even more important. In our opinion, the importance and benefit of industry expertise extends to the valuation specialist as well. Mercer Capital has performed purchase price allocations for clients across a variety of industries and transaction structures, including those giving rise to bargain purchases. We also have significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.Related LinksA Buyer’s Market: Accounting for Bargain PurchasesIn the Eye of the Beholder: Increasing SEC Scrutiny of Public Company Fair Value MarksMisleading Purchase Accounting Results in SEC Complaint and Fines for CVSSEC Signals Increased Focus on Financial ReportingThe Fair Market Value of Oil and Gas Reserves

Recent Trends in Asset Management

This week, we’re sharing some recent media on trends in asset management and the outlook for M&A activity. Most industry observers foresee an uptick in asset manager dealmaking as rising costs, asset outflows, and a heightened interest from consolidators incent many firms to pull the trigger on a sale or business combination with another RIA. Global Asset Management 2017 – The Innovator’s Advantageby The Boston Consulting Group BCG provides a detailed profile of the RIA industry, M&A trends, growth opportunities in a passive environment, and optimizing investment management for the digital age.Latest Mercer Move Highlights Hot M&A Demand for Smaller Firmsby Charles Paikert Though no relation to our firm, Mercer Advisors recently announced its fourth asset manager deal of the year, underscoring the desirability of smaller RIAs in a seller’s market.Skill through Scale? The Role of M&A in a Consolidating Industry – Investment Management M&A Outlookby Casey Quirk, a practice of Deloitte Consulting LLP Casey Quirk sees brisk M&A activity continuing in 2017 and beyond as a result of deteriorating economics, distributor consolidation, the need for new capabilities, and a shifting value chain.Asset Manager Deal Wave Has Just Begunby Aaron Black This Wall Street Journal piece predicts continued consolidation in the RIA space as struggling active managers combine to stem the tide of asset outflows.Minority Stake Sales Prop Up Investment Management Dealmaking Activityby Joe Mantone This recent piece by S&P Global Market Intelligence examines the heightened level of minority investments in asset managers in the context of slowing M&A volume for the sector.Renewed Appetite – Alts Manager M&A Heats Upby KPMG With the continued “bar-belling” of investors’ portfolios and strong demand for alternative strategies in the current low-growth, low-yield environment, KPMG sees renewed appetite for dealmaking involving hedge funds and private equity firms. As always, we are available to continue any of the above discussion further. Don't hesitate to call us.

An Example of Structuring Earn-outs for RIAs

Risk is enigmatic to investing. While we might all desire clairvoyance, it would only work if we were the sole investors who could see the future perfectly. If everyone’s forecasts were proven accurate, assets would all be priced at something akin to the risk-free rate, with no premium return attached. Uncertainty creates opportunity for investors, because opportunity is always a two-way street.Pricing uncertainty is another matter altogether. Not everyone “believes” in CAPM, or at least maybe not the concept of beta, but most agree that the equity risk premium exists to reconcile the degree of unlikelihood for the performance of a given asset with the value of that asset. In an ideal world, a reasonable cash flow projection and a reasonable cost of capital will yield a reasonable indication of value.In the real world, there can be genuinely differing opinions of what the future holds. Some think the future is all about batteries, with considerably stronger environmental regulations on the horizon (at least in Europe) not to mention the relative simplicity of battery power. This sentiment bid Tesla’s share price to a larger market capitalization than Ford. Others have equally questioned the wisdom of this, noting the reluctance of consumers, and many governments, to phase out the use of fossil fuels in transportation. Naysayers note that Tesla’s 400 thousand plus pre-orders for the Model 3 pale in comparison to, say, the over 16 million Ford F150 pickup trucks sold over the past 20 years. What would break that trend now?In the vacuum sealed world of fair market value, we can reconcile discordant outlooks with different cash flow projections. The differing projections can then be yoked together into one conclusion of value by weighing them relative to probability. The discount rate used in the different projection models captures some of the risk inherent in the cash flow, and the probability weights capture the remainder of the uncertainty. In a real world transaction, however, buyers want to be paid based on their expectations if proven right, and sellers also want to be paid if outcomes comport with their projections. With no clear way to consider the relative likelihood of each party’s expectations, no one transaction price will facilitate a transaction. Risk and opportunity can often be reconciled by contract, however, by way of contingent consideration.RIA Transaction ExampleConsider the example of a depository institution, Hypothetical Savings Bank, or HSB. HSB has a substantial lending platform, but it also has a trust department that operates as something of an afterthought. HSB’s senior executives consider options for closing or somehow spinning off the trust operation, but because of customer overlap, lengthy trust officer tenure with the bank, and concerns by major shareholders who need fiduciary services, HSB instead hopes to bolster the profitability of trust operations by acquiring a RIA.Following a search, HSB settles on Typical Wealth Management, or TWM. TWM has 35 advisors and combined discretionary assets under management of $2.6 billion (an average of $75 million per advisor). TWM has a fifteen-year track record of consistent growth, but with the founding generation nearing retirement age, the firm needs a new home for its clients and advisors.The Seller’s PerspectiveTWM’s founders are motivated, but not compelled, to sell the firm. TWM generates 90 basis points of realized fees per dollar of AUM and a 30% EBITDA margin. Even after paying executives and advisors, TWM makes $7MM of EBITDA per year, and the founders know that profitability has significant financial value to HSB, in addition to providing strategic cover to shore up the trust department.Further, Typical Wealth Management has experienced considerable growth in recent years, and believes it can credibly extend that growth into the future, adding advisors, clients, and taking advantage of the upward drift in financial markets to improve revenue and enhance margins. Given what it represents to be very conservative projections, and which don’t take into account any cross selling from the bank or potential fee enhancements (TWM believes it charges below-market fees to some clients), the seller wants 12x run rate EBITDA, or about $85 million, noting that this is only about 10x forward EBITDA, and less than 7x EBITDA three years hence. The Buyer’s PerspectiveThe bankers at HSB don’t really understand wealth management, but they know banks rarely double profitability in three years and suspect they’ll have a tough time convincing their board to pay top dollar for something without tangible book value.Bank culture and investment management frequently do not mix well, and they worry whether or not TWM’s clients will stay on if the senior staff starts to retire. Further, they wonder if TWM’s fee schedule is sustainable in an era of ETFs and robo-advisors. They create a much less sanguine projection to model their possible downside. Based on this, HSB management wants to offer about $40 million for Typical, which is about six times run rate EBITDA. This pricing gives the seller some credit for the recurring nature of the revenue stream, but doesn’t pay for growth that may or may not happen following a change of control transaction. The CompromiseWith a bid/ask spread of $45 million, the advisors for both buyer and seller know that a deal isn’t possible unless one or both parties is willing to move off of their expectations significantly (unlikely) or a mechanism is devised to reward the seller in the event of excellent performance and protect the buyer if performance is lackluster. Even though the buyer is cautious about overpaying, they eventually agree to a stronger multiple on current performance and offer $50 million up front for TWM. The rest of the payment, if any, will come from an earn-out. Contingent consideration of as much as $30 million is negotiated with the following features:TWM will be rebranded as Hypothetical Wealth Management, but the enterprise will be run as a separate division of the bank during the term of the earn-out. This division will not pay any overhead charge to the bank, except as specifically designated for marketing projects through the bank that are managed by the senior principals of the wealth management division. As a consequence, the sellers will be able to maintain control over their performance and their overhead structure during the term of the earn-out.The earn-out period is negotiated to last three years. Both buyer and seller agree that, in a three year period, the value delivered to the seller will become evident.Buyer and seller agree to modest credits if, for example, the RIA recommends a client develop a fiduciary relationship with the bank’s trust department, or if the bank’s trust department refers a wealth management prospect to the RIA. Nevertheless, in order to keep matters simple during the term of the earn-out, both parties agree to manage their operations separately while the bank determines whether or not the wealth management division can continue to market and grow as an extension of the bank’s brand.To keep performance tracking straightforward, HSB negotiates to pay five times the high-water mark for any annual EBITDA generated by TWM during a three year earn-out period in excess of the $7 million run-rate established during the negotiation. It is an unusual earn-out arrangement, but the seller is compensated if by steady marketing appeal or strong market returns, AUM is significantly enhanced after the transaction. The buyer is protected, at least somewhat, from the potentially temporary nature of any upswing in profitability by paying a lower multiple for the increase than might normally be paid for an RIA. As long as management of Typical can produce at least $6 million more in EBITDA in any one of the three years following the transaction date, the buyer will pay the full earn-out. Any lesser increase in EBITDA is to be pro-rated and paid based on the same 5x multiple.The earn-out agreement is executed in conjunction with a purchase agreement, operating agreement, and non-competition / non-solicitation agreements which specify compensation practices, reporting structures, and other elements to govern post-transaction behavior between the bank and the wealth manager. These various agreements are done to minimize misunderstandings and ensure that both buyer and sellers are enthusiastic participants in the joint success of the enterprise. As the earn-out is negotiated, buyer and seller run scenarios of likely performance paths for Typical after the transaction to see what the payout structure will look like per the agreement. This enables both parties to value the deal based on a variety of outcomes and decide whether pricing and terms are truly satisfactory.Structuring Earn-Outs Is the Key to a Successful TransactionMy very limited understanding of neuroscience has led me to a cursory knowledge of the shortfalls of human decision making. As much as we might like to believe we think analytically, we mostly act on impulse, responding emotionally to our environment faster than we can reason.This capacity kept us alive when rapid escape from a predator was a more reliable reaction than stopping to think about what was happening. This same brain function causes sellers to focus too much on the headline number offered in a deal negotiation and not enough on the terms surrounding the price.In RIA transactions, those terms frequently include large earn-out payments based on performance outlooks that are highly unlikely, or that at least should be discounted significantly. As a rule, buyers get more protection from contingent consideration than sellers, and frequently have more experience offering earn-outs than sellers have living with them. Seller beware!If you’re considering an offer for your firm that includes earn-out consideration, think about having some independent analysis done on the offer to see what it might ultimately be worth to you. If you’re working the buy-side, prepare to spend lots of time fine-tuning the earn-out agreement – you won’t get credit if things go well for the seller, but you will get blamed if it doesn’t.

Summer NAPE Expo: Observations & Thoughts

Mercer Capital attended the Summer NAPE Expo in Houston this month. Founded in 1993 by AAPL, with the addition of IPAA, SEG, and AAPG as partners over the next several years, NAPE is a well-known venue for oil and gas professionals to meet, network, and do business; it was a terrific event. The Expo also included a conference covering various industry issues. The session speakers were mostly a mix of company executives and industry analysts, including Wood Mackenzie. The presentations covered a number of supply and demand issues including:Market efficiencies in light of the low-cost environmentComments on various basins (Permian, Eagle Ford, Haynesville)Continued growth of drilled uncompleted wells (“DUC’s”)Market EfficienciesThere continues to be a relative market oversupply in both oil and gas. According to Wood Mackenzie, there may be approximately 1700 TCF of natural gas that could breakeven at $3.00/mcf. That’s a 20-year supply for the U.S. LNG is oversupplied because the U.S. is putting a ceiling on LNG prices. However, there are signs of a move towards more of a balance; for example, we are starting to see some slight inventory drawdowns and the market may find creative ways to create demand for some of these plentiful resources. All of this is being accomplished in light of significant industry capex drops since 2014. However, we are starting to witness growth again in 2017 for spending. This is corresponding with the increase of rig counts. Basin CommentaryAnalysts from Wood Mackenzie noted that the breakeven for new wells in the Permian Basin was at the bottom of the global cost curve. Some areas of the Permian are at a $35 per barrel breakeven level. In addition, it was mentioned that the Permian could match the Marcellus shale in natural gas production (to say nothing of oil and liquids) in the future. This significantly differentiates the Permian Basin in comparison to other plays.However, the Permian is not the only basin with favorable economics. Technology and innovation have pushed other areas along. For example, the Eagle Ford shale play is sustainable at today’s prices and the Haynesville Shale has had a “roller coaster” of activity lately. Some areas of the Haynesville can model gas as low as $2.40/mcf and still have a profitable well. BP, Exxon, and Exco all have activity in the Haynesville area.Continued Growth of DUC’sDUC’s are growing quickly and the market continues to pay more attention to them. In fact, the EIA this month included the Anadarko basin for the first time in its DUC data and drilling report. Two years ago this metric caught the industry’s attention. However, there are questions as to exactly how much potential inventory these DUC’s represent. It was noted that DUC wells may be comprised of lower estimated ultimate recovery (EUR) and may not have as much excess inventory as otherwise thought. In addition, completion crews are taking longer to perform jobs than before (6-7 days as opposed to 4-5). With drilling times going down and completion times going up, we are seeing a higher DUC count. One other interesting drilling related note from the conference was that an emerging theme (previously rarely, if ever, discussed) on analyst calls for publicly traded companies has to do with the percentage of acreage controlled by companies that is held by production (HBP). In fact, most of the Permian is 95% HBP – due to decades of prior drilling. It appears companies want investors to know that there isn’t as much of a requirement for companies to drill going forward. TakeawaysThe marketplace remains excited about the potential for the Permian Basin. Although there continues to be a supply glut, the U.S. is well positioned to continue to have positive economics due to increasingly efficient operations, technology, and innovation. More and more basins are beginning to catch up to the Permian in terms of efficiency and rig counts reflect this.However, our biggest takeaway was meeting and getting to know a plethora of new people. The conversations were terrific, and we enjoyed getting to know all of you. We look forward to seeing you at future NAPE events as well.If you were there, let us know your thoughts and comments about NAPE. We would love to hear them. Have a great week!

WHITEPAPER | How to Value Your Regional or Short-Line Railroad Company

In the railroad industry, Class I public company multiples are often used to estimate the fair market value of private railroads classified as Class II or Class III. In almost every case, this method significantly misrepresents the fair market value of private railroad operations. In this whitepaper, we explain why public company multiples can be misleading and discuss the mechanics of valuation used by professional business appraisers. We do so in order to provide you with the knowledge and vocabulary necessary to be an informed consumer of business valuation services and, more importantly, to understand the value of your regional or short-line railroad company.

How to Value Proven Undeveloped Reserves (PUDs)

One of the primary challenges for industry participants when valuing and pricing oil and gas reserves is addressing proven undeveloped reserves (PUDs) and unproven reserves. While the market approach can sometimes be used to understand the value of PUDs and unproven reserves, every transaction is unique. Additionally, many transactions that we see today are still a result of the crash in oil prices in 2014; and in some sales of non-core assets, PUDs and unproven reserves have been deemed worthless. Why then, and under what circumstances, might the PUDs and unproven reserves have significant value?Optionality ValueThe answer lies within the optionality of a property’s future DCF values. In particular, if the acquirer has a long time to drill, one of two forces come into play: either the PUDs potential for development can be altered by fluctuations in the current price outlook for a resource, or, as seen with the rise of hydraulic fracturing, drilling technology can change driving significant increases in the DCF value of the unproven reserves.This optionality premium or valuation increment is often most pronounced in unconventional resource play reserves, such as coal bed methane gas, heavy oil, or foreign reserves. This is additionally pronounced when the PUDs and unproven reserves are held by production. These types of reserves do not require investment within a fixed short timeframe.PUDs are typically valued using the same discounted cash flow (DCF) model as proven producing reserves after adding in an estimate for the capital costs (capital expenditures) to drill. Then the pricing level is adjusted for the incremental risk and the uncertainty of drilling “success,” i.e., commercial volumes, life and risk of excessive water volumes, etc. This incremental risk could be accounted for with either a higher discount rate in the DCF, a RAF or a haircut. Historically, in lower oil price environments like we face today, a raw DCF would suggest little to no value for PUDs or unproven reserves in a number of plays and basins.In practice, undeveloped acreage ownership functions as an option for reserve owners; they can hold the asset and wait until the market improves to start production. Therefore an option pricing model can be a realistic way to guide a prospective acquirer or valuation expert to the appropriate segment of market pricing for undeveloped acreage.Adaptation of Black Scholes Option ModelThe PUD and unproved valuation model is typically seen as an adaptation of the Black Scholes option model. The Black Scholes option model is a widely used model used to develop the value of European-style options. The adaptation is most accurate and useful when the owners of the PUDs have the opportunity, but not the requirement, to drill the PUD and unproven wells and the time periods are long, (i.e. five to 10 years). The value of the PUDs thus includes both a DCF value, if applicable, plus the optionality of the upside driven by potentially higher future commodity prices and other factors. The comparative inputs, viewed as a real option, are shown in the table below. When these inputs are used in an option pricing model the resulting value of the PUDs reflects the unpredictable nature of the oil and gas market. This application of option modeling becomes most relevant near the lower end of historic cycles for a commodity. In a high oil price environment, adding this consideration to a DCF will have little impact as development is scheduled for the near future and the chances for future fluctuations have little impact on the timing of cash flows. At low points, on the other hand, PUDs and unproved reserves may not generate positive returns and, thus, will not be exploited immediately. If the right to drill can be postponed for an extended period of time, (i.e. five to ten years), those reserves still have value based on the likelihood they will become positive investments when the market shifts at some point in the future. In the language of options, the time value of the out-of-the-money drilling opportunities can have significant worth. This worth is not strictly theoretical either, or only applicable to reorganization negotiations. Market transactions with little or no proven producing reserves have demonstrated significant value attributable to non-producing reserves, demonstrating the recognition by the pool of buyers of this optionality upside. ConclusionWe caution, however, that there can be limitations in the model’s effectiveness, as we describe in Bridging Valuation Gaps, Part 3. Specific and careful applications of assumptions are needed, and even then Black Sholes’ inputs do not always capture some of the inherent risks that must be considered in proper valuation efforts. Nevertheless, option pricing can be a valuable tool if wielded with knowledge, skill, and good information, providing an additional lens to peer into a sometimes murky marketplace.Today’s marketplace is particularly murky, and a quality appraisal is extremely valuable, since establishing reasonable and supportable evidence for PUD, probable and possible reserve values may assist in a reorganization process that determines the survival of a company, or the return profile for a potential investment, or simply standing up to third-party scrutiny. Given these conditions we feel that the benefits of using option pricing far outweigh its challenges.Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Webinar: How to Value an Early-Stage FinTech Company

Do you have a clear picture of your company’s value and do you know if you are creating value in your early-stage FinTech company? Hidden behind the veil of the private market, an early-stage FinTech company’s value can seem complex and obscure. In valuing a FinTech company, attention need be given to external factors such as unique industry dynamics and the regulatory environment as well as internal company factors such as risk exposure and shareholder preferences. Comparing to high-profile competitors is difficult, as reported values can be skewed if calculated from investors’ stock prices that omit layers of investment preferences. While a rule-of-thumb may be appealing, its simplicity does not adequately capture the company’s risk profile and growth potential. A clear picture of a company’s value offers notable opportunities for both entrepreneurs and investors. Measuring value creation over time is vital for planning purposes, and an awareness of valuation drivers can propel the company to higher growth. In addition, the knowledge gleaned from the valuation process provides insights and identifies key risk and growth opportunities that can improve the company’s strategic planning process–a process that might build to a successful liquidity event (sale or IPO) or the development of a stable company that can operate independently for a long time. Hosted by Jay D. Wilson Jr., CFA, ASA, CBA, this webinar identifies the key value drivers for an early-stage FinTech company for investors, entrepreneurs, and potential partners. A complimentary copy of Jay’s new book, Creating Strategic Value Through Financial Technology (MSRP $65), will be included with the registration fee of $79. TO REGISTER for this webinar, click here. About the Speaker:Jay D. Wilson Jr. heads Mercer Capital’s Financial Technology industry team and publishes research related to the FinTech industry in the bi-annual newsletter Value Focus: FinTech. Jay is also the author ofCreating Strategic Value Through Financial Technology(John Wiley & Sons, 2017).Mercer Capital's Financial Reporting BlogMercer Capital monitors the latest financial reporting news relevant to CFOs and financial managers. The Financial Reporting Blog is updated weekly. Follow us on Twitter at @MercerFairValue.

Five Considerations for Structuring Earn-Outs in RIA Transactions

As covered in last week’s post, RIA transactions usually feature earn-out payments as a substantial portion of total consideration because so much of the seller’s value is bound up in post-closing performance. Just as the financial press never writes about periods of “heightened certainty,” so too buyers of RIAs are justifiably concerned about the ongoing performance of their acquisition target after the ink dries on the purchase agreement.Earn-outs (i.e. contingent consideration) perform the function of incentives for the seller and insurance for the buyer, preserving upside for the former and protecting against downside for the latter. In asset manager transactions, they are both compensation, focusing on the performance of key individuals, and deal consideration, being allocated to the selling shareholders pro rata. And even though earn-out payments are triggered based on meeting performance metrics which are ultimately under the control of staff, they become part of overall deal consideration and frame the transaction value of the enterprise.For all of these reasons, we view contingent consideration as a hybrid instrument, combining elements of equity consideration and compensation, and binding the future expectations of seller and buyer in a contractual understanding.Twenty years ago, Toyota considered whether the future of automobiles would involve gasoline or batteries and developed a similar middle way, the hybrid engine. A hybrid motor uses regenerative braking to charge batteries that recapture power to augment or substitute for the car’s conventional internal combustion engine. Similar technology has been deployed in supercars like the Porsche 918 Spyder, but the Prius is responsible for helping shape the future of automotive transportation by making hybrid technology prevalent.As hybrids go, though, earn-outs are even more prevalent in asset manager transactions than Priuses are in Whole Foods parking lots, and it’s easy to understand why.Earn-Out ParametersContingent consideration makes deals possible that otherwise would not be. When a seller wants twice what a buyer is willing to pay, one way to mediate that difference in expectations is to pay part of the price up front (usually equal to the amount a buyer believes can safely be paid) and the remainder based on the post-closing performance of the business. In theory, earn-outs can simultaneously offer a buyer some downside protection in the event that the acquired business doesn’t perform as advertised, and the seller can get paid for some of the upside he or she is foregoing by giving up ownership. While there is no one set of rules for structuring an earn-out, there are a few conceptual issues that can help anchor the negotiation.1. Define the continuing business acquired that will be the subject of the earn-outDeciding what business’s performance is to be measured after the closing is easy enough if a RIA is being acquired by, say, a bank that doesn’t currently offer investment management services. In that case, the acquired company will likely be operated as a stand-alone enterprise with division level financial statements that make determining success or lack thereof fairly easy.If a RIA is being rolled into an existing, and similar, investment management platform, then keeping stand-alone records after the transaction closes may be difficult. Overhead allocations, how additions and losses to staff will be treated, expansion opportunities, and cross selling will all have some impact on the value of the acquired business to the acquirer. Often these issues are not foreseen or even considered until after the transaction closes. It then comes down to the personalities involved to “work it out” or be “fair.” As my neighbor’s father used to say: “fair is just another four letter word.”2. Determine the appropriate period for the earn-outWe have seen earn-out periods (the term over which performance is measured and over which contingent consideration is paid) as short as one year and as long as five years. There is no magic period that fits all situations, but a term based on specific strategic considerations like proving out a business model, defined investment performance objectives, or the decision cycle of key clients are all reasons to develop an earn-out timeframe.The buyer wants the term to be long enough to find out what the true transferred value of the business is, and the seller (who otherwise wants to be paid as quickly as possible) may want the earn-out term to be long enough to generate the performance that will achieve the maximum payment. Generally speaking, buyer-seller relations can get very strained during an earn-out measurement period, and after they’re done no one wishes the term had been longer.We tend to discourage terms for contingent consideration lasting longer than three years. In most cases, three years is plenty to “discover” the value of the acquired firm, organize a merged enterprise, and generate a reliable stream of returns for the buyer. If the measurement period is longer than three years, the “earn-out” starts to look more like bonus compensation, or some other kind of performance incentive to generate run-rate performance at the business. Earn-outs can be interactive with compensation plans for managers at an acquired enterprise, and buyers and sellers are well advised to consider the entirety of the financial relationship between the parties after the transaction, not just equity payments on a stand-alone basis.3. Determine to what extent the buyer will assist or impede the seller’s performance during the earn-outDid the buyer lure the seller in with promises of technology, products, back-office support, and marketing? Did the buyer promise the seller that they would be able to operate their business unit independently and without being micromanaged after the transaction? These are all great reasons for an investment management firm to agree to be absorbed by a larger platform, and they may also help determine whether or not the acquired firm meets performance objectives to get contingent consideration.We have seen bad deals saved by good markets, but counting on false confirmation is not a sound deal strategy. Instead, buyer and seller should think through their post-close working relationships well in advance of signing a deal, deciding who works for whom, under what circumstances, and what the particulars are of their mutual obligations to shared success look like. If things don’t go well after the transaction – and about half the time they don’t – the first person who says “I thought you were going to…” didn’t get the appropriate commitments from their counterparty on the front end.4. Define what performance measurements will control the earn-out paymentsIt is obvious that you will have to do this, but in our experience buyers and sellers don’t always think through the optimal strategy for measuring post-closing performance.Buyers, ultimately, want to see profit contributions from the seller, and so some measure of cash flow is a natural way to pay for the kind of desired performance from an acquired investment management operation. There are at least two problems with this, however, which suggest maybe another performance metric would be more effective for the buyer (and the seller).First, profitability is at the bottom of the P&L, and is therefore subject to lots of manipulation. To generate a dollar of profit at a RIA, you need some measure of client AUM, market performance, a fee schedule, investment management staff, office space, marketing expense, technology and compliance, capital structure considerations, parent overhead allocations, and any number of other items, some of which may be outside of the sellers’ control. Will the sellers accuse the buyer of impeding their success? Can the factors influencing that success all be sufficiently isolated and defined in an earn-out agreement? It’s more difficult than it looks.Second, much of the post-transaction profitability of the acquired business will depend on the returns of the financial markets, over which nobody has control. If the rising tide indeed lifts all boats, should the buyer be required to compensate the seller for beneficial markets? By the same token, if a deal is struck on the eve of another financial crisis, does the seller want to be held accountable for huge market dislocations? In our experience, returns from markets don’t determine success, over time, nearly as much as returns from marketing. Consider structuring an earn-out based on net client AUM (assets added, net of assets withdrawn), given a certain aggregate fee schedule (so nobody’s giving the business away just to pad AUM).5. Name specific considerations that determine payment termsIs the earn-out capped at a given level of performance or does it have unlimited upside? Can it be earned cumulatively or must each measurement period stand alone? Will there be a clawback if later years in the earn-out term underperform an initial year? Will there simply be one bullet payment if a given level of performance is reached? To what extent should the earn-out be based on “best efforts” and “good faith”?Because these specific considerations are usually unique to a given transaction between a given buyer and a given seller, there are too many to list here. I have two quick thoughts on that: 1) transaction values implied by earn-out structures are often hard to extrapolate to other parties to other transactions. 2) The earn-out can address many of the concerns and hopes of the parties to a transaction about the future – but it cannot create the future. Earn-outs manage uncertainty; they don’t create certainty.ConclusionAbove all, we would emphasize that a plan for contingent consideration be based on the particular needs of buyers and sellers as they pertain to the specific investment management business being transacted. There is no one-size-fits-all earn-out in any industry, much less the RIA community. If an earn-out is truly going to bridge the difference between buyer and seller expectations, then it must be designed based on buyer and seller considerations. A bridge that doesn’t successfully link two points is not a bridge, it’s a pier. A pier will eventually leave either buyer or seller in deep water.We’ll talk more next week about the structuring of earn-outs for RIAs, but drop us a line in the meantime if you’d rather not wait.

Why Earn-outs Matter in Asset Management M&A

Pity the senior auto executive these days: their product is bearing much of the blame for killing the planet, but gas is so cheap they can’t even sell boring fuel efficient cars to the local chapter president of the Sierra Club. The Economistran a cover story last week calling the internal combustion engine “Roadkill,” and repeated the estimate that car emissions kill more Americans every year than traffic accidents – yet the political climate in America doesn’t suggest that regulatory standards for burning fossil fuels of any kind will be tightening soon.Predicting what kinds of cars people will want to buy next year, let alone five years from now, has never been easy. Today, there are too many options. Will car buyers want all-wheel-drive pickups with huge internal combustion engines, or battery-powered autonomous-driving cars? Will people even own cars in 20 years or will we all be driven around by some Uber-like service, making car ownership, parking lots, and garages obsolete? Do you test the market with an expensive, limited production high-performance car like the BMW i8, or do you make a more affordable, mass market car like the Toyota Prius? If you invest heavily in technology, will the market shower you with orders like it did for the Tesla Model 3, or spurn you like the doomed Fisker Karma?M&A in the RIA Community Wouldn’t be Possible Without Earn-outsAs the saying goes (which has been attributed to at least a dozen famous figures), it’s difficult to make predictions, especially about the future. This reality is the single most difficult part of negotiating a transaction in the investment management industry. The value of an RIA acquisition target is subject not only to a large number of variables, but also a wide range of possible outcomes:The performance of financial markets (standard deviation varies)The skill of the investment management staff (difficult to measure)The sustainability of the acquired firm’s fee schedule (not as much a given as in the past)The retention of key staff at the acquired firm (absolutely necessary)The retention of key staff at the acquiring firm (absolutely necessary)The motivation of key staff (absolutely necessary)The retention of client assets (depends entirely on third party behavior)The marketing strength of the merged enterprise (tough to predict) Without faith in the upward drift of financial markets, favorable margins in investment management, and the attractiveness of the recurring revenue model, no one would ascribe equity value to an RIA. But actually buying an asset manager is making a bet on all of the above, and most people don’t have the stomach. Readers of this blog understand that only by way of an earn-out can most investment management firm transactions overcome so much uncertainty. Nevertheless, in our experience, few industry executives have more than an elementary grasp of the role of contingent consideration in an RIA transaction, the design of an earn-out agreement, and ultimately the impact that these pay-for-performance structures have on valuation. This blog kicks off a series which we’ll ultimately condense into a whitepaper to explore and maybe demystify some of the issues surrounding earn-outs in RIA transactions. If nothing else, earn-outs make for great stories. Some of them go well, and some wind up like this:From Earn-out to Burn-out: ACME Private Buys Fictional FinancialOn January 1, 20xx, ACME Private Capital announces it has agreed to purchase Fictional Financial, a wealth management firm with 50 advisors and $4.0 billion AUM. Word gets out that ACME paid over $100 million for Fictional, including contingent consideration. The RIA community dives into the deal, figures Fictional earns a 25% to 30% margin on a fee schedule that is close to but not quite 1.0% of AUM, and declares that ACME paid at least 10x EBITDA. A double-digit multiple brings other potential deals to ACME, and crowns the sellers at Fictional as “shrewd.” The rest of the investment management world assume their firm is at least as good as Fictional, so they’re probably worth 12x EBITDA. To the outside world, everybody associated with the deal is happy.The reality is not quite so sanguine. ACME structures the deal to pay half of the transaction value up front with the rest to be paid based on profit growth at Fictional Financial in a three-year earn-out. Disagreements after the deal closes cause a group of twelve advisors to leave Fictional, and a market downturn further cuts into AUM. The inherent operating leverage of investment management causes profits to sink faster than revenue, and only one-third of the earn-out was paid.In the end, Fictional Financial sold for about 6.5x EBITDA, much less than the selling partners wanted for the business. Other potential acquisition targets are ultimately disappointed when ACME, stung with disappointment from the Fictional transaction, is not willing to offer them a double-digit multiple. ACME thought they had a platform opportunity in Fictional, but it turns out to be more of an investment cul-de-sac.The market doesn’t realize what went wrong, and ACME doesn’t publish Fictional’s financial performance. Ironically, the deal announcement sets the precedent for interpretation of the transaction, and industry observers and valuation analysts build an expectation that wealth management practices are worth about 10x EBITDA, because that’s what they believe ACME paid for Fictional Financial.Earn-outs and Transaction StrategyMost post-deal performance doesn’t get reported, other than AUM disclosures in public filings. If the acquired entity is folded into another RIA, you can’t even judge a deal by that. Thus, we don’t have comprehensive data on ultimate deal value in many investment management firm transactions. One example we have reported previously was the disastrous post-transaction performance of Killen Group after it was acquired by Tri-State Capital. Killen missed by so much that it cut the total consideration paid by almost half and reduced the effective EBITDA multiple paid from nearly 11x to around 6x. Which multiple represents the real value of Killen? No doubt the buyer in this case, as in most others, would rather see the kind of performance that would justify paying the full earn-out, and the seller would prefer that as well.ConclusionSometimes bad deals can be saved by good markets, but that’s not much of an acquisition strategy. As a consequence, earn-outs are the norm in RIA transactions, and anyone expecting to be on the buy-side or sell-side of a deal needs to have a better than working knowledge of them. We’ll talk more next week about the structure of contingent consideration in investment management firm deals, but drop us a line in the meantime if you’d rather not wait.

Oil and Gas Investors Note Move Away From Contango

The Wall Street Journal recently published an encouraging article, “Oil Prices Flash a Buy Signal,” explaining that futures contracts are trending to a flat curve. Ever since the fall in crude oil prices in mid-2014, the market has remained in contango, signaling that the industry still faced rough times ahead. The current movement away from contango and toward backwardation is the first positive forward price estimate since 2014 and oil and gas investors are taking note. Before we jump into the details, let’s review the possible commodity market conditions. What is Contango/ Backwardation?ContangoF < E(S)A contango market simply means that the futures contracts are trading at a premium to the spot price. Contango is the result of an “oversupplied market with abundant inventories.” For example, if crude oil is trading at $45 per barrel right now, and the six month contract is trading at $50, the market is said to be in contango. For the last three years, we have been operating in a contango market.BackwardationF > E(S)Backwardation (or normal backwardation), on the other hand, is a symptom of an “undersupplied market with tight stockpiles.” If crude oil is trading at $45 per barrel right now, and the six month contract is trading at $40 per barrel, then that market would be said to be in a backwardation.It currently appears that pricing in the future contracts are moving closer to backwardation. The table below shows the future contract spread for the previous 13 months. The most recent data returns the narrowest spread since 2014 of ($0.73) compared to one year ago when the market had a wider contango spread of ($5.72). To break down the significant change over the previous three years, the chart below shows the 2014, 2016, and 2017 WTI futures curve for 24 months and the spread between Month 1 and Month 24. Positive spread indicates backwardation, while negative spread indicates contango. What is not clear, however, is the cause for the flattening curve. Is the cause on the supply side or demand side? Barron’s recently highlighted the improved economic outlook for the industry. Their investment strategists pointed at two factors which are helping keep crude oil prices steady and may lead to increases in the future. First, inventories are lower at this year than they were last year at this time. Second, the value of the dollar is falling which could cause the price of crude to rise. However, their optimism was accompanied by cautiousness. After Pioneer’s recent losses, we are reminded that even the Permian Basin is not protected from difficulties. Many investors have started to worry about the fate of the Permian Basin. Some companies have reported that they are producing more natural gas and natural gas liquids than previously expected and as oil wells age, they tend to produce more natural gas. ConclusionThe movement in the future spread away from a contango environment and toward backwardation is positive from a supply and demand perspective. Expectations are a backwardation environment will move crude oil prices higher. However, the exact cause of this change is unknown. While this shift is good news for the industry, company specific risk and investor's fickle attitudes create volatile equity markets.Mercer Capital has significant experience valuing assets and companies in the oil and gas industry, primarily oil and gas, bio fuels, and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 auditors. These oil and gas-related valuations have been utilized to support valuations for IRS estate and gift tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

What’s Got Our Eye

Current RIA Trends

This week, we’re sharing some recent media on trends in the RIA space. We’ve blogged about asset flows, bank interest in the RIA space, the plight of active management, and the fiduciary rule, but these articles represent a deeper dive into each of these topics."ETFs, ETPs Record Robust Asset Flows in First Half"by Michael S. Fischer of InvestmentAdvisor. The march of passive products continued full force in June, which saw record inflows of $63.6 billion to ETFs and ETPs around the globe, bringing year-to-date inflows to an impressive $347.7 billion, compared to net inflows of only $123.6 billion in the first half of 2016."Switching From Wirehouse to RIA"by Michael Kitces. Amidst the wave of advisors transitioning from wirehouses to independent firms, Kitces takes fifteen minutes to discuss the factors advisors should examine when considering making the transition."Banks Gobbling up RIAs as Consolidator Field Shrinks"by Janet Levaux of Investment Advisor. Though the year-to-date number of transactions in the RIA M&A space is up over 10% from 2016, fewer transactions were seen in Q2 compared to Q1 and the average AUM of RIAs involved in these transactions has fallen to $700 million, compared to an average of $1 billion over the last four years. DeVoe & Co. attribute this trend to the falling number of consolidators in the business."ETFs Now Have $1 Trillion More Than Hedge Funds"by Sarah Krouse of The Wall Street Journal. Assets in ETFs first surpassed investment in hedge funds two years ago and have accelerated ever since as investors continue to shun active products."Active Can Be Fiduciary; The Value of an Advisor"by Bob Veres of Inside Information. Bob discusses his vision of an active manager’s role in a post fiduciary rule investment environment as the enforcement date draws nearer. He also explores the many ways active managers can add value to clients outside of traditional money management. If you have valuation questions regarding your RIA firm or if you would like to continue any of the above discussion further, give us a call.

3 Things to Know Before Selling Your Oil and Gas Royalty Interest

There are many reasons that you may want to sell your oil and gas royalty interest, but a lack of knowledge regarding the worth of your royalty interest could be very costly. Whether an inflow of cash would help you make ends meet or finance a large purchase; you no longer want to deal with the administrative paperwork or accounting cost of reconciling monthly revenue payments; or you would prefer to diversify your portfolio or move your investments to a less volatile industry, understanding how royalty interests are valued will ensure that you maximize the value.There is a market for royalty interests, making them fairly liquid; therefore, most of the time, the difficulty is not finding a buyer, but determining whether the buyer’s offer is appropriate.Given that many royalty owners have little connection with the oil and gas industry aside from the monthly payments they receive, buyers may bid substantially below a royalty’s fair market value hoping to earn a profit at the expense of an uninformed seller. As such, it is critical that royalty owners looking to liquidate their interest understand its value to ensure that they can identify legitimate bids.We believe there are three points you need to understand before attempting to sell your mineral interest.1. Understand What You Are SellingA royalty interest represents a percent ownership in the revenue of an E&P company. Royalty interest owners have no control over the drilling activity of the operator and do not bear any costs of production. Royalty interest owners only receive revenue checks when their operator is producing minerals but see no monthly payments when production is suspended.12. Recognize Production and Price as Value driversThe value of a royalty interest is based on the present value of expected future cash flows, which are a percentage of an operator’s revenue.An operator’s revenue is dependent upon production and price. Thus, when determining the value of a royalty interest, it is critical to understand a well’s future potential for production and the market forces that affect price.Production: The Decline Curve’s ImpactAs oil and gas is extracted from a well, its production declines over time. Every well has a unique decline curve which dictates production. A decline curve graphs crude oil and natural gas production and allows us to determine a well’s Estimated Ultimate Recovery (EUR). A variety of factors can affect the shape of a well’s decline curve. For example, decline curves are generally much steeper if the well is drilled using unconventional techniques, like horizontal drilling, or hydraulic fracturing. When determining the value of an oil and gas royalty interest, it is critical to understand a well’s EUR because the value of your royalty interest is dependent upon future production.Price: Local and Global Market ForcesOil and gas prices are affected by both global and local supply and demand factors. The oil and gas industry is characterized by high price volatility. The size and global nature of this market mean that these prices are influenced by countless economic – and sometimes political – factors affecting individual producers, consumers, and other entities that comprise the global market. Most operators, however, sell their oil and gas at a slight discount or premium to the NYMEX because of local surpluses or shortfalls. Thus, it is important to understand the local market as well. For example, natural gas in the Marcellus and Utica sells at a substantial discount to the NYMEX due to the lack of infrastructure carrying gas out of the region.3. Understand Location’s ImpactDrilling economics vary by region. There are geological differences between oilfields and reserves that make it harder to drill in some places than others. Whereas some wells can be drilled using traditional, conventional techniques like vertical drilling, less permeable shale wells must be drilled using unconventional methods, like horizontal drilling or hydraulic fracturing. These unconventional methods tend to bear higher operating costs. Location also tends to influence drilling and transportation costs, ultimately making breakeven prices and profits vary across and within regions. Although a royalty interest owner is paid before any operating expenses are accrued, an operator considers break-even pricing when determining whether to continue operating a well or suspending operations. Accordingly, the value of any royalty interest is strongly influenced by its location, and it is important to consider geological differences when valuing any mineral interest.What to Look Out ForWhile there are legitimate online brokers who will buy your royalty interest for a fair price, it is important to be on the lookout for those who aim to profit at your expense.Since the crash in oil prices, many royalty owners stopped receiving royalty checks; however, this does not mean your royalty interests are worthless. One warning sign to be aware of is online royalty brokers who only consider rules of thumb such as 4x to 6x annual revenue.While industry benchmarks can be a helpful aid, they should not be relied upon solely to determine value, as they do not consider specific well economics.If the entity valuing your interest is also an interested party, it is critical to remember that they have an incentive to quote a low value.Mercer Capital is an employee-owned independent financial advisory firm with significant experience (both nationally and internationally) valuing assets and companies in the energy industry (primarily oil and gas, bio fuels and other minerals). Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors.As a disinterested party, we can help you understand the fair market value of your royalty interest and ensure that you get a fair price for your interest. Contact anyone on Mercer Capital’s Oil & Gas team to discuss your royalty interest valuation questions in confidence.End Note1 For more information on mineral interests see our recent post, Three Types of Mineral Interests.

2Q17 Call Reports

The More Things Change, the More They Stay the Same

Established trends from prior call reports continued into the second quarter of 2017. Capital continues to flow into ETFs and other passive investment products at a rate such that AUM and revenues are increasing despite the ongoing struggle of actively managed products. The trend towards fee-based compensation models continues as managers strive to maximize transparency and compete with passive products being offered at much lower rates. In addition, the DOL rule—having taken effect as of June 9—is set to start being enforced in January 2018. Resistance from members of the asset management industry, however, has some asset managers hoping for additional delays on the rule’s enforcement.As we do every quarter, we take a look at some of the earnings commentary on pacemakers in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: After a tough year for some asset managers in 2016, many firms are enjoying sustained net inflows quarter-over-quarter, with some experiencing record inflows and peak levels of AUM.“Net inflows for the last 12 months totaled $336 billion as organic growth accelerated in the second quarter. Total quarterly flows exceeded $100 billion and were positive across client types, asset classes and investment styles…second quarter long-term net inflows of $94 billion were a record for BlackRock and represented an annualized organic growth rate of 7%.” – Gary Shedlin, BlackRock CFO and Senior Managing Director“We ended the quarter with $33.5 billion in assets under management, the highest level of AUM in the firm’s history. Net flows have been positive, reflecting inflows from a range of existing clients and new relationships, and the lowest level of outflows we’ve experienced during the period since the global financial crisis.” – Richard Pzena, Pzena Investment Management Chairman and CEO“Open-ended funds had record assets under management of $21.6 billion, an increase of $1.3 billion or 6% from last quarter and an annualized growth rate of 9%. And assets under management in closed-ended funds increased to $149 million or 2% from last quarter. This marks the 11th consecutive quarter of net inflows.” – Matthew Stadler, Cohen & Steers CFO and Executive Vice PresidentBlackRock saw “$86 billion of net inflows to iShares and index funds in the second quarter. Global iShares momentum continued with a record $74 billion of net inflows for a total of $138 billion in net inflows year-to-date.” – Larry Fink, BlackRock Chairman and CEOTheme 2: The Department of Labor Fiduciary Rule officially took effect as of June 9, though the DOL has said it will not enforce the rule until after January 1, 2018. Uncertainty regarding the rule remains, however, as there is growing support for a further delay of the rules enforcement until January 2019.“I think, with the DOL, we’re in a comment period. It’s a little bit quiet right now. People are drafting responses to both the SEC and the DOL. Our sense is that the two now are talking and have been public in trying to work together. So our view is that the January 1 date will be pushed back. That’ll be the goal, I think, of most in the industry to try to give time to have a thoughtful overall standard developed with the two groups. And you also have momentum on the legislative front to do away with it completely. So I think that’s still a possibility. But I think the more probable is a delay and then the two groups working to come up with a workable standard.” – Greg Johnson, Franklin Resources Chairman and CEOTheme 3: Industry players embrace investment in technology and explore the applications of ETFs not simply as passive investment products, but as investing tools used by active managers.“The rapid growth we’re seeing in iShares and index funds is increasingly due to the fact that ETFs are no longer used only as a passive allocation, but by active investors to generate alpha in their portfolios. ETFs provide those investors targeting exposures without idiosyncratic risk of any one single stock or any one single bond.” – Larry Fink, BlackRock Chairman and CEO“Long-term net inflows were driven by iShares, which continues to benefit from the rapid adoption of ETFs as asset allocation tools and financial instruments by professional money managers.” – Gary Shedlin, BlackRock CFO and Senior Managing Director“Going forward, technology-enabled scale will be increasingly important for every aspect of an asset manager’s business, our client service, our asset generation and operational excellence. This year, we will be spending $1 billion on technology and data, and have over 3,500 employees working on technology and data-related roles.” – Larry Fink, BlackRock Chairman and CEO Mercer Capital provides business valuation and financial advisory services to asset managers. If you’d like to discuss a valuation for transaction need in confidence, give us a call.

Corporate Finance in 30 Minutes Whitepaper

Travis W. Harms, senior vice president of Mercer Capital, wrote a series of whitepapers that focused on demystifying corporate finance for board members and shareholders. In this whitepaper, he has distilled the fundamental principles of corporate finance into an accessible and non-technical primer. Structured around the three key decisions of capital structure, capital budgeting, and dividend policy, this whitepaper is designed to assist directors and shareholders without a finance background to make relevant and meaningful contributions to the most consequential financial decisions all companies must make. Mercer Capital’s goal with this whitepaper is to give directors and shareholders a vocabulary and conceptual framework for thinking about strategic corporate finance decisions, allowing them to bring their perspectives and expertise to the discussion.Mercer Capital has significant experience valuing assets and companies in the oil and gas industry, primarily oil and gas, bio fuels and other minerals. We also provide financial education services to family businesses. We help family ownership groups, boards, and management teams align their perspectives on the financial realities, needs, and opportunities of the business. Contact a Mercer Capital professional today to discuss your needs in confidence.Click here to read Corporate Finance in 30 Minutes.

Trends in the Oil and Gas Industry

Then & Now

You don’t need an expert to tell you that the oil and gas industry has significantly changed over the past three years. Simply looking at crude oil and natural gas prices from 2014 versus today can confirm this. However, understanding how the change in oil prices has affected the value of your oil and gas business is a little more difficult.Looking Back at the Price TrendIn early 2014, a barrel of oil cost more than twice what it does today. Three years ago the oil and gas industry appeared to be on an upward trend. Industry revenues were expected to increase over the next several years, oil prices (which were holding around $100/barrel) were expected to rise, and futures prices had already jumped, indicating that oil would become more expensive. Some analysts even believed that if the Iraq crisis escalated, crude oil prices could surpass $120/bbl. U.S. production increased, and for the first time in four years, demand in developed nations was expected to increase as well. Although there was concern about political instability in Iraq, due in large part to Al Qaeda activity, many saw 2014 as a “great entry point” into the energy industry. In the Fortune article “Energy Bulls Are Ready for a Run,” Craig Hodges, CEO of Hodges Capital said, “The opportunities are fantastic, and we’re in the very early innings of a renaissance in the energy industry.”Looking back, we know that the oil and gas narrative strongly deviated from expectations. After peaking at $107.95/barrel on June 22, 2014 oil prices began to spiral downward, ultimately reaching record lows in the first quarter of 2016 at just over $26/barrel. As a result of this price crash, more than 120 upstream and oilfield companies were forced into bankruptcy over the next two years.Looking Beyond PriceAs exemplified by the collapse of oil prices in mid-2014, market shifts can be hard to anticipate. Our professionals closely track trends and events affecting the oil and gas markets, analyzing their value implications. Many focus only on the decline in prices, but countless other factors have also fundamentally changed the industry over the past three years affecting oil and gas valuations. While there are far too many to list in full here, some highlights are included below.The Export BanIn December 2015, Congress lifted an export ban that kept all domestic crude oil within the U.S. for the past 40 years (with the exception of exports to Canada). In January 2016, the first shipments of oil left U.S. ports for Europe. Many analysts saw this as “symbolic of the country’s newfound role as a lead producer of oil,” and noted that the U.S. could now serve as a stable supplier in an energy market where many suppliers are located in regions fraught with unrest. This trend has continued by supplying China with significant quantities of crude oil in recent months.Improved Drilling TechnologyAdoption of innovative drilling techniques, such as horizontal drilling and hydraulic fracturing, has made production quicker, easier, and cheaper, while also unlocking reserves that were previously regarded as unattainable. Due in large part to technological advances, U.S. crude oil production has risen 10% since prices began to recover in late 2016. By cutting producer costs, technology allowed producers to continue operations in low price environments, which would have previously forced them to shut down. According to Rystad Energy analysis, “Since 2013, the average wellhead breakeven price (BEP) for key shale plays has dropped from US$80/barrel to US$35/barrel. This represents a decrease of over 55%, on average.”U.S. ShaleLargely as a result of improved technology, the U.S. Shale Revolution greatly impacted the oil and gas industry. As mentioned above, various drilling technologies unlocked shale plays throughout the U.S., particularly in the Bakken and Marcellus regions. Increased shale production significantly added to the U.S. oil supply, which is expected to be 800 mb/d greater in 2017 than it was in 2016. U.S. shale survived the 2014 oil price crash with cost cuts and lower breakeven prices and emerged more resilient from the downturn. On a global scale, U.S. production gains have essentially counteracted OPEC’s production cuts. Because the breakeven price for many U.S. shale plays has dropped, uncertainty looms regarding how low commodity prices must drop before U.S. producers will scale back production. The following graph shows U.S. oil and gas production over the past ten years.Political InstabilityMany oil and gas suppliers are located in regions fraught with civil and political unrest. In 2014, analysts focused on what impact potential disruptions in Iraqi oil supply, due to Al Qaeda activity, may have on the global market. While no longer centered on Iraq, concerns about political instability persist within the industry. Today, analysts are looking to the Persian Gulf to determine if unrest, particularly in Qatar, will alter the industry’s trajectory.The simultaneous impact of each of the events discussed here (among countless others) has flipped the oil and gas industry on its head, allowing the U.S. to become more energy independent and to grow its market share. While this is great news for the U.S. from an economic, security, and defense perspective, it is threatening to other countries – notably to historically influential producers like Saudi Arabia and Russia. As the U.S. continues to garner market share, political relationships are due to shift, likely impacting the oil and gas industry.Implications on Oil and Gas ValuationsMercer Capital tracks the performance of exploration and production companies across different mineral reserves in order to understand how the current pricing environment affects operators in each region. The dramatic drop in price, by itself, materially impacted the value of all companies operating within the oil and gas industry – upstream, midstream, or downstream. Of 60 companies Mercer Capital tracks in the E&P oil and gas industry, 81% saw their market cap decrease over the past three years, by an average of 26.63% and a median of 46.85%. The graph below shows different regions stock performance over the past three years. As shown above, as a result of the myriad of changes within the oil and gas industry, company values today are not what they were three years ago. Like many industries, the oil and gas industry not only changes quickly but it also changes dramatically. In order to set a proper context for the valuation, it is crucial to understand the industry climate as of your valuation date. Over the past three years, opening U.S. oil to exports, increasing driller productivity due to gains in technology, and the shale revolution have created an oversupply of oil, which has driven the price of oil down. While our analysts cannot say for certain what’s coming next for this industry, we invite you to follow these trends with us. Mercer Capital has significant experience valuing assets and companies in the oil and gas industry, primarily oil and gas, bio fuels and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence. Our thanks to Paige Klump who drafted and did much of the research for this post in collaboration with our Energy Group.

RIA Dealmaking

What’s the Hold-Up?

We’re always perplexed by the lack of transactions in the RIA industry. Sure, there are some out there, but a typical year reports less than a hundred deals in a space with almost 12,000 federally registered advisors. This means that less than 1% of industry participants transact in a given year. How could that be in an aging profession with a highly scalable business model? We offer a few explanations in this week’s post.1. Most RIAs are not big enough to be consistently profitableAccording to the Investment Adviser Association, the “typical” SEC-Registered Investment Adviser has $317 million in AUM, between 26 and 100 accounts, nine employees, and is headquartered in New York, California, Florida, Illinois, or Texas. It’s hard to envision that a business of this size would generate enough revenue to cover overhead and professional staff expenses (likely in an expensive market) and yield much profitability, particularly during a market downturn, especially if you consider that many believe $500 million in AUM to be the breakeven point for many asset managers to generate consistent levels of profitability (depending on size, headcount, location, client type, etc.). If valuation is based on earnings, then the average RIA may not have much to sell.2. Many asset managers don’t have sustainable enterprise value beyond their owner(s)A lot of RIA principals have not taken the necessary steps to transition their client relationships, investing acumen, business development capabilities, and/or managerial responsibilities to other staff or the next generation of firm leadership. To a prospective buyer, this means there is significant risk that the RIA’s accounts and firm viability will not outlive its owners. This is part of the reason why so many asset manager transactions are structured as earn-outs – to protect the buyer against future declines in fees or earnings associated with a principal’s departure or reduced activity levels in the business after the deal.3. Asset managers are (currently) expensiveDespite what you’ve been reading about industry headwinds (fee pressure, competition from passive products, etc.), most RIAs are more valuable than ever. Since the market is trading at an all-time high, many asset managers’ AUM balances are as well, which means higher fees, earnings, and valuations. Such a high price tag makes them less appealing to prospective buyers looking to maximize ROI.4. Many RIAs have distinct cultures that don’t necessarily jive with prospective buyersThis is probably the case with many industries but seems especially true for asset managers. The business and its reputation have come a long way from the Wolf of Wall Street broker culture of the late 80s and early 90s. Still, these businesses tend to have unique attributes and identities that aren’t necessarily conducive to firms in different (or even the same) industries. Banks, for example, have recently taken an interest in the business for its high margins and low capital requirements. In our experience, though, bank and RIA cultures often don’t mesh; this can be an unforeseen hurdle in a deal that may make a lot of sense on paper.5. Asset managers value independence and often prefer to transition the business internallyMost RIAs are employee-owned, and that’s by design. To keep the company’s culture and investment/client relations teams intact, many principals looking to exit the business will often look to the next generation of firm leadership as prospective buyers for their interest. They do this to avoid outside influence and appease institutional investors who often seek independent RIAs wholly controlled by the firm’s principals. Buy-sell or shareholders’ agreements that allow younger principals to buy in at a discount to fair market value are not uncommon for asset managers looking to encourage employee ownership and remain independent.ConclusionOn balance, though, we think the outlook for asset manager M&A is promising. The industry is still fragmented and ripe for further consolidation. An aging ownership base is another impetus, and the recent market gains might induce prospective sellers to finally pull the trigger. Fee compression could also lead to more transactions if RIAs look to create synergies and cost efficiencies to maintain their profit margin. We haven’t come across much of this yet but are seeing more clients and prospects ask about succession planning and exit strategies. Perhaps this is a sign of more to come, which isn’t saying a whole lot.

The Fair Market Value of Oil and Gas Reserves

Oil and gas assets represent the majority of value of an E&P company. The Oil and Gas Financial Journal describes reserves as “a measurable value of a company's worth and a basic measure of its life span.” Thus, understanding the fair market value of a company’s PDP, PDNP, and PUDs is key to understanding the fair market value of the Company. As we discussed before, the FASB and SEC offer reporting guidelines regarding the disclosure of proved reserves, but none of these represent the actual market price. It is especially important to understand the price one can receive for reserves as many companies have recently sold “non-core” assets to generate cash to pay off debt and fund operations. It is especially important to understand the price one can receive for reserves as many companies have recently sold “non-core” assets to generate cash to pay off debt and fund operations.The American Society of Appraisers defines the Fair market value as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.1The American Society of Appraisers recognizes three general approaches to valuation: (1) The Cost Approach, (2) The Income Approach, and (3) The Market Approach. The IRS provides guidance in determining the fair market value of an oil and gas producing property. Treasury Reg. 1.611–2(d) offers that if possible the cost approach or comparative sale approach should be used before a discounted cash flow analysis (DCF). When valuing acreage rights comparable transactions do provide the best indication of value. However, when valuing reserves, a DCF is often the best way to allocate value to different reserve categories because comparable transactions are very rare as the details needed to compare these specific characteristics of reserves are rarely disclosed.Cost ApproachThe cost approach determines a value indication of an asset by considering the cost to replicate the existing operations of an asset. The cost approach is used when reserves have not been proved up and there have been no historical transactions, yet a participant has spent significant time, talents, and investments into exploratory data on an oil and gas prospect project.Market ApproachThe market approach is a general way of determining a value indication of an asset by using one or more methods that compare the subject to similar assets that have been sold.Because reserve values vary between oil and gas plays and even within a single play, finding comparable transactions is difficult. A comparable sale must have occurred at a similar time due to the volatile nature of oil and gas prices. A comparable sale should be for a property that is located within the same play and within a field of similar maturity. Additionally, comparable transactions must be thoroughly analyzed to make sure that they were not transacted at a premium or discount due to external factors. Thus, the market approach is often difficult to perform because true comparable transactions are rare. However, the transaction method generally provides the best indication of fair market value for acreage and lease rights.Income ApproachThe income approach estimates a value indication of an asset by converting anticipated economic benefits into a present single amount. Treasury Reg 1.611 – 2(e)(4) provides a straightforward outline of how the approach should be used.In practice, this method requires that: The appraiser project income, expense, and net income on an annual basisEach year's net income is discounted for interest at the "going rate" to determine the present worth of the future income on an annual and total basisThe total present worth of future income is then discounted further, a percentage based on market conditions, to determine the fair market value. The costs of any expected additional equipment necessary to realize the profits are included in the annual expense, and the proceeds of any expected salvaged of equipment is included in the appropriate annual income. Although the income approach is the least preferred method of the IRS, these techniques are generally accepted and understood in oil and gas circles to provide reasonable and accurate appraisals of hydrocarbon reserves, and most closely resembles the financial statement reporting requirements discussed in our previous post. This method is the best indication of value when a seismic survey has been performed and reliable reserve estimates are available. In order to properly account for risk, we divide the reserves by PDP, PDNP, PUD, Probable, and Possible reserves. We will review the key inputs in a DCF analysis of oil and gas reserves below.Cash InflowsIn order to estimate revenue generated by an oil and gas reserve, we must have an estimate of production volume and price. Estimates of production are collected from Reserve reports which are produced by geological engineers.The forward price curve provides monthly price estimates for 84 months from the current date. Generally, the price a producer receives varies with the price of benchmark crude such as WTI or Brent. Thus, it is important to carefully consider a producers contract with distributors. For example a company may sell raw crude to the distributor at 65% of Brent.Cash OutflowsMany E&P companies do not own the land on which they produce. Instead they pay royalty payments to the land owner as a form of a lease payment. Royalty payments are generally negotiated as a percentage of the gross or net revenues derived from the use of the property. Besides royalty payments and daily operating costs, it is important to have conversations with management to understand future infrastructure maintenance and capital expenditures.DiscountOil and gas reserves can be based on pre-tax or after-tax cash flows. Pre-tax cash flows make reserve values more comparable as tax rates vary by location. When using pre-tax cash flows, we use a pre-tax cost of debt and pre-tax cost of equity to develop a WACC.Risk Adjustment FactorsWhile DCF techniques are generally reliable for proven developed reserves (PDPs), they do not always capture the uncertainties and opportunities associated with the proven undeveloped reserves (PUDs) and particularly are not representative of the less certain upside of the Probable and Possible reserve categories. A risk adjustment factor could be used to the discounted present value of cash flows according to the category of the reserves being valued to account for PUDs upside and uncertainty by reducing expected returns from an industry weighted average cost of capital (WACC). You could also add a risk premium for each reserve category to adjust a baseline WACC, or keep the same WACC for all reserves but discount the present value of the cash flows accordingly with comparable discounts to those shown below. The low oil price environment forced many companies to sell acreage and proved reserves in order to generate cash to pay off debt. In order to create a new business models in the face of low oil prices, it is critical for companies to understand the value of their assets. The valuation implications of reserves and acreage rights can swing dramatically in resource plays. Utilizing an experienced oil and gas reserve appraiser can help to understand how location impacts valuation issues in this current environment. Contact Mercer Capital to discuss your needs and learn more about how we can help you succeed. End Notes1 American Society of Appraisers, ASA Business Valuation Standards© (Revision published November 2009), “Definitions,” p. 27.

Why TAMs (Traditional Asset Managers) Continue to Thrive Despite Industry Headwinds

The Memphis Tams from the 1970s and Mike Conley from the Memphis Grizzlies in a Throw-Back UniformCondensed History of the TAMS – An American Basketball Association FranchiseMemphis is home to the NBA franchise, the Memphis Grizzlies. One of the predecessor organizations to our hometown Grizzlies was the Memphis Tams. Aptly named for the only professional basketball team in the [T]ennessee, [A]rkansas, and [M]ississippi tri-state area, the Tams were a quick afterthought in the ABA’s history, enduring a lackluster 45-123 record in just two seasons in the early seventies. My dad was one of the few attendees of their home games, played at the now obsolete Mid-South Coliseum, which never saw attendance crest the 5,000 mark. He recalls a bizarre “mustache clause” in each of the player’s contracts, that offered a $300 bonus to those who would grow one and a rather dubious hat-shaped mascot (apparently “tam” is also short for a tam o’shanter, which is a traditional Scottish bonnet, similar to the one donned by Meg Griffin on Family Guy). It was one of Memphis’s most pathetic sports franchises.Fortunately, this is no longer the case. The current Memphis mascot, though equally dubious given the lack of grizzlies in the tri-state area, is far more intimidating and appropriate for a professional sports franchise. The Grizz are one the few teams to have made the playoffs in each of the last seven seasons and regularly contend for one of the top spots in the tough Western Conference. The club has quietly become one of the league’s most consistent and well-attended franchises, despite attracting virtually no national media coverage or superstar athletes in its 22-year history.Current Performance of TAMS – Traditional Asset ManagersMost traditional asset managers (also sharing the TAM initials), a similarly consistent, yet overlooked subset of the RIA industry, are in bull market territory over the last year in the face of fee compression and continued outflows from active equity products.While hedge funds and PE firms tend to dominate current RIA headlines, TAMs are quietly gaining market share as investors question performance fees and the lack of transparency offered by many alternative asset managers. Indeed, all five components of our publicly traded TAM group below are up over the last year, and four of them have bested the market by a fairly considerable margin.Why Are TAMs Performing Well?We would attribute the group’s gains to both systematic and non-systematic factors. That is, the market’s gain (a systematic force affecting all stocks, especially RIAs) has clearly helped the group’s collective AUM balance, while non-systematic forces such as solid investment performance (PZN), new account additions (BLK), and prior acquisitions (AMG/LM) account for much of the residual success of the individual components. In our experience, most well-established RIAs similarly attribute their success to systematic (market-related) and non-systematic (marketing-related) growth factors.ConclusionSo, despite their name, most TAMs have performed more in line with the Grizzlies rather than its predecessor over the last several years. In fact the last true bear market for the TAMs and the Grizz alike occurred in the 2008-09 downturn when the TAMs collectively lost over half their market cap, and Memphis lost over two-thirds of its games. Since then, the (RIA) TAMs have more than doubled in value, and the Grizzlies have had one of the highest winning percentages in the NBA. Of note, the only time the Grizz had a worse record than the Tams occurred in the 1998-99 season, when the team went 8-42 and played in Vancouver, which is an actual bear market.Mercer Capital provides business valuation and financial advisory services to traditional asset managers. If you’d like to discuss a valuation for transaction need in confidence, give us a call.

How to Value an Oil and Gas Refinery

When valuing a business, it is critical to understand the subject company’s position in the market, its operations, and its financial condition. A thorough understanding of the oil and gas industry and the role of refineries is important in establishing a credible value for a business operating in the oil and gas refining space.Oil and Gas Supply ChainThe oil and gas industry is divided into three main sectors:Upstream (Exploration and Production)Midstream (Pipelines)Downstream (Refineries) Exploration and production (E&P) companies search for reserves of hydrocarbons where they can drill wells in order to retrieve crude oil, natural gas, and natural gas liquids. E&P companies then sell the commodities to midstream companies who use gathering pipelines to transport the oil and gas to refineries. Refiners convert raw crude and natural gas into products of value, such as transportation fuels.Oil and Gas Refinery OperationsCrude oil itself has little end use. Refiners create value by converting crude oil into various usable products. Transportation fuels, such as gasoline, diesel, and jet fuel, are some of the most commonly produced refined products. Other refined products include heating and lighting fluid, such as kerosene, lubricating oil and waxes, and asphalt. Refineries are capital intensive and their configuration depends largely on their physical location, available crude oils, product requirements, and environmental standards.Valuing an oil and gas refinery requires the consideration of a wide range of issues (far too many to list in full here), with primary considerations as outlined below.The price of inputs. The price of crude oil fluctuates due to changes in world demand and supply. Many refiners hold large volumes of crude inventory, but as the price of crude oil fluctuates, refiners face risk associated with the falling value of their inventory. Thus, in order to reduce risk refiners should shorten their timeline from purchasing crude oil to selling the finished product and/or use derivatives to hedge the risk associated with volatile oil prices.The price of refined products. There are four main components to refined product prices: (1) Crude Oil Prices, (2) Wholesale Margins, (3) Retail Distribution Costs, and (4) Taxes. Generally, input prices and wholesale margins drive fluctuations in product prices as the last two are relatively stable. However, President Trump has indicated that he hopes to lower corporate taxes.Crack spread. A refiner’s margins are generally determined by the crack spread, which measures the prices of refined products compared to the cost of crude oil. The price of transportation fuels generally moves in sync with the prices of crude oil, but the price of some refined products such as asphalt and lubricating oils is not as closely correlated with crude oil price changes.Environmental regulation. The refining industry has historically been heavily regulated. Regulations such as the RTR & NSPS aim to control air pollution from refineries and provide the public with information about refineries’ air pollution. President Trump is working to establish a more energy friendly environment and has signaled his intention to sign the repeal of many methane emission regulations if the repeal is passed through both Houses of Congress.Heavy vs. light crude. Most U.S. refineries were built to process heavy crude. However, the onset of U.S. shale drilling has led to a surplus of light sweet crude that U.S. refineries were not originally built to process. While the refining process of heavy and light crude is generally the same, the refining of light crude is less costly.Oil and Gas Refinery Financial AnalysisWhen valuing a business, it is critical to understand the subject company’s financial condition. A financial analyst has certain diagnostic markers that tell much about the condition of a business.Balance Sheet. The balance sheet of a refinery is dominated by inventory and fixed assets. According to RMA’s annual statement studies, 16.3% and 32.2% of petroleum refineries’ assets are inventory and fixed assets, respectively.1 Because refining is a capital intensive business, it is important to consider the current operating capacity of a company’s fixed assets in order to determine if future growth will require significant capital expenditures. If a refinery hopes to expand refinery throughput beyond the current refining capacity, it will have to invest in more equipment.Income Statement. The development of ongoing earning power is one of the most critical steps in the valuation process, especially for businesses operating in a volatile industry environment. Cost of goods sold account for approximately 75% of sales according to the RMA data. Thus it is important to consider possible supplier concentrations when analyzing the income statement because disruptions in the supply chain can have significant income statement impacts to oil refineries.How Does Valuation Work?There are fundamentally three commonly accepted approaches to value: asset-based, market, and income. Each approach incorporates procedures that may enhance awareness about specific business attributes that may be relevant to determining the final value. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value for the subject interest under consideration.The Asset-Based ApproachThe asset-based approach can be applied in different ways, but in general, it represents the market value of a company’s assets minus the market value of its liabilities. Investors make investments based on perceived required rates of return, and only look at assets as a source of rate of return. Oil and gas refineries are asset intensive businesses. They have distillers, crackers, cokers, and more. While an asset value consideration can be a meaningful component of the overall valuation of an oil and gas refinery, it is essentially the income generated by these assets that typically drives the value of a business. For this reason, the asset-based approach is typically not the sole (or even primary) indicator of value.The Market ApproachThe market approach utilizes market data from comparable public companies or transactions of similar companies in developing an indication of value. In many ways, this approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.In the downstream oil and gas sector, there are ample comparable public companies that can be relied on to provide meaningful market-based indications of value. Such options are Alon US Energy Inc., CVR Refining, LP, Valero Refining, and Western Refining. Acquisition data from industry acquisitions (typically a median from a group of transactions) can be utilized to calculate a valuation multiple on the subject company’s performance measure(s). This will often provide a meaningful indication of value as it typically takes into account industry factors (or at least the market participants’ perception of these factors) far more directly than the asset-based approach or income-based approach. Additionally earnings multiples such as EV/ EBITDA can be used to calculate indication of values.The market-based approach is not a perfect method by any means. For example, industry transaction data may not provide for a direct consideration of specific company characteristics. Say a company is a market leader and operates in a prime geographic market. Since the market and the specific company are relatively more attractive than the average transaction, the appropriate pricing multiple for this company is likely above any median taken from a group of industry transactions. Additionally, many companies in the oil and gas industry are vertically integrated and have significant midstream or marketing operations in addition to their refining operations. For example, Marathon Petroleum Company is a leading refiner in the US, but is also a marketer of refined products and has significant midstream operations. Clearly, the more comparable the companies and the transactions are, the more meaningful the indication of value will be. When comparable companies are available, the market approach can provide a helpful indication of value and should be used in determining the value of a refinery.The Income ApproachThe income approach can be applied in several different ways. Generally, such an approach is applied through the development of an ongoing earnings or cash flow figure and the application of a multiple to those earnings based on market returns. An estimate of ongoing earnings can be capitalized in order to calculate the net present value of an enterprise. When determining ongoing earnings historical earnings should be analyzed for non-recurring and non-normal income and expenses which will not affect future earnings. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market through the use of a capitalization rate.Income is the main driver of value of a business; thus, the income approach should be considered when determining the value of your business.Synthesis of Valuation ApproachesA proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations. This is why industry “rules-of-thumb” (be they some multiple of revenue, earnings, or other) are dangerous to rely on in any meaningful transaction. Such “rules-of-thumb” fail to consider the specific characteristics of the business and, as such, often fail to deliver insightful indications of value.An owner who is contemplating any kind of transaction or agreement based on value needs to know what their business is worth. Whether you are selling out or selling in, knowing the fair market value of your business will let you evaluate whether or not an offer for your company is reasonable. Additionally, many business owners fail to understand the valuation implications of buy-sell agreements. If you have other shareholders in your business who are non-family, and maybe some who are, you probably have some kind of buy-sell agreement between the shareholders that describes how the business (or business interests) will be valued in the event of a shareholder dispute, death, or departure from the business (even on friendly terms). A business owner executing or planning a transition of ownership can enhance confidence in the decisions being made only through reliance on a complete and accurate valuation of the business.Mercer Capital has long promoted the concept of managing your business as if it were being prepared to sell. In this fashion you promote the efficiencies, goals and disciplines that will maximize your value. Despite attempts to homogenize value through the use of simplistic rules of thumb, our experience is that each valuation is truly unique given the purpose for the valuation and the circumstances of the business.Mercer Capital has experience valuing businesses in the oil and gas industry. We hope this information, which admittedly only scratches the surface, helps you better shop for business valuation services and understand valuation mechanics. We encourage you to extend your business planning dialogue to include valuation, because sooner or later, a valuation is going to happen. Proactive planning and valuation services can alleviate the potential for a negative surprise that could complicate an already stressful time in your personal and business life.For more information or to discuss a valuation or transaction issue in confidence, do not hesitate to contact us at 901.685.2120.End Note1 2016-2017 RMA Statement Studies. NAICS #324110. Companies with greater than $25 million in sales.

A Rising Tide Lifts All Boats

All Classes of Asset Managers Up Over the Last Year

Favorable market conditions over the last twelve months have buoyed RIA market caps to all-time highs. This almost seems counterintuitive against a backdrop of fee compression, fund outflows, and generally negative press (some of it by us), but a rising market means higher AUM balances, leading to greater fees and profitability, regardless of other headwinds facing the industry - not a perfect storm by any means, but good enough to best the broader indices during a relatively strong stock market rally. RIA Market Performance as of 6/1/17 Publicly traded custody banks (BNY Mellon, State Street, and Northern Trust) outperformed other classes of asset managers over the last twelve months, continuing their upward trajectory over the last few years but still lagging the broader indices since the financial crisis of 2008 and 2009. Placing this recent comeback in its historical context reveals the headwinds these businesses have been facing in a low interest rate environment that has significantly compressed money market fees and yields on fixed income investments. Their recent success may, therefore, be indicative of a reversion to mean valuation levels following years of depressed performance, rather than a sudden surge of investor optimism regarding future prospects. Further, pricing improvements for this group appear to be more relative to an improved banking environment than a change in circumstances for trust and custodial services. Still, in recent quarters, most trust bank stocks outperformed other classes of asset managers, like mutual funds and traditional RIAs, as passive products and indexing strategies continued to gain ground on active management. A rising yield curve portends higher NIM spreads and reinvestment income, and the market has responded accordingly – our custody bank index gained 45% over the last year, surpassing the broader indices and all other classes of asset managers. Publicly traded alternative asset managers have also performed well in recent months, but, like custody banks, are still reeling from poor investment returns over the last decade. The value-added proposition (alpha net of fees) has been virtually non-existent for many hedge funds and PE firms over this period despite the sector’s recent gains. Once again, the RIA size graph seems to imply that smaller RIAs have significantly underperformed their larger peers over the last twelve months. The reality, though, is that this segment is the least diversified (only two components, Hennessy Advisors and US Global Investors, both of which are thinly traded) and certainly not a good representation of how RIAs with under $10 billion in AUM are actually performing. Specifically, Hennessy’s weakness is largely attributable to recent sub-par investment performance from its Cornerstone Growth Fund, and US Global’s focus on natural resource investing has taken a hit from softening commodity prices. Most of our clients fall under this size category, and we can definitively say that these businesses (in aggregate) haven’t lost half their value since August as suggested by this graph. Other sizes of publicly traded asset managers have performed reasonably in line with the market over this period. Market OutlookThe outlook for these businesses is similarly market driven - though it does vary by sector. Trust banks are more susceptible to changes in interest rates and yield curve positioning. Alternative asset managers tend to be more idiosyncratic but still influenced by investor sentiment regarding their hard-to-value assets. Mutual funds and traditional asset managers are more vulnerable to trends in active and passive investing. All are off to a decent start in 2017 after a strong end to 2016 as the market weighs the impact of fee compression against rising equity prices.

Creating Value at Your Community Bank Through Developing a FinTech Framework

This discussion is adapted from Section III of the new book Creating Strategic Value Through Financial Technology byJay D. Wilson, Jr., CFA, ASA, CBA. I enjoyed some interesting discussions between bankers, FinTech executives, and consultants at the FinXTech event in NYC in late April. One dominant theme at the event was a growing desire of both banks and FinTech companies to find ways to work together. Whether through partnerships or potential investments and acquisitions, both banks and FinTech companies are coming to the conclusion that they need each other. Banks control the majority of customer relationships, have a stark funding advantage and know how to navigate the maze of regulations, while FinTechs represent a means to achieve low-cost scaling of new and traditional bank services. So one key question emerging from these discussions is: Who will survive and thrive in the digital age? As one recent Tearsheet article that I was quoted in asked: Should fintech startups buy banks? Or as another article discussed: Will banks be able to compete against an army of Fintech startups?Build, Partner, or AcquireBanks face a conundrum of whether they should build their own FinTech applications, partner, or acquire. FinTech companies face similar questions, though the questions are viewed through the prism of customer acquisition rather than applications. Non-control investments of FinTech companies by banks represent a hybrid strategy. Regulatory hurdles limit the ability of FinTech companies to make anything more than a modest investment in banks absent bypassing voting common stock for non-voting common and/or convertible preferred.While these strategic decisions will vary from company to company, the stakes are incredibly high for all. We can help both sides navigate the decision process.As I noted in my recently published book, community banks collectively remain the largest lenders to both small business and agricultural businesses, and individually, they are often the lifeblood for economic development within their local communities. Yet the number of community banks declines each year through M&A, while some risk loosened deposit relationships as children who no longer reside in a community where the bank is located inherit the financial assets of deceased parents. FinTech can loosen those bonds further, or it can be used to strengthen relationships while providing a means to deliver services at a lower cost.Where to StartIn my view, it is increasingly important for bankers to develop a FinTech framework and be able to adequately assess potential returns from FinTech partnerships. Similar to other business endeavors, the difference between success and failure in the FinTech realm is often not found in the ideas themselves, but rather, in the execution.Banks face a conundrum of whether they should build their own FinTech applications, partner, or acquire.While a bank’s FinTech framework may evolve over time, it will be important to provide a strategic roadmap for the bank to optimize chances of success. Within this framework, there are a number of important steps:Determining which FinTech niche to pursue;Identifying potential FinTech companies/partners;Developing a business case for those potential partners and their solutions; andExecuting the chosen strategy. For a number of banks, the use of FinTech and other enhanced digital offerings represents a potential investment that uses capital but may be deemed to have more attractive returns than other traditional bank growth strategies. Community banks typically underperform their larger brethren (as measured by ROE and ROA) because fee income is lower and expenses are higher as measured by efficiency ratios. Both areas can be enhanced through deployment of a number of FinTech offerings/solutions.The Importance of a Detailed IRR AnalysisThe decision process for whether to build, partner, or acquire requires the bank to establish a rate of return threshold, which arguably may be higher than the institution’s base cost of capital given the risk that can be associated with FinTech investments. The range of returns for each strategy (build, partner, or acquire) for a targeted niche (such as payments or wealth management) provides a framework to help answer the question how to proceed just as is the case with the question of how to deploy capital for organic growth, acquisitions, and shareholder distributions. The same applies for FinTech companies, though often the decision is in the context of whether to accept dilutive equity capital.A detailed analysis, including an IRR analysis, helps a bank determine the financial impact of each strategic decision and informs the optimal course.While each option presents a unique set of considerations and execution issues/risks, a detailed analysis, including an IRR analysis, helps a bank determine the financial impact of each strategic decision and informs the optimal course. A detailed analysis also allows the bank to compare its FinTech strategy to the bank’s more traditional growth strategies, strategic plan, and cost of capital. See the table to the right for an example of a traditional community bank compared to a bank who has partnered with a FinTech company.Questions Regarding PartneringBeyond the strategic decisions and return analyses, some additional questions remain for community banks that consider FinTech partners, including:Is the bank comfortable with the FinTech company’s risk profile?What will the regulatory reaction be?Who will maintain the primary relationship with the customer?Is the FinTech partnership consistent with the bank’s long-term strategic plan (a key topic noted in the OCC’s whitepaper on supporting innovation)?Questions Regarding AcquiringShould the community bank ultimately decide to invest in a FinTech partner a number of other key questions emerge, such as:What is the valuation of the FinTech company?How should the investment be structured?What preferences or terms should be included in the shares purchased from the FinTech company?Should the bank obtain board seats or some control over the direction of the FinTech Company’s operations?How Mercer Capital Can HelpTo help both banks and FinTech companies execute their optimal strategies and create maximum value for their shareholders, we have a number of solutions here at Mercer Capital. We have a book that provides greater detail on the history and outlook for the FinTech industry, as well as containing targeted information to help bankers answer some of the key questions discussed here.Mercer Capital has a long history of working with banks. We are aware of the challenges facing community banks. With ROEs for the majority below 10% and their cost of capital, it has become increasingly difficult for many banks to deliver adequate returns to shareholders even though credit costs today, are low. Being both a great company that delivers benefits to your local community, as well as one that delivers strong returns to shareholders is a difficult challenge. Confronting the challenge requires a solid mix of the right strategy as well as the right team to execute that strategy.No one understands community banks and FinTech as well as Mercer Capital.Mercer Capital can help your bank craft a comprehensive value creation strategy that properly aligns your business, financial, and investor strategy. Given the growing importance of FinTech solutions to the banking sector, a sound value creation strategy needs to incorporate FinTech into it and Mercer Capital can help.We provide board/management retreats to educate you about the opportunities and challenges of FinTech for your institution.We can identify which FinTech niches may be most appropriate for your bank given your existing market opportunities.We can identify which FinTech companies may offer the greatest potential as partners for your bank.We can provide assistance with valuations should your bank elect to consider investments or acquisitions of FinTech companies. No one understands community banks and FinTech as well as Mercer Capital. We are happy to help. Contact me to discuss your needs. This article first appeared in Mercer Capital's Bank Watch, June 2017.

Refining | 2017 Issue II

Over the last six months of fiscal 2017, changes in the oil & gas market led to increasing refinery revenues and the expansion of margins.

E&P Third Quarter 2017

Region Focus: Bakken

Region Focus: Bakken Oil prices remained relatively steady at $50/barrel over the last twelve months despite OPEC’s wavering commitment to production cuts.

EQT’s Acquisition of RICE Energy

Our Valuation Analysis of This Marcellus and Utica Mega Deal

Deal OverviewOn June 19, 2017, EQT announced the acquisition of Rice Energy (RICE) for approximately $6.7 billion. RICE will receive approximately $4.1 billion in EQT common stock and $1.1 billion in cash as well as be relieved from $1.5 billion in net debt that EQT is assuming.Based on EQT disclosures, the assets owned by RICE include (1) 255 wells currently producing 1,145 mmcfe per day (mmcfepd) which are expected to increase to 1,300 mmcfepd; (2) 252,000 in net Marcellus and Utica acres with more than 1,100 net locations remaining to explore; (3) 92% of RICE GP interest including the incentive distribution rights (IDR’s); and (4) 28% of Rice Midstream Partners (RMP). By all accounts, the location of the acreage is contiguous or nearby to EQT’s current acreage and the combination of the two companies will create the largest gas producer in the Marcellus and Utica.Reported Valuation Multiples Do Not Present the Whole PictureIn comparison to other operators in the Marcellus and Utica, the transaction is on the higher end of the range with Antero Resources Corp (AR) and Cabot Oil and Gas (COG) when considering an EV/Daily Production multiple and on the high end with the acreage multiple (See Table 2). However, the “reported” value multiples may not be the whole picture. We have considered EQT’s offer to RICE shareholders, but RICE’s shareholders only own 28% of Rice Midstream and 92% of the GP interest. Due to the accounting rules for consolidation, the majority of the income statement and production figures capture activity for 100% ownership (the non-controlling interest is not taken out until the end). Therefore, by not including the non-controlling interest that is consolidated into Rice’s balance sheet, we previously compared less than 100% of the Company’s Enterprise Vale to 100% of the Company’s production, acreage, and EBITDA. What Does the “All In” Enterprise Value Mean to Investors?The non-controlling interest on the balance sheet of RICE amounts to $2.4 billion as of the end of Q1 2017. The offer for $6.7 billion was for the interest RICE owns in the business' assets. Therefore, to compare production and acreage multiples to the publics, we would need to calculate an “all in” enterprise value as shown in Table 3. Under the “all in” approach, the production multiple of 48,415x is well above the other operators in the area (see Table 2) and investors should be excited about the proposed transaction according to the surface data. The EBITDA multiple is not a great indication here as some companies in the guideline group were marginally profitable at the EBITDA level leading to abnormally high EBITDA multiples. In response to the announced transaction, the share price of RICE increased approximately 25% or $1 billion. Based upon our experience in performing valuation services in the Appalachian play, the analysis above appears reasonable. Table 4 shows the previous 20 transactions in the area. Not all transactions could be broken down into producing and non-producing acres; therefore, it is shown as a total price to total net acres multiple. The EQT and Rice transaction shows as the most expensive price / acre transaction of the last 20 in the area. In Chart 1, disclosed by RICE and EQT, shows the acreage position with the resource play for RICE. According to this map, RICE has acreage in some of the most prolific and hottest areas in the Marcellus and Utica. Allocating Assets in This Transaction to Fair ValueConsidering the purchase price implications of the Rice Energy transaction, based upon the publicly disclosed information, the assets to allocate to fair value appear as found in Table 5.Does This Transaction Result in a Marcellus and Utica Mega-Producer?The result of this transaction is the potential creation of a Marcellus and Utica mega-producer with over 1.9 million acres, 591 barrels of daily flowing oil equivalent and a stronghold in the gathering pipelines that can transport gas to the East, Midwest, and South in the near future. The implied enterprise value of $24 billion would approximately double the enterprise value of the company next closest in size, Antero Resources.Further Reading on This DealOver the previous week there have been many articles written on this transaction. We found the following articles most helpful:Rice Energy News Release: EQT To Acquire Ricer Energy for $6.7 BillionEQT Investor Relations: EQT Corporation to Acquire Rice Energy for $6.7 BillionOil & Gas Financial Journal: EQT to Acquire Rice Energy for $6.7 BHow Four Brothers Survived the Gas Bust to Make Family a BillionEQT to Acquire Rice Energy for $6.7 Billion -- UpdateThe EQT Corporation Acquisition of Rice Energy is SmartWith $8.2B Acquisition, Pittsburg’s EQT Becomes America’s Biggest Natural Gas ProducerMercer Capital’s ExperienceMercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Risk and Return: Working Interests and Royalty Interests

The U.S. Mineral Exchange defines a mineral interest as “the ownership of all rights to gas, oil, and other minerals at or below the surface of a tract of land.” Last week we reviewed the three types of mineral interests – royalty interests, working interests, and overriding royalty interests. This week we analyze the risks associated with working interests versus royalty interests. An overview of royalty interests and working interests is included below:Royalty Interest – an ownership in production that bears no cost in production. Royalty interest owners receive their share of production revenue before the working interest owners.Working Interest – an ownership in a well that bears 100% of the cost of production. Working interest owners receive their share of the profit after (i) royalty owners have received their share and (ii) after all operating expenses have been paid. Central to corporate finance is the principle that returns follow risk. As the risk of an investment increases, so do potential returns and potential losses; lower risk means less expectation for reward. The Oil and Gas Financial Journal illustrates oil and gas investment risk in the following graphic: When valuing mineral interests, it is important to consider the nuances of the each type of mineral interest. Given that risk and asset values are indirectly related, it is important to keep in mind the various risk factors which pertain to the mineral interest. We’ll begin by examining the various risks surrounding both types of interests. RiskBoth working interests and royalty interests are exposed to fluctuations in oil and gas prices. When crude oil prices fell in mid-2014, so did the value of working interests, whose worth is based on the present value of the cash flows generated from production, and the value of royalty interests, whose value is based on future payments of revenue. Further, both working interests and royalty interests face the risk of depletion as oil and gas wells are depleting assets. Even if the price of oil and gas is stable from one year to the next, a well may have 30% less production in its second year. This can dramatically decrease the yield of particular royalty and working interests.Holders of working interests can mitigate the risk of depletion by drilling new wells or improving production of existing wells. While this gives a working interest holder more flexibility, it also requires a substantial investment in CAPEX. Working interest holders accept all fiscal burdens associated with the drilling process.Royalty interest holders, on the other hand, bear no cost of production but are at the mercy of their operators. Only the working interest owner can decide to halt production when prices drop and to increase production when the drilling environment is favorable. The Oil and Gas Financial Journal compares buying a royalty interest to “buying an income strip in producing wells, and the risks are primarily price volatility and depletion.”Each type of interest has unique attributes, but the fact that working interest owners are responsible for operating expenses makes working interests inherently riskier than royalty interests which are characterized by monthly “mailbox money” precipitated by zero costs. We see this when examining the volatility of select E&P companies who spun off their royalty interests into royalty trusts structured as MLPs. The royalty trusts above generally demonstrate less volatility, which is often used as a proxy for financial risk, than their parent E&P companies. The principles of risk and return, however, tell us that because there are fewer risks associated with royalty interests they will yield lower returns than their riskier counterparts. Royalty interests range in percentage ownership of revenues from 0.025%-25%, meaning that, at the highest royalty interest, at least 75% of revenue is still funneled to the working interest owners. Due to differences in risk, royalty interests are unlikely to generate the magnitude of returns that working interests can experience. At the same time, they are less likely to experience the same degree of loss. ReturnThe standardized measure of investment performance for a given unit of time is return. Investment returns have two components. The first, yield, measures the current income (distributions) generated by an investment. Capital appreciation, the second component, measures the increase in value during the period. As shown below, total return is the sum of yield and capital appreciation. Royalty trusts commonly make substantial distributions because they generate revenue as long as their operators are drilling and they have minimal operating expenses. Thus it is important to examine total return when comparing interests in E&P companies, who own working interests, and royalty trusts who own royalty interests. In the chart below we examine the total returns of the companies introduced above and their associated royalty trusts. As expected, the E&P companies which hold working interests show higher returns and steeper losses than their associated royalty trusts. We have assisted many clients with various valuation and cash flow issues regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.

3 Types of Mineral Interests

The US Mineral Exchange defines mineral interest as “the ownership of all rights to gas, oil, and other minerals at or below the surface of a tract of land.” Mineral interests are divided into three categories – royalty interests, working interests, and overriding royalty interests. Each is defined as follows:Royalty Interest – an ownership in production that bears no cost in production. Royalty interest owners receive their share of production revenue before the working interest owners.Working Interest – an ownership in a well that bears 100% of the cost of production. Working interest owners receive their share of the profit after (i) royalty owners have received their share and (ii) after all operating expenses have been paid.Overriding Royalty Interest (ORRI)– a percentage share of production, or the value derived from production, which is free of all costs of drilling and producing, and is created by the lessee or working interest owner and paid by the lessee or working interest owner. A royalty interest is created when an exploration and production (E&P) company wants to extract gas, oil, or other minerals from privately held property. In this scenario, the E&P company could purchase the land, but it is generally much cheaper and more feasible to lease the rights to drill on the land. Under this type of agreement, the E&P company pays the landowner an up-front payment, called a lease bonus, as well as a monthly royalty payment – a specified percentage of all revenues generated by the minerals extracted from the land. Although the landowner profits from the drilling efforts on their property, they do not pay any production costs. A royalty interest is paid as long as minerals from the land generate revenue. Generally, if production stops so do royalty payments. Very rarely, however, some contracts specify certain levels of production which must be maintained. In the aforementioned situation, while landowners have a royalty interest, the E&P company has a working interest. As a result of the leasing agreement, the E&P company acquires the rights to the minerals on the property. This means that they bear the costs of exploration, drilling, and production, but they have rights to future cash flows generated once the wells are completed. The working interest owner must pay royalty interests, overriding royalty interests, and expenses before receiving their share of these cash flows. Overriding royalty interests are often used as an incentive for those who are affiliated with the drilling process but do not own the minerals or E&P company (a broker or geologist for, example). Owners of ORRI, like royalty interest owners, bear no cost of production but own a portion of the revenues generated by the drilling process. Unlike royalty interest owners, however, ORRI owners do not receive the royalty for the entirety of production; instead, they are bound by explicit leases, outlining the length of time in which the ORRI will be paid.Current Issues Surrounding Mineral InterestsStates also can receive royalties from oil production. Under the Gulf of Mexico Security Act of 2006, Texas, Louisiana, Alabama and Mississippi became part of a revenue sharing program from off-shore drilling royalties in the Gulf of Mexico. In his 2018 budget, however, President Trump has proposed to repeal this act in order to redistribute the funds to taxpayers. The White House believes that this will save approximately $3.6 billion over the next decade, but the proposal has been met with disapproval both from politicians and the oil and gas industry. Next year alone, the royalty disbursement to the four states is expected to total $275 million, which would be directed to support environmental protection, infrastructure improvements, and coastal restorations. It is unclear if this change will be approved, but the four states’ royalties, like many individual royalty interests, are enveloped in uncertainty in the current market.Valuations of Mineral InterestsAlong with the majority of the oil and gas industry, royalties were hit hard as a result of the oil price downturn beginning in 2014. Among other factors, the success of US shale drillers drove the supply of oil up and subsequently forced the oil price to decade-lows. As a result of shrinking margins for E&P companies, oil production drastically decreased. For some, oil production stopped completely and royalty payments were soon to follow. During the oil downturn, many royalty distributions shrank dramatically while others disappeared completely. Over 120 companies filed for bankruptcy since the crash of commodity prices and most royalty owners were left to fend for themselves while uncertainty encompassed their mineral interests.Trends in royalty trusts can be indicative of the value of individual royalty interests. Over the past two years, nineteen out of twenty royalty trusts have shown negative price performance. However, when focusing solely on the past year, this number shrinks to three of twenty trusts exhibiting negative price performance. This suggests that royalty trusts are on an upward trend, and by extension that royalty interests are recovering as well. However, no two royalty trusts are alike. Differences abound in asset mix, asset location, term, and resource mix and the value of royalty interests vary due to these factors.We will explore the valuation implications of each kind of interest in an upcoming blog post.We have assisted many clients with various valuation and cash flow issues regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.Our thanks to Paige Klump who drafted and did much of the research for this post in collaboration with our Energy Group.

IPO Supply and Demand

Past blog posts have covered the almost peculiarly sleepy IPO market in the United States, its causes, and its consequences. Megan Richards checks in this week to show that not much has changed despite the otherwise buoyant investment landscape. The steady erosion in the number of publicly traded equities has been a tailwind for the market, and by extension, the investment management industry so far. Longer term, we see challenges presented by the undercurrent of illiquidity brought about by the unavailability of public offerings as a reliable exit opportunity for private equity. The stock market rallied in the first five months of the year, with the Dow Jones and S&P 500 reaching record highs and continuing to climb. Nevertheless, IPOs remain scarce compared to prior years. Just nine venture-backed technology companies have gone public through May, down from 14 IPOs through the same period in 2016. With the availability of favorable financing options that remain in the private market, the supply and demand balance is changing and companies choosing to go public aren’t following the traditional route anymore. Snap’s public offering and Spotify’s potential IPO rumblings are indicative of these trends. Between the drought of new investment offerings and increasing support for passive investing that circulated in 2016, investors appear to be desperate to find the next big opportunity. So even though Snap announced that its public offering of Class A shares would be devoid of voting power, investors still jumped at the chance to own a portion of the company. Snap’s IPO, with its non-voting shares, was twelve times oversubscribed. The demand for new public offerings is there, but the supply side is lacking and this imbalance is tipping power away from investors. Only 105 companies went public during 2016, the lowest number since 2009 and 65 fewer than 2015. Total dollar value of public offerings fell to $18.8 billion from $30.0 billion the prior year. Despite investor optimism earlier in the year, the IPO environment remains stagnant as we approach the halfway mark of 2017. Many companies are realizing they just don’t need an IPO. Opportunities for M&A exits still exist, public company oversight is arguably onerous, and alternative sources of funding that are more favorable to the company – and its founders – are becoming increasingly popular. So when companies actually do decide to go public, they are finding ways that benefit the company – and founders – rather than investment banks or large investors. Spotify announced its consideration of offering public shares later this year, but bucked tradition by stating that it intended to do so through a direct offering. That means the company could bypass the investment bank, save on placement fees, and offer more of its shares to the general public, rather than to just large institutional investors. Doing so might mean that Spotify would lose out on a first day share price pop, but with $1 billion in debt financing, Spotify’s public offering could be as much a way to return capital to investors as a way to raise funds for growth. These companies aren’t by any means committed to the IPO route. AppDynamics has been another widely discussed deal this year after it entered into a transaction with Cisco shortly after announcing its plan to IPO. With many competing options for startups and the declining appeal of traditional public offerings, public investors may have to settle for less than ideal terms. In an environment where investor desperation is high and other profitable avenues for startups exist, the startups may be gaining the upper hand when it comes to going public and they are starting to play by their own rules.Related LinksCompensating for Something: Facebook’s GAAP ChangeIf It Was Easy, We’d All Be RichNon-Traditional Venture Investors are Changing The Rules Of The GameHow to Value a Company Planning to IPOMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

How to Use an EV/Production Multiple

As of 6/5/2017Current PriceFuture Price (12 months)% ChangeWTI$47.62$48.642.14%Natural Gas$2.84$2.871.06%Source: Capital IQOil and gas analysts use many different metrics to explain and compare the value of an oil and gas company, specifically an exploration and production (E&P) company. The most popular metrics (at least according to our eyeballs) include (1) EV/Production; (2) EV/Reserves; (3) EV/Acreage; and (4) EV/EBITDA(X). Enterprise Value (EV) may also be termed Market Value of Invested Capital (MVIC) and is calculated by the market capitalization of a public company plus debt on the balance sheet less cash on the balance sheet. In this post, we will dive into one of these four metrics, the EV/Production metric, and explore the most popular uses of it.DefinitionEV/Production is a commonly used valuation multiple in the oil and gas industry which measures the value of a company as a function of the total number of barrels of oil equivalent, or mcf equivalent, produced per day. When using this multiple, it is important to remember that it does not explicitly account for future production or undeveloped fields.Common UsesWhile the above definition was provided by Investopedia, the source goes on to explain the meaning of the multiple in the following way:All oil and gas companies report production in BOE. If the multiple is high compared to the firm's peers, it is trading at a premium, and if the multiple is low amongst its peers it is trading at a discount. However, as good as this metric is, it does not take into account the potential production from undeveloped fields. Investors should also determine the cost of developing new fields to get a better idea of an oil company's financial health.While some of the above explanation may appear true; the detail, analysis, and reason is lacking. Let’s more fully investigate the above notes:BOE or MCFE. Not all oil and gas companies report in barrel of oil equivalent per day (BOEPD). Those that are primarily dry gas producers will choose to report in MCF equivalent per day (MCFEPD). On the other hand, majority oil producers will report in BOEPD. One take away analysis to consider is that many times the metric a company uses to report production communicates the core production activity of the company (i.e. a company that reports in BOE wants to communicate they primarily target oil, while a company that reports in MCFE wants to communicate they primarily target gas).Premium or Discount. If the multiple is higher compared to its peers, it only appears to trade at a premium, but it does not mean the market value of the company is at a premium or more expensive than its peers. If it trades at a discount to its peers, the same is also true; it does not automatically mean the MVIC of a company is cheaper than its peers. To draw that conclusion, one assumes each of its peers has the exact same future production outlook, the exact same well locations and the exact same management team, just to name a few. Making this assumption in isolation is in error. Instead, analysis should be performed to understand the why behind a perceived “premium” or “discount.”Current or Future Production. The metric uses current production as an indication of value for the company. Using this metric, it could be assumed that (1) the current oil/gas/natural gas liquids mix will stay the same; (2) the current production level will continue on its previously experienced decline rate; and (3) the equivalency formula to translate gas production into oil production (typically 6.1 mcf = 1 barrel of oil equivalent) will not change. This metric fails to account for visibility into future production. When analyzing an E&P company, future production should always be considered.ExperienceWhile this multiple is useful, it also has its shortfalls. As with all multiples, it should never be used as the sole indicator of value. As an example, using this multiple in isolation would give zero value for an E&P flush with acreage and no production.We had a client with investments in an oil and gas company that was facing a transfer of ownership decision. During negotiations certain parties involved were convinced the only way to value, and therefore the only way they would pay for, an E&P was to utilize an EV/Production multiple and nothing else. They backed their position with their transaction experience of buying oil and gas assets as well as their knowledge of industry participants. We believed utilizing that particular method significantly undervalued our client. While the company had very little production, the acreage rights were significant as well as the PV 10 reserve report. We assisted our client through the transaction process by utilizing multiple valuation approaches, not solely the one a potential suitor strongly suggested.Multiples such as EV/Production can provide context for market pricing in the form of a range. We would never recommend using one market multiple as the only value indication for a subject company, particularly a non-publicly traded company. Ideally, market multiples should be used as one of many value indicators during analysis. While there may be facts and circumstances that prohibit the use of multiple value indicators, it is always advisable to (1) understand the implications of using a specific multiple; (2) understand its weaknesses; and (3) use other value indications together. When observing the EV/Production multiple, reconcile the observations with other valuation multiples and valuation indications for a reasonable analysis. For assistance in the process or other valuation analysis for an energy company, contact a member of our oil and gas team to discuss your needs in confidence.

Portfolio Valuation and Regulatory Scrutiny

Over the past decade, we have been retained by several investment funds to assist them in responding to formal and informal SEC investigations regarding fair value measurement of portfolio investments. Reflecting back on those engagements yields a couple observations and reminders for funds and fund managers as they go through the quarterly valuation process.First, fund managers should recognize that valuation matters, and it will really matter when something has gone awry. To that end, we recommend that funds:Document valuation procedures to follow (and follow them). Since valuation requires judgment, disagreements are inevitable. However, are you following the established valuation process? In hindsight, judgments are especially susceptible to second-guessing if established policies and procedures are not followed.Designate a member of senior management to be responsible for oversight of the valuation process. Placing valuation under the purview of a senior member of management demonstrates that valuation is an important function, not a compliance afterthought.Create contemporaneous and consistent documentation of valuation conclusions and rationale. No valuation judgment is “too obvious” to merit being documented. On the other side of the next crisis, what seems reasonable today may appear anything but. The middle of an investigation is not the best time to re-construct rationales for prior valuation judgments.Second, it is important for fund managers to stay abreast of evolving best practices (or know people who do). Fair value measurement for illiquid portfolio investments is an evolving discipline. We recommend that funds:Solicit relevant input from the professionals responsible for the investment, auditors, and third-party valuation experts. Relying on appropriate professionals demonstrates that the fund managers take compliance seriously and are committed to preparing reliable fair value measurements.Check your math. In the glare of the regulatory spotlight, few things will prove more embarrassing than elementary computational errors. The proverbial ounce of prevention is certainly worth the pound of cure.Disclose the valuation process and conclusions. Just like potential investors do, regulators take comfort in transparency.The best time to prepare for a regulatory investigation is before it starts. Call us today to discuss your portfolio valuation process in confidence.Originally published on Mercer Capital's Portfolio Valuation Newsletter: Second Quarter 2017

Are Oil and Gas Bankruptcies a Thing of the Past?

As of 5/22/2017Current PriceFuture Price (12 months)% ChangeWTI$50.33$51.492.30%Natural Gas$2.59$2.8811.20%On June 20, 2014, the price for a barrel of crude oil on the NYMEX reached $107. Few, if any, expected oil prices to fall, and then, keep falling to a dip below $30. Even with hedges in place, this unexpected, sustained price drop crippled oil revenues. Many investments in oil and gas that were once projected to generate strong positive cash flows and profits could no longer generate enough cash to support the debts used to fund the project. Thus, as prices remained low, more and more companies ran out of cash to support once manageable debts. Since the start of the oil downturn, more than 120 upstream and oilfield service companies declared bankruptcy.However, as we described in a previous post, for these E&P and services companies, the decision to file for bankruptcy did not always signal the demise of the business. Despite the sense of doom often associated with the word “bankruptcy,” if executed properly Chapter 11 reorganization afforded these financially distressed or insolvent companies an opportunity to restructure their liabilities and emerge as sustainable going concerns.Many E&P companies who reorganized are “emerging from bankruptcy, looking to grow.” The Financial Times reported that 80% of oil and gas companies who filed for Chapter 11 have emerged from bankruptcy and are still operating. They even claim that this wave of bankruptcies made the industry stronger as companies were able to shed billions of dollars of debt and were forced to increase drilling efficiency in order to survive. In the low oil price environment, companies worked to lower breakeven costs by using new technology to get more oil out of already developed wells. Additionally, many companies sold off assets they could not afford to develop to those who had the ability to finance the necessary capital expenditures to bring new wells online.Thus, as OPEC and partners cut production at the end of 2016, U.S. shale drillers continued to increase production, which kept oil prices comparatively low. Now, almost a year after the peak in bankruptcy activity, oil prices have stabilized around $50 per barrel, and U.S. shale drillers are well positioned to ramp up drilling activity. The U.S. is estimated to have more recoverable oil than any other country, including Saudi Arabia and Russia. Additionally, President Trump’s administration is expected to be a proponent of fracking.For the past two years, OPEC tried to squeeze U.S. shale drillers out of the market by increasing production to flood the market and lower prices, but it looks like domestic shale producers came out as the winners in this competition. Earlier this year, Vauhini Vara, wrote in The Atlantic, “It has become clear that the shale-oil business is going to survive, at least for now.” Over the first four months of 2017, only nine producers filed for bankruptcy, compared to 29 companies that went bankrupt in the first four months of 2016. Although there may still be more bankruptcies to come, the trend of bankruptcies caused by the crash in oil prices has slowed, and companies are prepared to grow with leaner balance sheets than before.Mercer Capital has significant experience valuing assets and companies in the energy industry. To learn more about Mercer Capital’s experience in oil and gas and bankruptcy valuations contact a Mercer Capital professional today.

1Q Call Reports

Despite gaining 4% last quarter, publicly traded RIAs are still coping with a low-fee, passive investment environment and continued delays on the Fiduciary Rule implementation. The proposed DOL rule prohibits compensation models that conflict with the client’s best interests, and is expected to induce active managers to provide lower-cost or passive products and to complete the shift from commission-based to fee-based accounts. Still, many industry participants see opportunity amidst these headwinds, and the market for these businesses seems to as well.As we do every quarter, we take a look at some of the earnings commentary of pacemakers in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Fees are ultimately determined by investment performance and capital market returns, creating serious challenges for hedge fund managers and other active investors that aren’t delivering alpha on a sustainable basis.There is a greater belief that long-term returns are structurally lower than they were ten and twenty years ago. So if you have an expected long-term return of, let’s say 6%, which many people think that might be high when you look at a balanced portfolio. Fees take up a lot of that return. And as long as we believe the world is going to be in a low-return environment, our clients are under a lot of pressure….and so when we talk about fee pressure, fee pressure comes from the real issue of lower expected returns. And I think this is one of the big issues around hedge funds and why we’re constantly reading about some hedge funds closing, some hedge funds are lowering their fees, because the fee structures are just too large versus the returns on a risk-adjusted basis that they’re achieving. – Larry Fink, BlackRock CEO and ChairmanI think fee rates going down are – I think is a reality of what’s happening. Some of that is mix shift. Some of that is changing regulation in terms of distribution. Some of that will ultimately – will accrue to the benefit, obviously, of the end client. I think ultimately, this comes down to our ability to generate sustainable alpha. I think if we can generate sustainable alpha in a way that, in some ways, kind of captures 3x to 4x the fee over time, I think we’ll be fine. If we’re in a period of significantly lower returns and lower sustainable alpha, then obviously, I think fee rates are going to have to come down accordingly. – Gary Shedling, BlackRock CFO and Senior Managing DirectorTheme 2: Active managers continue to justify their fees with investment performance on certain products and [the perception of] lower correlation among certain asset classes.I think performance wins in the end. There’s no question about that. And as we’ve said before, I mean it’s when you have a good quarter or a good year, it may slow redemptions a bit, but it takes a while to build back onto the shelf space. And we’ve seen, I think the number of 4 and 5-star funds for us has quadrupled here in the last quarter. So those are the things that really drive sales and shelf space…And that most of the industry that has more brokerage assets, it, as we all know, creates challenges in the transition to more of the advisory mode. But at the end of the day, if you have performance and you have reasonable fees, you’ll get distribution in that model as well. – Greg Johnson, Franklin Resources CEO and ChairmanOutside of the U.S. market, in lesser developed markets, less-efficient markets, more dispersion, less correlation, I think we still feel very strongly in places like Europe and Asia and certain emerging markets, that frankly, the ability to generate sustainable alpha can support higher fees. And I think our performance has certainly showed that over time. – Gary ShedlinTheme 3: RIAs are still bracing for the DOL’s implementation of the Fiduciary Rule and the Pension Protection Act, which is expected to accelerate assets into passive products.On April 7, the Department of Labor published a 60-day delay of its Fiduciary Rule until June 9. Following that announcement we evaluated the delay in relation to existing projects and the pre-established contingency plans developed in anticipation of the delay. We are continuing our efforts to complete projects established for full compliance on January 1, 2019…Our efforts associated with the new rule have touched nearly every business unit and required significant lift from our employees and business leaders whose commitment remains strong as we continue to work towards full implementation by early 2018. – Phillip Sanders, Waddell & Reed CEOIt’s something that we continue to be very engaged on…So we are very active on that, on the lobbying front. And we’ve been asking that questions, well, what does it mean? What kind of dollar number are we looking at? And I think it’s probably too early to say, because it depends just how clients react to the disclosure…But again, when you have that transparency and the questions, we don’t know how far it extends. And I wouldn’t want to try to extrapolate because we don’t know what that would mean. I think you’re right in saying there’s still quite a bit of uncertainty on it. – Greg JohnsonThe real headwind is in the DOL Pension Protection Act rule. They created a QDI, or a default option, which is primarily proprietary target date funds. Our view is that was going to open up and be more open architecture, customized solutions that would include more outside asset managers such as Artisan. Unfortunately, the litigations have increased the perceived diversification of an all-indexed oriented target date fund, and fee pressure has spurred more and more assets going to the proprietary target date funds, especially if it’s 100% passive. That has lowered our expectations in the short run of the DC assets turning around. We still think over the next couple of years you’ll see more and more customized solutions. But for right now, it just seems the passive solution is the safe approach right now. – Eric Colson, Artisan Partners CEO, Chairman, and PresidentMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

E&P: What We Learned from 1st Quarter Earnings

The first quarter of 2017 was productive and active for upstream E&P but the change in market capitalizations of many oil and gas companies does not match the reported increase in earnings and production estimates. Looking at our universe of energy companies in the E&P space, over 70% beat earnings estimates. This statistic held true no matter if the energy company was a global integrated operator or a pure upstream producer. To provide a flavor of the attitude, we selected two larger publicly traded energy companies involved in E&P (STO and XOM) as well as six companies with primary operations in the Permian Basin (PXD, CXO, NBL, XEC, FANG, and RSPP) and reviewed the highlights of their latest earnings releases. As summarized below, each of these companies exceeded analyst expectations. STO – StatOil ASA Over the first quarter StatOil’s market cap fell from $60.2 billion to $55.7 billion. But, Eldar Saetre, President and CEO of Statoil ASA had only good things to say about first quarter earnings. Our solid financial result and strong cash flow across all segments was driven by higher prices, good operational performance and an organic production growth of 5%.We delivered seven discoveries from nine exploration wells drilled during first quarter. Many of these can be quickly put into profitable production.We are also about to start our exploration programme in the Barents Sea, testing several new opportunities over the next six months. In the quarter, we received approval for three plans for development and submitted additional two projects for approval by Norwegian authorities, showing commitment to industrial development on the NCS.XOM – Exxon Mobil Corporation Exxon’s market cap fell over the first quarter from $373 to $340 billion but overall the company reported positive results. Darren W. Woods, Chairman and CEO, said, Our results reflect an increase in commodity prices and highlight our continued focus on controlling costs and operating efficiently.We continue to make strategic acquisitions, advance key initiatives and fund long-term growth projects across the value chain.Upstream volumes were 4.2 million oil-equivalent barrels per day, a decline of 4 percent compared with the prior year, primarily due to the impact of lower entitlements due to increasing prices, and higher maintenance.Upstream earnings of $2.3 billion improved on higher liquids and gas realizations.The following six companies’ operations are focused in the Permian Basin. The bulleted information below is summarized from each of their earnings releases.PXD – Pioneer Natural Resource Company Pioneer’s market cap remained relatively stable over the first quarter of 2017 at $31.3 billion in January and $31.6 billion at quarter end. Production for the first quarter increased by 3% from 4Q16 and was above the top end of Pioneer’s guidance rangeProduction growth was driven by Spraberry/ Wolfcamp horizontal drilling programThe company reduced production costs compared to 4Q16.CXO – Concho Resources, Inc. Over the first quarter Concho’s market cap fell somewhat from $19.6 billion to $18.6 billion but overall, the company reported positive earnings and activity results. Concho delivered quarterly production of 181.4 Mboepd, exceeding the high end of the company’s guidance range and raised full-year 2017 production outlook to a range of 21% – 25% annual growth while maintaining their capital expenditures outlook.They increased crude oil production to 113.6 Mbpd, up 28% year-over-year.The company achieved record well performance in their Delaware Basin and New Mexico Shelf assets.The shift to manufacturing mode was made with large-scale development projects in the Delaware Basin and in the Midland Basin.The company reduced per-unit production expense and interest expense by 27% and 42%, respectively, year-over-year.Concho lowered full-year 2017 guidance for per-unit production and depreciation, depletion and amortization expenses.NBL - Noble Energy, Inc. Nobel Energy’s market cap fell from $16.4 billion to $14.84 billion over the first quarter of 2017 even as President and CEO David L. Stover said, “Noble Energy is off to a great start in 2017, with strong operational and financial performance and importantly, numerous recent strategic accomplishments.” The company delivered quarterly sales volumes at or exceeding the top end of guidance. And total oil volumes were at the high end of guidance, led by Delaware and DJ Basin performance.The company saw continued strong well performance in the Delaware Basin.Three new Wolfcamp A wells commenced production.Noble Energy's leading position in the Southern Delaware Basin was solidified through the acquisition of Clayton Williams Energy, increasing the company's position to 118,000 net acres.Full year sales volumes trended toward the upper half of original expectations, driven primarily from increased crude oil and NGL sales.XEC – Cimarex Energy Co. Cimarex’s market cap decreased over the first quarter from $13.2 billion to $11.4 billion. Total production was up 11% sequentially.Oil production was up 15% sequentially.Total company production, which increased 9% over the first quarter, came in above the high end of our guidance.Commodity prices improved significantly from a year ago and had a positive impact on Cimarex's financial results for the quarter.Realized oil prices increased 70% from the first quarter of 2016.Realized natural gas prices were up 57% from the first quarter 2016.NGL prices were up 107% from the same period one year ago.FANG - Diamondback Energy, Inc. Over the first quarter Diamondback’s market cap increased from $9.3 billion to $10.1 billion. 1Q17 production was up 19% over 4Q16 with 13% quarterly organic growth.Estimated 1Q17 Midland Basin drill, complete and equip cost per completed lateral foot was down 5% quarter-over-quarter.Closed Brigham Resources acquisition, which increased Diamondback's total leasehold to approximately 189,000 net surface acres in the Permian Basin.Diamondback continues to decrease drilling times, lower costs, and achieve new company records.RSPP - RSP Permian, Inc. RSP’s market cap decreased from $6.5 billion to $5.9 billion over the first quarter of 2017. Production increased 84% compared to 1Q16 and increased 26% compared to 4Q16.Adjusted EBITDAX increased by 249% from 1Q16 and 37% compared to 4Q16.On March 1, 2017, RSP Permian closed their previously announced SHEP II acquisition for approximately $646 million of cash and 16.0 million shares of RSP common stock. As the above earnings excerpts explain, the first quarter brought (1) higher oil and gas prices; (2) higher production rates; (3) lower production costs; (4) investment in new wells; and (5) an active environment for asset purchase and divestures. However, the stock price performance does not reflect the positive quarter performance. Of the 64 energy companies we track, 49 had lower market capitalizations as of May 11, 2017 compared to December 31, 2016.Why Is This?One significant reason for this mismatch is the outlook for crude oil has declined approximately 14% from the end of Q4 to the middle of May 2017. The following is a comparison of the 12 months futures contracts for WTI at the end of 4Q16 and middle of May 2017: The fear of too much oil supply is dampening the pricing outlook for oil. Although 1Q17 resulted in slightly higher prices for oil, the successful increase in production from new drilling techniques and stacked reserve play wells is boosting production and moving prices lower. The industry now looks to OPEC and Russia for production cuts to assist in increasing the price. In a volatile oil and gas market, the market capitalization of companies is more of a representation of the future earning potential of companies rather than the past. While the first quarter of 2017 showed hopeful results, the change in the market pricing of these companies puts a damper on the increase in earnings and makes us question if these companies’ successes are short lived. Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. We have assisted many clients with various valuation and cash flow issues regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.

Focus Financial’s Quest for an Unfair Advantage

A Long Journey to an Uncertain Destination

Starting later this week, the roads throughout Italy will be filled with more than the usual complement of exotic sports cars as the annual endurance race known as the Mille Miglia kicks off on May 18. The 1000 mile (or so) race was a major event between 1927 and 1957 in which major European auto manufacturers competed to show off not just the speed but the durability of their cars. Ferrari and Alfa Romeo typically dominated the event, although BMW won the only race held during World War 2 (go figure). For the past 30 years, the Mille Miglia has been a classic car tribute race in which wealthy collectors extravagantly thrash their pricey antique sports cars over vast stretches of Tuscan countryside and their livers with oceans of prosecco. If Mille Miglia was ever about the destination, today it is certainly all about the journey.Focus Finds Another Way Point on the Journey to IPOAs part of the analyst community that closely follows developments in the investment management industry, we were disappointed (but not surprised) that Focus Financial Partners pulled their S-1, again, and found a private equity recap partner instead of going public. Picking up on last week’s blog theme, Focus likes to tout their strategy of building an international network of efficiently connected wealth management firms as an “unfair advantage”, but it appears that their real capability is finding capital when necessary to avoid a public offering. Stone Point Capital and KKR bought 70% of the company, enabling prior private equity partners, affiliates who had sold their firms to Focus in exchange for stock, and employees with equity compensation to monetize their positions while Focus remains private.Stone Point / KKR’s investment thesis probably works something like this: wealth management is idiosyncratic, but also a relatively stable source of fees over time. Less threatened by robo-advisors and passive investing than the press would like to think, Focus Financial offers the opportunity to standardize back-of-the-house issues with a scaled up wealth advisory firm while keeping the storefront identity of advisors in place. That gives pricing power on the front end and efficiency on the back end to ultimately build a better sustainable margin. If this is successful, margin widens by five or ten percentage points relative to a stand-alone RIA. Focus can add more scale and some multiple arbitrage by buying smaller practices at single digit multiples. Once AUM tops $100 billion, you might pick up a turn on the EBITDA multiple. If markets don’t experience a prolonged decline during the holding period, Focus will pay Stone Point / KKR a high single-digit coupon on an unleveraged basis and/or will support some leverage to enhance ROE. With motivated advisors seeking new business and a market tailwind, private equity returns of 20% or more are available over the usual holding period of five to seven years, which has been getting longer because of a persistently weak IPO environment.At present, private equity has the “unfair advantage” of tremendous access to capital and freedom from regulatory oversight. Focus has a significant head-start in creating a national platform for wealth advisory firms, and is positioned to take advantage of an increasing need for exits by the aging population of wealth advisors. Put Stone Point / KKR’s unfair advantage together with that of Focus, and suddenly there’s no need for an IPO.Focus FundamentalsThere is plenty we don’t know about the recap, but we can infer a few things which explain the value of the transaction to the buyers. The ADVs of the 45 or so affiliate firms of Focus Financial reveal aggregate discretionary AUM at year end 2016 of approximately $60 billion, plus nondiscretionary AUM of another $15 billion for total AUM of over $75 billion. Per these ADVs, it also appears that almost all of the firms are wholly owned by Focus, so their AUM is wholly attributable to Focus Financial as well.Revenue is a function of AUM and Focus’s realized (or actual) fee schedule. Focus Financial’s affiliate wealth management firms generally serve the upper end of the mass affluent market, such that we estimate realized fees of a little less than 100 basis points. Realized fees of 90 to 95 basis points on total AUM would suggest that Focus generates revenue of $700 million to $725 million annually.We are curious about what sort of margin Focus has been able to demonstrate. The theory behind a roll-up (Focus executives insist the firm is not a roll-up) is economies of scale through common platforms, bundled research and technology, centralized marketing support, and other back office necessities. The question is how much are these efficiencies mitigated by the need for executive infrastructure, corporate development staff, integration costs, and the like. One final complication is what compensation levels have to be to motivate revenue producers at Focus’s affiliate firms. The RIA community is famous for mixing equity returns and compensation, but once equity is sold to Focus, the line of demarcation becomes clear, and compensation is a charge to margin. Our guess is that Focus’s profitability isn’t very different than we might expect from the affiliate firms on a stand?alone basis, or somewhere between 25% and 35%. If their EBITDA margin is around 30%, then Focus should be generating annual cash flow a bit north of $200 million.Focus Valuation MetricsReports suggest that the Stone Point / KKR recap valued Focus at around $2.0 billion. Given the performance metrics we’ve estimated above, that pricing implies an EBITDA multiple of between 9x and 10x, which makes sense to us and is more or less consistent with public market pricing, minus a modest discount.Two weeks prior to the recap, firms like Legg Mason were trading at 12x EBITDA, with AMG at 14x. It is possible that Focus’s performance was a bit less than we estimate, and if fees realized were a bit shy of 90 basis points and/or if Focus’s EBITDA margin was closer to 25%, then a $2.0 billion valuation would require an EBITDA multiple of closer to 12x. However, we think it is unlikely that Stone Point and KKR paid a top-tic multiple for Focus; doing so would leave them with less upside at exit.Selling to private equity is a lower risk transaction, which no doubt pressured the valuation. Accepting some discount enabled sellers to get out clean rather than sell some through an IPO and the rest over an SEC regulated timeline. Selling to private equity also allowed the parties to keep the ultimate terms and conditions of sale private. We think it is also unlikely, however, that the discount to public market pricing was much greater than 20% or so for Focus, because a bigger haircut would have induced Focus to consummate their IPO.Are We There Yet?Plenty has been written over the past two years about holding periods lengthening because ample private equity funding has diminished the liquidity advantage of public markets. The expense of being public and the disclosure requirements are off putting to many, and the flow of capital into the private equity community makes it much easier to keep companies like Focus out of the public markets. We watched enthusiasm for going public wane fifteen years ago with the dotcom bust and the advent of Sarbanes-Oxley. We would still suggest that no matter how long the private equity journey, the destination hasn’t changed. The PE community can only recycle investment ideas and investment dollars so many times – eventually Focus and other companies like it will have to go public. Even the Mille Miglia has a finish line.

Building Value in Your Investment Management Firm

The Unfair Advantage

One recurring question we hear from clients is what business model builds the most value for an investment management firm. It’s a reasonable question to ask these days, given the irony of simultaneously strong financial markets and the degree of negativity surrounding the RIA community. In the past month alone, Focus Financial dropped plans for a public offering, Morningstar reported that passive mutual funds pulled in over $500 billion in 2016 while active funds lost nearly $350 billion, and the parent of AllianceBernstein fired most of AB’s senior leadership. All of this happened at the same time that the Nasdaq hit new all-time highs.Looked at from this perspective, building value in an investment management firm appears to be fairly challenging, but from our perspective the challenges are uneven. Further, we don’t know that the secret to building value in an investment management firm is so much about choice of model as it is developing and executing a strategy which no one else can match. We like to refer to this as finding a firm’s “unfair advantage.”Unfair AdvantageWe didn’t coin the term “unfair advantage”, but we get it from the title of a book about racecar driving by Mark Donohue. In the late 1960s and early 1970s there were many great race car drivers, but few were as highly regarded at the time as Donohue. He was important not just because of his success across a variety of racing platforms – everything from sports car racing to Indy cars to NASCAR to Can-Am – but because he approached auto racing more as an engineer than a daredevil.Mark Donohue studied mechanical engineering at Brown and was known on racecar circuits for his skill at reading the handling and performance characteristics of his cars. Donohue’s most noteworthy success was taming the Porsche 917K. Porsche had spent so much time developing a twelve cylinder boxer motor that developed over 1,000 horsepower that they neglected attention to the aerodynamics and suspension work that would actually keep the car on the road. The 917 was ferociously powerful, but it was also nearly uncontrollable. Donohue took the body off of the car and drove it to check out the drivetrain and suspension first, and then started working on the aerodynamics. Once he was done, the car was unbeatable, and Donohue’s legend was cast.After several successful seasons in the Porsche, Donohue retired from racing to write Unfair Advantage. The advantage he sought in a race was not his own talent – Donohue did not think he was a particularly skilled driver – but to have the very best car in the race. In truth, the unfair advantage that Donohue’s team, Penske, enjoyed during this time was to have an Ivy-League educated driver who could fine tune a car to fit a particular race on a particular track under particular conditions. Donohue returned to racing in 1974, and died in a crash on a practice lap in 1975. Were it not for his book, he might have been forgotten.Finding Your Firm’s Unfair AdvantageAfter years of working with investment management firms of all shapes and sizes, it is our opinion that building the most value in an RIA comes down to the same thing: developing and capitalizing on some unfair advantage. That may sound unnecessarily mysterious or metaphorical, but it really boils down to examining the basic building blocks of firm architecture and finding out where your firm can excel like none other. We’ll break this down for you over the next few weeks.

Why Aren’t We Talking About the Gulf of Mexico?

Artem Abramov, of Rystad Energy, recently published an article in the Oil and Gas Financial Journal comparing shale and offshore drilling. He claims, the “Gulf of Mexico [is] as important as [the] Permian Basin for U.S. oil production” but it has been overlooked since the advancement of shale gas. The EIA reports that offshore drilling accounts for 17% of total domestic crude oil production. So, why aren’t we talking more about oil and gas production from the Gulf of Mexico (GoM)?Unlike shale plays, where production varies with oil prices, production in the Gulf of Mexico has been resilient to fluctuations in prices because projects in the Gulf of Mexico have longer time horizons. After the downturn in oil prices drilling activity remained relatively flat at 25-35 wellbores per quarter. The relative price insensitivity over the short term meant that the Gulf of Mexico did not see substantial production drops like many other oil producing regions of the U.S. when prices fell in mid-2014. However, this also means that as oil prices have recently increased, the Gulf has not seen substantial increases in production.The Oil and Gas Financial Journal article stated:Only two sources of oil supply in the U.S. remained exceptionally resilient throughout the downturn: The Permian Basin and the Gulf of Mexico. The Permian Basin’s output was growing every quarter, adding 300 Mbbl/d from the first quarter of 2015 through the fourth quarter of 2016. While exposed to seasonal disruptions, GoM’s production was able to deliver a 240 Mbbl/d growth over the same period, contributing almost equally with the Permian Basin to the limited decline pace of the total U.S. oil production.Right before the 2014 downturn in oil prices, many deepwater drilling projects were approved. This led to increased start-up activity in the Gulf in the second half of 2016 which increased crude and condensate production by 400 Mbbl/d from 2014 to 2016. In 2016, eight projects came online in the GoM and another seven projects are expected to come online by the end of 2018. In 2016, crude oil production in the Gulf of Mexico reached an annual high of 1.6 Mmbbl/d which surpassed the previous high which was set in 2009. Oil production is expected to reach 1.7 Mmbbl/d in 2017 and 1.8 Mmbbl/d in 2018 in the Gulf of Mexico.Recently, most oil and gas news has been centered on the Permian Basin. As we explained in a recent post, the Permian Basin has had recent success due to its locational advantage, vast amount of untapped reserves, and low breakeven prices. Most of the major M&A deals in the upstream sector were in the Permian Basin in 2016. According to James Scarlett of RS Energy Group, approximately 25% of the U.S.’ lower 48 production came from the Permian Basin and 38% of the rigs in the U.S. are in the Permian. The reason for so much concentration is that about 80% of currently economic (economic meaning under $50 breakeven oil) oil is in the Permian, particularly the Delaware Basin. Secondly, due to the numerous potential production zones (Wolfcamp, Bone Spring, Leonard Shale, Delaware Sands, etc.), there is a huge amount of oil in place for potential recovery (3,000 feet of pay zones). Couple this with an area (West Texas) that has ample existing infrastructure from decades of development, and this has led to what some people are calling a land grab in the area.The Gulf of Mexico’s success can be similarly explained. The EAI reports that 45% of total petroleum refining capital and 51% of U.S. natural gas processing plant capacity is located along the Gulf Coast, giving the Gulf easy access to its downstream market. Additionally, much of the midstream infrastructure is already in place, which allows companies to save money by utilizing already developed pipelines. Further, the Gulf of Mexico had 4.8 billion barrels of crude oil proved reserves at year end 2015, according to the most recent information published by the EIA. In comparison, RRC Districts 7C, 8, and 8A, which includes the majority of the Permian Basin, combined proved reserves at year end 2015 of 7.3 billion barrels, and North Dakota, home to the Bakken shale play, had 5.2 billion barrels of proved reserves (2015 reserve estimates do not include some recent significant discoveries, including the discovery of an estimated 20 billion barrels in the Wolfcamp shale play in the Permian Basin). In addition, the Gulf of Mexico has been able to realize increased drilling efficiency for many years. Average drilling speed in shale increased by 100% from 2011 to 2016, but the Gulf of Mexico was not far behind, averaging an increase in drilling speeds by 60-75% from 2015 to 2016. As shown in the chart below sourced from the Oil and Gas Financial Journal, drilling efficiency improvement in the GoM is greater than in shale oil. While the energy sector as a whole is expected to benefit from President Trump’s pro-energy policy, offshore drilling has recently been at the center of political talks. Interior Department Secretary Ryan Zinke signed two secretarial orders last week which are expected to increase America’s offshore energy potential. The first order, directed by the Bureau of Ocean Energy Management (BOEM), is to develop a new five-year plan for offshore oil and gas exploration and to reconsider the regulations surrounding these activities. Secretary Zinke said that regulations which were created with good intentions, but that have been harmful to America’s energy industry, will be reviewed. While some regulations have been removed, such as the Offshore Air Quality Control, Reporting, and Compliance Rule, Offshore Petroleum Industry Training Organization (OPITO) officials are encouraging the U.S. to follow their common industry standards, which have been adopted by 45 other oil producing regions internationally. The second order established a new position to coordinate the Interior Departments energy portfolio. Zinke noted that in 2008 federal leasing revenue for the Outer Continental Shelf (OCS) was approximately $18 billion, but it was only $2.8 billion in 2016. Focused on increasing leasing revenue, President Trump is likely to experience some legal obstacles. In 2006, Congress placed a moratorium on drilling within 125 miles of the Florida Coast until 2022. However, this area is estimated to contain up to 2.35 billion barrels of oil. President Obama in November 2016 permitted 10 lease sales in areas of the Gulf of Mexico in moratorium, but this plan only covered a small portion of the eastern gulf coast. President Trump wants to expand leasing rights but will likely have to battle much of this argument in court because it requires a public comment period.1 One impact of the recent downturn in oil prices was the need for shorter term capital projects. As we talked about in a recent post, "The Wild Goose Chase Is Over", companies have been looking to invest in quick ventures that have short payback periods. The Gulf of Mexico is known to have longer payback periods but has been working to shorten investment time horizons. Companies are focusing on “Subsea completions and tiebacks where you already have the infrastructure – the platform in place, the pipeline to the market place – so those require significantly less capital and faster lead times than the big spars that people think of in offshore projects” as Deloitte’s Andrew Slaughter said in a recent interview with the Oil and Gas Financial Journal.2 While the Permian Basin has been the center of most oil and gas discussion recently, there are notable investments being made in other oil rich areas of the U.S. In February, Shell invested in the Kaikias oil and gas project in the Gulf of Mexico. It will start production in 2019 and will be able to generate profits even with oil prices lower than $40 /bbl. Last December BP made a similar announcement of a $9 billion investment, called “Mad Dog Phase 2” in the Gulf of Mexico that is expected to be profitable at $40/ bbl oil. With uncertainty surrounding the future price of oil due to the unpredictability of OPEC’s production cuts, it is important for oil and gas producers to find economically efficient plays. While the Permian is currently one of the most economical plays, we cannot rule out all others such as those in the Gulf of Mexico. Although the market is not rallying around the Gulf of Mexico like it is around the Permian, we can expect continued growth in the region over the next few years. Mercer Capital has significant experience valuing assets and companies in the energy and construction industries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence. End Notes1 Dlouhy, Jennifer. “Trump to Expand Offshore Drilling, Review Deepwater Horizon Regs. Bloomberg News. 2 Tiebacks are subsea lines that connect new wells to existing projects.

Is Cash Always King?

Travis Harms, CFA, CPA/ ABV, Senior Vice President at Mercer Capital, recently published a blog post on Mercer Capital’s Financial Reporting Blogcontemplating the appropriate amount of cash for a company to hold. This topic is especially pertinent to the oil and gas industry, in which 70 companies went bankrupt last year. Now as companies have started to increase capital expenditures again, they must consider how much cash they should keep as a cushion while considering the effect of this low-yielding asset on value. When it comes to money, “enough” is the hardest word to define in the English language. The challenge of defining “enough” extends to corporate managers deciding what cash balance is appropriate.Cash balances can provide a cushion against unanticipated adverse events in the business. The moment companies need cash is usually the worst time to try to raise capital. Having sufficient cash on hand to weather an unexpected downturn in the business can help shareholders avoid dilutive capital raises at inopportune times.On the other hand, cash is a very low-yielding asset. Large allocations to cash weigh down the returns to invested capital. If capital providers recognize the risk-reducing attributes of cash and reduce their return expectations accordingly, the effect of a large cash balance on value is probably negligible. If, instead, investors view the cash investment no differently than any other capital allocation, and fail to reduce their return expectations, then a large cash balance will be detrimental to value. As shown in Table 1 above, investors provide debt and equity capital (the right side of the balance sheet), which the company then allocates to a portfolio of assets (the left side of the balance sheet). The enterprise value of the business represents the “engine” that generates operating cash flow (of which EBITDA is often considered a proxy). Since cash balances do not generate EBITDA, cash and other short-term investments are excluded from enterprise value. In the current yield environment, the investment return on cash balances is nil. As a result, cash balances represent a drag on the weighted average return on the company’s assets. In both private and public companies, minority investors do not have any direct control regarding the allocation of the capital they provide. Corporate managers and directors need to evaluate the effect of large cash holdings on both the returns provided to capital providers and the required returns demanded by capital providers. In the balance of this post, we examine data from public markets to assess shareholder preferences with regard to cash holdings. Summary of the DataWe examined data pertinent to this question for non-financial companies in the S&P 1000 at the end of 2016. The S&P 1000 index is a combination of the S&P MidCap 400 and the S&P SmallCap 600. At December 31, 2016, the companies in the S&P 1000 index had market capitalizations ranging from about $200 million on the small end up to approximately $10 billion.Table 2 summarizes pertinent data by industry. Measured as a percentage of market value of invested capital (MVIC, or the sum of equity market capitalization and total debt), median cash balances for the various industry groups range from a low of 0.4% for utilities, to a high of 11.1% for information technology. We considered a number of characteristics that may contribute to industries allocating more or less of their capital to cash. The relationships between cash balances, capital expenditure intensity and expected revenue growth are not very compelling. In contrast, as shown in Table 3, there does appear to be a degree of correlation between cash balances and beta. Correlation is not causation, of course. However, what the data does begin to suggest is that higher-risk companies tend to hold more cash than lower-risk companies (if risk is measured using beta). This observation is consistent with the risk-reducing properties of cash mentioned above. Companies in riskier industries may hold more cash as a buffer against unexpected adverse changes. While this is intuitive from the perspective of corporate managers, the question remains as to whether shareholders perceive value in the allocation of capital to cash. What is Cash Worth?Analysts typically calculate valuation multiples relative to enterprise value – in other words, on a “cash-neutral” basis. The principal merit of this approach is the recognition that, all else equal, a company with greater cash reserves should be worth more than a company with lesser cash reserves. This approach also recognizes that cash balances do not contribute to the generation of operating cash flow. Implicit in this approach, however, is the assumption that shareholders give full dollar-for-dollar credit for cash held on the balance sheet.This is undoubtedly true at the time of a transaction for a private company, as purchase agreements inevitably include target working capital levels with dollar-for-dollar adjustments to the negotiated purchase price for excess or deficit working capital relative to the target.However, it is not necessarily the case that minority investors facing a potentially lengthy holding period have the same perspective. Such investors may view large cash balances as no more than negative net present value capital projects that diminish value. Table 4 below summarizes the two potential extreme positions.In the scenario on the left, investors assign the same enterprise value multiple to the high and low cash companies. This behavior is consistent with the notion that allocating resources to cash results in a corresponding reduction to the cash-hoarding company’s weighted average cost of capital. In other words, investors value the risk-mitigating properties of cash.In the scenario on the right, investors are unimpressed by management’s ability to hold onto cash. Since return expectations are not modified by the large cash balance and the cash balances do not generate any material cash flow, the ratios of MVIC to EBITDA are identical for the two companies. In an effort to screen out potential noise associated with industry factors, we examined the data summarized in Table 2 further by industry to discern which of the two possibilities more closely reflects investor attitudes toward corporate cash balances. In order to avoid unduly small sample sizes, we examined the four most populous industries (consumer discretionary, healthcare, industrials, and information technology). We sorted the companies within each industry by cash balance (measured as a percentage of MVIC), dividing each industry into cohorts of equal thirds. Table 5 summarizes key results for each industry. Consideration of the data summarized in Table 5 yields a number of observations. Within the more mature consumer discretionary and industrials segments, cash balances are unrelated to company size, as the revenue for companies in Cohort 3 (least cash) is comparable to that of the companies in Cohort 1 (most cash). In contrast, cash balances in the faster-growing healthcare and information technology segments are inversely related to company size. The cash-rich healthcare and IT companies are approximately one-half the size of the low-cash companies in the respective industries.While differences in beta within the industry segments are modest, the observed data points are generally consistent with the relationship between risk and cash holdings noted with respect to Table 2. Perhaps cash balances are viewed as a counter-weight to greater operating risk.Projected revenue growth is inversely related to cash balances for companies in the consumer discretionary and industrials segments. For companies in the healthcare and IT industries, however, the companies with the highest cash balances have the highest growth expectations. Perhaps in these industries, cash balances are perceived by investors as “dry powder” for future positive-NPV projects.While differences in expected growth obscure direct observations regarding the impact of cash balances on WACC, data for the consumer discretionary and industrials segments more closely approximate the right side of Table 4, suggesting that investors in mature companies are unimpressed with large cash balances. For healthcare and IT, the data is more closely aligned with the left side of Table 4, suggesting that investors view cash accumulation as a reasonable strategy in industries in which positive-NPV projects are presumably abundant.ConclusionOne of the primary tasks of corporate managers and directors is capital allocation. While cash balances can provide a safety net that allows corporate managers to sleep better at night, for shareholders, the risk-mitigating benefit of corporate cash balances is balanced by the corresponding drag on returns. Based on the market data summarized in this post, the perceived availability of positive-NPV projects seems to influence investor preferences regarding cash stockpiles.Positive-NPV projects are presumably abundant in higher-growth industries such as healthcare and IT. For firms in those industries, investors appear more likely to view cash as “dry powder” for future value-enhancing investments, and are more willing to bear the cost of lowered returns until such investments are identified and made.In more mature segments such as consumer discretionary and industrials, positive-NPV projects are presumably scarcer. The value of large cash holdings among firms in these industries seems to be discounted by investors.For corporate managers and directors, cash balances should not be treated simply as a residual, but rather actively evaluated in conjunction with the firm’s capital budgeting and distribution policies. Cash may be king, but shareholders aren’t necessarily monarchists.

Q1 Shows Glimmer of Hope for Active Managers and Continued Gains for Trust Banks

This quarter’s newsletter focuses on the mutual fund sector, which has been plagued by asset outflows into ETFs and other passive strategies for most of the last decade. The first two months of this year do, however, offer a ray of hope as 45% of U.S. based active managers beat their relevant benchmark, resulting in February being the first month of inflows into active products since April 2015.The newsletter also reviews RIA performance over the last year by size and type of asset manager. Unsurprisingly, trust banks have outperformed their peers with the prospect of higher interest rates and reinvestment income. On the size front, publicly traded asset managers with less than $10 billion in AUM were bested by their larger counterparts, but this is primarily attributable to the undiversified nature of this index (two components, both of which are thinly traded) and in no way suggestive of some broader trend of client preferences for larger RIAs.The M&A outlook remains fairly robust as owner demographics and the maturation of the mutual fund industry spur consolidation and buying opportunities for those looking to add scale. Standard Life’s $4.6 billion purchase of Aberdeen Asset Management last month is a perfect example of this and may be indicative of future deal-making in the sector.You can read the newsletter below or download it here. If you would like to receive the emailed newsletter each quarter, subscribe here.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

How to Invest in PUDs in the Permian Basin without Paying for the Well

In previous posts, we have discussed the existence of royalty trusts & partnerships and their market pricing implications to royalty owners. Many of those trusts have a set number of wells generating royalty income at declining rates for multiple years to come. Viper Energy Partners LP (VNOM) is not a trust, but a partnership, solely focused on the Permian Basin with royalty interests in producing wells as well as proven undeveloped (PUD), probable and possible wells. Per their latest 10K filing:Viper Energy Partners LP owns, acquires, and exploits oil and natural gas properties in North America. VNOM holds mineral interests covering an area of approximately 30,442 net acres in the Permian Basin, West Texas. As of December 31, 2015, its estimated proved oil and natural gas reserves consisted of 31,435 thousand barrels of crude oil equivalent. Viper Energy Partners GP LLC operates as the general partner of VNOM. VNOM was founded in 2013 and is based in Midland, Texas and is a subsidiary of Diamondback Energy, Inc (FANG).VNOM filed the initial public offering in June of 2014. Below is the entire trading history of VNOM: The following summarizes VNOM’s oil and gas assets in more detail per their latest 10K: VNOM’s primarily owns mineral interests located in the Permian Basin. As of December 31, 2016, VNOM owned mineral interests consisting of 107,568 gross acres in the Permian Basin. In total, Diamondback operates approximately 41% of this acreage. Details of VNOM’s acreage, as of December 31, 2016, are summarized below: Total Producing Wells: 545 vertical wells and 190 horizontal wellsNet Production during 4Q2016: 7,919 Boe/dEstimated Proved Reserves per Independent Petroleum Engineer: 31,435 Mboe 58% classified as PDP reservesIncludes 23 horizontal wells in various stages of completion68% Oil / 18% NGL / 14% Natural GasPUD Reserves from 86 gross horizontal well locationsRevenue generated from these mineral interests has increased from $77.8 million in 2014 to $78.8 million in 2016 VNOM, on average (on an acreage weighted basis), receives a 5.95% royalty interest from their 107,568 gross acres and they do not have to pay for any additional capital or operating expenses. The actual royalty percentages vary from 1% to 25% depending on the relative amount of production from the various leases. For example, in the Spanish trail area of Midland County, VNOM receives an average (on acreage weighted basis) of 20.4% for the 16,551 gross acres they own. Because Diamondback operates 41% of VNOM’s acreage, the performance of VNOM is closely tied to the activity of Diamondback Energy, Inc. (FANG). Below is the price history of VNOM and FANG: Market ObservationsThere are approximately 21 oil and gas focused royalty trusts and partnerships publicly traded, as of the date of this article. As demonstrated below, VNOM is unique from the other 20 similar entities. While many of these entities have assets located in the Permian Basin, the areas that make VNOM unique may include but are not limited to the following: Asset mix is primarily focused in the Permian Basin;Royalties are from producing wells;Future royalties are possible from PUD, probable and possible locations; andFANG is the operator of a significant portion of the VNOM’s acreage. As a result, VNOM has the second largest market capitalization, the 4th highest price to revenue multiple, the lowest yield (of the entities that have a yield) and has the longest implied payback period at 21.2 years. Each of these data points indicates VNOM’s popularity in the market place among investors, FANG being the largest owning approximately 74% of the total shares outstanding of VNOM. For many of the above entities, opportunity to participate in PUD, Probable and Possible wells does not exist. Based upon our knowledge of the exploration and production industry, opportunities to participate in new wells, without having to pay for the capital expenditure of drilling the well, casing the well and fracking the well, appears to be an exciting and valuable option. The market appears to agree.Implications for Royalty OwnersIn many respects, royalty owners can utilize publicly traded royalty trusts and partnerships to observe changes in investor behavior and get a feel for how much their royalty interests may be worth. Here are a few areas to consider for your specific situation to compare and contrast with royalty trusts and partnerships.Set Number of Assets. Royalty trusts and partnerships typically have a set number of wells and producing assets after they are formed. Does your property have a fixed number of assets or will it grow? If new oil and gas wells are not being added to the property, then the oil and natural gas reserves will deplete as they age and produce.Location. The royalty trusts and partnerships above have assets all over North America. Some are located in hot spots while others are not. Location drives investor appetite as operating costs and production levels, which vary by location, drive profitability in an industry that has zero control over the price of their product. This is a significant reason for the high transaction activity in the Permian Basin. Operators know they are able to make a profit through high production rates and low operating costs in Permian Basin even at $40 oil. Consider the investor activity, or lack there-of, in your area.Price and Production. Now that the U.S. has significant recoverable oil and gas reserves and the ability to export unrefined crude world-wide, the U.S. can be considered a swing producer, a power which historically characterized OPEC. As a swing producer, price dictates the level of production the market will consume and production will increase or decrease relatively quickly to meet demand. In response to price changes, operators will increase or decrease production levels at will. Consider how your operator has behaved in various pricing environments and the operators of the Royalty Trusts. In addition to the differences between your royalty assets and the royalty trusts and partnerships, consider the level of value indication provided by the royalty trusts and partnerships. The level of value is the publicly traded level of value verses the privately held royalty assets held by many land owners. Consider the following chart. Chris Mercer explains, The benchmark level is the marketable minority level of value, or the middle level in the chart above. Conceptually, it represents the pricing of the equity of a public company with an active and freely trading market for its shares. For a private company, it represents that same price as if there were a free and active market for its shares. The lowest level on the traditional levels of value chart is called the nonmarketable minority level of value. This level represents the conceptual value of illiquid (i.e., nonmarketable) minority interests of private companies, or entities that lack active markets for their shares.Publicly traded royalty trusts and partnership provide an indication of value at the marketable minority value level for minority interests in an entity with royalties as the primary asset. For royalty owners the value level can be a mixed bag. Many own the asset directly while others own equity interests in entities with royalties as their main assets. It is important to understand the value level comparability difference for your situation.To move from the marketable minority value to the nonmarketable minority value level, simply apply a marketability discount. Stated a different way, apply a discount for not having the ability to quickly sell your asset and receive cash. Fully marketable assets, like those publicly traded, have the ability to exchange the asset for cash in approximately three days. All other assets which do not have this access lack marketability. Therefore, in order to build and find a market for the assets, a discount is typically required by potential investors.We have assisted many clients with various valuation and cash flow issues regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.

Active Management Down But Not Out

Fresh off a 111-82 KO from the San Antonio Spurs on Saturday, our hometown Memphis Grizzlies are certainly battered but not totally eliminated from this year’s NBA title race. As this post goes to press, we still don’t know the outcome of Game 2, but it will undoubtedly be an uphill climb for the Grizz as it usually is against their divisional foes in Central Texas. Still, the Spurs/Grizz rivalry over the last ten years has not been nearly as one-sided as the battle for fund flows between active and passive investors in the ETF era. These dynamics are problematic for many mutual fund companies that rely on active equity products with higher fee schedules and profit margins. As a result, most publicly exchanged mutual fund companies are down while the market is up about 15% over the last year. Active fund outflows are not only attributable to the rise in popularity of low-cost ETF strategies, but also sector-wide underperformance against their applicable benchmarks. Both individual and institutional investors are now more inclined to shun active managers for cheaper, more readily available products, particularly when performance suffers. Many active managers and mutual funds have responded by cutting fees or offering their own passive products to stem the outflows, but this has adversely affected their revenue yields and profitability. Another potential headwind is the GOP’s current proposal to treat all 401(k) deferrals as after-tax contributions, which could disincentive employers from offering defined contribution plans that often invest in mutual funds and other active managers. Republican lawmakers still have a lot of work to do in getting this passed, but it is being seriously considered as one way to help finance the new administration’s proposed tax cuts. Despite these headwinds, 45% of domestic active managers were beating their benchmarks for the first two months of this year, after just 31% in 2016, according to Morningstar and The Wall Street Journal. To put this in perspective, the last year that even half of all active funds outperformed their index was 2009. Higher volatility, asset decoupling, and rising market conditions has been beneficial to most stock and bond pickers over the last few months. As a result, actively managed mutual funds posted their first month of positive new inflows in February since April 2015, according to Morningstar. The recent outperformance of some active managers means they may be gaining the upper hand on ETF’s value added proposition, which is all about alpha net of fees. ETFs and other passive strategies gained substantial inflows from active managers since their performance net of (lower) fees has been stronger than most active managers over the last decade, resulting in higher and higher allocations to index products. Active managers are now poised to reverse this trend, but it is going to take more than just two months of alpha to put much of a dent in this trend. We’ve all read that consistently beating the market is nearly impossible, even for the savviest of stock pickers, but none of that research was compiled when passive strategies dominated the investment landscape. We don’t foresee a huge shift back to active management any time soon, but we realize that we were probably overdue for some mean reversion. It is conceivable that the current market environment could be more conducive to stock picking, but we’ll need more time to judge whether this is truly the case. Regardless, it is hard to imagine that passive investing will completely replace active management. Such a scenario could lead to significant mispricing in the securities markets, which would be fertile ground for enterprising investors and mutual funds. This is why we say that active management, much like the Grizz, is down but not out as the series currently stands. Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

What Would You Do with $1 Billion?

Less than one month ago investors bet $1 billion on James Hackett, former President and CEO of Anadarko Petroleum Corp. Silver Run Acquisition Corp. II is a blank check company that will leverage James Hackett’s knowledge of the Eagle Ford Shale and Permian Basin to fund an opportunistic acquisition. Silver Run II was created by the Riverstone Holdings LLC, the bank that successfully started the blank check company over a year ago now known as Centennial Resource Production LLC. The original stock sale for Silver Run Acquisition Corp I, which raised $900 million is expected to exceed $1 billion. If the banks managing the deal exercise their options to buy shares, which they generally do, the Company would be tied for the record largest blank-check offering. Before we review the recent uptick in investment in oil and gas blank check companies, we will review the basics of blank check companies and special purpose acquisition companies (SPACs).What Is a Blank Check Company?A blank check company, as defined by the SEC, is a “development stage company that has no specific business plan or purpose or has indicated its business plan is to engage in a merger or acquisition with an unidentified company or companies, other entity, or person.” Because the acquisition opportunity has yet to be identified, investors do not know how their funds will be spent, so they write a blank check to the company. One kind of blank check company is a special purpose acquisition company (SPAC).What Is a SPAC?Alice Hsu, Partner at Akin Gump Strauss Hauer & Feld LLP, explained “SPACs are newly formed shell companies, without any revenue or operating history, that raise proceeds in an IPO” in order to finance a merger or acquisition in a specific timeframe. The money raised goes into a separate trust that can only be used for an eventual merger or acquisition. At least 80% of the assets held in the trust account must be used to fund the acquisition of the target business or businesses. If a SPAC does not meet certain goals within a specified time frame, generally 18 to 24 months, then the company will liquidate and return the pro-rata share of funds to investors.SPACs raise capital through IPOs, in which one unit and its attached warrant is typically priced at $10, making them “penny stocks.” A short period after the IPO, the common stock and the warrants comprising one unit will begin separate trading at which point holders have the option to continue to hold their units or separate them. SPACs are usually sponsored by an industry guru whose experience and knowledge of the industry gives them a unique position in to pursue acquisitions. In 2007, there were 58 SPACs that completed IPOs. But until 2016, oil and gas SPACs were uncommon.Oil and Gas SPACsSince the crash in oil prices in 2014, many oil and gas companies found themselves in dire need of capital. Many distressed companies sold off non-core assets for heavy discounts in order to quickly generate cash to pay off debt and avoid bankruptcy. This gave investors a unique opportunity to pick up assets at low prices and SPAC’s provide a source of private capital to do this.The first oil and gas SPAC, Avondale Acquisition (AACOU) founded in April 2015, never completed an IPO as its original sponsor former CEO of Chesapeake Energy & founder of American Energy Partners, LP, Aubrey McClendon, died in a car crash in March 2016. The Company formally withdrew its plans for an IPO to raise $200 million in November 2016.In early-2016 two oil and gas special purpose acquisition companies (SPACs) successfully completed IPOs. This included 2016’s largest U.S. IPO as of February 23, 2016: Silver Run Acquisition Corp. Corrie Driebusch and Ryan Dezember of the WSJ said the size of the deal in “an otherwise frozen market for initial public offering” […] “reaffirms investors’ appetite for bottom-feeding in the oil and gas business.” The timing the deal shows that investors believed in early 2016 that the oil and gas market had bottomed out and would rebound within the next two years when its term to make a deal would expire.Where Are Oil and Gas SPACs Investing?Silver Run Acquisition Corp (SRAQU) was sponsored by Mark Papa, former CEO of EOG Resources. Silver Run Acquisition Corp raised $500 million when it began trading on the NASDAQ. In July 2016, Silver Run acquired a controlling interest in Centennial Resource Production LLC, an independent natural gas company located in the core of the Delaware Basin. Centennial has acreage in Reeves, Ward, and Pecos Counties. The transaction was financed by Riverstone Holdings LLC, an energy investment banking firm. After the transaction Silver Run was renamed Centennial Resource Development Corp (CDEV).KLR Energy Acquisition Corp. (KLRE) raised approximately $85.1 million in its IPO. It is sponsored by Gary Hanna, former CEO of EPL Oil and Gas Inc. The Company announced a meeting date for stockholders to vote on the business combination with Tema Oil and Gas Company. The meeting is scheduled for April 26, 2017. Tema Oil and Gas Company is a privately held company operating in Texas and New Mexico and holds acreage in the core of the Deleware Basin in Loving County. After the Closing of the transaction the Company will change its name to Rosehill Resources Inc. and will trade on the NASDAQ under the tickers ROSE, ROSEU, and ROSEW.Kayne Anderson Acquisition Corp. started by a Los Angeles private equity firm which focuses on pipelines, raised $350 million in an IPO on March 30, 2017. This SPAC is different than most others in the oil and gas space as they do not have one industry guru as a sponsor but rather are sponsored by Kayne Anderson Sponsor, LLC which is most likely run by a team of investors at Kayne Anderson Capital Advisors, LLC.After listing on the NASDAQ just last week, Vantage Energy Acquisition Corp. (VEACU), a blank check special purpose acquisition company, raised $480 million. Vantage Energy Acquisition Corp. is sponsored by Roger Biemans who was the CEO of Vantage Energy until it sold to Rice Energy last October. It is likely that Vantage Energy will pursue investment opportunities in the Marcellus Shale, as Roger Bieman’s former experience was centered there.Additionally, it is rumored that Occidental Petroleum is in the talks to launch a SPAC sponsored by former CEO Stephen Chazen.ConclusionWhile the majority of M&A has been focused in the Permian Basin over the last year, the varying investments of oil and gas SPACs demonstrate that the knowledge of the industry experts is what investors find valuable. Investment by SPACs has been higher of course in the Delaware Basin, but some of the SPACs are focusing on natural gas in the Marcellus and Utica as well.The continuation of investment in oil and gas SPACs shows that investors still believe that there are opportunities to find bargain investments in the oil and gas space throughout many basins. The emergence of oil and gas SPACs however is still recent and there is little history to understand the success of such companies.Mercer Capital has significant experience valuing assets and companies in the energy and construction industries. Our valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Strategic Benefits of Stress Testing

“Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.”– Warren Buffett, Berkshire 2017 Annual Shareholder Letter While the potential regulatory benefits are notable, stress testing should be viewed as more than just a regulatory check-the-box exercise. The process of stress testing can help bankers find silver (or gold in Warren’s case) linings during the next downturn.What Stress Testing Can Do For Your BankAs we have noted before, a bank stress test can be seen as analogous to stress tests performed by cardiologists to determine the health of a patient’s heart. Bank stress tests provide a variety of benefits that could serve to ultimately improve the health of the bank and avoid fatal consequences. Strategic benefits of a robust stress test are not confined merely to the results and structure of the test. A robust stress test can help bank management make better decisions in order to enhance performance during downturns. A bank that has a sound understanding of its potential risks in different market environments can improve its decision making, manage risk appropriately, and have a plan of action ready for when economic winds shift from tailwinds to headwinds.By improving risk management and capital planning through more robust stress testing, management can enhance performance of the bank, improve valuation, and provide better returns to shareholders. For example, a stronger bank may determine that it has sufficient capital to withstand extremely stressed scenarios and thus can have a game plan for taking market share and pursuing acquisitions or buybacks during dips in the economic, valuation, and credit cycle. Alternatively, a weaker bank may determine that considering a sale or capital raise during a peak in the cycle is the optimal path forward. If the weaker bank elects to raise capital, a stress test will help to assess how much capital may be needed to survive and thrive during a severe economic environment. Beyond the strategic benefits, estimating loan losses embedded within a sound stress test can also provide a bank with a head start on the pending shift in loan loss reserve accounting from the current “incurred loss” model to the more forward-looking approach proposed in FASB’s CECL (Current Expected Credit Loss) model.Top Down Stress TestingIn order to have a better understanding of the stress testing process, consider a hypothetical “top-down” portfolio-level stress test. While not prescriptive in regards to the particular stress testing methods, OCC Supervisory Guidance noted, “For most community banks, a simple, stressed loss-rate analysis based on call report categories may provide an acceptable foundation to determine if additional analysis is necessary.” The basic steps of a top-down stress test include determining the appropriate economic scenarios, segmenting the loan portfolio and estimating losses, estimating the impact of stress on earnings, and estimating the stress on capital.While the first step of determining a stressed scenario to consider varies depending upon a variety of factors, one way to determine your bank’s stressed economic scenario could be to consider the supervisory scenarios announced by the Federal Reserve in February 2017. While the more global economic conditions detailed in the supervisory scenarios may not be applicable to community banks, certain detail related to domestic variables within the scenarios could be useful when determining the economic scenarios to model at your bank. The domestic variables include six measures of real economic activity and inflation, six measures of interest rates, and four measures of asset prices.The 2017 severely adverse scenario includes a severe global recession, accompanied by heightened corporate financial stress (real GDP contraction, rising unemployment, and declining asset values). Some have characterized the 2017 “severe” scenario as less severe than the 2016 scenario (given a relatively higher disposable income growth forecast and a lack of negative short-term yields, which were included in the 2016 economic scenarios). However, CRE prices were forecast to decline more in the 2017 scenario, and those banks more focused on CRE or corporate lending may find the 2017 scenarios more negatively impact their capital and earnings forecasts.For community banks facing more unique risks that are under greater regulatory scrutiny, such as those with significant concentrations in commercial real estate lending or a business model concentrated in particular niche segments, a top-down stress test can serve as a starting point to build their stress testing process. The current environment may be an opportune time for these banks to plan ahead.While credit concerns in recent quarters have been minimal and provisions and non-performing asset levels have trended lower for the banking sector as a whole, certain loan segments have shown some signs that the credit pendulum may have reached its apex and reversed course by swinging back in the other direction. REITs were net sellers of property in 2016 for the first time since 2009, and a rising rate environment could pressure capitalization rates higher and underlying commercial real estate asset values lower. Furthermore, banks with longer duration fixed rate loans could face a combination of margin pressure and credit quality concerns as rates rise.ConclusionRegulatory guidance suggests a wide range of effective stress testing methods depending on the bank’s complexity and portfolio risk–ranging from “top-down” to “bottom-up” stress testing. The guidance also notes that stress testing can be applied at various levels of the organization including transactional level stress testing, portfolio level stress testing, enterprise-wide level stress testing, and reverse stress testing.We acknowledge that community bank stress testing can be a complex exercise as it requires the bank to essentially perform the role of both doctor and patient. For example, the bank must administer the test, determine and analyze the outputs of its performance, and provide support for key assumptions/results. There is also a variety of potential stress testing methods and economic scenarios for a bank to consider when setting up their test. In addition, the qualitative, written support for the test and its results is often as important as the results themselves. For all of these reasons, it is important that bank management begin building their stress testing expertise sooner rather than later.In order to assist community bankers with this complex and often time-consuming exercise, we offer several solutions, including preparing custom stress tests or reviewing ones prepared by banks internally, to make the process as efficient and valuable for the bank as possible.To discuss your stress testing needs in confidence, please do not hesitate to contact us. For more information about stress testing, click here.This article originally appeared in Mercer Capital's Bank Watch, March 2017.

Eureka! Observations & Thoughts from the Permian DUG Conference

Last week, Mercer Capital attended the DUG Permian Basin Conference in Fort Worth. It was a solidly attended event hosted by Hart Energy. The session speakers were a mix of mostly company executives and industry analysts. The presentations were tinged with a lot of optimism – centered on the positive and unique economics of the Permian, tempered by (some) cautionary commentary. We will follow on in later posts with some more detail on specifics, but today we want to touch on a few thematic elements:The Permian was the center of the M&A activity in 2016 and will be in 2017Efficiency and productivity gains are helping to fuel activityRise in rig counts will eventually mean rise in costsActivity and M&A EpicenterMost of the major M&A deals in the upstream sector were in the Permian Basin in 2016. It is clearly the most sought after basin. According to James Scarlett of RS Energy Group approximately 25% of the U.S.’ lower 48 production came from the Permian Basin and 38% of the rigs in the U.S. are in the Permian. The reason for so much concentration here, as opposed to other plays such as the Bakken or Eagle Ford, is that about 80% of currently economic (economic meaning under $50 breakeven oil) oil is in the Permian, particularly the Delaware Basin.Secondly, due to the numerous potential production zones (Wolfcamp, Bone Spring, Leonard Shale, Delaware Sands, etc.) there is a huge amount of oil in place for potential recovery (3,000 feet of pay zones – or as one presenter described: a “cubic mile of oil”). Couple this with an area (West Texas) that has ample existing infrastructure from decades of development, and this has led to what some people are calling a land grab in the area. According to one presentation, we saw the re-emergence of the “strategic bid” which was a term all but lost since 2014.Efficiency & Productivity GainsOne of the key reasons for the positive economics for the Permian has been the increased gains in production efficiency. Much of this is simply the benefit of the Permian's superior geology; however, even within the play, drilling techniques and new technology have increasingly benefited production. The relative production of wells (measured by MBOE per 1000 feet of lateral drilling) has nearly doubled in the past three plus years: In addition, production type curves are actually exceeding predictions in many cases in the Delaware. This has led to operators considering drilling up to 60 wells per section (effectively 6 acre spacing)! In addition, costs have come down in the past two years by about 25% per perforated lateral foot. However, that cost reduction may be temporary as more demand pours into the Permian. Potential HeadwindsThere were some tempered presentations that noted how as more rigs are needed in the region, that costs will proportionately rise. Much of the cost efficiencies in 2015 and 2016 were a result of an oversupply of rigs, equipment, people, etc. The gap began to shrink at the end of 2016 and is continuing to balance out further in 2017. As a consequence, costs will flatten out and even rise. Early signs of this are already being felt.Although not mentioned much, conference goers were keenly aware that economics may change as well if OPEC decides to abandon its production cuts. This would change the supply balance in world oil prices and could further change the equation. However, this was not a centerpiece of discussion.TakeawaysThe marketplace is excited about the potential for the Permian Basin. One analyst mentioned that up to $100 billion of capital could be available for investment in the near future. Its exceptional economics with potential for outsized wells (3 million EUR) could keep the rig count high for decades. What does this mean from a valuation standpoint? Well, that question lies more on whether the marketplace is already capturing these potentials and risks in valuations. Deals are essentially priced at PDP plus a development program. PDP is pretty straightforward. Whether a development plan is properly valued is another, more complex issue.

How to Value Overriding Royalty Interests

What is a Royalty Interest?Ownership of a percentage of production or production revenues, produced from leased acreage. The owner of this share of production does not bear any of the cost of exploration, drilling, producing, operating, marketing or any other expense associated with drilling and producing an oil and gas well.What is an Overriding Royalty Interest (ORRI)?A percentage share of production, or the value derived from production, which is free of all costs of drilling and producing, and is created by the lessee or working interest owner and paid by the lessee or working interest owner.ORRI’s typically do not own a perpetual interest in the mineral rights. Typically they are structured to have rights to royalties for the term of the lease period. Royalty interests, on the other hand, generally have mineral ownership into perpetuity, even after a lease expires. Thus the main difference between royalty interests and ORRI’s is that royalty interests are tied to the ownership of the mineral rights below the surface, and ORRI’s are tied to the lease agreement and ceases to exist once the lease expires.Some may find it surprising that the popular publicly traded Permian Basin Royalty Trust (PBT) only owns ORRI’s, not royalties, in various oil and gas properties in the United States. PBT owns a 75% net ORRI in the Waddell Ranch properties comprising Dune, Judkins, McKnight, Tubb, University-Waddell, and Waddell fields located in Crane County, Texas. As of December 31, 2016, its Waddell Ranch properties contained 349 net productive oil wells, 64 net productive gas wells, and 102 net injection wells.The company also holds a 95% net overriding royalty in the Texas Royalty properties that consist of various producing oil fields, such as Yates, Wasson, Sand Hills, East Texas, Kelly-Snyder, Panhandle Regular, N. Cowden, Todd, Keystone, Kermit, McElroy, Howard-Glasscock, Seminole, and others located in 33 counties in Texas. Its Texas Royalty properties consist of approximately 125 separate ORRI’s containing approximately 51,000 net producing acres.Over the past four years, crude oil and gas prices have fluctuated significantly. While this is creating significant volatility on the E&P side of the industry on both an operational and investment decision level, many look at royalty trusts as a way to bypass the complexities of an operating E&P and attempt to “pure play” the price of oil and gas. Based upon this assumption, we will analyze the changes PBT has endured over the past four years.Production PBT derives revenue from ORRI’s which cover approximately 382,000 gross acres (85,205 net acres) in west Texas. Since the ORRI’s that PBT owns were not derived from a 100% working interest, their gross acreage differs from their net acreage. Net acreage is calculated as the company’s percentage interest multiplied by its gross acreage. Over the past four years, the amount of acreage has not changed. Production, on the other hand, has changed significantly as shown in the table below. Comparing the production levels to the price levels of oil and gas indicates that even after the decline in oil and gas prices during 2014, production increased during 2015. Oil production increased 3% while gas production increased 44%. The increased production was in part due to the 3 new wells drilled during 2014, 3 workovers completed during 2014 and 29 wells completed during 2014 and 2015. During 2016, investment activity was significantly different which resulted in a 28% decline in oil production and 33% decline in gas production. No wells were drilled and completed during 2016. Only 1 workover was performed. Clearly the operators were holding back capital as they waited for more price certainty in the future. Reserves The change in reserves tells the same story. After investing in the drilling and completion of new wells, and workover wells, the proved reserves increased from 2014 to 2015 for both oil and gas. The increase is significant as reserves are impacted by (1) investment in new/existing wells and (2) future prices of oil and gas. The price utilized in the 2015 reserves was significantly lower than what was used in the 2014 reserves. Therefore, the increase in reserves is significant as the additional proved reserves more than countered the reduction in the commodity prices in the reserve model. For 2016, the reserves declined due to the lack of investment in current and future wells. And while pricing stayed relatively the same from 2015 to 2016, the loss in proved reserves was directly attributed to the lack of investment in new and existing wells. Distributions PBT is at its lowest yield in the last four years. While the price was lower at the end of 2015, the dividend as a percentage of price was higher in 2015 relative to 2016. The above chart shows the impact of (1) changes in oil and gas prices; as well as (2) changes in production levels. These two areas are directly related to the dividend per share. The price, however, is directly related to the movement of buyers and sellers of PBT securities. While the dividend is “trailing” information, because it is the result of the previous 12 months of activity, the price factors in forward looking information. For example, as of 2013, buyers and sellers of PBT were expecting higher dividends in 2014 due to the high price of oil and gas, PBT’s investment in wells and increasing proved reserves1. When commodity prices declined during 2014, the price quickly reflected the new pricing environment, the impact on reserves, and the shift in management’s investment attitude for new and existing wells. All of these factors pressured prices downward while the trailing dividends showed strength, resulting in a higher than normal yield. During 2015 and 2016, the price, dividend and yield settled to relatively tempered levels. All data points above have had enough time to reflect the current environment and as such, are communicating a similar story. Finishing ThoughtWhen valuing a royalty interest or ORRI, here are a few items to keep in mind:Understand the rights and restrictions of the subject royalty interest: Royalty interests may have value into perpetuity as it is a direct ownership in the minerals;ORRI’s typically only have value for the life of the lease;Understand the differences between the subject ORRI and a publicly traded security that owns ORRI’s and make adjustments for the differences;Understand the historical, current and future outlook for commodity prices relating to the subject ORRI;Understand the historical, current and future outlook for reserves;Utilize publicly traded yields to assess the markets attitude for investments in similar securities; andAdjust for the differences between a publicly traded security and a non-marketable security. When comparing a royalty interest to an ORRI, it is critical to understand the subtle nuances of the rights and restrictions between the two. Owners of royalty interests utilizing PBT as a valuation gauge should adjust for such differences as well as other differences between publicly traded and non-marketable securities. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed. End Note1 Although not shown in the above chart, proved reserves increased 32% between 2012 and 2013 for PBT

Excuse Me, Flo?

Inflows and Outflows Drive Disparity in Performance between Different Classes of Asset Managers

Immediately before ordering the Soup Du Jour and duping Sea Bass into picking up his lunch tab, Jim Carrey’s character in Dumb and Dumber, Lloyd Christmas, rudely accosts his waitress at the Truk-Stop Diner with this inexplicable reference to the early 1980s sitcom starring Polly Holliday as Florence Jean “Flo” Castleberry. Decades after the movie’s release in 1994, the market seems to be postulating the same question in pricing RIAs. Breaking out the recent performance of various classes of asset managers, we see those sectors that are least dependent on active management (trust banks and traditional managers) as clearly outperforming those more reliant on investment returns (alternative asset managers and mutual funds). While there are other factors at work (a steepening yield curve and hedge fund scandals to name a few), this disparity is largely attributable to investment performance and the impact it has on asset flows. We touched upon this topic in last week’s post, and basically AUM gains (the primary driver of revenue and profitability for an RIA) are attributable to one or two sources – market gains or client inflows (net of outflows). Since one can’t rely on stocks to always go up, asset flows are a more reliable gauge of an RIA’s sustainable performance regardless of market conditions. As shown above, there is a strong correlation between publicly traded RIAs and the market, so the disparity in performance between the various classes of asset managers is largely attributable to net asset flows. Subpar investment performance and the recent flight to passive products have plagued alternative asset managers and mutual funds, but benefited index providers with more competitive fees. The market has taken notice and continues to bid up the valuations of passive managers with positive inflows. Part of this outperformance may also be due to the anticipation of more favorable regulation (e.g. the Fiduciary Rule) surrounding passive investors over active management. Stephen Tu, Senior Analyst at Moody’s Investor Service, says, “Under the new regulation, advisors are expected to ensure investments are in the best interests of their clients, rather than merely suitable for them. In practice, it will become more difficult for advisors to place their clients into higher-cost and more complex investment products. Selling low-fee index products, on the other hand, will eliminate many apparent conflicts of interest and minimize fiduciary risk.” In response, many traditional active managers like Janus Capital, Legg Mason, and Franklin Resources have begun offering passive products to take advantage of the prevailing trend. Despite the high fees and underperformance, we’re not characterizing mutual fund and alternative asset investing as dumb and dumber. The reality is that many active managers do outperform their benchmarks and justify their fees. A proven track record of alpha generation will likely continue to attract assets from institutional clients even if fees aren’t competitive to an ETF that tracks a given benchmark or asset class. It’s just that beating the market on a consistent basis is a near impossible feat, so most active managers are struggling to keep pace with the rise of passive products that offer a cheaper and more reliable alternative. Much like Harry and Lloyd’s rapid accumulation and subsequent squandering of other people’s money, active managers must improve their performance or lower their fees to avoid a similar fate.

The Wild Goose Chase Is Over

The Great Y2K scare led to approximately $134 billion in preparation for the world-altering event. The belief that computers would malfunction and the world as we then knew it would end at midnight of December 31, 1999, led all major companies and many families to seek out help in preparation for the event, no matter the cost. When the clocks struck midnight and everything but a few slot machines in Deleware continued running, we moved on to planning the next apocalyptic event – what if oil runs out?From 2000 to 2005, “concerns that supply could run out and soaring oil prices sent energy companies on a grand, often wildly expensive, chase for new production.” They were investing in multi-billion-dollar projects in the Arctic waters and Kazakhstan’s Captain Sea. A WSJ article titled, “Oil Companies Take Thrifty Bets,” explained that when oil was worth $100 per barrel oil companies had much higher risk tolerance and were able to invest heavily in the exploration of undeveloped land and ocean. But as the price of oil declined and has settled around $50 per barrel, the wild goose chase for oil has come to an end.Declining Capital ExpendituresWe are facing a different kind of supply crisis than previously imagined. Bloomberg analysts forecast that if OPEC cannot come to an agreement to extend cuts, it is forecasted that oil prices will fall to $40 per barrel. And if oil falls to $40 per barrel then much of the drilling activity that surged in the Permian Basin is expected come to a halt. Oil companies today can only focus on decreasing costs and reducing risks in order to stay afloat in an oversupplied market. From 2014 to 2016, capital expenditures of the E&P companies, shown below, declined, on average, by 64%. In mid-2014 when the price of oil fell, exploration and production companies struggled to continue pumping oil from current wells. In order to fund day-to-day operations, companies had to pull the plug on most of their capital projects. Now that the price of oil has settled around $50 per barrel, exploration and production companies have begun to allocate small portions of their budget to research for new reserves and the exploration of new wells. Even as exploration and production companies’ revenues declined dramatically, capital expenditures shrunk from an average of 71% of revenues in 2011 to 43% of revenues in 2016. However, as capex budgets are shrinking, the cost to explore and drill new wells is increasing. The price of fracking sand has increased recently as companies drill wells deeper in order to find efficiencies of scale. Deeper drilling, however, requires larger amounts of sand. As fracking has become more common, drilling in shale fields requires approximately 30% more sand every year. Although the price of fracking sand is still below $60 to $70 per ton, where it was before crude prices fell, Mr. O’Leary, director of oil-field services research at Tudor Pickering thinks that the price of sand will rise to $50 a ton this year. Last fall the cost of sand accounted for between 5% and 7% of the cost of a well but Mr. O’Leary expects that percentage to rise as exploration and production companies increase their usage of fracking sand this year. Further he said, “The millions of pounds of sand being poured down wells is pushing up sand prices, eroding some of the profits that energy companies have managed to regain since the oil bust ended.” In order to protect themselves from higher costs and shortages in fracking sand, some companies such as Pioneer Natural Resources have purchased their own sand mines. In order to reduce costs and minimize risk, companies are looking for investments with shorter payback periods. Exxon, BP, Shell, and Chevron are investing in quick ventures in Texas and in existing projects in the Middle East and Brazil. Companies are looking back at old basins to see if new technologies can be used to extract any remaining resources. This is a big shift for companies who used to believe that the large upfront costs that would be paid off over 20 to 30 years generated the best return. But what does the decline in capital expenditures today mean for supply and prices tomorrow? Due to the advancement of technology and the speed at which companies can bring new projects online, it is not likely that we will see a supply shortage any time soon. Rather low oil prices seem to be the new normal. When oil prices hit $60 then certain DUCS will be economical and will be brought online. And when oil hits $70… there will be more DUCs ready to be completed. Mercer Capital has significant experience valuing assets and companies in the energy and construction industries. Our valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

RIA Performance Metrics: Keep an Eye on Your Dashboard

A persistent truth about investment management is that no analyst ever saw a piece of information he or she didn’t want. Professional investors are, by their very nature, research hounds – digging deep into a prospective investment’s operating model, financials, competitive landscape, management biographies, and whatever else might be relevant to try to evaluate the relative merit of buying into one idea instead of another. This same diligence doesn’t always extend to practice management, though, and we are not infrequently surprised at how little attention management teams at RIAs devote to studying their own companies.I was pondering this vexing irony recently during a long family road trip. My older daughter is sixteen and wanted to do her part of the driving, which her mom and I were happy to oblige. That said, sitting in the passenger seat is somewhat unnatural for me, and I couldn’t stop nervously looking over at the speedometer as it crept five, seven, ten, twelve miles per hour over the speed limit. It didn’t help knowing that my daughter is related to me.When I was sixteen, a friend of my parents came over for dinner in his new Jaguar XJ6. It was British Racing Green, with biscuit leather seats and wool carpet that smelled like the countryside west of London where Wilton sheep still graze among stone-circles built by Druids. This was the 1980s, and there weren’t many fast cars made at the time – especially sedans. The Jaguar had four doors, but it also had the same motor derived from the XK series of the 1950s and 60s, a low center of gravity, and a set of Pirelli racing tires. I was enthralled. “Wanna drive?” He didn’t have to ask twice.Off we went into the Georgia summer evening, looking for uninhabited roads with long straight-ways. “You can wind her out some if you want to; she stays pretty stable at speed.” She did, and before long we were approaching triple digits. I couldn’t stop staring at the speedometer, pondering my good fortune at knowing an enabling adult with a new Jaguar – my dream (or at least one of them). The XJ6 could do about 135 mph, but we topped out just shy of 120 before a reasonably sharp curve and a bridge appeared in front of us, and I had to back off the right pedal. “We’ll do this again sometime when you can really open her up,” I was told. Good thing that never happened, and also good that another friend of my parents, who drove a Ferrari, never offered the same.Looking back on my first experience with speed I’m struck by two things: 1) my parents’ friend was remarkably calm given the circumstance, and, 2) I was far too fixated on the dashboard instead of the road. Most XJ6 owners are well served to keep an eye on the engine temperature gauge, but anyone traveling north of 100 mph only needs to be looking at one thing: the road ahead.RIA teams, by contrast, seem inclined to the opposite. If the “road ahead” for an RIA is the financial markets, and the dashboard offers a read on the firm’s internal performance, it seems like many investment managers never look down.Gauging performance for an RIA is often thought of in terms of the portfolio, particularly for product companies that specialize in particular strategies. But even though performance, in theory, should drive AUM flows, capital markets are fickle, and so can be customer behavior. So we prefer to start with a decomposition of AUM history, and then explore the “why” from there.Consider the following dashboard that breaks down the revenue growth of an example RIA. Over a five year period, this RIA boasted aggregate revenue growth of more than 50%, increasing from $3.7 million to $5.7 million. AUM growth was even more substantial, nearly doubling from $600 million to over $1.1 billion. Looking deeper, though, we notice a couple of unsettling trends. The five year period of measurement, 2012 through 2016, represent a bull market from which this RIA likely benefited substantially. Cumulative gains from market value were over $700 million, more than the total growth in AUM and masking the loss of clients over the period examined. Markets cannot always be counted on for RIA growth, so client terminations, totaling $285 million over the five year period or nearly half that of beginning AUM in 2012, is cause for concern. This subject RIA only developed $35 million in new accounts over five years, and we notice what appears to be an accelerating trend of withdrawals from remaining clients. Further, there appears to be loss in value of the firm to the marketplace. Realized fees declined four basis points over five years. Had the fee scheduled been sustained, this RIA would have booked another $372 thousand in revenue in 2016, all of which would have dropped to the bottom line. Pre-tax margins would have been almost seven percentage points higher. Small changes in model dynamics have an outsized impact on profitability in asset management firms, thanks to the inherent operating leverage of the model. But the materiality of these “nuances” can be lost in more superficial analysis of changes in revenue. So, we would ask, what’s going on? Did this RIA simply ride a rising market while neglecting marketing? Are clients concerned about something that is causing them to leave? Does this RIA suffer from more elderly client demographics that accounts for the runoff in AUM? If the RIA handles large institutional clients, did some of those clients rebalance away from this strategy after a period of outperformance? Is their realized fee schedule actually declining, or is it not? Is the firm negotiating fees with new or existing clients to get the business? Did a particularly lucrative client leave? What is happening to the fee mix going forward? Decomposing changes in revenue for an investment management firm can prompt a lot of questions which say more about the performance of the firm than simply the growth in revenue or AUM. Yet when we ask for this information from new clients, it isn’t unusual for us to hear that they don’t compile that data. All should. Some teenage drivers pay too much attention to the dashboard, some RIA managers not enough. The risk to both is the same: ending up in the ditch.

How to Perform a Purchase Price Allocation for an Exploration and Production Company

This guest post first appeared on Mercer Capital’s Financial Reporting Blog on January 18, 2016. When performing a purchase price allocation for an Exploration and Production (E&P) company, careful attention must be paid to both the accounting rules and the specialty nuances of the oil and gas industry. E&P companies are unique entities compared to traditional businesses such as manufacturing, wholesale, services or retail. As unique entities, the accounting rules have both universal rules to adhere as well as industry specific. Our senior professionals bring significant experience in performing purchase price allocations in the E&P area where these two principles collide. For the most part, current assets, current liabilities are straight forward. The unique factors of an E&P are found in the fixed assets and intangibles: producing, probable and possible reserves, raw acreage rights, gathering systems, drill rigs, pipe, working interests, royalty interests, contracts, hedges, etc. Different accounting methods like the full cost method or the successful efforts method can create comparability issues between two E&P’s that utilize opposite methods. We will explore the unique factors in future entries. In this blog post, we discuss the guidelines for purchase price allocations that all companies must adhere. Reviewing a purchase price allocation report can be a daunting task if you don’t do it for a living – especially if you aren’t familiar with the rules and standards governing the allocation process and the valuation methods used to determine the fair value of intangible assets. While it can be tempting as a financial manager to leave this job to your auditor and valuation specialist, it is important to stay on top of the allocation process. Too often, managers find themselves struggling to answer eleventh hour questions from auditors or being surprised by the effect on earnings from intangible asset amortization. This guide is intended to make the report review process easier while helping to avoid these unnecessary hassles. Please note that a review of the valuation methods and fair value accounting standards is beyond the scope of this guide. Grappling with these issues is the responsibility of the valuation specialist, and a purchase price allocation report should explain the valuation issues relevant to your particular acquisition. Instead, this guide focuses on providing an overview of the structure and content of a properly prepared purchase price allocation report.General RulesWhile every acquisition will present different circumstances that will impact the purchase price allocation process, there are a few general rules common to all properly prepared reports. From a qualitative standpoint, a purchase price allocation report should satisfy three conditions:The report should be well-documented. As a general rule, the reviewer of the purchase price allocation should be able to follow the allocation process step-by-step. Supporting documentation used by the valuation specialist in the determination of value should be clearly listed and the report narrative should be sufficiently detailed so that the methods used in the allocation can be understood.The report should demonstrate that the valuation specialist is knowledgeable of all relevant facts and circumstances pertaining to the acquisition. If a valuation specialist is not aware of pertinent facts related to the company or transaction, he or she will be unable to provide a reasonable purchase price allocation. If the report does not demonstrate this knowledge, the reviewer of the report will be unable to rely on the allocation.The report should make sense. A purchase price allocation report will not make sense if it describes an unsound valuation process or if it describes a reasonable valuation process in an abbreviated, ambiguous, or dense manner. Rather, the report should be written in clear language and reflect the economic reality of the acquisition (within the bounds of fair value accounting rules).Assignment DefinitionA purchase price allocation report should include a clear definition of the valuation assignment. For a purchase price allocation, the assignment definition should include:Objective. The definition of the valuation objective should specify the client, the acquired business, and the intangible assets to be valued.Purpose. The purpose explains why the valuation specialist was retained. Typically, a purchase price allocation is completed to comply with GAAP financial reporting rules.Effective Date. The effective date of the purchase price allocation is typically the closing date of the acquisition.Standard of Value. The standard of value specifies the definition of value used in the purchase price allocation. If the valuation is being conducted for financial reporting purposes, the standard of value will generally be fair value as defined in ASC 820.Statement of Scope and Limitations. Most valuation standards of practice require such statements that clearly delineate the information relied upon and specify what the valuation does and does not purport to do.Background InformationThe purchase price allocation report should demonstrate that the valuation specialist has a thorough understanding of the acquired business, the intangible assets to be valued, the company’s historical financial performance, and the transaction giving rise to the purchase price allocation.Company OverviewDiscussion related to the acquired company should demonstrate that the valuation specialist is knowledgeable of the company and has conducted sufficient due diligence for the valuation. The overview should also discuss any characteristics of the company that play a material role in the valuation process. The description should almost always include discussion related to the history and structure of the company, the competitive environment, and key operational considerations.Intangible AssetsThe intangible assets discussion should both provide an overview of all relevant technical guidance related to the particular asset and detail the characteristics of the asset that are significant to the valuation. The overview of guidance demonstrates the specialist is aware of all the relevant standards and acceptable valuation methods for a given asset.After reading this section, the reviewer of the purchase price allocation report should have a clear understanding of how the existence of the various intangible assets contribute to the value of the enterprise (how they impact cash flow, risk, and growth).Historical Financial PerformanceThe historical financial performance of the acquired company provides important context to the story of what the purchasing company plans to do with its new acquisition. While prospective cash flows are most relevant to the actual valuation of intangible assets, the acquired company’s historical performance is a useful tool to substantiate the reasonableness of stated expectations for future financial performance.This does not mean that a company that has never historically made money cannot reasonably be expected to operate profitably in the future. It does mean that management must have a compelling growth or turn-around story (which the specialist would thoroughly explain in the company overview discussion in the report).Transaction OverviewTransaction structures can be complicated and specific deal terms often have a significant impact on value. Purchase agreements may specify various terms for initial purchase consideration, include or exclude specific assets and liabilities, specify various structures of earn-out consideration, contain embedded contractual obligations, or contain other unique terms. The valuation specialist must demonstrate a thorough understanding of the deal terms and discuss the specific terms that carry significant value implications.Fair Value DeterminationThe report should provide adequate description of the valuation approaches and methods relevant to the purchase price allocation. In general, the report should outline the three approaches to valuation (the cost approach, the market approach, and the income approach), regardless of the approaches selected for use in the valuation. This demonstrates that the valuation specialist is aware of and considered each of the approaches in the ultimate selection of valuation methods appropriate for the given circumstances.Depending on the situation, any of a number of valuation methods could be appropriate for a given intangible asset. While selection of the appropriate method is the responsibility of the valuation specialist, the reasoning should be documented in the report in such a way that a report reviewer can assess the valuation specialist’s judgment.At the closing of the discussion related to the valuation process, the report should provide some explanation of the overall reasonableness of the allocation. This discussion should include both a qualitative assessment and quantitative analysis for support. While this support will differ depending on circumstances, the report should adequately present how the valuation “hangs together.”Something to RememberA purchase price allocation is not intended to be a black box that is fed numbers and spits out an allocation. The fair value accounting rules and valuation guidance require that it be a reliable and auditable process so that users of financial statements can have a clear understanding of the actual economics of a particular acquisition. As a result, the allocation process should be sufficiently transparent that you are able to understand it without excessive effort, and the narrative of the report is a necessary component of this transparency.

A Bright Spot at the Bottom of the Barrel

How has the Asphalt Industry been Affected by Depressed Oil Prices?Asphalt and road oil are used primarily by the construction industry for roofing and waterproofing and for road construction. Asphalt is a byproduct of petroleum refining. During the distillation process of crude oil, asphalt does not boil off and is left as a heavy residue. Generally around 90% of crude is turned into high margin products such as gasoline, diesel, jet fuel, and petrochemicals while the other 10% is converted into asphalt and other low margin products. Petroleum refiners sell asphalt to asphalt product manufacturers who produce retail products such as asphalt paving mixtures and blocks; asphalt emulsions; prepared asphalt and tar roofing and siding products; and roofing asphalts and pitches, coating, and cement. Demand for asphalt products is determined by the health of the construction industry and the level of infrastructure funding. How has the Construction Industry Impacted Demand for Asphalt?Spending on construction in December 2016 increased 0.2% from November 2016 and 4.2% from December 2015 to $1.18 trillion. After several years of steady growth followed by decelerating growth in 2016, Dodge Data & Analytics forecasts total construction starts will increase by 5% in 2017 reaching $713 billion. AIA believes that factors such as job growth, consumer confidence and low interest rates have propelled construction spending.How has Funding for Infrastructure Impacted Demand for Asphalt?About 93% of the 2.2 million miles of paved roads and highways in the U.S. are paved with asphalt. Most road construction is funded by states, counties, or other federal programs. Thus demand for asphalt and road oils are largely dependent on the level of funding available. During the recession most local governments collected less revenue and could not afford investment in infrastructure. Both federal and state level taxes designed to generate revenue for transportation use a per-gallon fuel tax. Due to increasing fuel efficiency and lower gas prices, fuel taxes have generated less money. Further, the 18.4 cent-per-gallon federal gas tax has not been increased in more than twenty years and has not kept up with inflation or increasing costs. Some states have increased their state gas tax in order to fund these programs, but funding of infrastructure over the last decade has generally been insufficient.For the past decade, the federal government has been funding transportation for short periods of time using extensions of previous plans. In August 2005, the Safe, Accountable, Flexible, Efficient Transportation Equity Act: A Legacy for Users (SAFETEA-LU) was signed into law. In July 2012, after multiple extensions of the SAFETEA-LU, the Moving Ahead for Progress in the 21st Century Act (MAP-21) was passed by Congress. MAP-21 extended SAFETEA-LU for the remainder of 2012, with new provisions for FY 2013 and beyond. Funding levels were maintained at FY 2012 levels with minor adjustments for inflation.President Obama signed the FAST (Fixing America’s Surface Transportation) Act in December of 2015. The FAST Act provided $305 billion from 2016 to 2022 for programs to improve highways, highway and motor vehicle safety, and other critical transportation projects. Included in this legislation is a new National Highway Freight Program which will focus most of its funding on highways. The legislation also aims to reduce administrative and bureaucratic obstacles allowing the DOT to delegate project oversight to states on a project and programmatic basis.While investment did modestly increase in 2016, it is likely that demand will pick up more in 2017 as projects funded by the FAST Act start being implemented. Mike Acott, president of the National Asphalt Pavement Association (NAPA) said that the most significant change since the FAST Act was passed has been a pickup in resurfacing activity. Resurfacing roads is a much cheaper alternative to repaving and many local governments were able to work the resurfacing of roads into the limits of their tight budgets. Increased demand for repaving materials led to industry innovation and new product developments to meet this demand.How did the Asphalt Industry Perform in 2016?As the price of crude oil fell so did the price of asphalt sold by petroleum refineries. Crude oil prices fell by 50% from June 2014 to January 2017 (the most recent PPI data available for asphalt) while asphalt prices fell 55% over this same time period. Refiner’s margins generally increased in 2015 and fell over the last year. As shown in the chart above, the movement of refined product prices lags changes in crude prices. Thus in 2015, refiners purchased crude for cheaper prices than before but sold their products at the same prices. In 2016 however, asphalt prices began to fall and margins narrowed. Marathon reported that their asphalt operations were weaker than their “exceptionally strong” year of operations in 2015. Analysts expect the price of asphalt to increase over the next few years. As refining technology improves refiners are able to produce more gasoline out of a barrel of oil leaving less to be made into paving grade asphalt. This reduction in supply will likely increase asphalt prices. As the price of crude fell, refiners margins narrowed, which led to a decrease in cost of goods sold for asphalt manufacturers resulting in a pickup in earnings. Because of the impact of transportation costs on the industry and the quick hardening time of ready mix asphalt, competition is based primarily on location and price. In general asphalt manufacturers’ margins increased in 2016 as their cost of goods fell. Vulcan Materials, Inc. (VMC) produces aggregates and ready mix asphalt in Birmingham, Alabama. Its asphalt mix segment’s gross profit increased 25% in 2016. While sales volume and sales price declined by 3% and 2%, respectively the cost of goods sold decreased and expanded the Company’s gross profit margin by 4.3 percentage points. Martin Marietta (MLM), which produces aggregate and asphalt products in North Carolina, realized a 15.7% gross profit margin in its asphalt and paving segment in 2016 compared to a 12.6% margin in 2015. How will the Asphalt Industry Perform in 2017?Going forward investment in infrastructure is expected to increase. After many states cut infrastructure funding, there is currently much work that needs to be done to improve the conditions of roads and highways. As state and local government budgets have improved since the recession, it is anticipated that tax revenue available for investment in road infrastructure will expand. Additionally, President Trump, during his campaign, pledged to invest $1 trillion in infrastructure in order to spur economic growth. Finally, prices for cement, which is a substitute for asphalt, are expected to rise which will increase the demand for asphalt. Overall, industry revenue is expected to increase by 2.3% over the next five years.1Mercer Capital has significant experience valuing assets and companies in the energy and construction industries. Our valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.End Note1 IBIS World Report 32412: Asphalt Manufacturing in the US: October 2016

An All-Terrain Clause for your RIA’s Buy-Sell Agreement

Clients writing new buy-sell agreements or re-writing existing ones frequently ask us how often they should have their RIA valued. Like most things in life, it depends. We usually recommend having a firm valued annually, and most of our clients usually do just that. “Usually,” though, is subject to many specific considerations.How many shareholders are there in the RIA? The more owners you have, the more transactions will occur and the more useful a semi-annual or quarterly valuation might be. Small firms with only a couple of owners typically don’t need to know their value on an annual basis, but checking in on some scheduled basis – such as every two or three years – is helpful to keep track of firm performance, update any life insurance coverage, and to plan for succession issues or sale of the firm.Is your firm growing rapidly? If so, an annual valuation might become stale very quickly. Mature firms probably only need to look at their valuation metrics once per year to see how their performance and outlook compares with the greater market for investment management firms.Even annual valuations can be inadequate, however, when an RIA experiences big increases or decreases in assets under management. Since we have been operating in a low volatility market (at least for U.S. equities) for some time, it’s easy to forget that normal, but nonetheless major, market swings can have a material impact on profitability and valuation. In the case of a market swoon, even a mature RIA with healthy margins can lose ground rapidly, and a valuation that looked reasonable six months earlier may no longer be practical. Consider an equity manager with $2 billion of AUM, realized fees of 60 basis points, and a 40% EBITDA margin. If the regular annual valuation is prepared at an effective EBITDA multiple of 9x, then enterprise value would come in at around $43 million.One might expect that a valuation such as that would satisfy the needs of an investment management firm over the course of a year, until the time came for the next update. Markets are fickle, though. Imagine the same RIA endures a significant market downturn late in the summer, and then an event happens which triggers the buy-sell. AUM drops 20% versus the start of the year, nothing changes in the expense base, and the valuation multiple is steady. Because of the inherent operating leverage in the asset management business, the profit margin drops from 40% to 25% on 20% lower revenue, and because of that compounding effect value declines by half. This example has more simplifying assumptions than not, and most firm valuations would not move so dramatically just because of a 20% downturn in AUM. That said, market events and client whims can have an outsized impact on RIA profits and, consequently, valuation, such that an annual valuation may not hold up over the course of a year. So what’s a firm to do? One option, of course, is to accept the vagaries of the market – any unusual events during the course of the year may be just as temporary as conditions at the annual valuation date. One of the functions of the buy-sell agreement is to get the parties to agree to what they are willing to live with, and what they are willing to live without. Many firms do just that. This brings me to the subject of the photo above. European rally car races have always fascinated me, although I’ve never been brave enough to actually attend one. During the 1980s Audi ruled the rally scene with the Ur-quattro. The Ur-quattro was a hatchback that Audi developed after the racing rules were changed in the late 1970s to allow four-wheel drive. The Audi could handle anything, and to underscore that point the manufacturer used both Italian (“quattro” for four wheel drive) and German (“Ur” for primordial or original) to name it. Regardless of snow, mud, gravel, flat curves or deep hills, the Ur-quattro couldn’t be beat. Audi’s rally reputation was such that they started to offer the quattro system in all of their passenger cars, and all-wheel drive has become commonplace today – from Subaru to Lamborghini. A client of ours that is drafting a new buy-sell agreement recently brought us an idea which we think offers a similar level of preparation for any circumstance. In their agreement, they’ve added a provision which would call for an interim update to their otherwise annual valuation if 1) the prospect of a transaction arises and 2) AUM is more than 10% higher or lower than at the time of the previous valuation. The annual valuation is important to set a pattern of expectations for parties to the buy-sell of how they’ll be treated in a transaction, and most of the time will suffice when a transaction occurs. Adding the update provision is a simple way to prepare for the possibility of substantial changes in the financial performance of the RIA. Even if they never use the provision, having it offers peace of mind for parties to the agreement that they’ll be treated fairly if the company’s performance changes radically over the course of the year. In the decades since the Ur-quattro was introduced, Audi has sold cars with quattro to millions of people whose morning commute is nothing like a rally race. Most people buy all-wheel drive cars for that “just-in-case” moment that will make the added expense worth it. Like all-wheel drive, you may never need an event-based update provision in your buy-sell agreement. It’s nice to know, though, that your buy-sell is all-terrain ready, no matter how rough the ride gets.

Looking through the Buffett Brouhaha

The Oracle Still Believes in Human Innovation

Since I gave up politics for Lent this year, I’ve had more time to keep up with the deeper recesses of the financial press, which led me to Warren Buffett’s annual letter to the shareholders of Berkshire Hathaway. Buffett’s prose is a literary genre unto itself; a remarkably plain-spoken approach to making even the most complex and dull aspects of investment management simple and entertaining. If all “management letters” were penned as well, shareholders might actually read them. Perhaps that’s why they aren’t.Press coverage of Buffett’s letter this year focused almost exclusively on the sections extolling the virtues of passive investing. Buffett updates us on his million dollar bet that a selected group of hedge funds won’t beat the S&P 500, after fees, over a ten year period; nine years in he’s winning handily. He nominates Jack Bogle for sainthood, and bemoans that wealthy people have squandered an estimated $100 billion (his estimate) on elaborate investment strategies that haven’t been as effective as index funds. In one of the more colorful passages in the letter, Buffett tells a family story that, while not directly addressing investment performance reporting standards, could be interpreted that way:Long ago, a brother-in-law of mine, Homer Rogers, was a commission agent working in the Omaha stockyards. I asked him how he induced a farmer or rancher to hire him to handle the sale of their hogs or cattle to the buyers from the big four packers (Swift, Cudahy, Wilson and Armour). After all, hogs were hogs and the buyers were experts who knew to the penny how much any animal was worth. How then, I asked Homer, could any sales agent get a better result than any other? Homer gave me a pitying look and said: “Warren, it’s not how you sell ‘em, it’s how you tell ‘em.”Buffett’s story could be the forward to the next edition of GIPS Standards; all you need is the right benchmark.All of this is, of course, a little hard to take from Warren Buffett. Not only has he made a (very successful) career out of asset management, he has previously been emphatically against spreading investment bets across too many assets – as one would in an index. Buffett and his longtime partner, Charlie Munger, have more than once characterized such breadth as “di-worse-ification.” Munger’s famous quote about bad mergers - “If you mix raisins with turds, they are still turds” – could equally apply to index investing, where the algorithm is to overweight Blockbuster and underweight Netflix. Despite a lengthy and successful career focusing on a few investments, Buffett appeared to have changed his mind.Predictably, there has been plenty of umbrage taken by the investment management community over the past week because of this. It doesn’t help that Moody’s latest quarterly Investors Service report tallied continued outflows from active managers in the fourth quarter of 2016. However, I’m not sure that this is the right time for portfolio managers to beat their chest and defend their alpha. For all of Buffett’s broadsides, this year’s letter is practically an apologia for active management.By my count, Berkshire Hathaway has beaten the S&P 500 in 34 of its 52 years, but more impressive than winning two thirds of the time is the order of magnitude. While the S&P 500 has produced a total compound annual return of 9.7% since 1965, Berkshire Hathaway has produced more than double that return, at 20.8%. Thanks to compounding, the aggregate return of Berkshire is 155 times that of the index. That’s a lot of alpha, and it isn’t just restricted to the early years. Berkshire has beaten the S&P 500 in seven of the last ten years, producing an average return 2.1% better than the index, and doubling the index return last year.The bulk of Buffett’s letter endorses active management. Berkshire Hathaway morphed over time from a stock-picking firm to one that also wholly owns businesses (the extreme end of active management). Consequently, when Buffett is particularly proud of one of Berkshire’s investments, he takes great pains to praise the humans who run those businesses. In particular, Buffett notes the accomplishments of his insurance company management teams who make profits out of managing underwriting risk and superior investment performance off of those companies’ float. And, as usual, Buffett gloats on Munger, noting that regardless of the future developments of artificial intelligence: “I will confidently wager that no computer will ever replicate Charlie.”The bulk of Buffett’s criticism of the hedge fund industry focuses on fees. He estimates that approximately 60% of the gains produced by the five hedge funds be measured against the S&P 500 were allocated to the fund managers. The issue seems not so much the value of humans in investment management, but the cost.

Are S&P Energy Stock Valuations Really Crazy Right Now?

A few days ago the Wall Street Journal published an article discussing what the author described as “crazy” stock valuations, and in particular the inflated valuations of oil and gas stocks from the perspective of operating earnings ratios.“The energy sector stands at more than 30 times Thomson Reuters IBES’s estimate of operating earnings over the next 12 months, higher than any time from when the sector data started in 1995 up to last year – when it briefly reached an extreme of almost 60 times.”The article also mentions that the S&P 500 as a whole is trading at almost 18 times estimated future operating margins. This got us to thinking - In light of what has transpired over the past two plus years in the energy sector, could it really be that stocks are overvalued? That certainly hasn’t been the sentiment that we hear from our clients. Maybe we’re all wrong? If so, what could be driving this?While we certainly are believers that value is driven by future operating earnings, and that earnings in the energy sector have fallen precipitously since 2014, is this all that determines the market’s pricing of the S&P 500 energy sector? As we reflect on this for a moment, a few additional considerations came to mind that may explain these “crazy” valuations more fully.Anticipated Tax ReliefOne consideration not captured in an operating earnings ratio that markets are using to impact values is expectations for future tax reform. Since the new administration has been inaugurated the stock market has risen significantly. Clearly, one of the sources of this market optimism is the platform of tax reform – including corporate taxes. There are a number of sources describing what this new structure may look like. One particularly insightful article was written by Jason B. Freeman in the January/February issue of Today’s CPA titled "Tax Reform Under a Trump Administration".President Trump’s plan would drop the corporate tax rate from 35% (among the highest in the world) to 15% or 20%. This would immediately bring tax relief at a corporate level and boost earnings. Judging by the equity market’s early reaction this morning to Mr. Trump’s State of the Union address, in which he highlighted this issue, anticipation of this action is fueling higher stock prices.Anticipated Regulation ReformThe market may also be considering the future impact President Trump’s regulation reform. While there is much uncertainty surrounding the future regulation of the oil and gas industry, President Trump ran as a friend to the oil and gas sector and promised to reduce regulations on the industry in order to boost the U.S. economy. Additionally, Oklahoma Attorney General Scott Pruitt was confirmed as the Environmental Protection Agency administrator. Pruitt has openly opposed the EPA, which is one of the main regulators of the oil and gas industry. Looser regulations on the oil and gas industry could reduce operating expenses associated with meeting current regulation and could provide new opportunities for the industry.Growth UnderpinningsThe energy sector has been hit hard, but a less visible aspect of the WSJ article’s premise is that there are signs that the energy sector’s depression in earnings may be short lived and the market is forecasting a rebound. Consider this, the price of oil is at or near decade lows and earnings are sensitive to commodity prices, particularly when the price of oil hovers close to breakeven costs for producers (which it is currently). Slight upward changes in oil and gas prices could have significant upward impacts on profits. In addition, due to the drop in commodity prices, the industry has responded by innovating and pushing costs downward for drilling shale wells.Reserves Reserves Reserves!Another aspect that can’t be detected by an operating earnings ratio is how awash in reserves we currently are. U.S. crude oil inventories have hit all-time highs, and demonstrate how poised the energy sector is to respond to manufacturing and consumer growth. Reserves are the foundation of value for E&P companies which is why this metric is oftentimes much more important than mere earnings. It shows the potential for earnings 5 to 10 years or even 20 years down the road, which is something one year earnings estimates do not consider. Better ratios to consider here are equity values relative to daily or annual production or total proved reserves. The Big PictureAt any given moment it can be hard to say if equities, sectors or companies are “overvalued”. Valuation is relative to begin with and ultimately at a point in time the “value” is what market participants will pay. As it pertains to oil and gas companies, it appears clear that earnings are low as the sector better copes with $50-55 oil and $3 gas. However, the market appears to see brighter days ahead, beyond 2017 and that confidence along with optimism for tax reform, operating efficiencies, and positioning for future growth are buoying prices. Perhaps investors aren’t crazy after all. Of course that’s just my opinion….I could be wrong.

Q4 Call Reports

Despite gaining 8% last quarter, publicly traded RIAs are still feeling the pressure from the regulatory overhang on the Fiduciary Rule and continued fee compression on most investment products. The proposed DOL rule prohibits compensation models that conflict with the client’s best interests and is expected to induce active managers to provide lower-cost or passive products and to complete the shift from commission-based to fee-based accounts. Still, many industry participants see opportunity amidst these headwinds, and the market for these businesses seems to as well.As we do every quarter, we take a look at some of the earnings commentary of pacemakers in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Continued fee pressure and chronic underperformance have caused many traditional RIAs to consider expense caps or variable fee structures that toggle with performance.There is no doubt that investors have felt more comfortable with what is perceived to be low cost and safe passive investing versus choosing active managers at higher fees and suffering on average, because that’s what the average numbers show, underperformance net of a fee. – Alliance Bernstein’s Peter KrausI would say, in general, that we are trying to do something different and say to clients, if we don’t perform, we don’t expect to be paid more than five basis points, and if we do perform, subject to all the limitations in those documents, we would expect that clients would be happy to pay us, and that is a pretty competitive offering to the passive world. – ibidThat’s something we think can be very useful answer to some of these high pressures around just fees and rationalizing versus passive is only paying on the alpha. And that’s something that we certainly are looking at. I don’t think we have the same kind of pressure on the retail side, nor do we think it makes a lot of sense certainly on the institutional side. We think that could be very additive to our overall line-up. – Franklin Resources’s Greg JohnsonTheme 2: The shift from active to passive management is a major headwind for many alpha hunters, but the best in class performers see opportunity for increased market share when the dust settles.Disruption was also a major theme in our industry. Asset flows into passive products continue to accelerate. The availability of these products and the perception that they are low cost, and in many cases lower risk is impacting all aspects of the investment management industry. As a high value-added investment manager, we welcome disruption in the industry. That causes investors to scrutinize their managers and advisors to determine whether value is being added, fees are transparent and rational, and the client’s experience comes first. We believe we are well positioned to benefit from the ongoing shake-up of the traditional active industry, as well as the increasing frustration of hedge fund investors. –Artisan Partners's Eric ColsonFirst and foremost, an oversupply of traditional active strategies resulted in too many products hugging indexes and not delivering value. As less expensive passive products came on-line, offering the same exposure at a substantially lower price, a large migration of assets was inevitable… Not all of those investors will go passive. Our experience over the last several years supports our belief that many of those investors will select managers who offer differentiated strategies with high degrees of investment freedom and strong investment track records. - ibidI think that the headwinds for active management, both long-only and hedged, frankly, remain significant. Relative returns have been largely poor, and fee structures have been high. We firmly believe for ourselves the way to grow is to focus on delivering top quartile or better performance…I think active managers who operate in alternative strategies like we do, and as well as multi-strategy implementations, and can deliver that performance efficiently can be big winners. –Cohen & Steers’s Joe HarveyTheme 3: There remains a great deal of uncertainty around the implementation and impact of the new Fiduciary Rule, but many believe larger fee-based advisors are better positioned to adapt to any large scale changes ahead.I don’t think there’s one consistent view. I think you have a trend that was already in place pre-fiduciary rule of going to more of a planning model against the advisor picking individual funds. That’s going to continue. I think the fiduciary rule accelerated that. I think some larger firms favor that rule because it helps them move towards that platform even faster. And that’s where you get a little bit, I think, some mixed opinions on what to do next. – Franklin Resources’s Ken LewisOur sense is that in some cases – and it depends on the type of assets you have and the average size of account and what product it is. It’s possible the total cost of revenue sharing could go up a bit, it could go down a bit. But the trend towards standardization is I think being well embraced throughout the industry. - Cohen & Steers’s Bob SteersWe believe that success in the post-DOL world will require a more institutionalized product approach to asset management in sales and marketing. Consistent with this approach, we continue to shake the culture and organization of our firm by enhancing our risk management capabilities, sharpening our investment philosophies and processes, evolving toward more team-managed portfolios, investing in our research capabilities, and emphasizing tighter integration between our investment in sales and marketing personnel. - Waddell & Reed’s Phil SandersMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

2016 and 2017: Buy the Rumor and Sell the News?

Last year was a volatile year for credit and equity markets that saw price moves that more typically play out over a couple of years. The year began with a broad-based sell-off in risk assets that got underway in late 2015 due to concerns about the impact of the then Fed intention to raise short-term rates up to four times, widening credit spreads, and a collapse in oil prices. Credit (i.e., leverage loans and high yield debt) and equities rebounded in March and through the second quarter after market participants concluded that media headlines about potentially sub $20 oil were ridiculous and that the Fed probably would not raise rates four times; or, stated differently—the U.S. economy was not headed for recession. Markets staged the second strong rally of the year immediately following the national elections on November 8th with the surprise election of Donald Trump as the next POTUS, and Republicans holding Congress.Not surprisingly, the heavily regulated financial sector outperformed the broader market, with bank stocks (as represented by the SNL U.S. Bank Index) gaining 23% versus 5% for the S&P from November 8th through the end of the year. Most of the return for the bank index was realized after the election given the full year total return of 26%. Banks in the $1 to $5 billion and $5 to $10 billion groups led the way in 2016 with total returns on the order of 44% for the year.The magnitude of the rally in bank stocks was notable because the U.S. economy was not emerging from recession – when bank earnings are near a cyclical trough, poised to turn sharply higher as credit costs fall and loan demand improves. Last year was a great year for most bank stock investors. Bank returns averaged around 40% in 2016, with 30% of the U.S. banks analyzed (traded on the NASDAQ, NYSE, or NYSE Market exchanges for the full year) realizing total returns greater than 50%. The returns reflected three factors: earnings growth, dividends (or share repurchases that were accretive to EPS), and multiple expansion. As shown in Figure 4, the median P/E for publicly-traded banks expanded about 30% to 20.6x trailing 12-month earnings at year-end from 15.9x at year-end 2015. Likewise, the median P/TBV multiple expanded to 181% from 140%. While bank stocks closed the year at the highest P/E level seen this century, P/TBV multiples remain below the pre-crisis peak given lower ROEs (ROTCEs), which in turn are attributable to higher capital and lower NIMs. Figure 5 summarizes profitability by asset size. Banks with assets between $5 and $10 billion were the most profitable on an ROA basis and realized the highest total returns for the year. This group stands to benefit the most from regulatory reform if the Dodd-Frank $10 billion threshold (and $50 billion for SIFIs) is raised. In the most optimistic scenario, the market appears to be discounting that banks’ profitability will materially improve with lower tax rates, higher rates, and less regulation. The corollary to this is that the stocks are not as expensive as they appear because forward earnings will be higher provided credit costs remain modest. Based upon our review, most analysts have incorporated lower tax rates into their 2018 estimates, which accounts for much more modest P/Es based upon 2018 consensus estimates compared to 2017 consensus estimates. 2016 M&A TrendsOn the surface, 2016 M&A activity eased modestly from 2014 and 2015 levels based upon fewer transactions announced; however, when measured relative to the number of banks and thrifts at the beginning of the year, 2016 was consistent with the long-running trend of 2-4% of institutions being acquired each year. The 246 announced transactions represented 3.8% of the 6,122 chartered institutions at the beginning of the year compared to 4.5% for 2014 and 4.2% for 2015. As for pricing, median multiples softened a little bit, but we do not read much into that. Last year, the median P/TBV multiple for transactions in which deal pricing was disclosed eased to 136% compared to 142% in 2015; the median P/E based upon trailing 12 month earnings as reported declined to 21.2x versus 24.4x in 2015. Elevated public market multiples since the national election have set the stage for higher M&A multiples in 2017 as publicly-traded buyers can “pay” a higher price with elevated share prices (Figure 8). The impact of this was seen among some larger transactions announced after the national election compared to when LOIs were announced earlier in the Fall. Activity may not necessarily pick-up with higher nominal prices, however, if would be sellers decide to wait for higher earnings as a result of anticipated increases in rates and lower taxes and regulations. In effect, some may wait for even better values or decide not to sell because ROEs improve sufficiently to justify remaining independent. Time will tell. Figure 9 shows the change in deal multiples from announcement to closing and compares the change between deals announced and closed pre-election to those closed post-election. With the run-up in pricing, P/E and P/TBV multiples increased 12% and 9% from announcement to close compared to 4% and a decline of 1% pre-election. 2017 OutlookNo one knows what the future holds, although one can assess probabilities. An old market saw states “buy the rumor; sell the news” which means stocks move before the expected news comes to pass. As of the date of the drafting of this note (February 7), bank stocks are roughly flat in 2017. The stocks have priced in the likelihood of some roll-back in Dodd-Frank, higher short-term and long-term rates, lower tax rates, and a generally more favorable economic backdrop that supports loan growth and asset quality. The magnitude of these likely – but not preordained – outcomes and the timing are unknown. Following a big rally in 2016, returns for bank stocks may be muted in 2017 even if events in Washington and the Fed prove to be favorable for banks.That said, higher stock prices and investor demand for reasonable yielding sub-debt from quality issuers implies the M&A market for banks should be solid. The one caveat is that there are fewer banks, so a healthy M&A market for banks could still entail fewer transactions than were recorded in 2016.Mercer Capital is a national business valuation and financial advisory firm. Financial Institutions are the cornerstone of our practice. To discuss a valuation or transaction issue in confidence, feel free to contact us.This article originally appeared in Mercer Capital's Bank Watch, February 2017.

RIA Matchmaking

Before World War 2, Alfa Romeo developed a successful brand building limited numbers of large, powerful cars for wealthy Italian buyers. That business model didn’t survive the war, however. By the 1950s the company realized that, in order to survive, it needed to create smaller and more practical vehicles that could be produced and sold in large volume to the mass-affluent. The second iteration of the new Alfa Romeo was the 750-series, which included not only a sedan and coupe but also a beautiful Pininfarina-designed convertible that Alfa Romeo romantically dubbed the Giulietta (as in Romeo and Juliette). The Giulietta was light, mechanically robust, and very sophisticated. Orders poured in, and Alfa Romeo’s future was assured.As the wealth management industry matures, we are sensing a similar shift to mass-produced wealth management services, building extensive technology platforms and centralized investment management to support broad networks of client service representatives. What was once the wild-west of commissioned brokers living off the “5% rule” is transitioning to salaried staff and ETFs. The transition is slow, but industry trends like fee pressure, regulatory upheaval, and partner demographics are persistent motivators. Ultimately, these industry trends can only lead to one thing for the wealth management community: more M&A.For now, the investment management industry is highly fragmented both in number and in business model. Even though the 12,000 or so individual RIAs operating in the U.S. mostly derive their revenues from a percentage of assets under management and have expense streams characterized mostly by personnel, office space, and strong coffee, we rarely see two business models that we think are similar to each other. Investment management firms are reflections of their people - from the approach to investing to the types of clients they attract. Consequently, putting two firms together is more difficult than a lot of people imagine.Hardly a week goes by that we don’t get asked what we think are optimal qualities of an RIA merger partner. Answering that always feels a little like giving dating advice: different partners suit different partners. No one disputes that the industry is ripe for consolidation, but there’s no easy way to “swipe-right” on a target company’s ADV, and it’s pretty unlikely that sec.gov is going to have its own version of Tinder anytime soon.Nevertheless, in honor of today's holiday, here are a few thoughts on what to think about when considering a merger partner.TrustNo amount of committee meetings, reporting metrics, or other disciplined management feedback mechanisms can guarantee how your new co-workers will behave when you aren’t around. If your trust of their actions is conditional, or grounded in things like incentive compensation, the relationship won’t work for you or for them. People do not even change for their spouses – certainly not for their business partners. Walk away.Shared ValuesDoes your prospective merger partner see the industry the same way you do? Is their approach to investing, staff development, and going after new business the same? Assuming that you and your merger partner have both been around long enough to develop your own way of working, you might learn a thing or two from each other, and you might have some influence over each other – but mostly you will be you, and they will be they. Make sure you’re okay with that.Similar FriendsI think an underrated due diligence metric on a merger partner is their client demographics. The type of client served by a merger partner is very telling as to what kind of firm they really are. If you and your prospective merger partner have similar clients, then you’ll probably have a lot in common after the merger.Common InterestsVegans don’t like seeing bacon in the refrigerator, even if they’re not forced to eat it. In our experience, firms that favor passive investing do not mix well with avid stock-pickers. On the front end, it might look like such a merger expands product offerings and investment approaches to the clients of both firms, but in the end your portfolio managers won’t understand each other and will confuse the message for your clients.Compatible GoalsIf you want four kids but your fiancé doesn’t want any, having two kids will not constitute a workable compromise. If you want to grow your RIA into a large business and sell it, but your merger partner wants to operate his as a practice until he’s too old to work, you’ll have conflict from day two. Life can change certain individual and business goals, but it helps to have a common baseline at the start.A Good Pre-nupIn our experience, the only thing more contentious than a marital dissolution is a “business divorce.” Your buy-sell agreement needs to offer a valid “out” that enables the parties to the merger to preserve at least some of their economic substance while maintaining the core business of providing investment management services to clients. Not only do the partners depend on a good buy-sell agreement, but your employees and your clients do as well. Granted, the best agreement doesn’t supplant the need to build a mutually beneficial relationship every day, but offering some certainty as to how to wind-down the relationship won’t hurt either.Notice I didn’t say anything about money. Fee schedules, compensation plans, commitment to IT spending, and all of the numbers matter, of course; but that’s the easiest part of a merger to make work. The real currency of work is people – so focus on that and the numbers will be what the numbers will be.The best RIA mergers aren’t necessarily composed of “like” firms so much as “like-minded” firms that have different strengths to supplement different weaknesses. If you can see genuine opportunities with a potential target or acquirer that you cannot see alone or with another firm, then you might have a mutually beneficial relationship.Oh, and if by some chance your merger partner drives an old Alfa Romeo, skip the roses today and give him or her a dozen quarts of motor oil. It won’t go to waste.

Refining Overview

There are four main components to refined product prices: (1) Input Prices (i.e. crude oil), (2) Wholesale Margins, (3) Retail Distribution Costs, and (4) Taxes. Generally, input prices and wholesale margins drive fluctuations in product prices as the last two are relatively stable. Thus, in order to understand refined product prices we consider the macroeconomic trends in the global oil and gas market which drive input prices.Oil and Gas Market OverviewGlobal oil production outpaced global crude demand for almost a year which led to a plummet in oil prices in mid-2014. Oil prices have remained depressed since then and an oversupply of crude caused downward pressure on the price of crude oil which for months benefitted refiners as their product costs fell. A shortage of crude storage forced producers to sell crude at increasingly low prices to refiners, who then could earn substantial profits.In a move that surprised many markets, OPEC instituted production cuts for the first time in eight years following a November 30, 2016 meeting. OPEC planned to reduce output by 1.2 million barrels a day by January 2017. In addition, Russia, who is not a member of OPEC, agreed to cut oil production. The reduction in output is designed to reduce high inventory levels around the globe. The cuts are expected to be effective through May 25, 2017, at which time OPEC may opt to extend the cuts an additional six months.Oil prices may have found a new home around $50-$60 per barrel, which remains below normal levels, but exploration and production activities have recovered partially. The Baker Hughes North American (U.S.) total oil rig count increased by 32% over the year ended February 3, 2016. Crude oil prices (“WTI”) ended 2016 nearly 45% higher than year-end 2015. The WTI gain is the first annual price increase in two years, and is the largest annual gain in seven years.The oil and gas industry is heavily regulated. The future impact of many regulations surrounding the oil and gas industry however is uncertain as President Trump ran as a friend to the oil and gas sector and promised to reduce regulations on the industry in order to boost the U.S. economy. Additionally, Oklahoma Attorney General Scott Pruitt is on his way to becoming the next Environmental Protection Agency administrator. Pruitt has openly opposed the EPA, which is one of the main regulators of the refining industry. As we work to understand the current position of refiners, it is key to analyze the impact of legislation and regulation surrounding the industry.Refining RegulationIn early 2016 the crude oil export ban that had been in place since 1975 was lifted. Industry experts thought that the lifting of the export ban would better align the production capabilities of U.S. refineries. Refiners, on the other hand, feared that the exportation of crude oil would increase crude prices, as the pressure on price in an oversupplied U.S. market gave way. However, due to the state of the global oil market there is not much incentive to buy crude oil from the U.S. in the current market. Currently, it is estimated that less than 400,000 barrels per day (bpd) is being exported form the U.S. Once the Brent-WTI spread widens, and it is cheaper for other countries to buy WTI and pay transportation costs than to buy Brent, we may better understand the effect of the lifting of the ban.Although the price of crude oil remains low in comparison to historical levels, refined product prices fell to a similar extent as crude prices. As shown below, the price of gasoline fell to a low of $1.05/gallon in February 2016, which was almost one-third of the price of gasoline in July 2014. Since February the price of gasoline has increased 36%. In general, refined product prices have fallen over the last two years but have seen some recovery over the last 10 months. Additionally, operating expenses have increased with the cost of Renewable Identification Numbers (RINS). The Renewable Fuels Standards (RFS) Program has had a significant impact on the refining sector over the last year. The RFS were signed into law by President George W. Bush in order to reduce greenhouse gas emissions and boost rural farm economies. Each November, the EPA issues rules increasing Renewable Fuel Volume Targets for the next year. RINs (Renewable Identification Numbers) are used to implement the Renewable Fuel Standards. At the end of the year, producers and importers use RINs to demonstrate their compliance with the RFS. Refiners and producers without blending capabilities can either purchase renewable fuels with RINs attached or they can purchase RINs through the EPA's Moderated Transaction System. While large integrated refiners have the capability to blend their petroleum products with renewable fuels, small and medium sized merchant refiners do not have this capability and are required to purchase RINS, which have significantly increased in price. A common theme across refiners’ earnings calls last quarter was the effect of the rising cost of RINs on already squeezed margins. President Trump promised to help small and medium sized merchant refiners who were disadvantaged by RFS, but he also spoke fondly of the program during his campaign. It appears that many Republican lawmakers hope to repeal or reform the Standards, but the future of the Standards and the RIN system is still unclear. Other regulations that might affect refiners’ margins going forward include the Petroleum Refinery Sector Risk and Technology Review (RTR) and the New Source Performance Standards (NSPS). Last December the RTR & NSPS rule was passed in in order to control air pollution from refineries and provide the public with information about refineries’ air pollution. These regulations range from fence line and storage tank monitoring to more complex requirements for key refinery processing units. The rule was expected to be fully implemented in 2018 however the expected new head of the EPA makes us to question the future implementation of the rules. We can understand refiner’s current earning power through the refiner maker margin. The refiner marker margin (RMM) is a general indicator, calculated quarterly by British Petroleum, which shows the estimated profit refiners earn from refining one barrel of crude. Refiners’ margins increased dramatically in the second and third quarters of 2015 as the price of crude fell and the price of refined petroleum products lagged behind. Refiners in the U.S. North West were making between $27 and $28 per barrel of oil, while global margins barely reached $20 per barrel. However, in the fourth quarter of 2015 refined product prices fell, refiners’ margins tightened, and the geographic gap in margins narrowed. After some relief in margin pressure in the second quarter of 2016, margins tightened to the lowest seen in three years. M&AM&A activity in the refining sector was sluggish in the first half of 2016, partially due to the uncertainty which surrounded the refining industry and future regulation. However, M&A activity picked up in the third and fourth quarter of 2016. The chart below shows key valuation metrics associated with refining transactions which were announced in 2016. Overall, valuation multiples are inflated, demonstrating that companies are buying the future earnings potentials of refiners and are not too discouraged by currently low earnings. Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

There Was Blood

Warren Buffett’s guidance is salt in the wound for those in the oil and gas industry: “You pay a very high price in the stock market for a cheery consensus.” That was the title of his article published in Forbes Magazine in November of 2008. Energy companies, investors and royalty owners all paid a very high price to invest in the oil and gas industry prior to July 2014. But, those who invested when there was a “Cheery Consensus” have now endured more than 20 months since the crash of oil started. Fear and uncertainty were so rampant that many anticipated oil prices to fall to $10 per barrel. Yet during this turmoil did you remember another famous investing principle from Baron Rothschild: “Buy when there's blood in the streets, even if the blood is your own." Okay, I’m sure you remembered it at some point during the fall, but did you have the moxy to act on it?There was blood in the street, lots of it, over the last two years. Many operators and oil and gas service companies didn’t survive the last 20 months and most of the news headlines focused on their story. For royalty owners, who might depend upon royalty checks for steady income, it was equally scary as their payments shrunk due to low oil prices which were magnified by lower production rates. Operators went belly up or were acquired, each of which leads to administrative complications and disruptions in check disbursements to royalty owners. Some unlucky royalty owners received demand letters indicating they received royalty payments for interests they didn’t own and therefore must pay back multiple years’ worth of royalty receipts to the operators. How does that happen? It appears, when there is a cheery consensus, details get overlooked until the environment turns dire.However, the last 12 months have provided some relief. Oil prices have increased more than 65%, acquisition activity in the Permian Basin is high, and the oil and gas equity markets have shown positive growth. Additionally, investors seeking income generating investments have been interested in royalty trusts which have had significant returns over the last 12 months. If you had the moxy to grab the “falling knife” back in early 2016, it appears you grabbed the handle and not the blade. Returns over the last 12 months have been in the double digits and perhaps triple digits depending on the investment vehicle. Sadly, the fall in oil price was so significant that investments made more than 18 months ago are largely still under water, while those made less than 12 months ago are sitting pretty. This is true for royalty owners as well.Market indications are available in the form of publicly traded oil & gas royalty trusts. There are approximately 20 oil and gas focused royalty trusts publicly traded, as of the date of this article. In the last two months, the implied payback period increased 1.1 years, on average, from 11.1 years to 12.2 years. This occurred from declining yields as equity prices increased.Market ObservationsRoyalty trusts, like the rest of the oil and gas industry, have been hit hard over the previous 24 months. Before the bottom fell out, oil traded as high as $107.95 in June of 2014 and plunged to a low of $29.05 in February of 2016. Since February, the price of oil appears to have found a new home between $50-$60 / barrel. That said the last two years have been a trying time to hold investments in oil and gas, especially in Royalty Trusts. Below is a chart of the market price performance for each royalty trust over the last two years. Only one is showing a positive price performance, Black Stone Minerals, LP, but this is slightly misleading as it’s only been publicly traded for the prior 42 months (just shy of two years). The above chart looks very similar to the performance of the price of oil and gas over the same time period. Royalty interest owners have seen their monthly payments move in the same manner. Yes, if you invested in the energy sector approximately two years ago, there is a good chance your investment is still underwater. However, if you invested one year ago, the results are dramatically different. We are approximately 12 months from the days oil prices hit the “bottom of the barrel” and since February 2016, WTI has increased more than 65%. Below is the same chart adjusted to show the performance over the last 12 months. Only three of the twenty royalty trusts have negative price performance over the last year, compared to 19 when observing performance over the last two years. Of the three that are negative, two were discussed in earlier posts. Sandridge Mississippian Trust I and II’s operator was going through bankruptcy and the location of their wells was not as desirable as other plays. The other royalty trust with negative performance is Chesapeake Granite Wash Trust. For the above 20 Royalty Trusts, we compared various pricing metrics between today and one year ago: Observations and Disclaimers1Price to revenue and price to distributable income indicate, on average, the trusts are more expensive now than a year ago. This trend has continued from our discussion in December 2016.Yields were higher last year as they did not reflect the quickly falling market price. Increase in pricing over the last 12 months is the primary cause of the lower yields. Some Trusts have cut their distributions in response to falling royalties. The combination of the two results in lower yields.As of today, market prices have leveled off and annual distributions are comprised of a full year of lower royalty payments, resulting in lower yields compared to a year ago.Price to PV-10 is significantly higher this year compared to last. The market is now willing to pay 2.5x more than the present value of future cash flows for the operating wells as opposed to 0.6x a year ago. However, PV 10 data is only disclosed annually, typically during the first quarter of the year. We are monitoring disclosures to update our models as the data becomes available. Stay tuned.A year ago, many expected oil prices to reach $43/ barrel, or increase by 44%, over the year. This turned out to be directionally correct, but understated the actual performance. The current spot price is $53.88/ barrel which was an increase of 80%. Natural gas prices performed much the same way, increasing 34%. However, for the next 12 months oil prices are expected to increase by only 4% while natural gas prices are anticipated to jump by 15%.Implications for Royalty OwnersIn many respects, royalty owners can utilize publicly traded royalty trusts to observe changes in investor behavior and get a feel for how much their royalty interests may be worth. Here are a few areas to consider for your specific situation to compare and contrast with Royalty Trusts:Set Number of Assets. Royalty trusts typically have a set number of wells and producing assets after they are formed. Does your property have a fixed number of assets or will it grow? If new oil and gas wells are not being added to the property, then the oil and natural-gas reserves will be depleted as they age and produce.Location. The Royalty Trusts above have assets all over North America. Some are located in hot spots while others are not. Location drives investor appetite as operating costs and production levels, which vary by location, drive profitability in an industry that has zero control over the price of their product. This is a significant reason for the high transaction activity in the Permian Basin. Operators know they are able to make a profit through high production rates and low operating costs in Permian Basin even at $40 oil. Consider the investor activity, or lack there-of, in your area.Price and Production. Now that the U.S. has significant recoverable oil and gas reserves and the ability to export unrefined crude world-wide, the U.S. can be considered a swing producer, a power which historically characterized OPEC. As a swing producer, price dictates the level of production the market will consume and production will increase or decrease relatively quickly to meet demand. In response to price changes, operators will increase or decrease production levels at will. Consider how your operator has behaved in various pricing environments and the operators of the Royalty Trusts. In addition to the differences between your royalty assets and the Royalty Trusts, consider the level of value indication provided by the Royalty Trusts. The level of value is the publicly traded level of value verses the privately held royalty assets held by many land owners. Consider the following chart. Chris Mercer explains, The benchmark level is the marketable minority level of value, or the middle level in the chart above. Conceptually, it represents the pricing of the equity of a public company with an active and freely trading market for its shares. For a private company, it represents that same price as if there were a free and active market for its shares. The lowest level on the traditional levels of value chart is called the nonmarketable minority level of value. This level represents the conceptual value of illiquid (i.e., nonmarketable) minority interests of private companies, or entities that lack active markets for their shares.Royalty trusts provide an indication of value at the Marketable Minority Value level for minority interests in an entity with royalties as the primary asset. For royalty owners the value level can be a mixed bag. Many own the asset directly while others own equity interests in entities with royalties as their main assets. It is important to understand the value level comparability difference for your situation.To move from the Marketable Minority Value to the Nonmarketable Minority Value level, simply apply a marketability discount. Stated a different way, apply a discount for not having the ability to quickly sell your asset and receive cash. Fully marketable assets, like those publicly traded, have the ability to exchange the asset for cash in approximately three days. All other assets which do not have this access lack marketability. Therefore in order to build and find a market for the assets, a discount is typically required by potential investors.We have assisted many clients with various valuation and cash flow issues regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.1 Disclaimer: no two of the above royalty trusts are alike. Differences abound in asset mix, asset location, term, and resource mix, just to name a few. In future blog posts, we will explore each trust individually and discuss their uniqueness.

Master Limited Partnerships

Master Limited Partnerships (MLPs) are publicly traded partnerships, which reap the tax benefits of a partnership and the liquidity benefits of a public company. There are many tax benefits to an MLP. Unlike public companies, MLPs are taxed only at the unitholder level. Distributions to unitholders are tax deferred, if the Partnership distribution is greater than Partnership income. And, units can be passed down to successors at a basis of fair market value, which means that the capital gains tax is not passed down along with the unit. There are also some serious tax implications of the MLP structure. For example, when an MLP’s debt is forgiven, the amount cancelled is treated as income and is taxed at the unitholder level. However, there is generally not a cash distribution which accompanies this tax payment.History of MLPsApache Oil established the first MLP in 1981 and had such great success with the structure that real estate investors, restaurants, hotels, and NBA teams restructured to become MLPs. In 1987, Congress revamped the tax code specifying that in order to be an MLP at least 90% of a company’s income must be generated from “qualified sources”. Qualified sources include, “the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil, or products thereof), or the marketing of any mineral or natural resource (including fertilizer, geothermal energy, and timber).” In 2008, Congress expanded this to include carbon dioxide, biofuels, and other alternative fuels.E&P companies are sensitive to swings in commodity prices and do not have stable enough cash flows to sustain the distribution requirement of MLPs. Often times E&P companies spun off their midstream assets into MLPs because midstream operations provide stable cash flows and have the ability to reliably make distributions. Thus the majority of MLPs are involved in the midstream oil and gas sector. Recently, however, the stability of midstream cash flows has been called into question.Midstream companies have long term contracts called take-or-pay contracts which require producers to pay midstream companies even if they are not currently using their gathering assets. It was always assumed that these contracts were inviolate; however, the recent turmoil in the oil and gas market, which led to a multitude of bankruptcies in the E&P sector, caused these contracts to be called into question in bankruptcy court proceedings. During the bankruptcy process, producers can request that certain contracts be rejected. If the midstream contracts are thought to be vastly different from market value then the producer can request the judge consider the rejection of midstream contracts. We saw this in March of 2015 when a New York judge ruled that Sabine Oil and Gas Corp., which was going through bankruptcy proceedings, could reject contracts it was in with midstream companies. This uncertainty caused the price of MLPs to fall as investors began to question the immunity of their cash flows. From December 2014 to December 2015 the price of MLPs on average fell by 25%.MLPs have two classes of Partners: General Partners, who are responsible for managing day to day operations and receive compensation for doing so, and Limited Partners (called unitholders) who are investors in the Partnership and receive periodic distributions. Unlike a public company which is governed by a board, a MLP is generally managed by a general partner. Legally, the general partner has no fiduciary duty to the unitholders, but mostly their interests align.MLPs payout a large portion of cash flows (generally 80% to 100%) to their unitholders. Distributions are based on each MLP’s partnership agreement and usually minimum quarterly distributions are written into the MLP’s partnership agreements. The General Partner typically owns a 2% equity interest along with incentive distribution rights (IDRs). Incentive distribution rights give a general partner an increasing share in the incremental distributable cash flow of the Partnership. IDRs are meant to incentivize the GP to increase distributions for the limited partners.Valuing an MLPThere are approximately 140 MLPs and in 2013 over 50% of MLPs operated in the midstream and downstream oil and gas sector. While each Company is unique the guideline approach can commonly be used to value MLPs in the oil and gas sector. A price to earnings multiple however is uninformative when valuing an MLP. MLPs generally have a lot of fixed assets on the balance sheet that result in high depreciation expenses charged to earnings. Thus earnings are not a good indicator of value. Instead we turn to companies’ distribution history.Several MLPs and their key financials are summarized in the chart below. MLPs generally pique the interest of investors looking for income generating investments, demonstrated by the dividend yield. But there are three other measures that should be used to understand the value and inherent risk of an MLP: (1) Distribution Coverage Ratio (DCR), (2) Price / Distributable Cash Flow (P / DCF), and (3) Debt / EBITDA.A MLP’s distribution coverage ratio (DCR) measures the sustainability of current distributions. A DCR of 1.0 indicates that an MLP is distributing all available cash flow and a DCR of greater than 1.0 indicates that a Partnership is retaining some cash. A DCR of less than 1.0 is not sustainable. All of the MLPs above have sustainable levels of distributions but Magellan Midstream’s (MMP) DCR of 1.0 does beg for further analysis as they are paying out all available cash flow.Instead of evaluating Price / Earnings multiples, we analyze Price / Distributable Cash Flow for MLPs. Generally a P / DCR of more than 15x or 16x is considered high. However, if the MLP has consistently grown distributions then the partnership may be worth the premium. Magellan Midstream was trading at 17.4x distributable cash flow, which is on the higher end of the range shown above. However, MMP has increased its quarterly distribution 59 times since it IPO-ed in 2001. This trend of an increasing yield merits a higher P / DCF multiple.The Debt to EBITDA multiple can give us further insight into the company’s risk position. Since MLPs must pay out the majority of their cash flows as distributions to unitholders, in order to fund capital expenditures and acquisitions an MLP must take on debt. Magellan has a debt to EBITDA ration of 3.9x. Generally a debt to EBIDTA multiple above 5x would be cause for concern, but Debt / EBITDA multiples for MLPs have trended upwards over the last four years. In 2013 the median Debt / EBITDA multiple was 3.8x but increased to 5.4x by 2015. Over the past three years the median EBITDA of our group increased by a compound annual rate of 8% while debt increased at a rate of 16% showing that the industry as a whole has become more leveraged.Mercer Capital’s oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

ESG Investing Comes of Age Despite (or Maybe Because of) Trump

Neuroscience teaches us that branding matters because our brains remember things by categorizing them. If we feel an affinity for a particular category of product, whether real or imagined, we are more drawn to that product than similar products that our brains place in different categories.As automotive brands go, Subaru has had more success than most into developing niche products that have a loyal following among specific demographic populations. Even though the automaker is part of the huge Japanese conglomerate Fuji (the six stars in Subaru’s badge represent the six companies that merged to create Fuji), Subaru is not an all-things-for-all-people automaker. As automotive products became more homogenized, Subaru used horizontally-opposed cylinder boxer-configuration motors (improves ground clearance while lowering the center of gravity) and all-wheel drive powertrains to make functional cars that serve the needs of the daily commute and the weekend adventure (even if that adventure is just to Costco).Many of my blogposts include stories about automobiles because investment management firms, like automakers, make their way by developing unique products that serve particular customers and particular needs. All cars are transportation and are ultimately designed to get you from point A to point B. All investment products are ultimately designed to make as much money while taking as little risk as possible. But commodification is bad for MSRPs and fee schedules, and ultimately bad for margins and company sustainability. Product development has been an antidote for commodification since the development of growth versus income strategies 40 years ago, and remains so today.Investment strategies that screen for environmental, social, and governance criteria (ESG) is a still developing product niche that has, until recently, been more about talk than action. The pitch is that investing in businesses that demonstrate broad-based corporate responsibility provides a pathway to management teams who think long term, mitigate risk, and lead their industries. Demographic studies have shown that ESG strategy is particularly appealing to millennial investors and women. Millennial investors will, of course, eventually control the majority of investible assets. Women already do.The beauty of an investment product like ESG is client stickiness. Subaru has a remarkable level of customer loyalty (with a 68% repurchase rate), and RIA’s providing competitive ESG products get some escape from the quarterly (or monthly or daily) comparison with the indexes. Client stickiness adds value to an investment manager in many ways, and ESG holds the promise – at least in the near term – of AUM retention in a way that other investment strategies do not.Nevertheless, in the RIA world, the rubber meets the road at performance, and many investment managers still shy away from ESG screens because they want the alpha that’s often inherent in “sin” stocks, or because their investment criteria just don’t overlay with ESG very well. For these reasons, the scale of ESG has, until recently, remained modest. The product category got a big boost a few years ago when Deutsche Bank published a research paper heralding the success of ESG in identifying companies with a lower cost of capital and outperforming business models. Since then, other studies have generally confirmed the result.As a consequence, the investment strategy is growing in an era when active management is otherwise losing ground. The question many are asking today is whether or not the election of Donald Trump will cause the trend line to roll over, marginalizing ESG as an idea out of sync with the markets.We think not. ESG is more common sense than high-minded idealism. Since the structural framework of ESG is not based in altruism, but in sustainable investing and risk mitigation, there is still ample reason to pursue it. Studies of investment returns show not only correlation but causation for the value of screening for environmental, social, and corporate governance issues. Thus, from a fiduciary’s perspective, ESG is prudent. And regardless of the political climate in the U.S., the crowd sizes that formed across America the day after the inauguration suggest that the new administration is not necessarily going to be a cultural vanguard. Instead, some political activists may see ESG as a way to right certain issues in the global balance that can’t be accomplished at the ballot box.This isn’t to say ESG will appeal to everyone. Not everyone wants to drive a Subaru; some prefer a Nissan. But for those who want it, ESG is a niche product that is still on the rise, and the current social environment in the developed world may provide a catalyst to that.

Noble Energy Buys Clayton Williams: A Closer Look at the Acquisition

Deal Details 1On January 16, 2017, Noble Energy, Inc. (NBL) announced the acquisition of all Clayton Williams Energy (CWEI) equity for approximately $2.7 billion in NBL stock and cash. Noble Energy is a global independent oil and gas exploration and production company. Over 50% of their sales volume is generated from domestic onshore production. The Company focuses onshore domestic operations in the DJ, Delaware, and Eagle Ford Basins and the Marcellus Shale. The Company’s acquisition of CWEI demonstrates their effort to accelerate high margin growth by focusing capital in productive regions such as the Permian Basin.Shareholders of CWEI will receive approximately $34.75/share in cash and 2.7874 NBL common shares for each share of CWEI stock. Based on CWEI disclosures, NBL will assume control of 330,000 net acres in the Permian Basin and Giddings area of the Eagle Ford which include 13.6 MBOE of net daily production. The 170,000 net acres in the Permian are located in Ward and Reeves County. Approximately 72% of the current production is crude oil. The transaction indicated a 48% premium to the publicly traded equity value for CWEI. Noble Energy was willing to pay a premium for the CWEI because the CWEI’s acreage was continuous to Noble’s which provides Noble with potentially cost saving synergies.Based upon the consideration given by NBL, here is the implied market value of invested capital (MVIC) for CWEI: A summary of CWEI’s book value balance sheet is shown below.2 Before venturing into our approach to the allocation, we have compared pricing multiples of the CWEI acquisition and other oil and gas public companies. At the time of the transaction, CWEI owned acreage rights in one of the most popular domestic resource plays, the Delaware Basin. The chart below shows the implied pricing metrics for CWEI versus selected transactions involving companies with a significant presence in the Permian Basin. Noble Energy’s pricing multiples are also presented to show size comparisons. Observations: Noble Energy’s purchase of CWEI was one of the largest acquisitions in the Permian basin over the last few years.Based on BOE per day production, CWEI was priced higher than Yates and SHE, as both companies were producing more than CWEI.Based upon net acres acquired, the CWEI transaction was priced in the middle of Yates and SHE and slightly above its’ suitor NBL.While this acquisition appears to be priced high on the BOEPD metric, the significant amount of acreage acquired by NBL indicates a net acre multiple that is consistent with other transactions.Assets PurchasedThe following maps, disclosed by CWEI, shows the acreage positions within each of the core resource plays, the Permian Basin and the Eagle Ford. The highlighted acquired assets include:65,000 net acres in Reeves County, Texas (Permian Basin map below) with over 100 wells producing or soon to be producing. A target pay zone of 3,500 feet wide (between the depths of 8,000 ft to 11,500 ft,) and 1 rig actively drilling in the area.Eagle Ford shale property includes 160,000 net acreage positions, 40 completed wells, a demonstrated and repeatable drilling program and new well costs of $4m per well. Chairman, President and CEO of NBL David Stover had the following comments on their acquisition: "This transaction brings all the key elements we value: excellent rock quality, a large contiguous acreage position adjacent to our own and robust midstream opportunities, reinforcing the Delaware Basin as a long-term value and growth driver for Noble Energy.""This combination creates the industry's second-largest Southern Delaware Basin acreage position and provides more than 4,200 drilling locations on approximately 120,000 net acres, with over 2 billion barrels of oil equivalent in net unrisked resource."Earlier, we displayed the high level categories for an allocation of purchase price. Two of these categories are oil and gas related assets: (1) the fixed assets on the balance sheet; and (2) the implied goodwill value. Each of these is inter-related as a majority of the fixed assets are related to the exploration and production of oil and gas resources. Based upon our experience, much of the “implied goodwill” is related to the present value of future benefits of the production of oil and gas. The valuation for current production and proved developed reserves can be straight forward. CWEI more than likely prepared a reserve report which would aid in the valuation of the currently producing wells and the remaining proved reserves. However, the valuation gap between the proved developed reserves and the remaining proved undeveloped, probable and possible reserves or acreage value can be detailed, tedious, and complex. The historically low oil and gas price environment and financial tension within the industry creates a complicated market place for using market transactions as indications of value.More information is needed to drill down into the specifics and valuation of each of the acquired oil and gas assets. Interested parties may want to consider the following information areas:Reserve Reports. Specifically, it is important to understand the amount of acreage in each of the maps above that have been drilled versus what areas are included in the drilling plan, PV 10 indications and price deck assumptions;Drilling plan and synergistic efficiencies. Rarely are specific drilling plans disclosed publicly, but they can be observed at a high level in the reserve report, as well as certain expense assumptions that provide company specific expense profiles for operating and capital expenditures for new wells. NBL’s acquisition of CWEI ranks as a top E&P transactions of 2017, not only because it is one of the first transactions of the year, but compared to 2016, it ranks in the top five in size. Based upon our experience involving public and private companies, we understand that pricing for proven undeveloped, probable and possible reserves have dropped significantly in the previous year, by upwards of 90% in some cases. In addition, due to the nature of the current oil and gas environment, we understand that historical transactions may have little comparability to transactions today and any comparison depends upon the details and assumptions of each transaction. Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence. End Notes1 Clayton Williams Energy, September 22, 2016 Johnson Rice Energy Conference Presentation 2 As of September 30, 2016 per S&P Capital IQ

2016 M&A Overview

When oil prices collapsed in mid-2014, the M&A market soon came to a standstill as investors waited for clarity regarding the future of the domestic oil and gas market. The low price environment led to a disconnect between the value of oil and gas reserves and the price that buyers and sellers negotiated in a distressed market. As prices remained low, deal volume picked up in the beginning of 2016 as companies were forced to sell assets in order to quickly generate cash to pay off debt and avoid bankruptcy. As the year continued, M&A activity increased and total deal value at the end of 2016 doubled that of 2015.Factors Leading to Increased M&A activity in 2016Price stabilization of crude in the range of $45 to $54 played a role in the increase in M&A activity as investors regained confidence in the sector.Cost reduction in certain plays from new technology has allowed more cost-efficient drilling.The low price environment made distressed companies’ assets acquisition targets as these companies were willing to sell them for heavy discounts.In order to decrease break-even costs, companies merged to realize potential synergies.Recent discoveries and low break-even costs in the Permian Basin attracted investors and producers to the play and increased overall M&A deal volume.Price StabilizationCrude oil price volatility declined over the last year as excess supply began to decline. Since mid-April of 2016, US crude oil inventories have declined by approximately 6%. Additionally, OPEC production declined in the second quarter of 2016 and had slower-than-normal growth in the fourth quarter, which helped to reduce excess supply 1.Cost ReductionIn a stacked play, multiple horizontal wells can be drilled from one main wellbore. This provides increased productivity as multilateral wells have greater drainage areas than single wellbore. Additionally, it can reduce overall drilling risk and cost. For deep reservoirs, a multilateral well eliminates the cost of drilling the total depth twice. In some plays such as the Permian, the reservoir is deep enough at some points that operators can drill multiple horizontal wells from one main wellbore. This advancement of drilling technology has allowed producers in certain plays to reduce costs so that drilling in lower price environment is economically feasible.Only the Strong SurviveIn early 2016, banks decreased lending to oil and gas companies. In a low price environment, the value of a company’s reserves falls when valued using a traditional PV-10 calculation. Lower valuations have led to decreased borrowing capacity, which in turn has caused cash flow pressure for many companies. Thus many companies have had to sell non-core assets in order to ease cash flow pressures. But in order to generate liquidity quickly, they often were forced to accept heavily discounted prices. This increased deal volume in 2016 as many companies tried to avoid bankruptcy and buyers moved quickly to get their hands on cheap assets.Mergers for SynergiesAs companies worked to reduce break-even prices, many looked for strategic acquisition targets in hopes of realizing operational efficiencies which could reduce costs and give them a competitive advantage in the market. This increased the number of mergers in 2016 in the E&P industry and also in the midstream sector which benefits from the network effect.The Permian BasinApproximately $69 billion dollars of North American E&P assets and companies changed ownership during 2016 with the Permian Basin resource accounting for nearly 40% of the deal dollar volume. The most significant trend in E&P this year was production companies’ move to the Permian Basin. Out of the 15 deals that were valued at over $1 billion, 8 were in the Permian Basin. The Permian became the center of the M&A stage due to its low drilling costs, resource diversity, and large remaining reserves. Although the Permian was discovered in the 1920s, the true potential of the Permian was not realized until 2007 when hydraulic fracturing techniques were used to access the tight sand layers of the play. Since then the Permian has been revitalized as producers have begun using unconventional drilling techniques in addition to traditional vertical wells. Because the crude in the shale layers has only recently been explored, there are still tremendous reserves left. Just this year the USGS announced an estimated 20 billion barrels of crude oil, 1.6 billion barrels of NGLs, and 16 trillion cubic feet of natural gas were discovered in four layers of shale in the Wolfcamp formation. Additionally, the Permian is a stacked play—which means that companies can drill multi-lateral horizontal wells to reduce costs. And, companies that operate in the Permian do not have to choose between oil and gas, but can diversify operations. Last week, we briefly looked at the six largest transactions in 2016. Recent asset deals in the US are summarized below. Due to the factors discussed above, average deals in Permian transacted at higher dollar per-acre multiples than other plays such as the Williston Basin. When prices declined, production in the Permian continued increasing while production in other domestic plays such as the Bakken and the Eagle Ford declined significantly. Unlike the Eagle Ford and the Bakken, which are mostly drilled for oil, the Permian holds a more diverse combination of oil, gas, and NGLs, making it more economical to produce at low prices. The Bakken was center stage in the early 2000s during the onset of hydraulic fracturing. The Eagle Ford, which was once the most active shale plays in the world, was the center of the M&A market in 2013 and 2014 when drilling activities increased there. M&A in the Eagle Ford and Bakken was sluggish in 2016, and the transactions that did occur there were largely motivated by distressed companies looking for liquidity or an exit. M&A OverviewM&A activity is expected to remain strong in 2017. It is expected that OPEC will follow through on production cuts and excess inventory should be absorbed in early 2017. This will cause the price of oil to continue increasing. As the price of oil continues to rise, drilling in other plays besides the Permian Basin will begin to become more economical and M&A activity should increase in other plays. However, it is expected that oil and gas companies will have to turn to private equity in order to gain liquidity as banks remain cautious in lending to the energy sector.End Note1 Data from Bloomberg

Are Robo-Advisors on Any Banker’s Wish List?

Christmas appears to have come early for some bankers and their investors with the SNL Bank index up over 30% from the November 8, 2016 election to mid-December. While optimism abounds, one inconvenient truth remains for the time being: ROEs for the banking industry as a whole remain below pre-financial crisis levels despite credit costs that are below most historical standards. The factors challenging ROEs for the sector are numerous but include: compressed net interest margins from a historically low rate environment, enhanced competition from non-banks, a challenging regulatory and compliance environment, and evolving consumer preferences regarding the delivery of financial services.These factors are particularly acute for most community banks that depend heavily on spread income and do not have the scale to absorb expense pressures as easily as their larger brethren. Further, many community banks are at a crossroad because their ROE consistently has fallen below the cost of capital, which in turn is forcing boards to consider strategic options like outright sales or potentially risky acquisition strategies to obtain scale.In an ideal world, community banks could easily add fee businesses that are capital-light, such as wealth management and trust operations, to boost returns. By pairing traditional banking services with other financial services like wealth management, banks can obtain more touch points for customer relationships, enhance revenue, and potentially improve the bank’s valuation. While we have previously spoken about the potential benefits to community banks of acquiring or building out a traditional wealth management operation, we have not addressed emerging FinTech companies, like robo-advisors, that are focused on the wealth management space.While there has been a race to partner and/or acquire robo-advisors by many of the larger asset managers and banks, there have also been some interesting partnerships with community banks. One such partnership struck is among Cambridge Savings Bank, a $3.5 billion bank located near Boston, and SigFig, a robo-advisor founded in 2007. While SigFig has relationships with UBS and Wells Fargo, its partnership with Cambridge Savings is notable because the two built a service called “ConnectInvest.“ When announced in the spring of 2016, the partnership was described as the “first automated investment service integrated and bundled directly into a retail bank’s product offerings in the U.S.” ConnectInvest, which is available to Cambridge’s customers digitally (mobile and website), “allows customers to easily open, fund, and manage an automated investment account tailored to their goals.” Cambridge’s customers are interested in the offering and have started using it. The goal is get up to 10% of its customer base using ConnectInvest.With this example in mind, the remainder of this article offers an overview of the robo-advisory space for our community bank readers so that they may gain a better understanding of the key players and their service offerings and assess whether their bank could benefit from leveraging opportunities in this area.An Overview of Robo-AdvisorsRobo-advisors were noted by the CFA Institute as the FinTech innovation most likely to have the greatest impact on the financial services industry in the short-term (one year) and medium-term (five years). Robo-advisory has gained traction in the past several years as a niche within the FinTech industry by offering online wealth management tools powered by sophisticated algorithms that can help investors manage their portfolios at very low costs and with minimal need for human contact or advice. Technological advances that make the business model possible, coupled with a loss of consumer trust in the wealth management industry in the wake of the financial crisis, have created a favorable environment for robo-advisory startups to disrupt financial advisories, RIAs, and wealth managers. This growth is forcing traditional incumbents to confront the new entrants by adding the service via acquisition or partnership rather than dismiss it as a passing fad.Robo-advisors have been successful for a number of reasons, though like many digital products low-cost, convenience, and transparency are common attributes.Low Cost. Automated, algorithm-driven decision-making greatly lowers the cost of financial advice and portfolio management.Accessible. As a result of the lowered cost of financial advice, advanced investment strategies are more accessible to a wider customer base.Personalized Strategies. Sophisticated algorithms and computer systems create personalized investment strategies that are highly tailored to the specific needs of individual investors.Transparent. Through online platforms and mobile apps, clients are able to view information about their portfolios and enjoy visibility in regard to the way their money is being managed.Convenient. Portfolio information and management becomes available on-demand through online platforms and mobile apps. Consistent with the rise in consumer demand for robo-advisory, investor interest has grown steadily. While robo-advisory has not drawn the levels of investment seen in other niches (such as online lending platforms), venture capital funding of robo-advisories has skyrocketed from almost non-existent levels ten years ago to hundreds of millions of dollars invested annually the last few years. 2016 saw several notable rounds of investment into not only some of the industry’s largest and most mature players (including rounds of $100 million for Betterment and $75 million for Personal Capital), but also for innovative startups just getting off the ground (such as SigFig and Vestmark). The table below provides an overview of the fee schedules, assets under management and account opening minimums for several of the larger robo-advisors. The robo-advisors are separated into three tiers. Tier I consists of early robo-advisory firms who have positioned themselves at the top of the industry. Tier II consists of more recent robo-advisory startups that are experiencing rapid growth and are ripe for partnership. Tier III consists of robo-advisory services of traditional players who have decided to build and run their own technology in-house. As shown, account opening sizes and fee schedules are lower than many traditional wealth management firms. The strategic challenge for a number of the FinTech startups in Tiers I and II is generating enough AUM and scale to produce revenue sufficient to maintain the significantly lower fee schedules. This can be challenging since the cost to acquire a new customer can be significant and each of these startups has required significant venture capital funding to develop. For example, each of these companies has raised over $100 million of venture capital funding since inception. Key Potential Effects of Robo-AdvisoryWe see five potential effects of robo-advisors entering the financial services landscape.Fee pressure. Robo-advisors may be a niche area for the time being, but the emergence and success of a technology-driven solution that challenges an age-old business (wealth management) epitomizes what has long been associated with internet (and digital) delivery of services: faster, better, and cheaper.The Democratization of Wealth Management. As a result of the low costs of robo-advisory services, new investors have been able to gain access to sophisticated investment strategies that, in the past, have only been available to high net worth, accredited investors.Holistic Financial Life Management. As more people have access to financial advice through robo-advisors, traditional financial advisors are being forced to move away from return-driven goals for clients and pivot towards offering a more complete picture of a client’s financial well-being as clients save for milestones such as retirement, a child’s education, and a new house. This phenomenon has increased the differentiation pressure on traditional financial advisors and RIAs, as robo-advisors can offer a holistic snapshot in a manner that is comprehensive and easy to understandDrivers of the Changing Role of the Traditional Financial Advisor. The potential shift away from return-driven goals could leave the role of the traditional financial advisor in limbo. This raises the question of what traditional wealth managers will look like going forward. One potential answer is traditional financial advisors will tackle more complex issues, such as tax and estate planning, and leave the more programmed decision-making to robo-advisors.Build, Buy, Partner, or Wait and See. As the role of the financial advisor changes, traditional incumbents like community banks are faced with determining what they want their relationship with robo-advisory to look like. In short, incumbents are left with four options: build their own robo-advisory in-house, buy a startup and adopt its technology, create a strategic partnership with a startup, or stay in a holding pattern in regard to robo-advisory and continue business as usual. Robo-advisory is an exciting development for wealth managers and offers opportunities potentially for bankers to expand or develop their offerings in this area. Similar to any other growth strategy, the goal will ultimately be for the bank to enhance profitability and shareholder value by adding desired customer services. For those bankers who may want to add a robo-advisor to their wish list, the key question of whether to build, buy, or partner is a challenging one. We will be speaking at the annual Acquire or Be Acquired (AOBA) conference in January on the topic of how to develop a framework to better assess this question. Additionally, for those who may go the investment route via a minority investment or outright acquisition, we offer some perspective on how to value and structure investments in FinTech companies like robo-advisors. Given the vast array of FinTech companies emerging in different areas of financial services, it will be important for bankers to develop a framework for both assessing potential opportunities and focusing in on those that provide the greatest potential to enhance profitability and shareholder value. We will post our slide deck from our AOBA session and make it accessible to BankWatch readers in the first quarter of 2017, so stay tuned. Additionally, we have a new book coming in the spring of 2017 – Creating Strategic Value Through Financial Technology. In this book, we illustrate the potential benefits of FinTech to banks, both large and small, so that they can gain a better understanding of FinTech and how it can create value for their shareholders and enhance the health and profitability of their institutions. As always, please do not hesitate to contact us if we can help in any way. This article originally appeared in Mercer Capital's Bank Watch, January 2017.

Trust Banks Thrive in 2016 on Steepening Yield Curve

All three publicly traded trust banks (BNY Mellon, State Street, and Northern Trust) outperformed the market in 2016, continuing their upward trajectory over the last few years but still lagging the broader indices since the financial crisis of 2008 and 2009. Placing this recent comeback in its historical context reveals the headwinds these businesses have been facing in a low interest rate environment that has significantly compressed their money market fees and yields on fixed income investments. Their recent success may therefore be more indicative of a reversion to mean valuation levels following years of depressed performance rather than a sudden surge of investor optimism regarding future prospects. Further, pricing improvements for this group appear to be more relative to an improved banking environment than a change in circumstances for trust services. Still, in recent quarters, most trust bank stocks outperformed other classes of asset managers like mutual funds and alternative investors that endured a rocky 2016 as passive products and indexing strategies continued to gain ground on active management. The steepening yield curve portends higher NIM spreads and reinvestment income, and the market has responded accordingly – our trust bank index gained 20% for the year, besting the broader indices and all other classes of asset managers. So have these securities gone from oversold to overbought? A quick glance at year-end pricing shows the group valued at 15x (forward and trailing) earnings with the rest of the market closer to 25x, so that alone would certainly suggest they aren’t yet too aggressively priced. Still, the three companies are all trading within 5% of their 52 week high (and all-time high for that matter), so it’s hard to say they’re really all that cheap either. So if you’re looking for mean reversion within the sector then alternative asset managers might be your best bet, though we’d be remiss not to point out the inherent risks associated with some of these businesses. Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

2016 Oil and Gas: A Year in Review

2016 was a year to remember and a year to forget for many in the oil and gas industry. On the positive side, energy commodity prices curbed their downward, volatile nature by finishing the year at higher prices than where they started. If this wasn’t enough good news, prices achieved this growth with relatively minimal volatility along the way. International and domestic supply are of particular importance as OPEC’s supply cuts and declining domestic supply helped bring a steady increase in the commodity prices. On the downside, many E&P companies were forced to restructure, through selling off assets or filing for bankruptcy, as a much need rebound in oil prices did not occur. The most popular area to snatch up assets was in the Permian Basin where approximately 40% of the North American deal volume occurred. This did not go unnoticed by many industry observers like Mercer Capital. Of our 31 Energy Valuation Insights posts from 2016, over 30% were related to the Permian Basin.Oil and Gas Commodity PricesAfter a volatile 2014 and shaky 2015, this past year brought about the feeling of stability in both natural gas and oil prices. For the year, WTI increased 43% and Henry Hub natural gas increased 58%. This was the first year-over-year increase in both WTI and Henry Hub since 2013, and prior to that 2007. The WTI to Brent crude spread averaged 3% during 2016, the lowest overall annual average since 2010 when the average was 0%. Factors related to the lower spread include a strong U.S. Dollar, and a full year of U.S. crude oil exports since the 40-year ban was lifted in December 2015. International Supply NewsInternational production decisions, especially those of OPEC, will continue to drive much of the change in oil price going forward. The primary supply factor for 2016 was the actions of OPEC and agreements to cut supply in an effort to stabilize the oil markets. Compounding the issues were OPEC members Iran and Libya which returned to production levels not seen in years due to the lifting of economic sanctions and stabilization of governments. Most recently, OPEC’s latest production cut agreements led to changes in trade. For example, Middle Eastern suppliers are working to keep their market share in Asia by keeping America and Africa’s trade confined to the Atlantic. OPEC in the past has been able to maintain market share by increasing production, driving prices down, and outlasting the competition. In the commodities market, the flow of trade dictates supplier’s ability to take advantage of price gaps in certain areas.Domestic Supply NewsDomestically, production was mixed based upon reserve location and financial wellbeing of producers. Because drilling costs in the Permian are lower than many other plays in the U.S., when oil prices began to show signs of recovery, rig counts in the Permian picked up faster than in any other domestic play. Producers were eager to begin operating after two years of an uneconomical drilling environment, and for many producers, the Permian was the first play in which the cost of oil rose above breakeven costs. Additionally, the Export Ban lifted at the beginning of the year provided more avenues for producers to sell crude.Domestic reserve estimates increased significantly this year as the USGS announced an estimated 20 billion barrels of crude oil, 1.6 billion barrels of NGLs, and 16 trillion cubic feet of natural gas were discovered in four layers of shale in the Wolfcamp formation. This discovery alone is 3x larger than the entire Bakken play in North Dakota, and equates an estimated $900 billion of oil.BankruptciesAs anticipated, many E&P operators and servicers needed a sharp increase in oil prices to avoid restructuring or filing for bankruptcy during 2016. As the sharp increase in oil prices did not occur, tough decisions were made during the year. As mentioned in our July 2016 post, there were four types of energy companies operating in 2016:The “I need to restructure yesterday” company;The “In denial about restructuring” company;The “Racing to restructure” company (to be healthier when oil prices recover); andThe “Low leverage / healthy” company (looking for opportunities); Three of the above types are characterized as being in a motivated seller position. Midway through the year, industry analysts noted over 100 oil and gas companies have filed for bankruptcy with an estimate that we may only be half way done. By the end of the year, “more than 220 upstream and oilfield service companies have declared bankruptcy since the start of the downturn in 2014.” While this is a significant number of bankrupt companies, the higher oil price may give reason to have a positive outlook for 2017. Additionally, 2016 provided significant acquisition opportunities for those companies looking for strategic purchases.TransactionsCrude oil price stability and financially weak E&P companies resulted in an increase in sellers, voluntary or involuntary, which created a relatively robust merger and acquisition market. In comparison to the last ten years, 2016 was the 4th highest year for number of deals. Approximately $69 billion dollars of North American E&P assets and companies changed ownership during 2016 with the Permian Basin resource accounting for nearly 40% of the deal dollar volume. The Marcellus/Utica and Scoop/Stack were a distant 2nd and 3rd, respectively accounting for $6.7 billion and $5.1 billion in deal value. The top six deals during 2016 in terms of dollar value are listed in the chart below. While the top three transactions were scattered throughout North America, the next three involved companies with core assets in the Permian Basin. The largest deals in 2016 are summarized below. Largest North American Deal in 2016: Suncor Energy purchases Canadian Oil Sands2nd Largest North American Deal In 2016: Range Resources purchases Memorial Resources3rd Largest North American Deal In 2016: Rice Energy purchases Vantage Energy4th Largest North American Deal In 2016: Diamondback purchases Brigham Resources5th Largest North American Deal In 2016: RSP Permian purchases Silver-Hill Energy. We explored an allocation of purchase price for this transaction in an earlier post.6th Largest North American Deal In 2016: EOG purchases Yates Petroleum: Refer Here for more information. We explored an allocation of purchase price for this transaction in an earlier post.Outlook for 2017The impacts of the oil and gas downturn will continue into 2017 and likely past that. While OPECs decision to cut production should help supply and demand rebalance and prices to continue recovering, the path to recovery is likely to be slow. There are reasons to expect improvement in the oil and gas market in 2017, but many producers are hesitant to be too optimist.Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

RIA Valuation Insights: Best of 2016

Happy New Year 2017! Here are this past year’s 5 most popular posts from the RIA Valuation Insights Blog.1. The Valuation of Asset Management FirmsThis posts introduced a whitepaper summarizing thoughts on the valuation of RIAs. Understanding the value of an asset management business requires some appreciation for what is simple and what is complex. On one level, a business with almost no balance sheet, a recurring revenue stream, and an expense base that mainly consists of personnel costs could not be more straightforward. At the same time, asset management firms exist in a narrow space between client allocations and the capital markets, and depend on revenue streams that rarely carry contractual obligations and valuable staff members who often are not subject to employment agreements. In essence, RIAs may be both highly profitable and prospectively ephemeral. Balancing the particular risks and opportunities of a given asset management firm is fundamental to developing a valuation.2. What Does the Market Think About RIA Aggregators? Focus Financial is About to Find Out.Focus Financial Partners started preparing documents to file an initial public offering. While it may seem like a good idea on paper, we have many questions about the Focus IPO including: why now, how much, and how is this not a roll-up?3. Portfolio Valuation: How to Value Venture Capital Portfolio InvestmentsIn this guest post from Mercer Capital’s Financial Reporting Blog, our process when providing periodic fair value marks for venture capital fund investments in pre-public companies is described. This process includes examining the most recent financing round economics, adjusting valuation inputs the measurement date, measuring fair value, and reconciling and testing for reasonableness.4. What is Normal Compensation at an Asset Management Firm?Investment management is a talent business, and that talent commands a substantial portion of firm revenue which often exceeds the allocation to equity holders. While there is no perfect answer as to what an individual or group of individuals should be compensated in an RIA, we can look to market data and compensation analysis, measured against the particular characteristics of a given investment management firm’s business model, to make reasonable assumptions about what compensation is appropriate and, by extension, what level of profitability can be expected.5. Updated: Valuation Best Practices for Venture Capital and Private Equity FundsThe International Private Equity and Venture Capital Valuation (IPEV) Guidelines were developed in 2005 to set out recommendations on best practices in the valuation of private equity investments. The IPEV Board is made up of leading industry associations from around the world, including the National Venture Capital Association (NVCA) and the Private Equity Growth Capital Council (PEGCC) in the United States. In October 2015, the IPEV Board published draft amendments to the existing guidelines that, if approved, will go into effect at the beginning of 2016.

Quick Facts: Bakken

Each quarter, Mercer Capital’s Exploration & Production Industry newsletter provides an overview of the E&P sector, including world demand and supply, public market performance, valuation multiples for public companies, and a region focus. Mercer Capital closely follows oil and gas trends in the Permian Basin, Eagle Ford Shale, Bakken Shale, and Marcellus and Utica Shale. Last quarter our E&P newsletter, focused on the Bakken Shale. Today, we take a step back and review the broad characteristics of the Bakken Shale. Download this information in a convenient PDF at the bottom of this post.Bakken at a GlanceFirst Discovered1951Discovery as Viable Play2000Primary ProductionOilOil TypeSweet, Light CrudePlayUnconventional ShaleDrillingHorizontal, Multi-Stage Hydraulic FracturingTop 3 Production CompaniesContinental, Whiting, HessBreakeven$29 – $77 per barrel 1Abnormal DUCs526 2Production Since 20072,517 MMBOE 3IssuesCost of Extraction & Cost of TransportationPotentialImproving Technology, Dakota Access Pipeline Project, and Large, Undiscovered Quantities of Oil & Gas1 North Dakota Dept. of Mineral Reserves Sept. 2015 county-level estimates 2 Drilled Uncompleted Wells with > 3 months in inventory as of January 2016; also referred to as fraclog (Bloomberg Intelligence) 3 EIA as of June 2016OverviewAt 14,700 sq. miles, the Bakken and associated Three Forks formation is the largest continuous crude oil source in the U.S. Discovered in 1951, it remained largely unproductive until 2000 when technological advances such as hydraulic fracturing and horizontal drilling enabled economically viable production of its sizable reserves.The region has struggled recently due to falling oil prices.Geography & DrillingThe Bakken is primarily an oil producing region. It is made up of three layers: top and bottom shale layers, and a siltstone and sandstone middle member. The two shale layers function as source rock that traps oil in the middle member. Even this middle member, however, has low permeability and low porosity, making this a tight, unconventional play. Multi-stage hydraulic fracturing and horizontal drilling are used to extract oil, and pad drilling is commonly used to enhance efficiency. Underlying the Bakken shale layers is a more extensive, thicker shale play called the Three Forks. This layer is accessed using the same unconventional techniques, and is estimated to hold a little over half the undiscovered, recoverable resources of the total Bakken/Three Forks petroleum system.Issues & Future PotentialLimited shipping options from the Upper Midwest create high transportation costs in the play. In combination with the low price of oil and the use of advanced drilling techniques, this lack of transportation pushes the cost of production above the realized wellhead price for most wells in the play. Looking to the future, the Bakken will benefit from new pipelines, continued technological improvements, the likelihood of eventual increases in oil prices, and the formation’s large remaining quantities of oil and gas.Bakken ProductionUndiscovered, Recoverable Resources in BakkenResource Estimate*Oil7,383 MMBNatural Gas6,726 BCFLiquid Natural Gas527 MMB*Mean estimates in the 2013 USGS report.AVAILABLE RESOURCEQuick Facts: BakkenDownload this information in a convenient, one-page PDF. Download

First Quarter 2017 | Segment Focus: Residential Construction

30-Year mortgage rates and 10-Year treasury yields have increased 51 and 59 BPS year-over-year. Favorable macroeconomic environment led to increased residential construction activity and home sales.

Refining | 2017 Issue I

Despite profit margin improvement since the start of 2017, the high cost of RINs led to an increase in operating expenses which more than offset the decrease in cost of goods sold.

E&P First Quarter 2017

Region Focus: Eagle Ford

Region Focus: Eagle Ford Oil prices increased over the last twelve months from $38/bbl at March 31, 2016 to $50/bbl at the end of the first quarter 2017.

E&P Second Quarter 2017

Region Focus: Permian Basin

Region Focus: Permian Basin: Although oil prices have increased over the last 12 months, they fell over the second quarter from $50.54/bbl to $46.02/bbl on June 30, 2017.

Renewable Fuel Standards and Refiners

The Renewable Fuel Standards (RFS) program, which originated from the Energy Policy act of 2005, set a goal to use 36 billion gallons of renewable fuels by 2022. RFS was signed into law by President George W. Bush in order to reduce greenhouse gas emissions and boost rural farm economies. Each November, the EPA issues rules increasing Renewable Fuel Volume Targets for the next year. The following table shows the Renewable Fuel Volume requirements for the past three years and the targets for 2017. Separate quotas and blending requirements are determined for cellulosic biofuels, biomass-based diesel, advanced biofuels, and total renewable fuel. The individual obligations for producers are called Renewable Volume Obligations (RVO). Refiners and importers of gasoline and diesel fuel must meet Renewable Volume Obligations (RVOs) by blending ethanol and biodiesel into gasoline and diesel fuel. An RVO is determined by multiplying the output of the producer by the EPA's announced blending ratios for each of the four standards described above. RINs (Renewable Identification Numbers) are 38-digit numbers used to implement the Renewable Fuel Standards. RBN Energy describes RINs as the “Currency of the […] RFS program”. The EPA explains that when a producer makes one gallon of renewable fuel, RINs are generated. At the end of the year, producers and importers use RINs to demonstrate their compliance with the RFS. Refiners and producers without blending capabilities can either purchase renewable fuels with RINs attached or they can purchase RINs through the EPA's Moderated Transaction System. RINs can be carried over from one compliance year to another, if unused. On the other hand, a RIN deficit can be carried over into the next year but must be made up for during the following year. While integrated refiners blend their petroleum products with renewable fuels, merchant refiners do not have the capability to blend their own petroleum products. Tesoro Corp., an integrated refiner, is not affected by RIN costs. Steven Sterin, EVP & CFO explained in their third quarter earnings call, “in a quarter where RIN costs rise, we reflect the higher obligation in refining and the benefit from blending in our marketing segment. It's important to know that we run our business in the integrated manner. This does not have a material impact on total Company results.” But he did acknowledge that gasoline blending is where the true benefit of integration is realized. Even Tesoro faces challenges acquiring cellulosic and biodiesel RINs. Merchant refiners are required to obtain RINs for RFS compliance purposes. A common theme across refiners’ earnings calls last quarter was the effect of the rising cost of RINs on already squeezed margins. Holly Frontier, a merchant refiner, spent $63 million on RINs, in the third quarter alone. Holly Frontier’s President and CEO, George Damiris, said in their third quarter earnings call that they have considered expanding into fuel marketing because of the current RINs environment. The increase in RIN costs is at the simplest, an issue of supply and demand. Production targets that are greater than equilibrium supply and demand cause price increases to correct the shortage of goods. As Renewable Fuel Volume targets have increased year over year, the price of RINs continue increasing. Reuters quoted that on average Renewable fuel credits saw a 25% increase in price from 2Q 2015 to 2Q 2016. What’s Next?President-elect Trump voiced a pro-ethanol platform when visiting America’s farm states implying that he would keep increasing RFS targets. However, he is also known to be pro-oil and many oil groups have called for changes or the repeal of the RFS program which is known to hurt independent refiners.President-elect Trump has nominated Exxon CEO, Rex Tillerson, as Secretary of State and former Texas Governor, Rick Perry, for Secretary of Energy. Additionally, many more cabinet positions are stacked with oil and gas supporters such as Montana Republican Ryan Zinke, who was nominated to the Department of the Interior, and Oklahoma Attorney General and EPA critic Scott Pruit, who was nominated to head the EPA.Trump’s nominations suggest that the upcoming presidential term will provide a friendly oil and gas environment. While it is unclear what the President-elect’s plan is for the RFS program, it is likely that he will face challenges balancing farm and oil interests.

The Rise of Robo-Advisors

Part 2

As the second part to last week’s blogpost, the following section from Jay Wilson’s forthcoming book on FinTech describes ways to think about the valuation of robo-advisors, including some real world examples of technology based investment management platforms that transacted.Build, Buy, Partner, or Wait and SeePerhaps even more so than other FinTech industry niches, robo-advisory is well positioned for mergers, acquisitions, and partnerships. As mentioned earlier, traditional incumbents are being forced to determine what they want their future relationship with robo-advisors to look like as the role of the financial advisor changes. This quandary leaves incumbents with four options: attempt to build their own robo-advisory platform in-house; buy out a startup and incorporate its technology into their investment strategies; create a business-to-business partnership with a startup; or sit out the robo-advisory wave and continue to operate as usual.Of these options, we are seeing a rise in incumbents acquiring robo-advisory expertise. Large firms that have followed this strategy include Invesco’s acquisition of Jemstep, Goldman Sachs’ acquisition of Honest Dollar, BlackRock’s Acquisition of Future Advisor, and Ally’s acquisition of TradeKing.Other incumbents have elected to be more direct and build their own robo-advisory services in-house. Schwab’s Intelligent Portfolio service launched in March 2015 and was on the leading edge of traditional players building and offering their own robo-advisory services. Two months later, Vanguard launched its internally built robo-advisor, named Personal Advisor, which has already become quite large and manages $31 billion in assets. Furthermore, Morgan Stanley, TD Ameritrade, and Fidelity have all announced plans to release their own homegrown robo-advisories in the future.The partnership strategy has also popped up among traditional incumbents. Partnerships allow traditional incumbents to gain access to a broader array of products to offer their customers without acquiring a robo-advisor. In May 2016, UBS’ Wealth Management Americas group announced a major partnership with startup SigFig in which SigFig will design and customize digital tools for UBS advisors to offer their clients. In exchange, UBS made an equity investment in SigFig, showing the confidence UBS has in SigFig’s ability to create an innovative platform. Also, FutureAdvisor, operating under the auspices of Blackrock, announced partnerships with RBC, BBVA Compass, and LPL in 2016 to offer these institutions’ clients more affordable and automated investment advice, as the institutions continue to explore the idea of building their own robo-advisory service. Personal Capital, a robo-advisor started in 2009, announced a partnership with AlliancePartners to offer its digital wealth management platform to approximately 200 community banks. As seen in the actions of these incumbents, partnering with a startup is becoming an increasingly attractive option, as it allows the incumbent to give robo-advisory a test drive without wholly committing to the idea yet.Lastly, we have also seen traditional incumbents elect to ignore the robo-advisory trend altogether. Raymond James indicated that they would not be offering or launching a robo-advisory platform to compete with its advisors. Raymond James noted that their core business is serving financial advisors and a robo-advisory solution that offers wealth management solutions directly to consumers does not fit their business model. They did indicate that they are looking to expand technology and other services to help their investment advisors but noted that robo-advisory is not a solution that they plan to launch presently.Thus, there are a number of strategic options with varying degrees of commitment by which traditional incumbents can either enter the robo-advisory field, or elect to stay on the sideline near-term. The question of whether to build, buy, partner, or wait and see will become increasingly asked and may extend from large incumbents to smaller RIAs, banks, and wealth managers as robo-advisories continue to pop up across the financial landscape and consumers increasingly desire these products.For those financial institutions considering strategic options as it relates to robo-advisory, we take a closer look at two of the announced robo-advisory transactions–BlackRock/Future Advisor and Ally/TradeKing–in greater detail.BlackRock’s Acquisition of Future Advisor1Blackrock’s acquisition of robo-advisory startup FutureAdvisor for an undisclosed amount in August 2015 is perhaps the most notable example of a robo-advisor acquisition strategy. The acquisition showed the increased staying power of robo-advisors, as Blackrock is the world’s largest asset manager. FutureAdvisor provides investors with a low cost index investing service that diversifies their portfolio in a personalized and holistic manner based on the individual investor’s age, needs, and risk tolerance. A series of algorithms automatically rebalance investors’ accounts, constantly look for tax savings and manage multiple accounts for investors. Assets are held by Fidelity or TD Ameritrade in the investor’s name, to assuage investors’ fears concerning safety and accessibility of funds.FutureAdvisor was founded by Jon Xu and Bo Lu, former Microsoft employees, in early 2010. Significant funding rounds included a first round of seed funding ($1M in early 2010), another seed funding round and a $5 million Series A issue in 2012 and a Series B issue of $15.5 million in 2014. As previously noted, following Blackrock’s acquisition announcement in August 2015, FutureAdvisor announced several significant partnerships (BBVA Compass, RBC, and LPL) to offer low cost investment advice to each entities clients.Bo-Lu, a co-founder of Future Advisor, referred to the acquisition as a “watershed moment, not just as an entity but for the broader financial services industry as a whole.” To better understand the mindset of Blackrock, consider two quotes from members of Blackrock.“Over the next several years, no matter what you think about digital advice, you would be pressed to argue that it won’t be more popular versus less popular five to ten years from now” – Rob Goldstein, Head of Blackrock’s Tech Division2 “More Americans are responsible for investing for the important life goals, whether that is retirement, education, etc. We think that a broad cross section of that market may be slightly under-served. We believe that is the mass-affluent or those who don’t want to seek out a traditional advice model.” - Frank Porcelli, head of BlackRock’s U.S. Wealth Advisory business3The acquisition confirmed the increased staying power of automated investment advice. Blackrock is the world’s largest asset manager and the acquisition of FutureAdvisor signaled Blackrock’s intent to stay ahead of the robo-advisory curve. In addition, FutureAdvisor’s partnership with LPL, BBVA Compass, and RBC prompted other banks to follow suit, including UBS’ partnership with FinTech startup SigFig and Morgan Stanley’s effort to build its own robo-advisor.After the acquisition, FutureAdvisor was able to evolve into a “startup within a huge company,” according to founder Jon Xu. The company still held on to the creative culture and environment of a tech startup, but now has the resources and tools of asset management giant Blackrock at its disposal.The acquisition also reinforced the trend towards a model based on convenience for the consumer rooted in the automated processes. The evolution of financial advising and wealth management will hinge on whether or not the knowledge and personal attention of a human can add enough value to outweigh the benefits of convenience fostered by automation.Ally’s Acquisition of TradeKing4In April 2016, Ally Financial Inc., a bank holding company that provides a variety of financial services including auto financing, corporate financing, and insurance, announced an acquisition of TradeKing for a total purchase price of $275 million. TradeKing is a discount online brokerage firm that provides trading tools to self-directed investors. TradeKing initially offered some of the lowest cost stock trade commissions (at ~$5 share on equity trades) and was also one of the earlier online brokers to integrate social networking and an online community where customers could discuss trading analysis and strategies. Interestingly, Ally noted that it was not interested in offering traditional advisor led investment services but it was interested in digital offerings such as robo-advisors and robo-advisory was cited as a primary consideration for Ally’s interest in TradeKing. In 2014, TradeKing formed TradeKing Advisors, which offers robo-advisory services for a minimum investment of $500.The acquisition reflected creative thinking in the banking industry as bank M&A is typically primarily about cost savings and secondarily about expansion into new markets. Revenue synergies are touted periodically in bank acquisitions but they tend to be secondary considerations for investors and bank managers/directors. The TradeKing acquisition represents a shift in this mindset as the potential benefits from the transaction will largely be in the form of revenue synergies as Ally leverages TradeKing’s brokerage platform and attempts to achieve greater revenues by offering trading and wealth management services to its existing customer base. Convenience for Ally’s customers was clearly top of mind as evidenced by the following quotes from the CEO of both TradeKing and Ally around the time of announcement:“Banking and brokerage should be together so you can save and invest—and easily move money between the two.” Don Montonaro, CEO TradeKing5 “We have a good composition of customers across all demographic segments, from affluent boomers to millennials… Our customers have been happy with our deposit products, but are asking for more from the online bank.”– Diane Morais, Ally Bank, CEO6End Notes1Sources: Financialadvising.com, “Jon Xu Interview”; Forbes.com, “BlackRock To Buy FutureAdvisor, Signaling Robo-Advice Is Here To Stay.”; Financial-planning.com, “FutureAdvisor co-founder: Risk, robos and 'hyperpersonalization.” 2Samantha Sharf, “BlackRock To Buy FutureAdvisor, Signaling Robo-Advice Is Here To Stay,” Forbes, August 26 2015. 3Ibid. 4Sources for Case Study: Techcrunch; S&P Global Market Intelligence; Various articles including: “Ally, Fidelity to Launch Robo-Advisory Services by Theresa W. Carey on Digital Investor; TradeKing Website; and Bloomberg Business. 5Theresa W. Carey, “Ally, Fidelity to Launch Robo-Advisory Services,” Barron’s, April 23, 2016. 6Ibid.

WHITEPAPER | Understand the Value of Your Veterinary Practice

It is inevitable; all successful businesses eventually undergo some form of ownership transition. People do not live forever, so businesses must be passed on in one way or another. There are numerous scenarios under which such transitions occur; however, all transitions must invariably address the question of value. The purpose of this whitepaper is to provide an informative overview regarding the valuation of a veterinary practice.A lack of knowledge regarding the value of your practice could be very costly. Opportunities for successful liquidity events may be missed or estate planning could be incorrectly implemented based on misunderstandings about value. In addition, understanding how veterinary practices are valued may help you understand how to grow the value of your practice and maximize your return when it comes time to sell.

The Rise of Robo-Advisors

Part 1

Despite the potential for FinTech innovation within wealth management, significant uncertainty still exists regarding whether these innovations will displace traditional wealth management business models. In this two part blogpost, excerpted from colleague, Jay Wilson's, new book on FinTech forthcoming from Wiley in early 2017, we look at the potential of Robo-Advisors and offer some thoughts on valuation. Robo-advisory has the potential to significantly impact traditional wealth management. It represents a FinTech niche that is similar to the transition from full-service traditional brokers to discount online brokers. Robo-advisors were noted by the CFA Institute as the FinTech innovation most likely to have the greatest impact on the financial services industry in the short-term (one year) and medium-term (five years). Robo-advisory has gained traction in the past several years as a niche within the FinTech industry offering online wealth management tools powered by sophisticated algorithms that can help investors manage their portfolios at low costs and with minimal need for human contact or advice. Technological advances making this business model possible, coupled with a loss of consumer trust in the wealth management industry in the wake of the financial crisis, have created a favorable environment for the growth of robo-advisory startups meant to disrupt financial advisories, RIAs, and wealth managers. This growth is forcing traditional incumbents to explore their treatment of the robo-advisory model in an effort to determine their response to the disruption of the industry. While there are a number of reasons for the success of robo-advisors attracting and retaining clients thus far, we highlight a few primary reasons.Low Cost. Automated, algorithm-driven decision-making greatly lowers the cost of financial advice and portfolio management.Accessible. As a result of the lowered cost of financial advice, advanced investment strategies are more accessible to a wider customer base.Personalized Strategies. Sophisticated algorithms and computer systems create personalized investment strategies that are highly tailored to the specific needs of individual investors.Transparent. Through online platforms and mobile apps, clients are able to view information about their portfolios and enjoy visibility in regard to the way their money in being managed.Convenient. Portfolio information and management becomes available on-demand through online platforms and mobile apps. Consistent with the rise in consumer demand for robo-advisory, investor interest has grown steadily. While robo-advisory has not drawn the levels of investment seen in other niches (such as online lending platforms), venture capital funding of robo-advisories has skyrocketed from almost non-existent levels ten years ago to hundreds of millions of dollars invested annually the last few years. 2016 saw several notable rounds of investment into not only some of the industry’s largest and most mature players (including rounds of $100 million for Betterment and $75 million for Personal Capital), but also for innovative startups just getting off the ground (such as SigFig and Vestmark). The exhibit below provides an overview of the fee schedules, assets under management and account opening minimums for several of the larger robo-advisors. The robo-advisors are separated into three tiers. Tier I consists of early robo-advisory firms who have positioned themselves at the top of the industry. Tier II consists of more recent robo-advisory startups that are experiencing rapid growth and are ripe for partnership. Tier III consists of robo-advisory services of traditional players who have decided to build and run their own technology in-house. As shown, account opening sizes and fee schedules are lower than many traditional wealth management firms. The strategic challenge for a number of the FinTech startups in Tiers 1 and II is generating enough AUM and scale to produce revenue sufficient to maintain the significantly lower fee schedules. This can be challenging since the cost to acquire a new customer can be significant and each of these startups has required significant venture capital funding to develop. For example, each of these companies has raised over $100 million of venture capital funding since inception. Key Potential Effects of Robo-AdvisoryWe see four potential effects of robo-advisors entering the financial services landscape.The Democratization of Wealth Management. As a result of the low costs of robo-advisory services, new investors have been able to gain access to sophisticated investment strategies that, in the past, have only been available to high net worth, accredited investors.Holistic Financial Life Management. As more people have access to financial advice through robo-advisors, traditional financial advisors are being forced to move away from return-driven goals for clients and pivot towards offering a more complete picture of a client’s financial well-being as clients save for milestones such as retirement, a child’s education, and a new house. This phenomenon has increased the differentiation pressure on traditional financial advisors and RIAs, as robo-advisors can offer a holistic snapshot in a manner that is comprehensive and easy to understandDrivers of the Changing Role of the Traditional Financial Advisor. The potential shift away from return-driven goals could leave the role of the traditional financial advisor in limbo. This raises the question of what traditional wealth managers will look like going forward. One potential answer is traditional financial advisors will tackle more complex issues, such as tax and estate planning, and leave the more programmed decision-making to robo-advisors.Build, Buy, Partner, or Wait and See. As the role of the financial advisor changes, traditional incumbents are faced with determining what they want their relationship with robo-advisory to look like. In short, incumbents are left with four options: build their own robo-advisory in-house, buy a startup and adopt its technology, create a strategic partnership with a startup, or stay in a holding pattern in regard to robo-advisory and continue business as usual. We discuss each option in more depth in the following section. The debate about the impact of technology on wealth management has moved on to considerations about how best to respond. In the second part of this post, we pick up on this last thought about strategies to capitalize on FinTech in the investment management industry, and include a couple of case studies for how it has been done.

Exploration & Production 3Q16 Newsletter | Region Focus: Bakken

Each quarter, Mercer Capital’s Exploration & Production Industry newsletter provides an overview of the E&P sector, including world demand and supply, public market performance, valuation multiples for public companies, and a region focus. This quarter we focus on the Bakken Shale.Excerpting from the third quarter newsletter:Oil prices trended up for the beginning of the third quarter but ended the quarter about where they started. For the last two years companies have postponed exploration activities and cut capital projects to drill new wells. Now that oil prices show signs of recovery, production has increased across the U.S. Although oil prices have increased slightly, oil and gas bankruptcies continued in the third quarter as 52 companies filed for bankruptcy. The majority filed for Chapter 11 protection in hopes to reorganize. Many of the firms that went bankrupt were smaller companies who had less flexibility to exchange debt or draw a second-lien. The price of crude oil is determined by market forces: supply and demand. In order to understand the current pricing environment, we analyze these metrics on pages 1 and 2 of the newsletter.View the newsletter below or download the PDF.

Royalty Interests Discover the Permian

In August 2016, we discussed bankruptcy and valuation issues related to royalty interest owners. We mentioned using the publicly traded market as one method to value royalty interests, specifically observing royalty trusts. As a primer for O&G royalty trusts, these trusts hold various royalty and net profit interests in wells operated by large exploration & production companies. These trusts have little in the way of operating expenses, have defined termination dates and can serve as an investment opportunity that provides exposure to oil and gas prices. This Motley Fool article, from 2014, explains the pros and cons of investing in this sort of vehicle.Market indications are available in the form of publicly traded oil & gas (“O&G”) royalty trusts. There are approximately 20 oil and gas focused royalty trusts publicly traded, as of the date of this article.1Market ObservationsRoyalty trusts, like the rest of the oil and gas industry, have been hit hard over the previous 29 months. Before the bottom fell out, oil traded as high as $106.86 in June of 2014 and plunged to a low of $29.05 in February of 2016. Since February, the price of oil appears to have found a new home around $50 / barrel. Here is a comparison of the 20 publicly traded royalty trusts’ metrics today versus one year ago.Observations and Disclaimers:Price to revenue and price to distributable income indicate, on average, the trusts are more expensive now than a year ago. This is a flip from our August 2016 blog post when multiples were lower in July 2016 than July 2015.Yields were higher last year as trailing yields did not reflect the quickly falling market price.As of today, market prices have leveled off and annual distributions are comprised of a full year of lower royalty payments, resulting in lower yields compared to a year ago.Price to PV 10 is higher this year compared to last. The remaining observations are for commodity prices, both current and futures price for the 12 month contract.Disclaimer: no two of the above royalty trusts are alike. Differences abound in asset mix, asset location, term, and resource mix, just to name a few. In future blog posts, we will explore each trust individually and discuss their uniqueness. Below is a chart of the market price performance for each royalty trust over the last two years. The above chart looks very similar to the performance of the price of oil and gas over the same time period. Royalty interest owners have seen their monthly payments move in the same manner, and possibly have not experienced the small rebound during 2016. Uncertainty is high as some operators have been forced to file bankruptcy after commodity prices have remained low for too long for them to survive. Three of the above 20 royalty trusts are tied to SandRidge Energy. In May 2016, SandRidge Filed for Bankruptcy Reorganization and Emerged from Bankruptcy in October 2016. During this time, the three royalty trusts: (1) SandRidge Mississippian Trust 12, (2) SandRidge Mississippian Trust II3 and (3) SandRidge Permian Trust4 experienced the following performance: The popularity of the Permian Basin is nothing new this year. In oil and gas, location is key when trying to generate returns on invested capital. Even as the price of oil is near three year lows, transaction activity is high in this area of the country. Royalty Trusts appear to support the trend to try to get a piece of the very hot Permian Basin. Add on the reserve discovery in the Wolfcamp formation by the United States Geological Survey last month and it is clear that there is no other place to be drilling for oil right now. This attention appears to have spread into the royalty trusts. As the publicly traded price indicates, after SandRidge Energy files for bankruptcy, albeit “pre-arranged reorganization,” each of the three related royalty trusts decline. The price of the two trusts which do not own properties in the Permian Basin decline more than 20% initially after the bankruptcy filing while the SandRidge Permian Trust’s price declines only 6%. Upon emergence from bankruptcy, the trust with Permian related assets was up 11% while the two non-Permian related trusts were down more than 35%. Depending on your situation, the current pricing environment may provide excellent planning opportunities as market prices are relatively low. With the Treasury Department attempting to change the way gift and estate planning can be performed, it is even more timely to execute a transfer plan. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed. End Notes1 Data for charts and tables for this post are from Capital IQ 2 The Trust holds Royalty Interests in specified oil and natural gas properties located in the Mississippian formation in Alfalfa, Garfield, Grant and Woods counties in Oklahoma. (respective 10-K, March 2016) 3 The Trust holds Royalty Interests in specified oil and natural gas properties located in the Mississippian formation in Alfalfa, Grant, Kay, Noble and Woods counties in northern Oklahoma and Barber, Comanche, Harper and Sumner counties in southern Kansas. (respective 10-K, March 2016) 4 The Trust holds Royalty Interests in specified oil and natural gas properties in the Permian Basin located in Andrews County, Texas. (respective 10-K, March 2016)

Sterling National Regifts Trust Department to Midland

Last Christmas, a gift grab almost ripped my entire family apart. If you have never participated in a gift grab and all of its associated horrors, the rules are simple enough. Each participant is tasked with finding a gift under a specific price point that (hopefully) everyone would enjoy. On the day of the gift exchange, numbers are drawn by random to determine the order, with the first player choosing a gift to open, and the second player choosing whether to steal the opened gift or open a new one, and so on. If a player has a gift stolen from them, they get to open a new gift.What was supposed to be a “fun” game soon devolved into a sort of passive-aggressive warfare, the likes of which I have never seen. By the time every gift had been allotted, factions had been made, treaties broken, and at least three of us were on the verge of tears. I, meanwhile, was happy as a clam with my punny bag of “hand soap” – quite literally, soap shaped into little hands that was once lovingly described as looking like a “bag of amputated baby hands.” No one else wanted them, but what can I say; I’m a sucker for word play.As inspiration for fair deals and perfect swaps, we looked into Midland State Bancorp’s recent acquisition of Sterling National Bank’s trust department. From what we’ve read about the deal, it appears both parties walked away with what they wanted.In November of 2014, Sterling National Bank announced the acquisition of Hudson Valley Bank (“HVB”) in order to expand Sterling’s loan and deposit market into the greater New York City metropolitan area. The deal was a lucrative one in terms of both market expansion and balance sheet growth. As of the closing in June of 2015, Sterling acquired 28 new branches across five counties, with $288 million in assets, $1.8 billion in loans, and $3.2 billion in deposits. Along with the deal, however, Sterling also happened to acquire HVB’s small, but not immaterial, trust department with over $423 million in managed assets. The only problem was that Sterling had opened an additive gift that they did not have the structure for and was too small to stand on its own, but too large to ignore.Midland States Bank announced its acquisition of Sterling’s wealth management assets in February of this year, the majority if which happened to be in Special Needs and Settlement Trusts. Midland’s structure was well suited for the deal, with a specialty in trusts that had developed through a prior acquisition in 2013. The deal closed for $4.8 million, retaining all 12 members of Sterling’s trust department, and bringing its wealth management AUM up to $1.6 billion. The EBITDA margin was not disclosed in the announcement of the deal (the fact that the price alone was reported, is unusual), but following a typical EBITDA margin of 20% to 30% for a trust department, the deal falls within a range of EBITDA multiples from 5.7x to 8.6x. The midpoint of the range, 6.8x, depicts a strategic sale that was neither a fire sale nor a purse buster. This appears to be a gift exchange done well – greater manpower and AUM for Midland’s trust department, and a cleaner balance sheet and some cash to boot for Sterling’s bank practice - a strategic deal for both buyer and seller. My family should take note. With another holiday season upon us, we hope that if you get dragged into a gift grab, your gift be perfect for you. And if you’re in need of some creepy soap, I know a guy… Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

An Introduction to Dividends and Dividend Policy for Private Companies

As the calendar year draws to a close, many private companies consider the issue of dividends and dividend policy. Originally published in Unlocking Private Company Wealth, Z. Christopher Mercer, ASA, CFA, ABAR provides an introduction to dividends and dividend policy. He begins with the obvious observation that no matter how informal, your company has a dividend policy. Reprinted with permission. The issue of dividends and dividend policy is of great significance to owners of closely held and family businesses and deserves considered attention. Fortunately, I had an early introduction to dividend policy beginning with a call from a client back in the 1980s. I had been valuing a family business, Plumley Rubber Company, founded by Mr. Harold Plumley, for a number of years. One day in the latter 1980s, Mr. Plumley called me and asked me to help him establish a formal dividend policy for his company, which was owned by himself and his four sons, all of whom worked in the business. Normally I do not divulge the names of clients, but my association with the Plumley family and Plumley Companies (its later name) was made public in 1996 when Michael Plumley, oldest son of the founder and then President of the company, spoke at the 1996 International Business Valuation Conference of the American Society of Appraisers held in Memphis, Tennessee. He told the story of Plumley Companies and was kind enough to share a portion of my involvement with them over nearly 20 years at that point. Let’s put dividends into perspective, beginning with a discussion of (net) earnings and (net) cash flow. These are two very important concepts for any discussion about dividends and dividend policy for closely held and family businesses. To simplify, I’ll often drop the (net) when discussion earnings and cash flow, but you will see that this little word is important.(Net) Earnings of a BusinessThe earnings of a business can be expressed by the simple equation:Earnings = Total Revenue – Total CostCosts include all the operating costs of a business, including taxes.C Corporations. If your corporation is a C corporation, it will pay taxes on its earnings and earnings will be net of taxes. The line on the income statement is that of net income, or the income remaining after all expenses, including taxes, both state and federal, have been paid. By the way, if your company is a C corporation, feel free to give me a call to start a conversation about this decision.S Corporations and LLCs. If your corporation is an S corporation or an LLC (limited liability company), the company will make a distribution so that its owners can pay their pass-through taxes on the income. To get to the equivalent point of net income on a C corporation’s income statement, it is necessary to go to the line called net income (but it is not) and to subtract the total amount of distributions paid to owners for them to pay the state and federal income taxes they owe on the company’s (i.e., their pass through) earnings. This amount would come from the cash flow statement or the statement of changes in retained earnings. Ignoring any differences in tax rates, the net income, after taxes (corporate or personal) should be about the same for C corporations and pass-through entities.(Net) Cash FlowCompanies have non-cash charges like depreciation and amortization related to fixed assets and intangible assets. They also have cash charges for things that don’t flow through the income statement. Capital expenditures for plant and equipment, buildings, computers and other fixed assets are netted against depreciation and amortization, and the result is either positive or negative in a given year. Capital expenditures tend to be "lumpy" while the related depreciation expenses are amortized over a period of years, often causing swings in the net of the two.There are other "expenses" and "income" of businesses that do not flow through the income statement. These investments, either positive or negative, relate to the working capital of a business. Working capital assets include inventories and accounts receivable, and working capital liabilities include accounts payable and other short-term obligations. Changes in working capital can lead to a range of outcomes for a business. Consider these two extremes that could occur regarding cash in a given year:Make lots of money but have no cash. Rapidly growing companies may find that while they have positive earnings, they have no cash left at the end of the month or year. They have to finance their rapid growth by leaving all or more than all of earnings in the business in the form of working capital to finance investments in accounts receivable and/or inventories and in the purchase of fixed assets to support that growth.Make little money, even have losses, and generate cash. Companies that experience sales declines may earn little, or even lose money on the income statement, and still generate lots of cash because they collect prior receivables or convert previously accumulated inventories into cash during the slowdown. Working capital on the balance sheet is the difference between current assets and current liabilities. Many companies have short-term lines of credit with which they finance working capital investments. The concept of working capital, then, may include changes in short-term debt. In addition, companies generate cash by borrowing funds on a longer-term basis, for example, to finance lumpy capital expenditures. In the course of a year, a company may be a net borrower of long-term debt or be in a position of paying down its long-term debt. So we’ll need to consider the net change in long-term debt if we want to understand what happens to cash in a business during a given year. We are developing a concept of (net) cash flow, which can be defined as follows in Figure 11.Most financial analysts and bankers will agree that this is a pretty good definition of Net Cash Flow.Net Cash Flow is the Source of Good ThingsWe focus on cash flow because it is the source of all good things that come from a business. The current year’s cash flow for a business is, for example, the source of:Long-term debt repayment. Paying debt is good. Bankers are extremely focused on cash flow, because they only want to lend long-term funds to businesses that have the expectation of sufficient cash flow to repay the debt, including principal and interest on the scheduled basis. Interest expense has already been paid when we look at net cash flow. Companies borrow on a long-term basis to finance a number of things like land, buildings and equipment, software and hardware, and many other productive assets that may be difficult to finance currently. They may also borrow on a long term basis to finance stock repurchases or special dividends.Reinvestment for future growth. Investment in a business is good if adequate returns are available. If a company generates positive cash flow in a given year, it is available to reinvest in the business to finance its future growth. Reinvested earnings are a critical source of investment capital for closely held and private companies Reinvesting with the expectation of future growth (in dividends and capital gains) is an important source of shareholder returns, but the return is deferred, at least in the form of cash, until a future date.Dividends or distributions. Corporate dividends are also good, particularly if you are a recipient. Cash flow is also the normal source for dividends (for C corporation owners) or what we call “economic distributions,” or distributions net of shareholder pass-through taxes (for S corporation and LLC owners).What is a Dividend?At its simplest, a dividend (or economic distribution) reflects the portion of earnings not reinvested in a business in a given year, but paid out to owners in the form of current returns.For some or many closely held and family businesses, effective dividends can include another component, and that is the amount of any discretionary expenses that likely would be “normalized” if they were to be sold. Discretionary expenses include:Above-market compensation for owner-managers. Owners of some private businesses who compensate themselves and/or family members at above-market rates should realize that the above-market portion of such compensation is an effective dividend.Mystery employees on the payroll. Some companies place non-working spouses, children or other relatives on the payroll when no work is required of them.Expenses associated with non-operating assets used for owners’ personal benefit. Non-operating assets can include company-owned vacation homes, aircraft not necessary for the operation of the business, vehicles operated by non-working family members, and others. It is essential to analyze above-market compensation and other discretionary expenses from owners’ viewpoints to ascertain the real rate of return that is obtained from investments in private businesses. In an earlier chapter, we touched on the concept of the rate of return on investment for a closely held business. Assuming that there were no realized capital gains from a business during a given year, the annual return (AR) is measured as follows:Now, we add to this any discretionary expenses that are above market or not normal operating expenses of the business that are taken out by owners:We now know what dividends are, and they include discretionary benefits that will likely be ceased and normalized into earnings in the event of a sale.We won’t focus on discretionary benefits in the continuing discussion of dividends and dividend policy. However, it is important for business owners to understand that, to the extent discretionary benefits exist, they reflect portions of their returns on investments in their businesses.In summary, dividends are current returns to the owners of a business. Dividends are normally residual payments to owners after all other necessary debt obligations have been paid and all desirable reinvestments in the business have been made.Dividends and Dividend Policy for Private CompaniesWith the above introduction to dividends for private companies, we can now talk about dividend policy. The remainder of this chapter focuses on seven critical things for consideration as you think about your company’s dividend policy.Every company has a dividend policy.Dividend policy influences return on business investment.Dividend policy is a starting point for portfolio diversification.Special dividends enhance personal liquidity and diversification.Dividend policy does matter for private companies.Dividend policy focuses management attention on financial performance.Boards of directors need to establish thoughtful dividend policies. We now focus on each of these seven factors you need to know about your company’s dividend policy.Every Company Has a Dividend PolicyLet’s begin with the obvious observation that your company has a dividend policy. It may not be a formal policy, but you have one. Every year, every company earns money (or not) and generates cash flow (or not). Assume for the moment that a company generates positive earnings as we defined the term above. If you think about it, there are only three things that can be done with the earnings of a business:Reinvest the earnings in the business, either in the form of working capital, plant and equipment, software and computers, and the like, or even excess or surplus assets.Pay down debt.Pay dividends to owners (or economic distributions – after pass-through taxes – for S corporations and LLCs) or repurchase stock (another form of returns to shareholders). That’s it. Those are all the choices. Every business will do one or more of these things with its earnings each year. If a business generates excess cash and reinvests in CDs, or accumulates other non-operating assets, it is reinvesting in the business, although likely not at an optimal rate of return on the reinvestment. Even if your business does not pay a dividend to you and your fellow owners, you have a dividend policy and your dividend payout ratio is 0% of earnings. On the other hand, if your business generates substantial cash flow and does not require significant reinvestment to grow, it may be possible to have a dividend policy of paying out 90% or even up to 100% of earnings in most years. This is often the case in non capital intensive service businesses. Recall that if a business pays discretionary benefits to its owners that are above market rates of compensation, or if it pays significant expenses that are personal to the owners, it is the economic equivalent of paying a dividend to owners. So when talking to business owners where such expenses are significant, we remind them that they are, indeed, paying dividends and should be aware of that fact. Some may think that discretionary expenses are the provenance of only small businesses; however, they exist in many businesses of substantial size, even into the hundreds of millions in value. Discretionary expenses are not necessarily bad, but they can create issues. In companies with more than one shareholder, discretionary expenses create the potential for (un)fairness issues. However, discretionary expenses are paid for the benefit of one shareholder or group of shareholders and not for others, they are still a return to some shareholders. Every company, including yours, has a dividend policy. Is it the right policy for your company and its owners?Dividend Policy Influences Return on Business InvestmentTo see the relationship between dividend policy and return on investment we can examine a couple of equations. This brief discussion is based on a lengthier discussion in my book, Business Valuation: An Integrated Theory Second Edition (John Wiley & Sons, 2007). There is a basic valuation equation, referred to as the Gordon Model. This model states that the price (P0) of a security is its expected dividend (D1) capitalized at its discount rate (R) minus its expected long term growth rate in the dividend (Gd). This model is expressed as follows:D1 is equal to Earnings times the portion of earnings paid out, or the dividend payout ratio (DPO), so we can rewrite the basic equation as follows:What this equation says is that the more that a company pays out in dividends, the less rapidly it will be able to grow, because Gd, or the growth rate in the dividend, is actually the expected growth rate of earnings based on the relevant dividend policy.We can look at this simplistically in word equations as follows:Dividend Income + Capital Gains = Total ReturnDividend Yield + Growth (Appreciation) = Cost of Equity (or the discount rate, R)These equations reflect basic corporate finance principles that pertain, not only to public companies, but to private businesses as well. There is an important assumption in all of the above equations – cash flow not paid out in dividends is reinvested in the business at its discount rate, R.There are many examples of successful private companies that do not pay dividends, even in the face of unfavorable reinvestment opportunities. To the extent that dividends are not paid and earnings are reinvested in low-yielding assets, the accumulation of excess assets will tend to dampen the return on equity and investment returns for all shareholders.Further, the accumulation of excess assets dampens the relative valuation of companies, because return on equity (ROE) is an important driver of value. For example, consider the following relationship without proof:ROE x Price/Earnings Multiple = Price/Book ValueAt a given multiple of (net) earnings available in the marketplace, a company’s ROE will determine its price/book value multiple. The price/book value multiple tells how valuable a company is in relationship to its book value, or the depreciated cost value of its shareholders’ investments in the business.Let’s consider a simple example. Assume that a company generates an ROE of 10% and that the relevant market price/earnings multiple (P/E) is 10x. Using the formula above:In this example, the company would be valued at its book value and the shareholders would not benefit from any “goodwill,” or value in excess of book value. Consider, however, that a similar company earns an ROE of 15%.Assuming the same P/E of 10x, it would be valued at 150% of its book value.Suppose the second company, because of its superior returns, received a P/E of 11x. In that case the price/book multiple would be 165%. To the extent that a company’s dividend policy influences its ongoing ROE, it influences its relative value in the marketplace and the ongoing returns its shareholders receive. In short, your dividend policy influences your return on investment in your business, as well as your current returns from that investment.Dividend Policy is a Starting Point for Portfolio DiversificationRecall the story of my being asked to help develop a dividend policy for a private company. The company had grown rapidly for a number of years and its growth and diversification opportunities in the auto parts supply business were not as attractive as they had been. The CEO, who was the majority shareholder, realized this and also that his sons (his fellow shareholders) could benefit from a current return on their investments in the company, which, collectively, were significant.We reviewed the dividend policies of all of the public companies that we believed to be reasonably comparable to the company. I don’t recall the exact numbers now, but I believe that the average dividend yield for the public companies was in the range of 3%. As I analyzed the private company, it was clear that it was still growing somewhat faster than the publics, so the ultimate recommendation for a dividend was about 1.5% of value.The value that the 1.5% dividend yield was compared to was the independent appraisal that we prepared each year. Based on the value at the time, I recall that the annual dividend began at something on the order of $300,000 per year. But, for the father and the sons, it was a beginning point for diversification of their portfolios away from total concentration in their successful private business.Your dividend policy can be the starting point for wealth diversification, or it can enhance the diversification process if it is already underway.Special Dividends Enhance Personal Liquidity and DiversificationA number of years ago, I was an adviser to a publicly traded bank holding company. Because of past anemic dividends, this bank had accumulated several million dollars of excess capital. The stock was very thinly traded and the market price was quite low, reflecting a very low ROE (remember the discussion above).Because of the very thin market for shares, a stock repurchase program was not considered workable. After some analysis, I recommended that the board of directors approve a large, one-time special dividend. At the same time I suggested they approve a small increase in the ongoing quarterly dividend. Both of these recommendations provided shareholders with liquidity and the opportunity to diversify their holdings.Since the board of directors collectively held a large portion of the stock, the discussion of liquidity and diversification opportunities while maintaining their relative ownership position in the bank was attractive.At the final board meeting before the transaction, one of the directors did a little bit of math. He noted that if they paid out a large special dividend, the bank would lose earnings on those millions and earnings would decline. I agreed with his math, but pointed out (calculations already in the board package) that the assets being liquidated were very low in yield and that earnings (and earnings per share) would not decline much. With equity being reduced by a larger percentage, the bank’s ROE should increase. So that increase in ROE, given a steady P/E multiple in the marketplace, should increase the bank’s Price/Book Value multiple.The director put me on the spot. He asked point blank: "What will happen to the stock price?" I told him that I didn’t know for sure (does one ever?) but that it should increase somewhat and, if the markets believed that they would operate similarly in the future, it could increase a good bit. The stock price increased more than 20% following the special dividend.Special dividends, to the extent that your company has excess assets, can enhance personal liquidity and diversification. They can also help increase ongoing shareholder returns. I have always been against retaining significant excess assets on company balance sheets because of their negative effect on shareholder returns and their adverse psychological impact. It is too easy for management to get "comfortable" with a bloated balance sheet.If your business has excess assets, consider paying a special dividend. Your shareholders will appreciate it.Dividend Policy Does Matter for Private CompaniesSomeone once said that earnings are a matter of opinion, but dividends are a matter of fact. What we know is that when dividends are paid, the owners of companies enjoy their benefit, pay their taxes, and make individual choices regarding their reinvestment or consumption.The total return from an investment in a business equals its dividend yield plus appreciation (assuming no capital gains), relative to beginning value. However, unlike unrealized appreciation, returns from dividends are current and bankable. They reduce the uncertainty of achieving returns. Further, if a company’s growth has slowed because of relatively few good reinvestment opportunities, a healthy dividend policy can help assure continuing favorable returns overall.Based on many years of working with closely held businesses, we have observed that companies that do not pay dividends and, instead, accumulate excess assets, tend to have lower returns over time. There is, however, a more insidious issue. The management of companies that maintain lots of excess assets may tend to get lazy-minded. Worse, however, is the opposite tendency. With lots of cash on hand, it is too easy to feel pressure to make a large and perhaps unwise investment, e.g., an acquisition, that will not only consume the excess cash but detract from returns in the remainder of the business.Dividend policy is the throttle by which well-run companies gauge their speed of reinvestment. If investment opportunities abound, then a no- or low-dividend payout may be appropriate. However, if reinvestment opportunities are slim, then a heavy dividend payout may be entirely appropriate.Any way you cut it, dividend policy does matter for private companies.Dividend Policy Focuses Management Attention on Financial PerformanceBoards of directors are generally cautious with dividends and once regular dividends are being paid, are reluctant to cut them. The need, based on declared policy, to pay out, say, 35% of earnings in the form of shareholder dividends (example only) will focus management’s attention on generating sufficient earnings and cash flow each year to pay the dividend and to make necessary reinvestments in the business to keep it growing.No management (even if it is you) wants to have to tell a board of directors (even if you are on it) or shareholder group that the dividend may need to be reduced or eliminated because of poor financial performance.Boards of Directors Need to Establish Thoughtful Dividend PoliciesIf dividend policy is the throttle with which to manage cash flow not needed for reinvestment in a business, it makes sense to handle that throttle carefully and thoughtfully. Returns to shareholders can come in the form of dividends or in the form of share repurchases.While a share repurchase is not a cash dividend, it does provide cash to selling shareholders and offsetting benefits to remaining shareholders. Chapter 10 of the book (Leveraged Share Repurchase: An Illustrative Example) provides an example of a substantial leveraged share repurchase from a controlling shareholder to provide liquidity and diversification.From a theoretical and practical standpoint, the primary reason to withhold available dividends today is to reinvest to be able to provide larger future dividends – and larger in present value terms today. It is not a good dividend policy to withhold dividends for reasons like the following:A patriarch withholds dividends to prevent the second (or third or more) generations from being able to have access to funds.A control group chooses to defer dividends to avoid making distributions to certain minority shareholders.Dividends are not paid because management (and the board) want to build a large nest egg against possible future adversities.Dividends are not paid to accumulate excess or non-operating assets on the balance sheet for personal or vanity reasons.Dividend policy is important and your board of directors needs to establish a thoughtful dividend policy for your business.ConclusionDividends and dividend policies are important for the owners of closely held and family businesses. Dividends can provide a source of liquidity and diversification for owners of private companies. Dividend policy can also have an impact on the way that management focuses on financial performance.To discuss corporate valuation or transaction advisory issues in confidence, please contact us.

Buy-Sell Agreements for Investment Management Firms

An Ounce of Prevention is Worth a Pound of Cure

The classic car world is full of stories of “barn finds” – valuable cars that were forgotten in storage for decades, found and restored and sold for mint. One of the most famous is pictured above, a Ferrari 250 GT SWB California Spyder once owned by a French actor and found in a barn on a French farm in 2014. The car was one of 36 ever made and one of the most valuable Ferraris in existence. Once the Ferrari was exhumed, it was lightly cleaned and sold, basically as found, for $23 million at auction. As difficult it is to imagine such a valuable car being forgotten, what we see more commonly are forgotten buy-sell agreements, collecting dust in desk drawers. Unfortunately, these contracts often turn into liabilities, instead of assets, once they are exhumed, as the words on the page frequently commit the signatories to obligations long forgotten. So we encourage our clients to review their buy-sell agreements regularly, and have compiled some of our observations about how to do so in the whitepaper below. You can also download it as a PDF at the bottom of this page. We hope this will be helpful to you; call us if you have any questions.IntroductionAlmost every conversation we have with a new RIA client starts something like this: “We hired you because you do lots of work with asset managers, but as you get into this project you need to understand that our firm is very different from others.” Our experience, so far, confirms this sentiment of uniqueness that is not at all unique among investment managers. Although there are twelve thousand or so separate Registered Investment Advisors in the U.S. (not to mention several hundred independent trust companies and a couple thousand bank trust departments), there seems to be a comparable number of business models. Every client who calls us, though, has the same issue on their plate: ownership.Ownership can be the single biggest distraction for a professional services firm, and it seems like the RIA community feels this issue more than most. After all, most asset managers are closely held (so the value of the firm is not set by the market). Most asset managers are owned by unrelated parties, whereas most closely-held businesses are owned by members of the same family. A greater than normal proportion of asset management firms are very valuable, such that there is more at stake in ownership than most closely held businesses. Consequently, when disputes arise over the value of ownership in an asset management firm, there is usually more than enough cash flow to fund the animosity, and what might be a five figure settlement in some industries is a seven figure trial for an RIA.Avoiding expensive litigation is one reason to focus on your buy-sell agreement, but for most firms the more compelling reasons revolve around transitioning ownership to perpetuate the firm. Institutional clients increasingly seem to query about business continuity planning, and the SEC has of course recently proposed transition planning guidelines. There are plenty of good business reasons to have a robust buy-sell agreement in any closely held company, but in RIAs there are client and regulatory reasons as well.SEC Proposed RuleEvery SEC-registered investment adviser must adopt and implement a written business continuity and transition plan that reasonably addressed operational risks related to a significant disruption or transition in the adviser's business.Business Continuity PlanningTransition PlanningMaintenance of critical operations/systems, as well as protection, backup and recovery of dataPolicies and procedures to safeguard, transfer, and/or distribute client assets during a transitionAlternate physical office locationsPolicies and procedures to facilitate prompt generation of client specific information necessary to transition each accountCommunication plans for clients, employees, vendors and regulatorsInformation regarding the corporate governance structure of the adviserIdentification and assessment of third-party services critical to the operationIdentification of any material financial resources available to the adviserKey Elements of the SEC’s Proposal: “Adviser Business Continuity and Transition Plans,” 206 (4)-4Buy-Sell Agreement BasicsSimply put, a buy-sell agreement establishes the manner in which shares of a private company transact under particular scenarios. Ideally, it defines the conditions under which it operates, describes the mechanism whereby the shares to be transacted are priced, addresses the funding of the transaction, and satisfies all applicable laws and/or regulations.These agreements aren’t necessarily static. In investment management firms, buy-sell agreements may evolve over time with changes in the scale of the business and breadth of ownership. When firms are new and more “practice” than “business,” these agreements may serve more to decide who gets what if the partners decide to go separate ways. As the business becomes more institutionalized, and thus more valuable, a buy-sell agreement – properly rendered – is a key document to protect the shareholders and the business (not to mention the firm’s clients) in the event of an ownership dispute or other unexpected change in ownership. Ideally, the agreement also serves to provide for more orderly ownership succession, not to mention a degree of certainty for owners that allow them to focus on serving clients and running the business instead of worrying about who gets what benefit of ownership.The irony of buy-sell agreements is that they are usually drafted and signed when all of the shareholders think similarly about their firm, the value of their interest, and how they would treat each other at the point they transact their stock. The agreement is drafted, signed, filed, and forgotten. Then an event occurs that invokes the buy-sell, and the document is pulled from the drawer and read carefully. Every word is parsed, and every term scrutinized, because now there are not simply co-owners with aligned interests – but rather buyers and sellers with symmetrically opposed interests.Our Advice: Key Considerations for Your Buy-Sell AgreementAt Mercer Capital we have read hundreds, if not thousands, of buy-sell agreements. While we are not attorneys and do not attempt to draft such agreements, our experience has led us to a few conclusions about what works well and what doesn’t. By “working well”, we mean an enduring agreement that efficiently manages ownership transactions and transitions in a variety of circumstances. Agreements that don’t work well become the subject of major disputes – the consequence of which is a costly distraction.The primary weaknesses we see in buy-sell agreements relate to issues of valuation: what is to be valued, how, when, and by whom. The following issues and our corresponding advice are drawn from our experience of agreements that performed well and those that did not. While we haven’t seen everything, we have been more involved than most in helping craft agreements, maintaining compliance with valuation provisions, and resolving disagreements.1. Decide What You Mean By “Fair”A standard refrain from clients crafting a buy-sell agreement is that they “just want to be fair” to all of the parties in the agreement. That’s easier said than done, because fairness means different things to different people. The stakeholders in a buy-sell at an investment management firm typically include the founding partners, subsequent generations of ownership, the business itself, non-owner employees of the business, and the clients of the firm. Being “fair” to that many different parties is nearly impossible, considering the different motivations and perspectives of the parties:Founding owners. Aside from wanting the highest possible price for their shares, founding partners are usually desirous of having the flexibility to work as much or as little as they want to, for as many years as they so choose. These motivations may be in conflict with each other, as ramping down one’s workload into a state of partial retirement and preserving the founding generation’s imprint on the company requires a healthy business, which in turn necessarily requires consideration of the other stakeholders in the firm. We read one buy-sell agreement where the founder had secured his economic return by requiring the company, in the event of his death, to redeem his shares at a value that did not consider the economic impact of his death (the founder was a significant rainmaker). One can only imagine, at the founder’s death, how that would go when the other partners and employees of the firm “negotiated” with the estate – as if a piece of paper could checkmate everything else in a business where the assets of the firm get on the elevator and go home every night.Subsequent generation owners. The economics of a successful RIA can set up a scenario where buying into the firm can be very expensive, and new partners naturally want to buy as cheaply as possible. Eventually, however, there is symmetry of economic interests for all shareholders, and buyers will eventually become sellers. Untimely events can cause younger partners to need to sell their stock, and they don’t want to be in a position of having to give it up too cheaply. Younger partners also tend to underestimate the cost of building their own firm instead of buying into the existing one; other times, they don’t.The firm itself. The company is at the hub of all the different stakeholder interests, and is best served if ownership is a minimal consideration in how the business is run. Since hand-wringing over ownership rarely generates revenue, having a functional shareholder’s agreement that reasonably provides for the interests of all stakeholders is the best case scenario for the firm. If firm leadership understands how ownership is going to be handled now and in the future, they can be free to do their jobs and maximize the performance of the company. At the other end of the spectrum, buy-sell disputes are very costly to the organization, distracting the senior-most staff from matters of strategy and client service for years, and rarely ending with a resolution that compensates for lost business opportunities which may never even be identified.Non-owner employees. Not everyone in an investment management firm qualifies for ownership or even wants it, but all RIAs are economic eco-systems in which all employees depend on the presence of a stable and predictable ownership.Clients. It is no surprise that the SEC made ownership continuity planning part of its recent proposed regulations for RIAs. The SEC may not care, per se, who gets the benefits of ownership of an investment management firm, but they know that the investing public is best served by asset managers who have provided for the continuity of investment management in the event of changes in the partner base. Institutional clients are often very interested in continuity plans, so it is to the benefit of RIAs to have fully functioning ownership models with buy-sell agreements that provide for the long term health of the business. As the profession ages, we see transition planning as either a competitive advantage (if done well) or a competitive disadvantage (if disregarded) – all the more reason to pay attention.The point of all this is to consider whether or not you want your buy-sell agreement to create winners and losers, and if so, be deliberate about defining who wins and who loses. Ultimately, economic interests which advantage one stakeholder will disadvantage some or all of the other stakeholders, dollar for dollar. If the pricing mechanism in the agreement favors a relatively higher valuation, then whoever sells first gets the biggest benefit of that, to the expense of the other partners and anyone buying into the firm. If pricing is too high, internal buyers may not be available and the firm may need to be sold (truly the valuation’s day of reckoning) to perfect the agreement. At relatively low valuations, internal transition is easier and business continuity is more certain, but the founding generation of ownership may be perversely encouraged to not bring in new partners, stay past their optimal retirement age, or push more cash flow into compensation instead of shareholder returns as the importance of ownership is diminished. Recognizing and ranking the needs of the various stakeholders in an RIA is always a balancing act, but one which is probably best done intentionally.Buy-Sell Agreements and Contract TheoryThe 2016 Nobel Prize in Economics was awarded to Professors Oliver Hart (Harvard) and Bengt Holmstrom (MIT) for their work in developing contract theory as a foundational tool of economics. The notion of contract theory organizes participants in an economy into principals (owners) and agents (employees), although the principal/agent relationship can be applied to many economic exchanges.Agents act on behalf of principals, but those actions are at least partially unobserved, so contracts must exist to incentivize and punish behavior, as appropriate, such that principals can be reasonably assured of getting the benefit of compensation paid to agents. The optimal contract to accomplish this weighs risks against incentives. The problem with contracts is that all of them are incomplete, in that they can’t specify every eventuality. As a consequence, parties have to be designated to make decisions in certain circumstances on behalf of others.Contract theory has application to the design of buy-sell agreements in the ordering of priority of stakeholders in the enterprise. If the designated principal of the enterprise is the founding generation, then the buy-sell agreement will be written to protect the rights of the founders and secure their ability to liquefy their interest on the best terms and pricing. Redemption from a founder’s estate at a premium value would be an example of this type of contract.If, on the other hand, the business is the designated principal of the enterprise, and all the shareholders are treated as agents, then the buy-sell agreement might create mechanisms to ensure the long term profitability of the investment management firm, rewarding behaviors that grow the profits of the business (with greater ownership percentages or distributions or performance bonuses) and punish agent actions that do not enhance profitability.If the clients of the firm are the designated principals of a given RIA, then the buy-sell agreement might be fashioned to direct equity returns to agents (partners or non-owner employees) based on investment performance or client retention. An example of this would be carried interest payments in hedge funds and private equity.2. Don’t Value Your Stock Using Formula Prices, Rules-Of-Thumb, or Internally Generated Valuation MetricsSince valuation is usually the most time consuming and expensive part of administering a buy-sell agreement, there is substantial incentive to try to shortcut that part of the process. Twenty years ago, a client told us “asset management firms are usually worth about 2% of AUM.” We’ve heard that maxim repeated many times, although not so much in recent years, as some firms have sold in noteworthy transactions for over twice that, while others haven’t been able to catch a bid for much less.We have written extensively about the fallacy of formula pricing. No multiple of AUM or revenue or cash flow can consistently estimate the value of an interest in an investment management firm. A multiple of AUM does not consider relative differences in stated or realized fee schedules, client demographics, trends in operating performance, current market conditions, compensation arrangements, profit margins, growth expectations, regulatory compliance issues, and a host of other issues which have helped keep our valuation practice gainfully employed for decades.Imagine an RIA with $1.0 billion under management. The old 2% of AUM rule would value it at $20.0 million. Why might that be? In the (good old) days, when RIAs typically garnered fees on the order of 100 basis points to manage equities, that $1.0 billion would generate $20 million in revenue. After staff costs, office space, research charges and other expenses of doing business, such a manager might generate a 25% EBITDA margin (close to distributable cash flow in a manager organized as an S-corporation), or $2.5 million per year. If firms were transacting at a multiple of 8 times EBITDA, the value of the firm would be $20.0 million, or 2% of AUM.Today, things might fall more into the extremes of firms A and B, depicted in the chart below. Assume firm A is a small cap domestic equity manager earning 65 basis points on average from a mix of high net worth and institutional clients. Because a shop like that can earn a relatively high EBITDA margin of 40% or so, a $20 million valuation is a little less than 8x, which in some circumstances might be reasonable.Firm B, on the other hand, manages a range of fixed income instruments for large pension funds who are expert at negotiating fees. Their 30 basis point realized fee average doesn’t leave much to cover the firm’s overhead, even though it’s fairly modest because of the nature of the work. The 15% EBITDA margin yields less than a half million dollars in cash flow, which against the rule-of-thumb valuation metric, implies a ridiculous multiple. The real problem with short cutting the valuation process is credibility. If the parties to a shareholders agreement think the pricing mechanism in the agreement isn’t robust, then the ownership model at the firm is flawed. Flawed ownership models eventually disrupt operations, which works to the disservice of owners, employees, and clients.3. Clearly Define The “Standard” of Value Effective for Your Buy-Sell AgreementThe standard of value essentially imagines and abstracts the circumstances giving rise to a particular transaction. It is intended to control for the identity of the buyer and the seller, the motivation and reasoning of the transaction, and the manner in which the transaction is executed.Portfolio managers have a particular standard of value perspective, even though they don’t always think of it that way. The trading price for a given equity represents market value, and some PMs would make buying or selling decisions based on the relationship between market value and intrinsic value, which is what they think the security is worth based on their own valuation model. Investment analysts inside an RIA think of the value of their firm in terms of intrinsic value, which depending on their unique perspective could be very high or very low. CEOs, in our experience, think of the value of their investment management firm in terms of what they could sell it for in a strategic, change of control transaction with a motivated buyer – probably because those are the kinds of multiples that investment bankers quote when they meet with them.None of these standards of value are particularly applicable to buy-sell agreements, even though technically they could be. Instead, valuation professionals such as our group look at the value of a given company or interest in a company according to standards of value such as fair market value or fair value. In our world, the most common standard of value is fair market value, which applies to virtually all federal and estate tax valuation matters, including charitable gifts, estate tax issues, ad valorem taxes, and other tax-related issues. It is also commonly applied in bankruptcy matters.Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60. It is defined in the International Glossary of Business Valuation Terms as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.The benefit of a fair market value standard is familiarity in the appraisal community and the court system. It is arguably the most widely adopted standard of value, and for a myriad of buy-sell transaction scenarios, the perspective of disinterested parties engaging in an exchange of cash and securities for rational financial reasons fairly considers the interests of everyone involved.The standard known as “fair value” can be considerably more opaque, having two different origins and potentially very different applications. In dissenting shareholder matters, fair value is a statutory standard that varies depending on legal jurisdiction. In many states, fair value protects minority shareholders from oppressive actions by providing them with the right to payment at a value equivalent to that which would be received in the sale of the company. A few states are not so generous as to providing aggrieved parties with undiscounted value for their shares, but the trend favors not disadvantaging minority owners in certain transactions just because a majority owner wants to remove them from ownership. The difficulty of statutory fair value, in our experience, is the dispute over the meaning of state statutes and the court’s interpretations of state statutes. Sometimes the standard is as clearly defined as fair market value, but sometimes less so.If a shareholders agreement names the standard of “Fair Value”, does it mean statutory fair value, GAAP fair value, or does it really mean fair market value? It pays to be clear.The standard of value is critical to defining the parameters of a valuation, and we would suggest buy-sell agreements should name the standard and cite specifically which definition is applicable. The downsides of not doing so can be reasonably severe. For most buy-sell agreements, we would recommend one of the more common definitions of fair market value. The advantage of naming fair market value as the standard of value is that doing so invokes a lengthy history of court interpretation and professional discussion on the implications of the standard, which makes application to a given buy-sell scenario more clear.Which Fair Value?Making matters more complex, fair value is also a standard under Generally Accepted Accounting Principles, as defined in ASC 820. When GAAP fair value was originally established, members of the Financial Accounting Standards Board, which is responsible for issuing accounting guidance, suggested that they wanted to use a standard similar to fair market value but didn’t want their standard to be governed and maintained by non-related institutions such as the U.S. Tax Court.GAAP fair value is similar to fair market value, but not entirely the same. As GAAP fair value has evolved, it has become more of an “exit value” standard, suggesting the price that someone would pay for an asset (or accept to transfer a liability) instead of a bargain reached through consideration of the interests of both buyers and sellers.The exit value perspective is useful from an accounting perspective because it obviates financial statement preparers’ tendency to avoid write-downs in distressed markets because they “wouldn’t sell it for that.” In a shareholder dispute, however, the transaction is going to happen, so the bid/ask spread has to be bridged by valuation regardless of the particular desires of the parties.4. Avoid Costly Disagreement as to “Level of Value”Just as the interests and motivations of particular buyers and sellers can affect transaction values, the interest itself being transacted can carry more or less value, and thus the “level” of value, as it has come to be known, should be specified in a buy-sell agreement.A minority position in a public company with active trading typically transacts as a pro rata participant in the cash flows of the enterprise because the present value of those cash flows is readily accessible via an organized exchange. Portfolio managers usually think of value in this context, until one of their positions becomes subject to acquisition in a takeover by a strategic buyer. In a change of control transaction, there is often a cash flow enhancement to the buyer and/or seller via combination, such that the buyer can offer more value to the shareholders of the target company than the market grants on a stand-alone basis. The difference between the publicly traded price of the independent company, and value achieved in a strategic acquisition, is commonly referred to as a control premium.Closely-held securities, like common stock interests in RIAs, don’t have active markets trading their stocks, so a given interest might be worth less than a pro rata portion of the overall enterprise. In the appraisal world, we would express that difference as a discount for lack of marketability. Sellers will, of course, want to be bought out pursuant to a buy-sell agreement at their pro rata enterprise value. Buyers might want to purchase at a discount (until they consider the level of value at which they will ultimately be bought out). In any event, the buy-sell agreement should consider the economic implications to the RIA and specify what level of value is appropriate for the buy-sell agreement. Fairness is a consideration here, as is the sustainability of the firm. If a transaction occurs at a premium or a discount to pro rata enterprise value, there will be “winners” and “losers” in the transaction. This may be appropriate in some circumstances, but in most RIAs, the owners joined together at arm’s length to create and operate the enterprise and want to be paid based on their pro rata ownership in that enterprise. That works well for the founders’ generation, but often the transition to a younger and less economically secure group of employees is difficult at a full enterprise level valuation. Further, younger employees may not be able to get comfortable with buying a minority interest in a closely held business at a valuation that approaches change of control pricing. Ultimately, there is often a bid/ask spread between generations of ownership that has to be bridged in the buy-sell agreement, but how best to do it is situation specific. Whatever the case, the shareholder agreement needs to be very specific as to level of value. We even recommend inserting a level of value chart, like the one you see above, and drawing an arrow as to which is specified in the agreement. One thing to avoid in buy-sell agreements is embedded pricing mechanisms that unintentionally incentivize the behavior of some partners to try to “win” at the expense of other partners. We were involved in one matter where a disputed buy-sell agreement could be read to enable other partners to force out a minority partner and redeem their interest at a deeply discounted value. Economically, to the extent that a minority shareholder is involuntarily redeemed at a discounted value, the amount of that discount (or decrement to pro rata enterprise value) is arithmetically redistributed among the remaining shareholders. Generally speaking, courts and applicable corporate statutes do not permit this approach in statutory fair value matters because it would provide an economic incentive for shareholder oppression. By way of example, assume a business is worth (has an enterprise value of) $100, and there are two shareholders, Sam and Dave. Dave owns 60% of the business, and Sam owns 40% of the business. As such, Dave’s pro rata interest is worth $60 and Sam’s pro rata interest would be valued at $40. If the 60% shareholder, Dave, is able to force out Sam at a discounted value (of, say, $25 – or a $15 discount to pro rata enterprise value), and finances this action with debt, what remains is an enterprise worth $75 (net of debt). Dave’s 60% interest is now 100%, and his interest in the enterprise is now worth $75 ($100 total enterprise value net of debt of $25). The $15 decrement to value suffered by Sam is a benefit to Dave. This example illustrates why fair value statutes and case law attempt to limit or prohibit shareholders and shareholder groups from enriching themselves at the expense of their fellow investors. Does the pricing mechanism create winners and losers? Should value be exchanged based on an enterprise valuation that considers buyer-seller specific synergies, or not? Should the pricing mechanism be based on a value that considers valuation discounts for lack of control or impaired marketability? Exiting shareholders want to be paid more and continuing shareholders want to pay less, obviously. What’s not obvious at the time of drafting a buy-sell agreement is who will be exiting and who will be continuing. There may be a legitimate argument to having a pricing mechanism that discounts shares redeemed from exiting shareholders, as this reduces the burden on the firm or remaining partners and thus promotes the continuity of the firm. If exit pricing is depressed to the point of being punitive, the other shareholders have a perverse incentive to artificially retain their ownership longer and force out other shareholders. As for buying out shareholders at a premium value, the only argument for “paying too much” is to provide a windfall for former shareholders, which is even more difficult to defend operationally. Still, all buyers eventually become sellers, so the pricing mechanism has to be durable for the life of the firm.5. Don’t Forget to Specify the “As Of” Date for ValuationThis seems obvious, but the particular date appropriate for the valuation matters. We had one client (not an RIA) spend a quarter million dollars on hearings debating this matter alone. The appropriate date might be the triggering event, such as the death of a shareholder, but there are many considerations that go into this.If the buy-sell agreement specifies that value be established on an annual basis (something we highly recommend to manage expectations and avoid confusion), then the date might be the calendar year end. The benefit of an annual valuation is the opportunity to manage expectations, such that everyone in the ownership group is prepared for how the valuation is performed and what the likely outcome is given various levels of company performance and market pricing. Annual valuations do require some commitment of time and expense, of course, but these annual commitments to test the buy-sell agreement usually pale in comparison to the time and expense required to resolve one major buy-sell disagreement.If, instead of having annual valuations performed, you opt for an event-based trigger mechanism in your buy-sell, there is a little more to think about. Consider whether you want the event precipitating the transaction to factor into the value. If so, prescribe that the valuation date is some period of time after the event giving rise to the subject transaction. This can be helpful if a key shareholder passes away or leaves the firm and there is concern about losing clients as a result of the departure. After an adequate amount of time, it becomes apparent as to the impact on firm cash flows of the triggering event. If, instead, there is a desire to not consider the impact of a particular event on valuation, make the as-of date the day prior to the event, as is common in statutory fair value matters.6. Appraiser Qualifications: Who’s Going to Be Doing the Valuation?Obviously, you don’t want just anybody being brought in to value your company. If you are having an annual appraisal done, then you have plenty of time to vet and think about who you want to do the work. In the appraisal community, we tend to think of “valuation experts” and “industry experts”.Valuation experts are known for:Appropriate professional training and designationsUnderstanding of valuation standards and conceptsPerspective on the market as consisting of hypothetical buyers and sellers (fair market value mindset)Experienced in valuing minority interests in closely held businessesAdvising on issues for closely held businesses like buy-sell agreementsExperienced in explaining work in litigated mattersIndustry experts, by contrast, are known for:Depth of particular industry knowledgeUnderstanding of key industry concepts and terminologyPerspective on the market as typical buyers and sellers of interests in RIAsTransactions experienceRegularly providing specialized advisory services to the industryIn all candor, there are pros and cons to each “type” of expert. We worked as the third appraiser on a disputed RIA valuation many years ago in which one party had a valuation expert and the other had an industry expert. The resulting rancor bordered on the absurd. The company had hired a reasonably well known valuation expert who wasn’t particularly experienced in valuations of investment management firms. That appraiser prepared a valuation standards-compliant report that valued the RIA much like one would value a dental practice, and came up with a very low appraised value (his client was delighted). The departing shareholder hired an also well-known investment banker who arranges transactions in the asset management community. The investment banker looked at a lot of transactions data and valued the RIA as if it were a department at Blackrock. Needless to say, that indicated value was many, many times higher than the company’s appraiser. We were brought in to make sense of it all. Vetting a valuation expert for appropriate credentials and experience should focus on professional standards and practical experience:Professional Requirements. The two primary credentialing bodies for business valuation are the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA). The former awards the Accredited Senior Appraiser designation, or ASA, and the latter the Accredited in Business Valuation, or ABV, designation. Without getting lost in the weeds, both are substantial organizations that require extensive education and testing to be credentialed, and both require continuing education. Also well known in the securities industry is the Chartered Financial Analyst charter issued by the CFA Institute, and while it is not directly focused on valuation, it is a rigorous program in securities analysis. CFA Institute offers, but does not require, continuing education.Practical Requirements. Experience also matters, though, in an industry as idiosyncratic as investment management. Your buy-sell agreement should specify an appraiser who regularly values non-depository financial institutions such that they understand the dynamic differences between, say, an independent trust company and a venture capital manager. While there are almost 12,000 RIAs in the U.S., the variety of business models is such that you will want a valuation professional who understands and appreciates the economic nuances of your firm.In any event, your buy-sell agreement should specify minimum appraisal qualifications for the individual or firm to be preparing the analysis, but also specify that the appraiser should have experience and sufficient industry knowledge to appropriately consider the key investment characteristics of RIAs. Ultimately, you need a reasonable appraisal work product that will withstand potential judicial scrutiny, but you should not have to explain the basics of your business model in the process.7. Manage Expectations by Testing Your AgreementNo matter how well written your agreement is or how many factors you consider, no one really knows what will happen until you have your firm valued. If you are having a regular valuation prepared by a qualified expert, then you can manage everyone’s expectations such that, when a transaction situation presents itself, parties to the transaction have a reasonably good idea in advance of what to expect. Managing expectations is the first step to avoiding arguments, strategic disputes, failed partnerships, and litigation.If you don’t plan to have annual valuations prepared, have your company valued anyway. Doing so when nothing is at stake will make a huge difference if you get to a situation where everything is at stake. Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled. Going ahead and getting a valuation done will help to center, or reconcile, those expectations and might even lead to some productive revisions to your buy-sell agreement.Putting It All TogetherIf you have not yet crafted a buy-sell agreement for your RIA, you can see that there is much to consider. Most investment management firms have some shareholders agreement, but in many cases the agreements do not account for the many circumstances and issues briefly addressed in this whitepaper. That said, our advice is to first pull your buy-sell agreement out of the drawer and read it, carefully, and compare it to the commentary in this paper. If you don’t understand something, talk with your partners about what their expectations are and see if they line up with the agreement. Consider having a valuation firm review the agreement and tell you what they might see as issues or deficiencies in the agreement, and then have the firm appraised. If there is substantial difference of opinion in the partner base as to the value of the firm, or the function of the agreement, you know that you don’t actually have an agreement.On the positive side of the equation, a well-functioning agreement can serve the long term continuity of ownership of your firm, which provides the best economic opportunity for you and your partners, your employees, and your clients. Strategically, it may well be the lowest hanging fruit available to enhance the value of your company, and your own career satisfaction.WHITEPAPERBuy-Sell Agreements for Investment Management FirmsView Whitepaper

WHITEPAPER | Buy-Sell Agreements for Investment Management Firms

There are roughly 13,000 Registered Investment Advisors (“RIAs”) in the U.S., and each tailors its services to a unique set of clients and maintains an individualized business model. Be that as it may, most who call us face one common issue: ownership succession.Ownership can be the single biggest distraction for a professional services firm, and it seems like the investment management community feels this issue more than most. In Schwab’s 2019 Benchmarking Study, which surveyed 1,300 RIAs, a full 92% of respondents indicated that they were considering internal succession, but only 38% of firms have a documented path to partnership.Most investment management firms are closely held, so the value of the firm is not set by an active market.They are typically owned by unrelated parties, whereas most closely held businesses are owned by members of the same family.Compared to other industries, a greater-than-normal proportion of investment management firms have significant value, such that there is more at stake in ownership than most closely held businesses.Consequently, when disputes arise over the value of an interest in an investment management firm, there is usually more than enough cash flow to fund the animosity, and what might be a five-figure settlement in some industries is a seven-figure trial for these businesses.Avoiding expensive litigation is one reason to focus on your buy-sell agreement, but for most firms, the more compelling reasons revolve around transitioning ownership to perpetuate the firm and provide liquidity for retiring partners.Clients increasingly seem to ask us about business continuity planning—and for good reason.In times of succession, tensions can run high.Having a clear and effective buy-sell agreement is truly imperative to minimizing costly and emotional drama that may ensue in times of planned or unplanned transition.

The Permian Basin: Loaves and Fishes

One of the most commonly taught Bible stories is the miracle of Jesus feeding five thousand people with only five loaves of bread and two fish. Last week we learned of a new miracle story of never ending sustenance. The Permian Basin, which has been drilled since the 1920s and produced billions of barrels of oil, was discovered to hold the largest unconventional crude accumulation in the US.Less than 10 years ago, the United States Geological Survey (USGS) estimated that the Permian Basin held just 1.0 billion barrels of conventional oil and 1.3 billion barrels of unconventional oil classified as technically recoverable reserves.1 The advancement of horizontal drilling techniques, however, increased the amount of recoverable reserves. Now, according to the Texas Rail Road commission, over 29 billion barrels of oil and 75 trillion cubic feet of gas have been produced from the Permian over the last 90 years. Further, last Tuesday, the USGS announced an estimated 20 billion barrels of crude oil, 1.6 billion barrels of NGLs, and 16 trillion cubic feet of natural gas were discovered in four layers of shale in the Wolfcamp formation. This discovery alone is 3x larger than the entire Bakken play in North Dakota, and equates an estimated $900 billion of oil. The Wolfcamp Shale has been a recent target of E&P companies in the face of two years of low oil prices. The Wolfcamp is an oil and gas zone located below the Spraberry oil play in the Midland Basin. The Spraberry oil play has been developed since 1943 but the Wolfcamp was not developed until the onset of horizontal drilling. Companies saw opportunity in the Wolfcamp shale because of its depth and geological makeup. The Permian Basin is a stacked play which means that multiple horizontal wells can be drilled from one main wellbore. This provides increased productivity as multilateral wells have greater drainage areas than single wellbore. Additionally, it can reduce overall drilling risk and cost. For deep reservoirs like the Permian, a multilateral well eliminates the cost of drilling the total depth twice. The Wolfcamp is as much as a mile deep at some points which means that operators can drill multiple horizontal wells from one main wellbore. M&A activity in the E&P sector has picked up this year due to the opportunity seen in the Permian. There have been 132 deals in the Permian this year so far, totaling $20.8 billion in deal value, which is more than 40% of total E&P deal value generated throughout the US. Much of this activity has been focused in the Midland Basin. Because drilling costs in the Permian are lower than many other plays in the US, when oil prices began to show signs of recovery, rig counts in the Permian picked up faster than in any other domestic play. Producers were eager to begin operating after two years of an uneconomical drilling environment, and for many producers the Permian was the first play in which the cost of oil rose above breakeven costs. The chart below shows the combined rig counts of oil and gas rigs in various domestic plays. What Does This Mean?Business Insider associates some of the collapse of oil prices in 2014 to be driven by the increase in production in the Permian. The oversupply of oil pushed prices down worldwide. Just as oil prices have started recovering, this new discovery makes producers seriously consider if $50 per barrel oil is a thing of the past. Walter Guidroz, program coordinator for the USGS Energy Resources Program said, “The fact that this is the largest assessment of continuous oil we have ever done just goes to show that, even in areas that have produced billions of barrels of oil, there is still the potential to find billions more.”From a valuation perspective, acreage values in the Permian are likely to continue increasing as more producers try to get their hands on valuable Permian acreage and available land becomes scarcer. However, there is one problem with talking about technically recoverable resources: cost is not considered. Many headlines recently boasted that the discovery in the Wolfcamp is worth $900 billion in revenue at today’s prices… but what about cost? When using the income approach to value oil and gas assets, earnings estimates, not revenue, are capitalized. Art Berman, a petroleum geologist, described this best: “if the oil magically leaped out of the ground without the cost of drilling and completing wells; if there were no operating costs to produce it; if there were no taxes and no royalties” then the Wolfcamp discovery would be worth $900 billion.This is not to say that the Wolfcamp discovery is inconsequential, but to simply highlight the affect the pricing environment has on oil and gas valuations. The oil and gas industry is constantly changing. Each location in the Permian is different and costs vary by region. As a result, the valuation implications of reserves and acreage rights can swing dramatically in resource plays. Utilizing an experienced oil and gas reserve appraiser can help to understand how location impacts valuation issues in this current environment. Contact Mercer Capital to discuss your needs and learn more about how we can help you succeed.End Note1 The USGS defines recoverable resources as those that can be produced using currently available technology and industry practices. Whether or not it is profitable to produce these resources has not been evaluated.

U.K. Based Henderson Group Acquires Janus Capital for $2.6 Billion

Coming to America

Though probably not as historic as Plymouth landing or even the Eddie Murphy comedy, Henderson’s purchase of Denver RIA Janus Capital last month is a rare sign of confidence in active managers that have been losing ground to passive investors for quite some time. The era of ETFs and indexing has dominated asset flows for quite some time, so this transaction seems to counter the recent trend.Last week, we touched on the recent election’s possible impact on active management, and the gist of it is that potentially heightened volatility and lower asset correlations under a Trump presidency could bode well for stock and bond pickers (though most fixed income investors would not agree with that position at the moment). Indeed, a quick look at active manager pricing over the last two weeks shows several industry leaders (Pzena, Diamond Hill, Hennessy, GAMCO, etc.) up 10% to 20% since the election. Investor sentiment seems to be shifting, or is at least less bearish on the sector than just a few months ago.As for whether JNS or HGG will be more likely to give thanks this Thursday, both sides are up modestly since the deal was announced in early October, though it has been a rocky seven weeks. Janus-Henderson should benefit from the ability to cross-sell each other’s products, though it is often harder to capitalize on this potential in practice. They’ve also both been adversely affected by asset flows out of active strategies, but are now poised to benefit from any semblance of mean reversion. With Janus serving primarily U.S. investors with domestic funds and Henderson having more of a European and global focus, there doesn’t appear to be much product overlap either. Janus CEO Dick Weil recently told analysts that the two companies are “almost mirror images of each other on opposite sides of the Atlantic,” and they certainly do seem to complement one another. Since Janus shareholders will now benefit from a lower (UK) corporate tax rate (and Thanksgiving is not celebrated in England), we suspect they’ll be more inclined to give thanks on turkey day.Looking strictly at the economics of the deal in the context of other recent transactions that we’ve analyzed, it doesn’t appear that Henderson overpaid for Janus with earnings and activity (revenue and AUM) metrics reasonably in line with precedent multiples. Given the size of Janus and expected synergies ($110 million in annual net costs savings) of the deal, one might have expected a higher valuation, but recent share price volatility and client outflows likely precluded much of a premium. Putting it all together, the transaction price appears appropriate to both sides from a financial perspective. One potential wrinkle in the deal is how famed 72 year-old bond investor, Bill Gross, and his new total return fund will be managed by the merged entity. There is also the question of his succession planning and client retention once he finally retires, since there’s certainly the possibility that all those (non-Gross) assets could flow back to PIMCO or another actively managed bond fund. Since Gross’ former co-manager, Kumar Palghat, recently left for another bond fund at Janus and his former boss, Dick Weil, just moved to Henderson’s offices in London (while Gross remains in Newport Beach), investors may hold some concern over the former bond king’s further alienation from the rest of the company. At this point, we don’t yet know if the Janus-Henderson marriage will end up as happily as Prince Joffer’s, but since Janus is named after the ancient Roman god of change and new beginnings, we’re hopeful for a smooth transition.

What Donald Trump’s Presidency Means to the Investment Management Industry

No doubt, 2016 will be remembered for two major left-tailed events – Brexit and the election of Donald Trump as President of the United States. In hindsight, the former should have been a clear suggestion of the latter, but even though some political wonks pointed that out, most of us were caught flat footed on both occasions.I won’t devote this blogpost to a market outlook – there are plenty of those out there written by people more knowledgeable than I. The purpose of this blog is to consider the implications of the election for the investment management industry, which is no easy feat. The Trump campaign was generally heavy on rhetoric and light on policy details. The investment management industry rarely came up, other than when Trump suggested that he would advocate taxing carried interest returns as ordinary income. He never mentioned, for example, the DOL’s Fiduciary Rule, which is set to phase in three months after the inauguration.The clearest indication of what a Trump presidency means to financial services, so far, appears to be its impact on the banking industry. The promise of a steepening yield curve and a pullback in portions of Dodd-Frank have sent bank valuations soaring since the election. If core banking is to become more profitable, banks will either a) be content with their basic operations and stop exploring diversification like asset management, or, b) feel comfortable enough with the outlook of their main business to look for avenues to diversify, like asset management.The Certainty of Uncertainty (about Trump)The striking thing about President-elect Trump is how little we know about him, despite the fact that he has been a very public figure for decades. He’s never held elected office, so he has no voting record. In the past, he’s been friendly and unfriendly with both political parties, and he ran his campaign in such a way that, despite being the Republican nominee, he has little, if any, debt to the Republican Party. This either empowers him to be pragmatic, or makes him a loose cannon.We can expect Trump to be pro-growth, even if the price is spiraling deficits and inflation. He is, after all, primarily a real estate developer. Making money in real estate requires risk-taking financed by outsized leverage to create binary outcomes: profits or bankruptcy. After a career in that industry, and having been brought up in it by a father who practiced a similar craft, he’s unlikely to change his world view. Trump likely won’t be concerned about the consumer price index, either. Inflation doesn’t scare people who have appreciating hard assets on one side of their balance sheet and a fixed amount of debt on the other. This perspective is likely to create a lot of conflict with congressional Republicans, which will probably bother them more than Trump. Whatever comes of it, it is very unlikely that the President-elect will prove to be fiscally conservative.Trump is also unlikely to prove to be socially conservative. He has spent his entire adult life in Midtown Manhattan, not exactly the sanctum sanctorum of the Moral Majority. Social issues, again, are not a subject of this blog, but because he has no stake in that soil, President Trump can use social issues as bargaining chips to entice legislators from both parties to support his agenda, once he clarifies what that agenda is. Because he is not an ideologue, President Trump will probably reveal his agenda one day at a time, which will be as fascinating to watch as it is maddening to invest around.If these early indications prove correct, the looming Trump Presidency will be hard on segments of the fixed income community, and favorable to pro-volatility segments of the equity management world. Asset correlations are probably going to be much lower. All this suggests that active management will be back in style. It’s amazing sometimes what it takes to make a trend-line roll over.What We Do Know (about Nationalism)Exit polls strongly suggest that Trump was elected on a nationalist agenda. At the moment, the GOP thinks it controls the White House, and the Democrats feel disempowered. The truth appears to be more nuanced, as Trump fashioned his message around a careful (and, it turns out, accurate) reading of public sentiment rather than polls or party platforms.Much of Trump’s support comes from middle class voters whose standards of living have either not improved or have declined over the past thirty to forty years. At the same time, wealthy America has become much more so, and that disparity fueled resentment that led to this election outcome. There is ample research to suggest middle class America feels left out of both parties’ agenda. The Pew Research Center has done an exhaustive amount of study on the distribution of income and wealth in America. One such dataset notes that upper income households in America (those earning twice the median household income) now enjoy a greater share of aggregate U.S. household income than middle income households (defined as those earnings between two-thirds and double median household income). In the early 1970s, when U.S. middle class life was being celebrated by television shows like The Brady Bunch, middle income households collectively earned twice the amount of national income commanded by upper income households. The trends in household wealth in the U.S. have been even more striking. The same Pew Research report looks at the median net worth of U.S. households since 1983 – not going back quite as far as the income portion of their study. In 1983, the median net worth of high income families was a little over three times that of middle income families. Fast forward 30 years to 2013, and that disparity doubled, to six and a half times. During that time, the median net worth of middle income families barely changed when adjusted for inflation, but the wealth of upper income households doubled. Also note that the credit crisis seems to have exacerbated this disparity; upper income households had a median net worth of approximately four times that of middle income households in 2007. Further, as has been widely reported elsewhere, the increase in wealth concentration is greatest at the upper end. In an oft-cited study published last year by Berkeley professors Emmanuel Saez and Gabriel Zucman, the top one tenth of one percent of U.S. households held between 7% and 8% of household wealth in the 1970s. Less than forty years later, that share had tripled, with the wealthiest U.S. households owning around 22% of aggregate U.S. household wealth. Middle income Americans may not read a lot of economic studies, but they sense they’ve been left behind by a changing economy; the data just confirms it. The 117 episodes of The Brady Bunch covered a wide variety of topics, but I don’t remember Mike and Carol Brady reviewing their wealth manager’s account statements and discussing whether or not they were GIPS compliant. Needless to say, the growth of household income and wealth on the right-tail has been a boon to the RIA industry. Mean reversion might not be as generous to asset management. Assuming mean reversion, either the middle class is going to accumulate a lot of investible assets, or the wealthiest Americans are somehow going to become less so. The current nationalist fervor may be a cause of that, or may be just a barometer. What We’ll Be WatchingIn any event, it is difficult to imagine the election of a wealthy New York real estate developer leading to middle income families enjoying a greater share of national income and household wealth, but there are other possibilities that could cause wealth and income trendlines to mean-revert:Declining value of financial assets – Rising inflation and rising interest rates could result in a decline in fixed income and equity valuations, compressing the value of the primary wealth assets held by upper income households. This is obviously not bullish for RIAs.Rising interest rates – In a rising rate environment, borrowers are relatively better off, because fixed cost borrowing is, over time, below market. Symmetrically, lenders (those who save money and invest in interest bearing assets) are achieving returns that are chronically below market. Obviously, upper income households tend to be lenders, and middle income households tend to be borrowers.Increasing value of housing – All asset values are relative, and homes make up a greater proportion of household net worth for middle income families than upper income families. If housing appreciates (outside of the major U.S. markets where it already has), then wealth redistribution will improve.Taxes – Unlikely in a Trump administration, but higher taxes would probably fall disproportionately on upper income households. Again, this would not be bullish for the investment management industry.Inflation – Inflation is more likely to help wage earners than investors in many financial assets, and thus would cause some long standing economic trends to change. The election of Donald Trump may forestall some of these changes while accelerating others, and the advent of new investment platforms like robo-advisors may help maintain industry revenues and margins if economics improve for middle income households relative to more wealthy Americans. What is difficult to debate, however, is that the RIA space has enjoyed a tailwind from certain economic trends over the past three or four decades that may not persist.RIA Market is Favorable, so FarAs all readers of this blog know, when the election results started coming in differently than most expected, equity futures and global markets plummeted, and then recovered and rallied. Publicly traded investment management firms have seen significant increases in valuation since Election Day, with many up between 10% and 20%, so these notes about the potential challenges of economic nationalism don’t appear to be widely held.All in all, though, with a Trump presidency the RIA community is faced with more unknowns than knowns, and despite what the president-elect said in his campaign, governing is very different than campaigning. The market’s performance so far suggests that most investors were relieved we once again had a peaceful transfer of power, and – whatever fight is coming – at least we’re in the fight.

Quick Facts: Permian Basin

Over the past few weeks, we have discussed the increase in M&A activity in the Permian and looked at specific characteristics that make the Permian attractive in a low price environment. Today, we take a step back and review the broad characteristics of the Permian Basin. Download this information in a convenient PDF at the bottom of this post.Permian at a GlanceFirst Discovered1920Discovery as Viable PlayBegan in 1923, declined post 1970s, increased again after 2007Primary ProductionOilOil TypeSweet, Light CrudePlayConventional & Unconventional PlaysDrillingVertical (traditionally), Horizontal (81% of recent drilling) and Multi-Stage Hydraulic FracturingTop 3 Production CompaniesOccidental, Pioneer, ApacheBreakeven$25 – $63 per barrel 1Abnormal DUCs433 2Production Since 20077,156 MMBOE 3IssuesCheapest Oil Has Already Been ProducedPotentialImproving Technology, Easy Entry, Stacked Play Efficiency, Low Service & Transport Costs, & Under-Explored Layers1 Bloomberg Intelligence county-level estimates 2 Drilled Uncompleted Wells with > 3 months in inventory as of January 2016; also referred to as fraclog (Bloomberg Intelligence) 3 EIA as of June 2016Overview of Permian BasinStretching over 86,000 sq. miles in western Texas and New Mexico, the Permian Basin is the most productive formation in the U.S. Since 2007, new technologies have created a boom in the region by increasing the production of old wells and enabling drilling in previously underdeveloped geological layers. In the current low price environment, Permian production has been affected less than other large U.S. reserves.Geography & DrillingThe Permian Basin produces from a variety of geological formations. These formations are layered on top of each other, creating stacked reservoirs of limestone, sandstone, and shale. For decades, wells have targeted conventional, permeable reservoir layers that trap oil and gas produced primarily in the shale layers. Recently developed enhanced extraction techniques have maintained these reservoirs’ outputs. However, since 2007, hydraulic fracturing targeting the less permeable tight sand and shale layers has driven over 60% of new production growth. Many of these new wells are “stacked plays” that capitalize on the region’s layered geography by exploiting multiple producing zones (conventional and unconventional) from one surface drill point. The Permian is divided into basins such as the Delaware Basin and Midland Basin which are further divided into zones, or stacks, such as the Wolfcamp, Spraberry, Clearfork, Avalon, and Bone Springs.Issues & Future PotentialThe easiest, cheapest oil and gas to extract from the Permian Basin was produced long ago making many areas uneconomical to produce at low oil prices. However, Permian wells tend to be more efficient than pure shale plays because they drill through many productive layers. For example, Wolfcamp wells are estimated by Bloomberg Intelligence to have the lowest break-even point of any U.S. shale oil play. The Permian will benefit from continued technological advances, development of less-known, potentially productive layers, and an abundance of low cost support services and pipelines.Permian Production Baker Hughes collects and publishes information regarding active drilling rigs in the United States and internationally. The number of active rigs is used as a key indicator of demand for oilfield services & equipment. However, rig counts can be misleading if not considered along with production. Rig counts in the Permian drastically decreased in late 2014 and throughout 2015. However, production did not experience the same decline. This demonstrates that producers with average or poor locations, higher costs, and inefficiencies were forced out of the market, while those with good locations and lower costs continued to drill for oil and gas in the Permian. AVAILABLE RESOURCEQuick Facts: Permian BasinDownload this information in a convenient, one-page PDF. Download

3Q16 Call Reports

The Times They are A-Changin’

After a rough start to the year, the asset management industry is facing a new reality dominated by passive managers and rising regulation. Although most publicly traded active managers have benefited from a relatively stable third quarter, management comments suggest fee pressure is on the rise and margins have compressed as pricier offerings from hedge funds and PE firms continue to underperform the market. However, the greatest concern this past quarter has been the impending Department of Labor’s Fiduciary Rule. The ruling prohibits compensation models that conflict with the client’s best interests, and is expected to create pressure on active managers to provide lower-cost, passive products and to complete the shift from commission-based to fee-based accounts.1 With the final implementation date less than six months away, we expect the ruling and its consequences will be the topic of discussion for several quarters to come.As we do every quarter, we take a look at some of the earnings commentary of pacemakers in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: With a better understanding of the various requirements of the DOL’s Fiduciary Rule, asset managers are focused on reassuring investors of their compliance and anticipating costs of implementation.Well, the rule is slightly less onerous than was originally proposed, so compliance with it will be more manageable than it might have otherwise been. We don’t anticipate any significant issues in complying with it. […] But I do think the DOL changes are going to have – and we’ve all talked about this, all meaning all people in the industry have talked about it – are going to have significant adjustments to how financial advisors engage with their clients all over the country. And it’s going to have a significant effect on what those clients actually populate their accounts with, meaning active versus passive. It will have a significant effect on the fees that managers charge, the manner in which those fees are charged and the manner in which the advice is given. It will have an effect on how services are arranged, how services are modelled, how risk controls are actually reviewed, how firms actually create consistency around their risk management and around the advice they give in that channel. […] None of it is particularly clear, meaning specifically clear. Generally, it’s absolutely clear, meaning that as transparency goes up, there is more fee pressure, the character of the assets in the funds are going to be subject to greater scrutiny from a firm-wide point of view. – Alliance Bernstein’s Peter KrausIf clients believe they have a fair opportunity to be in the market to build a better financial future for themselves, if they believe the Department of Labor rules gives them that security that people are working on their behalves, and they put more money to work and keep and keep getting, moving money out of all this cash into bank deposits into the financial markets, we will be the best-positioned firm for that. So we welcome these changes. – BlackRock’s Laurence FinkFee pressure is not new, and so, this is sort of a grinding long-term pressure on the industry. I don’t think we’re going through a fork in the road right now, specifically. I think the DOL legislation creates additional pressure, more grinding. – Janus Capital’s Richard MaccoyWe believe success under the new DOL construct will require a more institutionalized process for both investment management and the sales and marketing parts of our organization. By institutionalize, I mean the ability to clearly articulate a product’s investment philosophy and process with all relevant data analytics related to portfolio construction, risk parameters, attribution analysis, sources of alpha generation, etc. – Waddell & Reed’s Philip James SandersTheme 2: Despite slightly improved market conditions, the plight of the active manager remains challenged as both regulation and consumer sentiment continue to favor passive management.For the market, the past quarter was a solid performance period across most asset classes and a generally better environment for the performance of active management. And while one quarter does not make a trend, we are encouraged by this, as we benefited across a number of our portfolios. 2016 investment performance has gradually improved across the complex as the year has progressed, but we understand that this is a process and will take some time to get back to our historical levels of success. I will note, however, that the improved investment performance of active managers industry-wide did not translate into active management flows regaining traction versus passive. – Waddell & Reed’s Philip James SandersI don’t think there’s anybody that I’ve spoken to in the active world that doesn’t see the DOL as a challenge in the active to passive debate. […] And so yes, I think the early on reaction is going to be to keep it simple, passive is going to be easier, it’s low cost. How do you argue with low cost? But over time that low cost solution is going to have a cost. Unless you assume that there’s just no alpha in the world, and that’s a pretty tough assumption, because we know there is alpha in the world. The question is what do you pay for it. – Alliance Bernstein’s Peter KrausAs we’ve been reading almost every day in the press and as we discussed in our 2015 Letter to Shareholders, most active managers are battling significant headwinds. Disruptive innovation, waves of new regulations and unprecedented market interventions are adversely affecting broad swaths of active only, active long only and alternative managers. This has manifested itself in persistent organic decay and fee pressures for a majority of these managers, but especially for those that are focused on core style boxes. We are anticipating that going forward these trends will intensify rather than abate. – Cohen & Steers’s Bob SteersTheme 3: In light of continued fee pressure and shrinking margins, most companies within the RIA industry are pausing to take a hard look at their expense structures. As we discussed a few weeks ago, the industry is in need of consolidation as the current market has exposed a number of weak performers.Well, I think that the lower growth environment is clearly going to make companies think hard about how do they expand their income, if not their margins. On a standalone basis that becomes more and more challenging. And so that does lead people to think about consolidation. The interesting question is how much expense can you take out when you put these organizations together? And that, I think, that remains a challenging transaction or a challenging process for the industry. - Alliance Bernstein’s Peter KrausLooking ahead and taking into account current industry trends, we are planning to closely manage expenses while also selectively investing in people and new products to compete globally for a share of asset allocations. This will mean adding select investment vehicles and fund share classes, both here and intentionally, selectively adding depth to our existing investment teams, and being competitive and forward-looking with regard to investment management fees and expenses. – Cohen & Steers’s Bob SteersWe have viewed this as an opportunity to rethink our internal structure within this changing, converging industry context. And as a result, we are bringing together many elements of retail, unaffiliated and institutional efforts, including relationship management, marketing and product, and in addition, restructuring some aspects of wholesale sales management. We believe this will make us more efficient and responsive to industry trends and also create meaningful expense savings. – Waddell & Reed’s Thomas W. ButchEnd Note1 “Implications of the Final DOL Fiduciary Rule for Asset Managers.” DST Kasina. April 2016.

What Hillary Clinton’s Presidency Means to the Investment Management Industry

Barring some extraordinary circumstance, in one week Hillary Clinton will be elected the 44th president of the United States. Her election will mean a lot of different things to a lot of different people, but since this blog is called RIA Valuation Insights, we’ll narrow the focus of this outlook on her upcoming term as president to the possible impact on the investment management community.A good friend of mine from high school is a Republican lobbyist in Georgia. Charlie’s mood these days oscillates between stoicism and apoplexy, as his party is not only about to lose this presidential election, but also because the G.O.P. is as divided, if not more so, than it was following Barry Goldwater’s bid for the White House. For all of Goldwater’s accolades, his 1964 campaign alienated so many voting blocks in the U.S. that the conservative wing of the G.O.P. was suppressed for 16 years. Indeed, the biggest risk to the investment community may be that Republicans can’t get their act together for several elections to come.Financial Markets Profit from Divided GovernmentIf there’s one thing the financial markets fear absolutely, it’s one-party rule. The hardest thing for a president to do isn’t working with the opposition party to solve real problems, it’s controlling the demagogues in one’s own party who tend to create problems. George H. W. Bush had to cope with these kinds of distractions in the first half of his term (flag burning amendment), as did Bill Clinton (don’t ask, don’t tell). Republican congressional losses in the midterm election in 1990 plus Iraq invading Kuwait got Bush’s presidency on track, just not enough to overcome the recession. Mid-term losses in 1994 got Clinton refocused on getting legislation through by bargaining with Republicans, arguably turning him into the most conservative president of recent memory - to the delight of financial markets and the chagrin of liberal Democrats. If the G.O.P. is in too much disarray following this year’s dissection-election, Hillary Clinton won’t need to manage her political capital in the same way.We foresee that financial markets are being set up, in some regard, to be a victim of their own success. ZIRP has inflated valuation multiples and AUM balances across most financial asset classes, and with nowhere to go but down, some external factor could eventually lead markets lower on a sustained basis. We don’t say this based on some elaborate technical analysis other than mean reversion. With low rates and market liquidity, it seems like asset prices can stay up, but it’s difficult to see opportunities for significant topline growth, widening of margins, or multiple expansion. The question of when financial markets falter becomes when, not if. In this environment, the markets feel more vulnerable to politics than usual.The Warren AdministrationClinton’s election secures the ascendency of Senator Elizabeth Warren, particularly if Democrats gain control of the Senate. Senator Warren is going to be very powerful over the next four years and highly influential on President Clinton – at least as much as Vice President Cheney and the Watergate-era cronies were on President George W. Bush. One helpful thing about Senator Warren is that she makes no secret of her intent; we don’t have to spend a lot of time reconciling what she says in closed door speeches to Goldman Sachs with what she says at political rallies. Warren is convinced that the financial services community profits to the detriment of the rest of the economy, and she has accumulated more than a little evidence from the credit crisis to back that up.Because of Senator Warren, and the likely new ranking Democratic member of the House committee on Financial Services, Maxine Waters, one theme facing the financial services industry in general, and asset management in particular, is increasing regulation. Wells Fargo’s ex-CEO John Stumpf may be glad he endured his congressional grilling in 2016 instead of 2017. You can expect to see more of the same. There may not be a Basel IV, but we may be in for a creeping reintroduction of some features of Glass-Stegall (ironically repealed under the previous Clinton administration). That said, it’s difficult to deconsolidate an industry with narrow and shrinking margins.Then there’s the SEC. Senator Warren famously called for the ouster of Mary Jo White as Chair of the Securities and Exchange Commission, in spite of the fact that the SEC’s investigative and enforcement divisions appear to have become considerably more aggressive on her watch. We think fair value marks on illiquid securities held by PE funds, BDCs, and mutual funds will get much more scrutiny. Chairperson White has targeted the PE industry, and any successor is likely to continue this theme.Tax Rates are Headed HigherDespite the brouhaha over Donald Trump’s use of net operating loss carryforwards and accelerated depreciation, both are far too esoteric - not to mention economically defensible - to change under the Clinton Administration. The story is different for taxes on carried interest, social security, and estates. An increase in any or all of those tax rates would mean significant changes for the asset management industry – none of them favorable.In some regards, it’s remarkable that carried interest taxes have been treated at capital gains rates as long as they have. There is some economic rationale for it, of course, and the complexity of explaining performance fees to the average taxpayer has kept the issue from being front page news in most local papers. Unfortunately for the alt asset business, PE fund managers have been a little too visible in their success, such that it has become easier to paint a target on their back. One rare area of agreement between Clinton and Trump is taxing carry at ordinary income tax rates. Assuming tax rates on performance fees change, GPs will be indifferent to being paid through ordinary management fees or carry. If fee pressure continues, managers might be more interested in a “2 and 10” model instead of a “1 and 20”. No word yet on what LPs want.I read recently that, had the cap on taxable income for purposes of social security been indexed for inflation, it would be about $250 thousand today, or roughly twice what it is. This tax is more difficult to change, because the aggregate benefit paid out of social security is proportionate to the taxes paid in. Nonetheless, the rate may not change, but the cap will likely increase. A logical cap would be the Section 415 limit (currently $265 thousand). This could have a big impact on financial planning models in the wealth management space, but little impact on your typical hedge funder. Many will point out that the least expensive and most logical change for social security would be raising the qualifying retirement age. Nevertheless, we are probably moving into a period where notions of curtailing benefits are unlikely to gain much traction: a Democrat in office, a growing retiree population, and lagging financial markets.As for estate taxes, under the previous Clinton administration, rates were very high and exclusions were very low, but the law offered lots of leeway for creative estate planning. Lately, the IRS has been trying to limit key estate planning techniques, and they may or may not succeed. Candidate Hillary Clinton has suggested lowering the size of estates excluded from taxes, but there’s probably more than a little uncertainty as to whether President Hillary Clinton will pay much attention to this.Peak Margins and the Dearth of Growth OpportunitiesEarlier this year a portfolio manager at one of our clients explained to us his dislike of investing in “spread businesses” like banking and energy. His argument was simple: because of potentially countervailing forces, businesses that lived by the spread would eventually die by the spread. Unrelenting economic relationships would, over time, arbitrage away margin. Asset management is its own kind of spread business: buying investment management talent and reselling it, at a 40% EBITDA margin, to end users. Spread businesses like banking and energy seem to be more at risk than most in a Clinton presidency. We don’t mean to imply that the asset management industry is at risk of going the way of prime brokerage, but there’s no rationale to suggest the industry, as a whole, will experience margin expansion anytime soon. Expect more consolidation.One bright spot for the most beleaguered sectors of the RIA world - active management in general and hedge funds in particular - is the likely return of volatility to the asset landscape. The slow unwinding of ZIRP, BREXIT and the collapse of the pound, challenges to the sustainability of the euro, the sustained deflationary impact of technology, global aging and global warming, the oil collapse and destabilization in the Middle East, and the rightward political march of Europe in contrast to the U.S. moving to the left all add up to less asset correlation across the globe. The indexers risk having a huge position in the next Blockbuster Video while missing out on Netflix. All this is happening right on time as The Wall Street Journal and the CFA Institute declare active management dead and buried. We may yet have a moment of schadenfreude for active managers.The Only ConstantChange is inevitable, of course; and bemoaning change isn’t productive. Several long running trend-lines in the investment management industry seem to be rolling over, and that is anxiety inducing. So I’ll close this blog with some wisdom from an unfortunately departed member of the investment management community, Louis Rukeyser, who said (long before this election):“Roaming the world as a foreign correspondent for more than a decade, I was able to observe how a variety of vastly different nations organized themselves economically. The inescapable conclusion was that no politician anywhere on the planet has ever actually created a rupee’s worth of prosperity.”He also said: “The best way to keep money in perspective is to have some.”God Bless America.

The Fair Market Value of Oil and Gas Reserves

A couple of weeks ago we looked at Exon Mobil Corp.’s lack of asset write-downs to understand different values placed on oil and gas reserves in a GAAP, Non-GAAP, and IFRS context. This week we explain how to find the fair market value of oil and gas reserves. Oil and gas assets represent the majority of value of an E&P company. The oil and gas financial journal describes reserves as “a measurable value of a company's worth and a basic measure of its life span.” Thus understanding the fair market value of a company’s PDP, PDNP, and PUDs is key to understanding the fair market value of the Company. As we discussed last time, the FASB and SEC offer reporting guidelines regarding the disclosure of proved reserves. But none of these represent the actual market price. It is especially important to understand the price one can receive for reserves as many companies have recently sold “non-core” assets to generate cash to pay off debt and fund operations. The American Society of Appraisers defines the Fair market value as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.1The American Society of Appraisers recognizes three general approaches to valuation: (1) The Cost Approach, (2) The Income Approach, and (3) The Market Approach. The IRS provides guidance in determining the fair market value of an oil and gas producing property. Treasury Reg. 1.611–2(d) offers that if possible the cost approach or comparative sale approach should be used before a discounted cash flow analysis (DCF). When valuing acreage rights comparable transactions do provide the best indication of value. However, when valuing reserves, a DCF is often the best way to allocate value to different reserve categories because comparable transactions are very rare as the details needed to compare these specific characteristics of reserves are rarely disclosed.Cost ApproachThe cost approach determines a value indication of an asset by considering the cost to replicate the existing operations of an asset. The cost approach is used when reserves have not been proved up and there have been no historical transactions, yet a participant has spent significant time, talents, and investments into exploratory data on an oil and gas prospect project.Market ApproachThe market approach is a general way of determining a value indication of an asset by using one or more methods that compare the subject to similar assets that have been sold.Because reserve values vary between oil and gas plays and even within a single play, finding comparable transactions is difficult. A comparable sale must have occurred at a similar time due to the volatile nature of oil and gas prices. A comparable sale should be for a property that is located within the same play and within a field of similar maturity. Additionally, comparable transactions must be thoroughly analyzed to make sure that they were not transacted at a premium or discount due to external factors. Thus the market approach is often difficult to perform because true comparable transactions are rare. However, the transaction method generally provides the best indication of fair market value for acreage and lease rights.Income ApproachThe income approach estimates a value indication of an asset by converting anticipated economic benefits into a present single amount. Treasury Reg 1.611 – 2(e)(4) provides a straightforward outline of how the approach should be used.In practice, this method requires that: The appraiser project income, expense, and net income on an annual basisEach year's net income is discounted for interest at the "going rate" to determine the present worth of the future income on an annual and total basisThe total present worth of future income is then discounted further, a percentage based on market conditions, to determine the fair market value. The costs of any expected additional equipment necessary to realize the profits are included in the annual expense, and the proceeds of any expected salvaged of equipment is included in the appropriate annual income. Although the income approach is the least preferred method of the IRS, these techniques are generally accepted and understood in oil and gas circles to provide reasonable and accurate appraisals of hydrocarbon reserves, and most closely resembles the financial statement reporting requirements discussed in our previous post. This method is the best indication of value when a seismic survey has been performed and reliable reserve estimates are available. In order to properly account for risk, we divide the reserves by PDP, PDNP, PUD, Probable, and Possible reserves. We will review the key inputs in a DCF analysis of oil and gas reserves below.Cash InflowsIn order to estimate revenue generated by an oil and gas reserve, we must have an estimate of production volume and price. Estimates of production are collected from Reserve reports which are produced by geological engineers.The forward price curve provides monthly price estimates for 84 months from the current date. Generally, the price a producer receives varies with the price of benchmark crude such as WTI or Brent. Thus, it is important to carefully consider a producers contract with distributors. For example a company may sell raw crude to the distributor at 65% of Brent.Cash OutflowsMany E&P companies do not own the land on which they produce. Instead they pay royalty payments to the land owner as a form of a lease payment. Royalty payments are generally negotiated as a percentage of the gross or net revenues derived from the use of the property. Besides royalty payments and daily operating costs, it is important to have conversations with management to understand future infrastructure maintenance and capital expenditures.DiscountOil and gas reserves can be based on pre-tax or after-tax cash flows. Pre-tax cash flows make reserve values more comparable as tax rates vary by location. When using pre-tax cash flows, we use a pre-tax cost of debt and pre-tax cost of equity to develop a WACC.Risk Adjustment FactorsWhile DCF techniques are generally reliable for proven developed reserves (PDPs), they do not always capture the uncertainties and opportunities associated with the proven undeveloped reserves (PUDs) and particularly are not representative of the less certain upside of the Probable and Possible reserve categories. A risk adjustment factor could be used to the discounted present value of cash flows according to the category of the reserves being valued to account for PUDs upside and uncertainty by reducing expected returns from an industry weighted average cost of capital (WACC). You could also add a risk premium for each reserve category to adjust a baseline WACC, or keep the same WACC for all reserves but discount the present value of the cash flows accordingly with comparable discounts to those shown below. The low oil price environment forced many companies to sell acreage and proved reserves in order to generate cash to pay off debt. In order to create a new business models in the face of low oil prices, it is critical for companies to understand the value of their assets. The valuation implications of reserves and acreage rights can swing dramatically in resource plays. Utilizing an experienced oil and gas reserve appraiser can help to understand how location impacts valuation issues in this current environment. Contact Mercer Capital to discuss your needs and learn more about how we can help you succeed. End Note1 American Society of Appraisers, ASA Business Valuation Standards© (Revision published November 2009), “Definitions,” p. 27.

RSP Permian / Silver Hill Energy: A Closer Look at the Acquisition

On October 13, 2016 RSP Permian (RSPP) announced the acquisition of Silver Hill Energy (SHE) for approximately $2.4 billion dollars. SHE will receive approximately $1.182 billion in RSPP common stock and $1.25 billion in cash. Based on RSPP disclosures, the assets received include (1) wells currently producing 15,000 barrels of oil equivalent per day (BOEPD); and (2) 41,000 in net acreage throughout Loving and Winkler County Texas. Approximately 69% of the current production is crude oil. Based upon the consideration given by RSPP, here is the implied market value of invested capital (MVIC) for SHE: The other side of the transaction ledger is the value of the individual assets acquired. Since SHE is not a public company, allocating the purchase price to the individual assets is, dare we say, educated guesswork at best. Here is our guestimate of the assets that will need allocated value. 1 Before venturing into our approach to the allocation, we have compared pricing multiples of the SHE acquisition and other oil and gas public companies. At the time of the transaction, SHE owned acreage rights in one of the most popular domestic resource plays, the Delaware Basin. The chart below shows the implied pricing metrics for SHE versus the market pricing multiples for publicly traded operators in the Delaware Basin. Valuation Metrics Based upon these ratios2, we have the following observations: RSPP is approximately 2x larger than SHE;Of the seven public companies, SHE is very close in size to Matador Resources Company (MTDR). SHE has acreage adjacent to acreage operated by MTDR;Based on per day production, the SHE transaction was priced at the highest indicated value;Based upon net acres acquired, the SHE transaction was priced at the higher end of the indicated value of all the publicly traded companies. Note that approximately 95% of the acreage acquired is considered developed; Based upon these observations, we have the following commentary on SHE:It appears the majority of SHE’s asset values are in the producing 58 wells: 95% of the 41,000 net acreage is considered producing;49 of the 58 producing wells are horizontal;Less than 5% of the net acres are undeveloped;58 wells over 39,050 acres equates to well spacing of one per 673 acres. While 49 are horizontal wells, it appears they may be opportunities to add additional wells;Additionally, with less than 5% of the net acres to be explored, a higher than average BOEPD multiple may be explainable.Lastly, based on the data reviewed to date and the location of SHE’s acreage, RSPP may have identified opportunities to recomplete existing wells, with longer lateral and horizontal wells which may produce from other resource plays within the area. The following map, disclosed by RSPP, shows the acreage position within the resource play as well as the depths of the highly sought after Wolfcamp resource. According to this map, SHE’s acreage is centered in the deepest portions of the Wolfcamp, approximately 7,500 to 8,500+ feet. This location allows for penetration into multiple zones. RSPP has thus far identified seven zones they would target. Additionally RSPP has identified other wells around the acquired acreage (shown below) that have seen success from multi-zone production. Some of these wells are that of SHE, others from competing operators. 3 Assets PurchasedEarlier, we displayed the high level categories for an allocation of purchase price. Three of these categories are oil and gas related assets: (1) 58 wells currently producing 15,000 barrels of oil equivalent per day; (2) proved developed reserves; and (3) 41,000 net acres, of which 5% are considered undeveloped. The valuation for current production and proved developed reserves is fairly straight forward. No doubt SHE prepared a reserve report which would aid in the valuation of the currently producing wells and the remaining proved reserves. However, the valuation gap between the proved developed reserves and the remaining proved undeveloped, probable and possible reserves or acreage value can be detailed, tedious, and complex. The historically low oil and gas price environment and financial tension within the industry creates a complicated market place for using market transactions as indications of value.More information is needed to drill down into the specifics and valuation of each of the acquired oil and gas assets. Interested parties may want to consider the following information areas:Reserve Reports. Specifically, we would like to understand the amount of acreage in each of the maps above that have been drilled versus what areas are included in the drilling plan, PV 10 indications and price deck assumptions;Financial Statements. It would also be helpful to understand more about SHE’s decision to sell and perhaps the financial situation immediately prior to the sale. If SHE was backed by private equity investors rather than a typical oil and gas operator, management could have had different reasons to exit their investments. Timing may also have played a part as Permian dominated assets currently appear to be selling for a Premium compared to other domestic plays.Synergistic efficiencies. Drilling efficiencies have been disclosed by RSPP, but we don’t know how many are new well locations verses recompletion of existing into multiple resource plays. Much of the acquisition details have not been disclosed, and we’ll wait for additional filings from RSPP to learn more. Regardless, RSPP’s acquisition of SHE ranks as a top five E&P related transactions of 2016 based on size and analyzing available information can help us to better understand the current marketplace. Based upon our experience involving private companies, we understand that pricing for proven undeveloped, probable and possible reserves have dropped significantly in the previous year, by upwards of 90% in some cases. In addition, due to the nature of the current oil and gas environment, we understand that the historical transactions may have little comparability to today. Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence. End Notes1 We have used publicly available information. As such this is a high level summary of approaching an allocation without having all the needed information. 2 BOEPD = Barrels of Oil Equivalent Produced Per Day PD Reserves = Proved Developed Reserves 3 RSP Investor Presentation Acquisition of Silver Hill on October 13, 2016

TriState Buys Aberdeen’s Domestic Fixed Income Business

A Pleasant October Surprise

In the late 1960s, BMW introduced a simple product that made the company what it is today. The 2002 was a straightforward, useful, two door coupe with a small but powerful motor, light weight, four seats, and a decent trunk. It was economical, easy to work on, and fun. It sold like crazy, and morphed over time into what is now known as their 3-series, the mainstay of their global automotive line. One lesson from this trajectory is that strategy doesn’t have to be complicated to be successful – a lesson that has broad applications, including the topic of this blog post.It’s no secret that banks are facing tough times, with lousy spreads, exponential increases in regulation, indifferent customers, and cunning competition. There are many fancy ways to navigate this, but one simple one is deploying capital in attractive financial businesses that generate strong margins – such as asset management.Banks looking to diversify their revenue stream with investment management fee income would be well advised to study TriState Capital’s acquisition-fueled buildout of its RIA, Chartwell. The Pittsburgh depository started with an internal wealth management arm, bought $7.5 billion wealth manager Chartwell Investment Partners in early 2014, picked up the $2.5 billion Killen Group in late 2015, and last week announced the acquisition of a $4.0 billion domestic fixed income platform strategy from Aberdeen Asset Management.The Aberdeen acquisition represents about $4.0 billion in domestic fixed income over four strategies. Realized fees appear to be just shy of 20 basis points. Six portfolio managers from Aberdeen are coming with the acquisition, and the operation looks fairly profitable on a pro forma basis, with TSC expecting EBITDA on the order of $3.5 million (annualized on a run rate basis), for a margin of approximately 45%.A few things stand out about the TriState/Aberdeen acquisition.Consistent acquisition criteria. TSC has a well-defined acquisition criterion for growing the RIA that has remained consistent from the original Chartwell acquisition. Appropriate and well-defined criteria are significant for any bank looking to augment asset management products through acquisition, because in many cases there are too many, often dissimilar, RIAs from which to choose. TSC seeks out asset management capabilities with compatible product structures, competent management teams, and consistent profitability that will grow and enhance their existing business. They also have consistently shopped within their existing geographic markets.Attractive Pricing. TriState’s acquisitions are consistently well-bought. Aberdeen had a strategic motivation to sell these fixed income products, which were a small enough part of their overall business to let go of fairly cheaply. As a consequence, TSC is paying 1.5x run-rate revenue, and more importantly, a little less than 4.0x EBITDA – a very compelling valuation that sets up TriState Chartwell for an attractive internal rate of return.Embracing the RIA Strategy. TSC appears to have gotten past the usual cultural angst that depository institutions have developing an RIA. The TriState investment management business has a separate identity, and it doesn’t seem to bother bank management that these acquisitions are dilutive to the bank’s tangible book value – in fact, they don’t even mention it. The RIA does what it is supposed to do – deploy the bank’s excess capital to produce discretionary cash flow. The bank’s earnings grow, and so does the bank’s valuation. With the latest acquisition, TSC has nearly doubled run-rate assets under management since 2014, putting excess capital at the bank to work in attractively priced acquisitions which have been individually and collectively accretive to earnings. The strategy has worked well for TriState, and investors have taken notice. Over the past two years, TSC’s share price is up nearly 80%, while SNL Securities’ Small Cap U.S. Bank Index is up less than half that much. Asset managers in general have fared much worse, with the broad U.S. Asset Manager Index constructed by SNL showing a modest decline over the same period. Many banks are understandably wary of trying their hand at investment management. RIAs are a different kind of financial institution in every way, cross-selling is often more myth than reality, and it can be difficult to explain to bank investors how to reconcile the differences in investment management performance characteristics and more traditional bank measures. Still, in a world where banks are caught in the gravitational pull of low NIMs and Basel III, and the asset management industry is in need of consolidation, there is ample reason to consider the possibilities of pairing up for mutual success.

Oil and Gas Reserve Values

This is the first of two posts in which we will investigate the different values placed on oil and gas reserves in a GAAP, Non-GAAP, IFRS, and fair market value context. As an example we will consider Exxon Mobil Corp., the nation’s largest energy company, which is under investigation for its lack of asset write-downs amid falling oil and gas prices. The Exploration and Production sector focuses on finding and using oil and gas reserves; thus the value of an E&P company exists in the value of its reserves. For many companies, such as professional service firms and tech start-ups, book value is meaningless from a valuation perspective because the true value of the company is not reflected on the balance sheet. But, because E&P companies’ value lies in the value of their reserves, investors often look to book value in order gauge future performance. In order to protect investors from misleading information, the SEC, FASB, and IFRS have specific rules for reporting and accounting for proved reserves. When we talk about reserve values there is a difference between the fair market value of reserves, the value of reserves as shown on a company’s 10-K, and the GAAP standard measure for oil and gas reserves. The SEC uses a reported value known as PV-10 in order to make proved reserves comparable across companies. PV-10 is the value of reserves calculated as the present value of estimated future revenues less direct expenses discounted at an annual rate of 10%. But, PV-10 is a non-GAAP accepted measure. The FASB’s ASC 932 requires a similar standardized measure for the value of proved reserves called SMOG (standardized measure of oil and gas). SMOG is calculated with the same methodology as PV-10 but deducts income taxes whereas PV-10 does not. Both PV-10 and SMOG require (1): reserve estimates (2): a sales price and (3): an estimate of cost.All reserve estimates involve some degree of uncertainty, which can be minimized with dependable geological and engineering data and proper interpretation of the data. There are two methods of reserve estimates. While both are based on geological, engineering, and economic data, a deterministic estimate is single estimated value while a probabilistic estimate is a range of values given with their associated probabilities.The price of oil/natural gas used to calculate future income must be the twelve-month average price not the year end spot price.While the SEC and FASB provide guidelines for what should be included as a direct expense, costs, realistically, are estimated differently by every company leading to some inconsistency in these standardized values across firms. The SEC’s Modernization of Oil and Gas Reporting requires that PUDs only include wells that are “economically producible” within five years. As the price of oil dropped in 2014, companies had to revise revenue estimates for many of their wells and some wells were no longer considered economically viable during the SEC’s five year time period. Thus many companies had to reclassify certain proved reserves as probable or possible reserves. Bradley Olson, of the Wall Street Journal, reported:With low crude oil and natural gas prices, billions of barrels of fuel in the ground cannot be tapped cost effectively, making reserves revisions and write-downs staples of oil-patch earnings in recent years, and helping push energy company losses to record levels.Competitors of Exxon have booked over $200 billion of write downs since oil prices collapsed in 2014, but Exxon has not recorded losses associated with reserve write downs. Exxon says that they have not written down the value of their reserves because they use conservative accounting techniques when they initially book the value of new fields and wells. Unlike its competitors, Exxon’s proved reserves only consist of fields in which “management has made significant funding commitments toward the development of the reserves.” Exxon’s CEO challenges management to make sure that capital expenditure projects will be viable even in a low price environment. Thus, when the price of oil fell Exxon claimed that they still had the necessary funding to develop its PUDs and did not have to write down the value of its reserves. However, if a 60% drop in oil prices did not impair reserve values, then maybe Exxon’s reserves were undervalued before.The SEC recently broadened the definition of proved reserves as:those quantities of oil and gas, which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible—from a given date forward, from known reservoirs, and under existing economic conditions, operating methods, and government regulations[… ]The SEC elaborates on many details such as what is a reasonable time frame, what part of the reservoir is included as proved, and when can improved recovery techniques be used to estimate future production. But there is still room for interpretation. Although Exxon executive, Alan Jeffers said that Exxon is confident that its financial reporting is legal, it is clear that Exxon has used the somewhat ambiguous definition of proved reserves to do something different than many of its peers. Additionally, this investigation overlaps with another investigation into Exxon’s asset values in consideration of the future cost of environmental regulations and the global response to climate change.Just as there are differences in reporting standards when determining the value of proved reserves, there are differences in the way companies determine if reserves are impaired. Companies that have overseas operations often keep two sets of books because they must also follow International Financial Reporting Standards (IFRS). Both GAAP and IFRS have the same goal of making sure that assets are not reported above the value that could be recovered from liquidating the asset, but they have different methodologies to determine if an asset is impaired. Under IFRS, future discounted cash flows are compared to the book value of the asset, while under GAAP, undiscounted future cash flows are compared to book value. Although the threshold of impairment is higher under GAAP, GAAP write downs cannot be reversed when economic conditions recover, unlike IFRS write downs which are reversible. In order to write down assets, discounted cash flows are used by both IFRS and GAAP.It is important to remember, especially, in a low oil price environment that the reserve values presented on company’s 10-Ks may not be an accurate representation of fair market value. Fair market value represents the price at which property would change hands between a hypothetical buyer and seller. Next time we will discuss how to determine the fair market value of oil and gas reserves.Contact Mercer Capital to discuss your valuation needs in confidence and learn more about how we can help you succeed.

M&A in the Permian: The Trend Continues

Last week, we looked at the recent transition of E&P companies out of the Bakken and the Eagle Ford to the Permian. We concluded that E&P companies are moving to the Permian for its (1) upside potential, (2) low break even prices, and (3) diversity of resources. This week M&A activity reinforced this idea. In the last week, there were 18 E&P deals in the U.S.1 Seven of those transactions were in the Permian and over half of the total deal value generated ($768 million in total) from September 30 to October 6 was in the Permian. Today we focus on two transactions: Resolute Energy’s acquisition of Delaware Basin Acreage and Apollo and Post Oak Energy’s merger to form Double Eagle Energy Permian. Before we drill down the details of these transactions, here’s a breakdown of total announced deal value generated in the U.S. this year.Resolute Energy / Firewheel Energy TransactionResolute Energy, a Denver based company, received notice twice in 2015 that it was at risk of being delisted from the NYSE and its EBITDA fell so low that the Company considered a Chapter 11 restructuring in late 2015. The Company sold its Powder River and Midland Basin assets for $275 million which allowed it to reduce its debt and increase its drilling activity in the Delaware Basin. Since then they have more than tripled their Delaware Basin output. They estimated third quarter output for 2016 to be between 16,000 and 16,500 Boe/d, which is a 37% increase from the second quarter of 2015.On October 4 Resolute announced its acquisition of 3,293 acres in the Delaware Basin from Firewheel Energy, a portfolio Company of EnCap Investments. The acquired acreage will increase Resolute’s position in Reeves County in the Delaware Basin by 25%, according to their press release. The acquired acreage includes thirteen horizontal and fifteen vertical wells, which produce approximately 1,200 Boe/d.Resolute’s purchase price consisted of $90 million payable in cash and $45 million payable in common stock. Although Resolute’s stock had been at risk of being delisted just 9 months prior, the Company was able to increase the value of its stock by refocusing operations in the Permian, which investors have lately placed a premium on, and by participating in a one-for-five reverse stock split. This allowed the Company to fund this transaction with common stock and generate cash to fund the acquisition with an offering of a new class of preferred shares.Resolute reported the value of the Proved reserves as $45.8 million and Undeveloped Acreage as $79.8 million.Double Eagle Lone Star LLC / Veritas Energy Partners Holdings LLC MergerTwo private-equity backed E&P companies recently merged their Permian focused operations. Double Eagle Lone Star LLC, an affiliate of Apollo Global Management, assembled a portfolio of assets in the Powder River Basin, the DJ Basin, Mid-Continent, Eagle Ford and Permian. The Company sold its SCOOP (South Central Oklahoma Oil Province) and STACK (Sooner Trend Anadarko Basin Canadian and Kingfisher Counties) assets for $250 million in order to transition its focus away from Anadarko Basin in Oklahoma to the Permian in west Texas. Veritas Energy acquired acreage mainly in the Midland Basin and Fort Worth Area and formed a partnership with Post Oak Energy Capital to focus on increasing acreage in the Midland Basin. The two announced their merger on October 3rd. The new Company will have more than 63,000 net acres in the Permian’s Midland Basin. The deal values were not disclosed.Analysts with 1Derrick predict that the Company was formed in order to prepare for an IPO in order to take advantage of the high equity valuations of pure play Permian producers. Industry averages of EV/ Boe of proved reserves are estimated to be $13.45, while Permian producers multiples are often higher than $25 / Boe.2In order to prepare for an IPO, however, Double Eagle Permian will have to focus on developing its assets as only 70% of the assets are currently operated. The Texas Railroad commission reports that the combined Texas production of both Double Eagle and Veritas is about 3,000 Boe/d. The appeal of the Permian to market participants is the low cost of drilling. Thus in order to reach its full potential, the Company must be able to achieve the double-digit production growth that many of its peers have.These two transactions demonstrate that market is currently placing high value on the equity of companies located in the Permian and E&P companies are doing what they can to take advantage of this. Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels, and other minerals. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs.End Notes1Only includes packages valued at greater than $100 million. 21Derrick

Recent Bribery Scandal, Another Blow to Alternative Asset Managers

Just a few days ago, the largest publicly traded hedge fund, Och-Ziff Capital Management Group, agreed to pay $413 million to settle federal charges that it disbursed more than $100 million in bribes to African government officials. Even before this announcement, the hedge fund industry was in quite the slump. Since June of last year, publicly traded hedgees and PE firms have lost 40% of their market cap. We’ve discussed the many headwinds facing this industry in prior posts but generally speaking, investors are simply fed up with the low return, high fee combination that has recently characterized the industry, particularly over the last year and a half. The Fed’s anti-volatility campaign hasn’t helped matters, and isn’t likely to abate any time soon. The Och-Ziff scandal reveals another potential headwind that isn’t necessarily company-specific. While difficult to measure, reputational risk is very real for these businesses that rely heavily on investor trust, transparency, and overall status within the financial community to raise capital. FIFA-like scandals are unacceptable to institutional investors already wary of high fees and sub-par performance. With this as a backdrop, it is hard to envision much of a silver lining. Still, as we’ve noted in a prior post, asset bubbles are relative. With a third of the developed world selling bonds at negative yields, and the U.S. stock market trending up after six straight quarters of earnings declines, bidding for any return at all in the private company space looks, at least on a relative basis, attractive. Fund raising is still alive and well in alt assets, and should be for some time to come. The old 2 and 20 management fee / carry model, however, is on life support and probably not going to make it - at least not as the industry standard. The few PE firms and hedge funds still capable of charging such high rates are consistently in the top 5% of investment performance, and sustaining that level of alpha over the long term is nearly impossible. One and ten over a predetermined hurdle is the new normal, and even that could come under pressure if performance continues to suffer while fees tighten for other classes of asset managers. A glance at current multiples doesn’t reveal much except that Blackstone’s earnings are likely depressed, and analysts are expecting some recovery next year as LTM multiples exceed forward P/E ratios for most of these businesses. In an era of fee compression and passive investing, this seems optimistic, though some mean reversion is entirely possible. AUM multiples, on the other hand, have always been high for this sector and are likely to remain that way due to performance fees and non-asset-based sources of income for PE firms. Still, with most of the group trading close to their 52 week high, any significant upside seems unlikely, and OZM shares may never recover. Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

M&A Overview: Race to the Permian

M&A activity in the exploration and production industry has recovered from the standstill experienced one year ago as oil and gas companies waited to see what the market would throw at them next. When crude oil prices dropped, companies reduced their exploration budgets and stopped drilling new wells. When prices remained low, many companies began to sell off non-core assets in order to generate cash to pay off debt. Companies, who cut drilling activity when prices collapsed, are now looking to replace their reserves through acquisitions. Bloomberg analysts predict that the majority of M&A activity going forward will be asset purchases as E&P companies look to acquire more than 50% of their reserve replacement.The majority of these transactions have occurred in the Permian. This year, 38% of total E&P deal value was generated from deals in the Permian, and 24% of the number of total deals occurred in the Permian.1 This demonstrates that more deals and larger deals are happening in the Permian than in other plays in the U.S. Last week we looked in depth at EOG’s acquisition of Yates Petroleum for $2.5 billion. The acquisition helped EOG shift from the Eagle Ford into the Permian. EOG’s CEO Bill Thomas told investors, “We’ll be able to grow oil (production) with less capital and more efficiently than we do now.” EOG’s share price rose by more than 6% the day after the transaction. E&P companies are flocking to the Permian for many reasons, including its (1) upside potential, (2) low break even prices, and (3) diversity of resources. Upside PotentialAlthough the Permian was discovered in the 1920s, the true potential of the Permian was not realized until 2007 when hydraulic fracturing techniques were used to access the tight sand layers of the play. Since then the Permian has been revitalized as producers have begun using unconventional drilling techniques in addition to traditional vertical wells. Because the crude in the shale layers have only recently been explored, there are still tremendous reserves left.Low Breakeven PricesThe Permian has low break even prices compared to other reserves in the U.S. Although production costs may not be as low as Pioneer Natural Resources CEO, Scott Sheffield, boasted ($2.25 per barrel excluding taxes), costs are lower than other plays due to the geological makeup of the shale.The Permian is a stacked play which means that multiple horizontal wells can be drilled from one main wellbore. This provides increased productivity as multilateral wells have greater drainage areas than single wellbore. Additionally, it can reduce overall drilling risk and cost. For deep reservoirs like the Permian, a multilateral well eliminates the cost of drilling the total depth twice.2In many plays, the low price of crude oil has made drilling uneconomical. Many companies are trying to acquire acreage in the Permian, where production is cheaper, because it is unclear when crude prices will rise and if they will ever rise to the same levels as before.Diversity of ResourcesThe Permian is the largest producer of oil and the second largest producer of gas, after the Marcellus. Even as gas prices collapsed, production in the Permian increased. Companies that operate in the Permian do not have to choose between oil and gas, but can diversify operations. The market for commodities is inherently risky because producers are price takers. Although related, the price of natural gas and crude oil are not perfectly correlated. Thus when the price of natural gas fell six years ago, producers in the Marcellus and Utica were entirely exposed to the natural gas market, while producers in the Permian were able to rely on their profits from crude oil to fund operations. Exploration and Production companies are trying to get their hands on acreage in the Permian now before the next swing in crude oil prices. OPEC agreed on Wednesday to cut its production of crude oil. IEA analysts believe that the proposed cuts to between 32.5 million and 33 million barrels per day would bring production back in line with demand until the second half of 2017. Definitive policies are expected to be set in November, but there still remains doubt that the deal will be able to relieve supply due to OPEC’s inability to enforce these quotas. This uncertainty about the future price of crude oil has caused producers to leave other plays and increase their acreage in the Permian. Consequently, this has increased acreage prices in the Permian compared to other plays, such as the Bakken and Eagle Ford. A summary of some transactions in the Permian this year is shown below. Callon Petroleum increased its position in the Permian the same day as the EOG / Yates transaction. Callon was traditionally an offshore driller in the Gulf of Mexico. They began shifting out of the Gulf in 2010 due to the high costs of offshore drilling and sold their last offshore asset in 2013. Since then the company has steadily been increasing its stake in the Permian. Since the second quarter of last year the Company has increased production by 56%, while at the same time reducing capital expenditures by 48%.3 The company has recently been using its highly valued stock to fund acquisitions in the Permian. The price of Callon’s stock price has tripled since January even though they have increased their shares outstanding by 50% over the same time period. This demonstrates investor’s confidence in the Permian. The valuation implications of reserves and acreage can swing dramatically in resource plays. Utilizing an experienced oil and gas reserve appraiser can help to understand how location impacts valuation issues in this current environment. Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels, and other minerals. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs. End Notes1 1Derrick 2 New Aspects of Multilateral Well Construction. Fraija, José; Ohmer, Hervé; and Pulick, Tom. Online Available at http://www.slb.com/~/media/Files/resources/oilfield_review/ors02/aut02/p52_69.ashx. 3 1Derrick

E&P Fourth Quarter 2016

Region Focus: Marcellus & Utica Shale

Region Focus: Marcellus & Utica Shale: Oil prices increased over the last twelve months from $37/bbl at January 4, 2016 to $55/bbl at year end.

Refining Fourth Quarter 2016

The refining industry has struggled with margin compression over the last six months.

Portfolio Valuation: Private Equity Marks & Trends

Fourth Quarter 2016

A Market Participant Perspective on the Size Premium

Performance Fees are Dead! Long Live Performance Fees!

Earlier this month, Mercer Capital had the pleasure of helping sponsor the Southern Capital Conference, an annual gathering of venture capital and private equity GPs, as well as the LPs who invest with them. Many of the firms and investors were from the Southeast, but there was some representation from the New York-Boston corridor and even a few from Palo Alto. If you believe everything you read about this segment of the investment community, you might expect a fair amount of groaning from the General Partners, with private equity managers under pressure to improve performance, negotiate fees, and increase transparency. The reality was very different.This particular conference started meeting annually over 30 years ago, when alternative asset funds like PE and VC were a cottage industry that appealed to a small niche of investors. Now this conference is just one of hundreds of alt asset conferences held in the U.S. every year. With all that growth and development there has inevitably been some change in the space, and no doubt there is more to come. I was reflecting on this at the conference when a friend emailed me an article about the 1954 introduction by Mercedes-Benz of the 300SL, best known for distinctive gull wing doors which other car companies have tried to emulate, including Tesla in their Model X.Today we would call a 300SL an “exotic” car, but in the mid-1950s there was no such thing. One of Mercedes’s distributors, Max Hoffman, suggested the development of a mildly toned-down Grand Prix racer into a fast but comfortable road car. The 300SL was a technological marvel at the time, with a focus on aerodynamics and a tubular space frame that necessitated the famous doors. It was also the first car to feature direct fuel injection, which has only recently become common in passenger vehicles. The Gullwing was the fastest production car at the time. It was also very expensive, similar in price to a contemporary Ferrari and well above the rest of the Mercedes line. In exchange for paying an exorbitant price and tolerating difficult ingress and egress, the 300SL buyer got quite a conversation piece and leading performance. It worked; and in the process Mercedes discovered a whole new product category.The enduring appeal of private equity and hedge funds seems to mimic the success of the Gullwing. Pay managers more for the hope of better returns, and in exchange accept less transparency and liquidity than one could achieve allocated to registered securities. This sentiment was echoed by the closing speaker at the conference, head of a wealth management firm serving ultra-high net worth families. After giving us what has become a fairly common forecast of much lower returns from equities and bonds, he explained that he’s commonly suggesting private equity to his clients - not just for diversification but also to boost returns. Fees are high, yes, but at least this one wealth manager thought you get what you pay for.So there was little lament about fee compression or LP demands at the conference. If anything, the concerns voiced by the GP community were that there was too much money chasing too few opportunities. It’s tough to “make your money on the buy” when you get locked in a bidding war with four other firms for the same portfolio company – as the price bids up, the prospective return on investment bids down. The entry prices paid with recent vintage year PE funds portend lower returns going forward – even if a fund avoids unicorn rounds and IPO downrounds.That said, asset bubbles are relative. With a third of the developed world selling bonds at negative yields, and the U.S. stock market trending up after six straight quarters of earnings declines, bidding for any return at all in the private company space looks, at least on a relative basis, attractive. So fund raising is still alive and well in alt assets, and should be for some time to come.This isn’t to say, though, that change isn’t on the way. We all know that the tremendous growth of the PE space hasn’t come strictly from wealthy families who can stomach huge return volatility and illiquidity. Much of the growth has been sovereign wealth funds, pensions, endowments, and other institutional class investors that ultimately have to serve the public good. The SEC has gotten interested in the industry, and that only leads to one outcome: more uniformity, more transparency, and more competitive pricing.So what’s next for performance fees? We have some clues to this mystery in Mercedes’s development of its successor to the Gullwing: the 230SL. Introduced nine years after the original SL, the model was upgraded twice over its nine year product life, and provided a more conventional sports car than the Gullwing. The 230SL wasn’t the fastest production car when it was introduced in 1963; it was powered by a stock inline-six cylinder motor that Mercedes used in other vehicles (the 300SL had a unique engine derived from the German Messerschmitt ME109 fighter aircraft). Nor did the 230SL have as much distinctive bodywork, although the large greenhouse of the hardtop was affectionately nicknamed the “Pagoda-Top.” But despite being a more conventional product, the 230SL was every bit a performance sport car, was cost effective to produce, and was profitable to sell at about two-thirds the sticker price of the original 300SL. Mercedes sold fifteen-times as many Pagoda-Tops as they had Gullwings, in the same number of model years.So, despite the fact that alternative investment vehicles are inevitably going to endure some homogenization, increased regulation, and some fee compression, there remains a need for the product category. And we think performance fees will endure – at least as long as there is still some performance to fee.1964 230SL. Photo Credit: Wikipedia

EOG/Yates Merger

A Closer Look at the Acquisition

On September 6, 2016 EOG Resources (EOG) announced the acquisition of Yates Petroleum (Yates) for approximately $2.4 billion dollars, by our calculations. Yates will receive approximately $2.2 billion in EOG common stock and $37 million in cash. In addition, EOG assumed $114 million (net) in Yates debt.1 Based on EOG’s disclosures, the assets received by EOG include (1) Wells currently producing 29,600 barrels of oil equivalent per day (BOEPD); (2) proved developed reserves of 44 million barrels of oil equivalent; and (3) 1.624 million in net acreage throughout New Mexico, Wyoming, Colorado, Montana, North Dakota and Utah. Approximately 48% of the current production and proved developed reserves are crude oil. Based upon the consideration given by EOG, here is the implied market value of invested capital (MVIC) for Yates: The other side of the transaction ledger is the value of the individual assets acquired. Since Yates is not a public company, allocating the purchase price to the individual assets is, dare we say, educated guesswork at best. Here is our guestimate of the assets that will need allocated value and their key information items.2 Before venturing into our approach to the allocation, we have compared pricing multiples of the Yates acquisition and other oil and gas public companies. At the time of the transaction, Yates owned acreage rights in several domestic resource plays with the most popular resource play of 186,000 net acres in the Delaware Basin. The below chart shows the implied pricing metrics for Yates versus the market pricing multiples for publicly traded operators in the Delaware Basin. Valuation MetricsBased upon these ratios, we have the following observations:3EOG is approximately 25x larger than Yates;Of the six public companies, Yates is very close in size to Matador Resources Company (MTDR);Based on per day production, the Yates transaction was priced at the lowest indicated value except for Apache Corp (APA);Based upon net acres acquired, the Yates transaction was priced at the lowest indicated value of all the publicly traded companies;Based on proved developed reserves, the Yates transaction was priced at the highest indicated value of the group. Based upon these observations, we have the following commentary on Yates:The attractive upside for Yates is not in the current production, but in the undeveloped acreage, possibly adjacent to EOG acreage (explains the low MVIC to BOEPD metric);Of the acreage that Yates owned, a large majority of it is not highly coveted by Yates and EOG (explains the low MVIC to net acre metric);Of the proved developed reserves known by Yates, EOG believes they can develop significantly more reserves in the future (explains the high MVIC to proved developed reserves metric);As the interest for EOG does not appear to be in vast amounts of acreage that Yates owns, the current production nor the developed reserve, this leads us to believe the highly coveted Delaware Basin positions were the primary drivers for the acquisition.Assets PurchasedEarlier, we displayed the high level categories for an allocation of purchase price. Three of these categories are oil and gas related assets: (1) Wells currently producing 29,600 barrels of oil equivalent per day; (2) proved developed reserves of 44 million barrels of oil equivalent; and (3) 1.624 million in net acreage. The valuation for current production and proved developed reserves is fairly straight forward. No doubt Yates prepared a reserve report which would aid in the valuation of the currently producing wells and the remaining proved reserves. However, the valuation gap between the proved developed reserves and the remaining proved undeveloped, probable and possible reserves or acreage value can be detailed, tedious, and complex. The historically low oil and gas price environment and financial tension within the industry creates a complicated market place for using market transactions as indications of value.Acreage Owned by Yates The highly publicized acreage includes: (1) 186,000 net acres in the Delaware Basin; (2) 138,000 net acres in the Northwest Shelf; (3) 200,000 net acres in the Powder River Basin and (4) other western basins which add up to 1.1 million net acres. The following maps, disclosed by EOG, show the resource plays Yates owned acreage within. These resource plays range from Texas to Canada. Of the eight resource plays named in the map, EOG classifies two as the “best plays”. These are the Delaware Basin and the Powder River Basin. Delaware Basin EOG then allows us a closer look at the location of Yates acreage in the Delaware Basin in comparison to EOG’s acreage. Many instances exist where Yates acreage is right next to EOG’s acreage, this could allow for longer and more cost effective lateral wells. Market transactions for acreage in this area vary significantly based on seller motivation, buyer synergies and commodity price timing. Our experience indicates acreage rights historically transact from $50 per acre to $14,000 per acre and above, depending on location. Northwest Shelf Another map comparing Yates and EOG’s acreage location in the Northwest Shelf shows less instances where the two companies acreage is connected but clearly demonstrates Yates is seemingly centered in the most desired areas of the Northwest Shelf. In addition to these two plays, the map shows Yates acreage located in northern Chaves and Lea counties. EOG does not show any acreage in these areas. Our historical transaction data indicates acreage rights transact for $50 to $350 per acre in northern Chaves, Lea, and Roosevelt counties. Compare this to the Delaware Basin and Northwest Shelf areas which have spots that historically transact for $5,000 per acre and above. Powder River Basin EOG also discusses their interest in the Powder River Basin. As the map shows, EOG has significant acreage positions in the middle of the play. Similarly, Yates has large clumps of acreage rights in the same general area and in some cases, right next to EOG. This tends to indicate efficient drilling benefits may exist in the Powder River Basin too. Similar to the resource plays in New Mexico, acreage rights pricing varies widely by location. Drilling DeeperMore information is needed to drill down into the specifics and valuation of each of the acquired oil and gas assets. Interested parties may want to consider the following information areas:Reserve Reports. Specifically, we would like to understand the amount of acreage in each of the maps above that have been drilled versus what areas are included in the drilling plan, PV 10 indications and price deck assumptions.Financial Statements. It would also be helpful to understand more about Yate’s decision to sell, and perhaps, the financial situation immediately prior to the sale. What we know is approximately 48% of the current production is oil which leaves 52% of the production as either natural gas or natural gas liquids. This leads us to ask: is Yates an example of oil prices exposing a struggling natural gas company? Yates had $245 million in debt, and $114 million in net debt. Based upon our calculated $2.3 billion MVIC indication, debt is approximately 4.85% of the capital structure. While this is just a guess on our part, this doesn’t indicate a financially stressed company. It does make us question their ability to obtain additional financing for new wells.Synergistic efficiencies. Drilling efficiencies have been disclosed by EOG, but we don’t know how many new well locations EOG created by having access to Yates acreage. Yates may not have been able to release on their own for many reasons. Much of the acquisition details have not been disclosed and we’ll wait for additional filings from EOG to learn more. Regardless, EOG’s acquisition of Yates was one of the largest E&P related transactions of 2016 and analyzing available information can help us to better understand the current marketplace. Based upon our experience involving private companies, we understand that pricing for proven undeveloped, probable and possible reserves have dropped significantly in the previous year, by upwards of 90% in some cases. In addition, due to the nature of the current oil and gas environment, we understand that the historical transactions may have little comparability to today. Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels, and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence. End Notes1 $245 million in Yates debt less $131 million in Yates cash 2 We have used publicly available information. As such this is a high level summary of approaching an allocation without having all the needed information. 3 BOEPD = Barrels of Oil Equivalent Produced Per Day, PD Reserves = Proved Developed Reserves

5 Trends to Watch in the Medical Device Industry in 2016

Medical Device OverviewThe medical device manufacturing industry produces equipment designed to diagnose and treat patients within global healthcare systems. Medical devices range from simple tongue depressors and bandages, to complex programmable pacemakers and sophisticated imaging systems. Major product categories include surgical implants and instruments, medical supplies, electro-medical equipment, in-vitro diagnostic equipment and reagents, irradiation apparatuses, and dental goods.The following outlines five structural factors and trends that influence demand and supply of medical devices and related procedures.1. DemographicsThe aging population, driven by declining fertility rates and increasing life expectancy, represents a major demand driver for medical devices. The U.S. elderly population (persons 65 and above) totaled 48 million in 2015 (15% of the population). The U.S. Census Bureau estimates that the elderly will roughly double by 2060 to 98 million, representing 24% of the total U.S. population.The elderly account for nearly one third of total healthcare consumption. Personal healthcare spendingfor the 65 and above population segment was $19,000 per person in 2012, five times the spending per child ($3,600) and almost triple the spending per working-age person ($6,600).According to United Nations projections, the global elderly population will rise from 608 million (8.3% of world population) in 2015 to 1.8 billion (18.1% of world population) in 2060. Europe’s elderly are projected to reach 28% of the population by 2060, making it the world’s oldest region. While Latin America and Asia are currently relatively young, these regions are expected to experience drastic transformations over the next several decades, with the over 65 population segments expected to expand from 8% in 2015 to more than 23% of the total population by 2060.2. Healthcare Spending and the Legislative Landscape in the U.S.Demographic shifts underlie the expected growth in total U.S. healthcare expenditure from $3.2 trillion in 2015 to $5.6 trillion in 2025. Healthcare spending as a percentage of GDP is also expected to expand from 17% in 2015 to over 20% by 2025.Since inception, Medicare has accounted for an increasing proportion of total U.S. healthcare expenditures. Medicare currently provides healthcare benefits for an estimated 57 million elderly and disabled Americans, constituting approximately 15% of the federal budget in 2015. Medicare represents the largest portion of total healthcare costs, constituting 20% of total health spending in 2014. Medicare also accounts for 26% of hospital spending, 29% of retail prescription drugs sales, and 23% of physician services. Owing to the growing influence of Medicare in aggregate healthcare consumption, legislative developments can have a potentially outsized effect on the demand and pricing for medical products and services. Netoutlays to the four parts of Medicare totaled $540 billion in 2015, and spending is expected to reach $709 billion by 2020. Between 2000 and 2010, growth in Medicare spending per capita was comparable or lower than private health insurance spending. The Patient Protection and Affordable Care Act (“ACA”) of 2010 incorporated changes that are expected to constrain annual growth in Medicare spending over the next several decades by curtailing increases in Medicare payments to healthcare providers, and establishing several new policies and programs designed to reduce costs. On a per person basis, Medicare spending is projected to grow at 4.3% annually from 2015 and 2025, compared to 5.7% average annualized growth realized from 2000 to 2014. As part of ACA legislation, a 2.3% excise tax was imposed on certain medical devices for sales by manufacturers, producers, or importers. The 2.3% levy was expected to net nearly $30 billion over a decade into the early 2020s. The tax became effective on December 31, 2012, but met resistance from industry participants and policy makers. In July of 2015, the U.S. House of Representatives voted to repeal the medical device tax. In late 2015, Congress passed legislation promulgatinga two-year moratorium on the tax beginning January 2016. 3. Third-Party Coverage and ReimbursementThe primary customers of medical device companies are physicians (and/or product approval committees at their hospitals), who select the appropriate equipment for consumers (the patients). In most developed economies, the consumers themselves are one (or more) step removed from interactions with manufacturers, and therefore pricing of medical devices. Device manufacturers typically receive payments from insurers, who usually reimburse healthcare providers for routine procedures (rather than for specific components like the devices used). Accordingly, medical device purchasing decisions tend to be largely disconnected from price.Third-party payors (both private and government programs) are keen to reevaluate their payment policies to constrain rising healthcare costs. Several elements of the ACA are expected to limit reimbursement growth for hospitals, which form the largest market for medical devices. Lower reimbursement growth will likely persuade hospitals to scrutinize medical purchases by adopting i) higher standards to evaluate the benefits of new procedures and devices, and ii) a more disciplined price bargaining stance. The transition of the healthcare delivery paradigm from fee-for-service (FFS) to value models is expected to lead to fewer hospital admissions and procedures, given the focus on cost-cutting and efficiency. In 2015, the Department of Health and Human Services (HHS) announced goals to have 85% and 90% of all Medicare payments tied to quality or value by 2016 and 2018, respectively, and 30% and 50% of total Medicare payments tied to alternative payment models by the end of 2016 and 2018, respectively. In March 2016, the HHS estimated 30% of Medicare payments were tied to alternative, value-based models, nearly one yearahead of schedule. Ultimately, lower reimbursement rates and reduced procedure volume will likely limit pricing gains for medical devices and equipment. The medical device industry faces similar reimbursement issues globally. A number of countries have instituted price ceilings on certain medical procedures, which could deflate the reimbursement rates of third-party payors, forcing down industry product prices. Whether third-party payors consider certain devices medically reasonable or necessary for operations presents a hurdle that device makers and manufacturers must overcome in bringing their devices to market. 4. Competitive Factors and Regulatory RegimeHistorically, much of the growth for medical technology companies has been predicated on continual product innovations that make devices easier for doctors to use and improve health outcomes for the patients. Successful product development usually requires significant R&D outlays and a measure of luck. However, viable new devices can elevate average selling prices, market penetration, and market share.Government regulations curb competition in two ways to foster an environment where firms may realize an acceptable level of returns on their R&D investments. First, firms that are first to the market with a new product can benefit from patents and intellectual property protection giving them a competitive advantage for a finite period. Second, regulations govern medical device design and development, preclinical and clinical testing, premarket clearance or approval, registration and listing, manufacturing, labeling, storage, advertising and promotions, sales and distribution, export and import, and post market surveillance.Regulatory Overview in the U.S.In the U.S., the FDA generally oversees the implementation of the second set of regulations. Some relatively simple devices deemed to pose low risk are exempt from the FDA’s clearance requirement and can be marketed in the U.S. without prior authorization. For the remaining devices, commercial distribution requires marketing authorization from the FDA, which comes in primarily two flavors.The premarket notification (“510(k) clearance”) process requires the manufacturer to demonstrate that a device is “substantially equivalent” to an existing device that is legally marketed in the U.S. The 510(k) clearance process may occasionally require clinical data, and generally takes between 90 days and one year for completion.The premarket approval (“PMA”) process is more stringent, time-consuming and expensive. A PMA application must be supported by valid scientific evidence, which typically entails collection of extensive technical, preclinical, clinical and manufacturing data. Once the PMA is submitted and found to be complete, the FDA begins an in-depth re- view, which is required by statute to take no longer than 180 days. However, the process typically takes significantly longer, and may require several years to complete. Pursuant to the Medical Device User Fee Modernization Act (MDUFA), the FDA collects user fees for the review of devices for marketing clearance or approval, as well as establishment registration. The current iteration of the act, MDUFA III, was enacted in 2012 and expected to collect approximately $400 million in user fees over five years. The FDA and the medical device industry have reached a broad agreement on the outlines of the next iteration. The FDA is expected to collect nearly $1 billion in user fees over five years pursuant to MDUFA IV, which would go into effect in in October 2017. Regulatory Overview Outside the U.S.The European Union (EU), along with countries such as Japan, Canada, and Australia all operate strict regulatory regimes similar to that of the U.S. FDA, and international consensus is moving towards more stringent regulations. Stricter regulations for new devices may slow release dates and may negatively affect companies within the industry.Medical device manufacturers face a single regulatory body across the EU, the Company’s second largest end market behind the U.S. In order for a medical device to be allowed on the market, it must meet the requirements set by the EU Medical Devices Directive. Devices must receive a Conformité Européenne (CE) Mark certificate before they are allowed to be sold on the market. This CE marking verifies that a device meets all regulatory requirements for the EU, and that they meet EU safety standards. A set of different directives apply to different types of devices, and the device must be compliant with the directive that purviews it.5. Emerging Global MarketsEmerging economies are claiming a growing share of global healthcare consumption, including medical devices and related procedures, owing to relative economic prosperity, growing medical awareness, and increasing (and increasingly aging) populations. As global health expenditure continues to increase, sales to countries outside the U.S. represent a potential avenue for growth for domestic medical device companies. According to the World Bank, all regions (except Sub-Saharan Africa) have seen an increase in healthcare spending as a percentage of total output over the last two decades. Global medical devices sales are estimated to increase 6.4% annually from 2016 to 2020, reaching nearly $440 billion according to the International Trade Administration. While the Americas are projected to remain the world’s largest medical device market, the Asia and Pacific and Western Europe markets are expected to expand at a quicker pace over the next several years. SummaryDemographic shifts underlie the long-term market opportunity for medical device manufacturers. While efforts to control costs on the part of the government insurer in the U.S. may limit future pricing growth for incumbent products, a growing global market provides domestic device manufacturers with an opportunity to broaden and diversify their geographic revenue base. Developing new products and procedures is risky and usually more resource intensive compared to some other growth sectors of the economy. However, barriers to entry in the form of existing regulations provide a measure of relief from competition, especially for newly developed products.

Quick Facts: Eagle Ford

Over the previous weeks, we have discussed specific factors in the Eagle Ford like DUCs (Drilled but Uncompleted Wells) and how certain operators behave in this resource play. Today, we take a step back and review the broad characteristics of the Eagle Ford Shale resource. Download this information in a convenient PDF at the bottom of this post.Eagle Ford at a GlanceFirst Discovered2008Discovery as Viable Play2008Primary ProductionOilOil TypeSweet, Light CrudePlayUnconventional ShaleDrillingHorizontal, Multi-Stage Hydraulic FracturingTop 3 Production CompaniesEOG Resources, BHP Billiton, Conoco PhillipsBreakeven$27 – $63 per barrel 1Abnormal DUCs416 2Production Since 20074,338 MMBOE 3IssuesLikely to have High Entry Cost & Low Oil PricesPotentialLow Breakeven Oil & Gas Prices due to High Productivity per Well & New Play so Large Amounts of Oil & Gas Remain1 Bloomberg Intelligence county-level estimates 2 Drilled Uncompleted Wells with > 3 months in inventory as of January 2016; also referred to as fraclog (Bloomberg Intelligence) 3 EIA as of June 2016Eagle Ford ShaleLocated in south Texas, the Eagle Ford is the most active shale play in the world. The shale’s potential was first recognized in 2008 when the first drillers, Petrohawk, found natural gas. Soon after that, other drillers began to enter the play and discovered not only significant natural gas reserves, but also large quantities of oil. Since then companies have invested heavily in Eagle Ford, with almost $30 billion spent on developing the play in 2013. In 2015, 57% of production was oil, and 43% of production was natural gas.As with other oil and gas formations, the current price environment hampers profitability. However, the region has some of the lowest natural gas breakeven prices in the U.S. (according to Barclays) and the lowest shale oil breakeven prices after the Permian (according to Bloomberg). Such low costs are likely to attract many large players to the region, particularly as other areas struggle. This in turn will raise the cost to enter the play.Undiscovered, Recoverable Resources in Eagle FordResource Estimate*Recoverable Oil994 MMBRecoverable Natural Gas52,428 BCFRecoverable Liquid N.G.2,059 MMB*Estimate calculated from the mean undiscovered, recoverable reserve estimates in the 2011 USGS report.The U.S. Geological Survey (USGS) completed a geology-based assessment of the undiscovered, technically recoverable oil and gas resources in Upper Cretaceous strata of the U.S. Gulf Coast region, which includes the Eagle Ford Group. The amount of undiscovered, recoverable natural gas in the Eagle Ford exceeds that in the Permian Basin.Eagle Ford Production Baker Hughes collects and publishes information regarding active drilling rigs in the United States and internationally. The number of active rigs is used as a key indicator of demand for oilfield services & equipment. However, rig counts can be misleading if not considered along with production. Rig counts in the Eagle Ford drastically decreased in late 2014 and throughout 2015. However production did not experience the same scale of decline. This demonstrates that producers with average or poor locations, higher costs, and inefficiencies were forced out of the market, while those with good locations and lower costs continued to drill for oil and gas in the Eagle Ford. AVAILABLE RESOURCEQuick Facts: Eagle FordDownload this information in a convenient, one-page PDF. Download

An Investor’s View of Major League Sports Franchises: Outsized Returns or a Risky Play?

This following article was originally published by The Texas Lawbook. It has been often discussed, particularly in recent years, that the value of privately held professional sports franchises is a newsworthy item. Analysts, investors, and fans alike have an interest in observing team owners buy and sell teams and watch the prices at which they trade. However, are team owners doing as well as some may portray? How about their investments as compared to their investing peers in the stock markets. We attempt to answer these questions based on some known data sources and return analytics over time. The answers are interesting but not entirely clear. There are two components to an investor’s rate of return: (i) interim returns in the form of cash flows or dividends, and (ii) price appreciation. Many commentators and writers have noted that some major league sports franchises have incurred operating losses in past years. For example, at one point it appeared that the MLB franchises on average had operating losses as players’ salaries increased faster than revenues. This was a big factor underlying the NFL and NHL lockouts in 2011 and 2012. There is a silver lining, however, and that appears to be the price appreciation realized from the increased values of these major league franchises. We traced over time the estimated appreciation (by league) of the values of sports teams, according to Forbes magazine. We also tracked the returns over the same time frames of several familiar equity market indices. The table below summarizes our findings. We tracked this data going all the way back to 1991. We then sorted the returns over different decades – the 1990s, the 2000s, and our current decade. We aggregated it for the 25 total years of data.1 We observe that equity markets outperformed league appreciation in the 1990s, but the leagues caught up in the 2000s and 2010s. The biggest reason for the significant increase in the 2000s and the 2010s (among others) is television contracts – specifically, increases in national TV contracts for the NFL and NBA and regional and local contracts for MLB and NHL (and to a lesser degree the NBA as well). Consider a few examples: The NFL had its national TV contract increase dramatically in the last several renewals, most significantly, the most recent one. The 2014 season was the first year of the NFL’s nine-year deal with Fox, CBS, and NBC. The networks will pay about $3.1 billion in rights fees every season or 63% more than the previous TV deal.The NBA, which signed a nine-year deal with ESPN and Turner Broadcasting and other networks, had total fees worth $24 billion in 2014. This skyrocketed to $3.6 billion a year, up from about $930 million in the contracts reached in 2007. In addition, NBA teams have benefited from increased local TV rights that have usually doubled or even tripled in annual rights fees in the last 5 years.For MLB and NHL teams, the majority of the TV revenue comes from local TV contracts. These contracts have also appreciated substantially in the last five years increasing 3 to 5 times in comparison to the contracts signed 5 to 7 years ago. This increased TV revenue has been the primary driver of the very strong price appreciation in the 2000s and particularly in last five years (2011-2016). In the last five years (2011-2016), the MLB team values have increased on average 19.8% compounded according to Forbes. The NBA Forbes value estimates increased by 27.6% for the same period. The NFL increased 17.4% and the NHL 21.3%. This short 5-year period has seen the highest percentage increase in the last 25 years. The compounded increases are 10% to 13% for the four major sports leagues over a 25-year period (1991-2016). In comparison, the DOW increased 7.4% compounded, the NASDQ 10.1% the S&P 500 7.0% and the Russell 2000 8.2%. Therefore, solely from an appreciation point of view, an investment in a major league sports franchise appears to have been a very good return in the last 25 years, especially in the last five years. Of course, these returns vary by team and nothing is guaranteed. It is also notable that some teams have incurred operating losses that will offset a significant amount of the total return. This can impact investments in the form of debt or even capital calls from investors. This gets even more complicated when considering the value of minority interests in teams whereby the ability to monetize their returns is more uncertain. In fact, minority interests typically trade (however infrequently) at lower value levels than what the pro-rata value of a franchise would otherwise be worth. Therefore, appreciation returns that appear positive can come with drawbacks as well. Critical analysis is important to investors to help them determine if their returns are worth the risks. Mercer Capital has arguably the most expertise in sports valuation and related stadium advisory in the country. For more information, contact one of our professionals.End Note1 We would note that Forbes does not have access to many team financials as teams are closely held (with the notable exception of the Green Bay Packers).Forbes relies on limited data and educated estimates of actual revenues and profits in order to make their estimated values.This is a limiting factor to properly value a single franchise at a single point in time.That said, as part of Forbes’ analysis they have interview access to a number of team owners to test the reasonableness of their valuations and key assumptions.In addition, their estimated values are adjusted year-to-year to account for actual sale prices of teams that sell.This is helpful when observing estimated aggregate values over a long period of time.

Long Term Value Drivers in the Eagle Ford

Get Your DUCs in a Row

The Eagle Ford Shale is one of the largest economic developments in the state of Texas. Almost $30 billion was spent developing the play in 2013. However, that figure dropped off dramatically in 2015 and 2016. In the wake of that drop-off some of the key residuals of that investment remain and are still on the precipice of becoming more active. These residual investments exist in the form of drilled, but uncompleted horizontal wells – sometimes known as “DUCs” or “Fracklog”.Economically, these DUCs function as a form of storage for companies who do not want to complete and produce these wells at current pricing. Thus, they sit idle – waiting to be completed and graduate to a full-fledged producing PDP well. This is a phenomenon that exists in all the major shale plays in the U.S. and second only to the Bakken, the Eagle Ford has the largest inventory of DUCs (460) in the U.S. Many of the big shale producers are jumping on board the fracklog bandwagon. The largest U.S. shale producer to fracklog is EOG Resources (EOG). It started 2015 with 200 DUCs and announced it would “intentionally delay” about 85 more wells this year (these are overall figures, not Eagle Ford specific). Anadarko Petroleum (APC) said it expects to have about 440 uncompleted wells by the year’s end. As a point of comparison, last week there were only a total of 44 rigs in the Eagle Ford, as compared to 205 at year-end 2014. As it pertains to the Eagle Ford specifically, Chesapeake leads the way with 86 DUCs with several other major Eagle Ford players with significant counts as well. Producers have hoped this would bring value to their shareholders, by delaying capital expenditures and functioning as storage for future reserves. These companies can then wait for more favorable oil and gas prices that justify the capital investment to complete the wells. This brings a favorable ROI to the costs, which is the core metric that management teams are tracking. How much value that this creates (or preserves depending on point of view) is linked to how much capital it requires to complete the well as compared to production and price (production x price = revenue). The Eagle Ford shale has pockets of some of the best possible wells for this ROI potential. Bloomberg Intelligence has estimated that breakeven prices for oil in the Eagle Ford can be as low as $27 per barrel. This helps explain why DUCs in the Eagle ford actually decreased in 2015 while other plays had a marked increase; several groups of wells in the Eagle Ford still had positive ROI’s and were economical to be drilled. However, there is a flip side to simply waiting until oil prices go up. Some estimates claim it will take only one to three months to get production from these now-uncompleted wells. Bloomberg Intelligence has projected the output from these wells to be as high as three million barrels per day. This onslaught of new oil could serve to cap any rally in the oil prices. “The destruction of production potential that we've needed to see to complete the bust cycle in oil and completely rebalance markets, allowing for a long-term constructive rise in the prices of oil and natural gas, have yet to be seen.” – Daniel Dicker, Real MoneyIf Eagle Ford producers wish to capitalize on these undrilled wells, timing, resources and capital must be ready to go when the time becomes right.

If the Pathstone–Convergent Combo is the Shape of Things to Come

RIA Heads Need to Remember that MOEs are Tricky

Culture trumps everything. A big part of RIA consolidators’ pitch to target firms is that they can trade paper, give the sellers access to their administrative and marketing infrastructure, but keep their unique culture. We’ll hear more about this as Focus Financial gets closer to their IPO. MOEs (mergers of equals) are a different animal, and not just because “some of us are more equal than others” (ask Tom Hiddleston). When firms of similar size join forces to get a bigger footprint, solve leadership issues, stop advisors from competing with each other, etc. – realizing those benefits is the easy part. The hard work happens because different firms have different histories, and different histories create different cultures. Blending cultures can be awkward. My father was on a business trip in Asia at Christmastime 30 years ago. He walked into a large mainline department store in Tokyo and was stunned at the holiday display just inside the front door: Santa Claus on a cross (!).I don’t know that Pathstone Federal Street is going to have quite as difficult a time merging in Convergent Wealth Advisors, but no doubt there will be moments. If it works, others will want to follow suit. If it doesn’t, it will be a cautionary tale we’ll talk about for some time. For now, it might be helpful for RIA managers considering MOEs to read the following piece written by one of our colleagues, Jeff Davis. Jeff usually works with depository institutions, but no doubt his checklist of dos and don’ts for MOEs will ring true in the investment management community as well.– Matthew R. Crow, ASA, CFA When asked about his view of a tie years before the NCAA instituted the playoff format in the 1990s, Coach Bear Bryant famously described the outcome as “kissing your sister.” If he were a portfolio manager holding a position in a company that entered into a merger of equals (MOE), his response might be the same. Wall Street generally does not like MOEs unless the benefits are utterly obvious and/or one or both parties had no other path to create shareholder value. In some instances, MOEs may be an intermediate step to a larger transaction that unlocks value. National Commerce Financial Corporation CEO Tom Garrott once told me that part of his rationale for entering into a $1.6 billion MOE with CCB Financial Corp. in 2000 that resulted in CCB owning 47% of the company was because bankers told him he needed a bigger retail footprint to elicit top dollar in a sale. It worked. National Commerce agreed to be acquired by SunTrust Banks, Inc. in 2004 in a deal that was valued at $7 billion.Kissing Your Sister?MOEs, like acquisitions, typically look good in a PowerPoint presentation, but can be tough to execute. Busts from the past include Daimler-Benz/Chrysler Corporation and AOL/Time Warner. Among banks the 1994 combination of Cleveland-based Society Corporation and Albany-based KeyCorp was considered to be a struggle for several years, while the 1995 combination of North Carolina-based Southern National Corp. and BB&T Financial Corporation was deemed a success.The arbiter between success and failure for MOEs typically is culture, unless the combination was just a triumph of investment banking and hubris, as was the case with AOL/Time Warner. The post-merger KeyCorp struggled because Society was a centralized, commercial-lending powerhouse compared to the decentralized, retail-focused KeyCorp. Elements of both executive management teams stuck around. Southern National, which took the BB&T name, paid the then legacy BB&T management to go away. At the time there was outrage expressed among investors at the amount, but CEO John Allison noted it was necessary to ensure success with one management team in charge. Likewise, National Commerce’s Garrott as Executive Chairman retained the exclusive option to oust CCB’s Ernie Roessler, who became CEO of the combined company, at the cost of $10 million if he chose to do so. Garrett exercised the option and cut the check in mid-2003 three years after the MOE was consummated.Fairness Opinions for MOEsMOEs represent a different proposition for the financial advisor in terms of rendering advice to the Board. An MOE is not the same transaction as advising a would-be seller about how a take-out price will compare to other transactions or the company’s potential value based upon management’s projections. The same applies to advising a buyer regarding the pricing of a target. In an MOE (or quasi-MOE) both parties give up 40-50% ownership for future benefits with typically little premium if one or both are publicly traded. Plus there are the social issues to navigate.While much of an advisor’s role will be focused on providing analysis and advice to the Board leading up to a meaningful corporate decision, the fairness opinion issued by the advisor (and/or second advisor) has a narrow scope. Among other things a fairness opinion does not opine:The course of action the Board should take;The contemplated transaction represents the highest obtainable value;Where a security will trade in the future; andHow shareholders should vote. What is opined is the fairness of the transaction from a financial point of view of the company’s shareholders as of a specific date and subject to certain assumptions. If the opinion is a sell-side opinion, the advisor will opine as to the fairness of the consideration received. The buy-side opinion will opine as to the fairness of the consideration paid. A fairness opinion for each respective party to an MOE will opine as to the fairness of the exchange ratio because MOEs largely entail stock-for-stock structures. Explaining the benefits of an MOE and why ultimately the transaction is deemed to be fair in the absence of a market premium can be challenging. The pending MOE among Talmer Bancorp Inc. (45%) and Chemical Financial Corp. (55%) is an example. When the merger was announced on January 26, the implied value for Talmer was $15.64 per share based upon the exchange ratio for Chemical shares (plus a small amount of cash). Talmer’s shares closed on January 25, 2016 at $16.00 per share. During the call to discuss the transaction, one analyst described the deal as a “take under” while a large institutional investor said he was “incredibly disappointed” and accused the Board of not upholding its fiduciary duty. The shares dropped 5% on the day of the announcement to close at $15.19 per share. Was the transaction unfair and did the Board breach its fiduciary duties (care, loyalty and good faith) as the institutional shareholder claimed? It appears not. The S-4 notes Talmer had exploratory discussions with other institutions, including one that was “substantially larger”; yet none were willing to move forward. As a result an MOE with Chemical was crafted, which includes projected EPS accretion of 19% for Talmer, 8% for Chemical, and a 100%+ increase in the cash dividend to Talmer shareholders. Although the fairness opinions did not opine where Chemical’s shares will trade in the future, the bankers’ analyses noted sizable upside if the company achieves various peer-level P/Es. (As of mid-July 2016, Talmer’s shares were trading around $20 per share.) Fairness is not defined legally. The Merriam-Webster dictionary defines “fair” as “just, equitable and agreeing with what is thought to be right or acceptable.” Fairness when judging a corporate transaction is a range concept. Some transactions are not fair, some are in the range—reasonable, and others are very fair. The concept of “fairness” is especially well-suited for MOEs. MOEs represent a combination of two companies in which both shareholders will benefit from expense savings, revenue synergies and sometimes qualitative attributes. Value is an element of the fairness analysis, but the relative analysis takes on more importance based upon a comparison of contributions of revenues, earnings, capital and the like compared to pro forma ownership.Investment Merits to ConsiderA key question to ask as part of the fairness analysis: are shareholders better off or at least no worse for exchanging their shares for shares in the new company and accepting the execution risks? In order to answer the question, the investment merits of the pro forma company have to be weighed relative to each partner’s attributes.Profitability and Revenue Trends. The analysis should consider each party’s historical and projected revenues, margins, operating earnings, dividends and other financial metrics. Issues to be vetted include customer concentrations, the source of growth, the source of any margin pressure and the like. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated.Expense Savings. How much and when are the savings expected to be realized. Do the savings come disproportionately from one party? Are the execution risks high? How does the present value of the after-tax expense savings compare to the pre-merger value of the two companies on a combined basis?Pro Forma Projected Performance. How do the pro forma projections compare with each party’s stand-alone projections? Does one party sacrifice growth or margins by partnering with a slower growing and/or lower margin company?Per Share Accretion. Both parties of an MOE face ownership dilution. What is obtained in return in terms of accretion (or dilution) in EBITDA per share, (for non-banks) tangible BVPS, EPS, dividends and the like?Distribution Capacity. One of the benefits of a more profitable company should be (all else equal) the capacity to return a greater percentage of earnings (or cash flow) to shareholders in the form of dividends and buybacks.Capital Structure. Does the pro forma company operate with an appropriate capital structure given industry norms, cyclicality of the business and investment needs to sustain operations? Is there an issue if one party to an MOE is less levered and the other is highly levered?Balance Sheet Flexibility. Related to the capital structure should be a detailed review of the pro forma company’s balance sheet that examines such areas as liquidity, funding sources, and the carrying value of assets such as deferred tax assets.Consensus Analyst Estimates. This can be a big consideration in terms of Street reaction to an MOE for public companies. If pro forma EPS estimates for both parties comfortably exceed Street estimates, then the chances for a favorable reaction to an MOE announcement improve. If accretion is deemed to be marginal for the risk assumed or the projections are not viewed as credible, then reaction may be negative.Valuation. The valuation of the combined company based upon pro forma per share metrics should be compared with each company’s current and historical valuations and a relevant peer group. Also, while no opinion is expressed about where the pro forma company’s shares will trade in the future, the historical valuation metrics provide a context to analyze a range of shareholder returns if earning targets are met under various valuation scenarios. This is particularly useful when comparing the analysis with each company on a stand-alone basis.Share Performance. Both parties should understand the source of their shares and the other party’s share performance over multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Liquidity of the Shares. How much is liquidity expected to improve because of the MOE? What is the capacity to sell shares issued in the merger? SEC registration and even NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently.Strategic Position. Does the pro forma company have greater strategic value as an acquisition candidate (or an acquirer) than the merger partners individually?ConclusionThe list does not encompass every question that should be asked as part of the fairness analysis for an MOE, but it points to the importance of vetting the combined company’s investment attributes as part of addressing what shareholders stand to gain relative to what is relinquished. We at Mercer Capital have over 30 years of experience helping companies and financial institutions assess significant transactions, including MOEs. Do not hesitate to contact us to discuss a transaction or valuation issue in confidence.

What Would Warren Buffet Do?

[caption id="attachment_12679" align="aligncenter" width="349"] Photo Credit: Gus's Fried Chicken[/caption] One of my favorite pastimes is sampling the amazing food Memphis has to offer. Many of the best restaurants are located in buildings that are unassuming – or sometimes downright disconcerting. I am a little hesitant about walking down back streets and into old buildings to find my next meal, but I find comfort in the reviews of others. With its Styrofoam plates and 40 ounce bottles of beer, Gus’s World Famous Fried Chicken may not seem very promising, but the reviews are excellent … “lurking below that crunch is a subterranean flesh so moist and tender that it almost defies reality.” How could you not give it a try? We often rely on the reviews of experts for decisions as trivial as where to eat lunch. When it comes to investing, we pay even more attention to what the experts say. It caught investors’ attention when Warren Buffet further increased his stake in Phillips 66 from 78.782 million shares as of June 30, 2016 to 79.6 million as of August 30, 2016. He now has invested over $6 billion in Phillips 66 and owns almost 15% of Phillips’ available shares. His recent move has sparked a lot of questions regarding what Warren Buffet was thinking. Does he think the delayed effect of the export ban won’t hurt refining margins?Does he think crack spreads are on the rise for good?Or does he know something that I don’t? Uncertainty currently surrounds the refining industry. In early 2016 the crude oil export ban that had been in place since 1975 was lifted. Industry experts thought that lifting the export ban would better align the production capabilities of U.S. refineries. Refiners, on the other hand, feared that the exportation of crude would increase crude prices, as the pressure on price, in an oversupplied U.S. market, gives way. Nine months later, we do not know all the consequences as the Brent-WTI spread is still insignificant. Once the spread widens — and it is cheaper for other countries to buy WTI and pay transportation costs than to buy Brent — the true effect will be understood. Until then, refiners should enjoy currently low input prices. Adding to the uncertainty, the refining industry is heavily regulated. One of the newest rules is the Petroleum Refinery Sector Risk and Technology Review (RTR) and the New Source Performance Standards (NSPS) rule. The RTR & NSPS was passed in December of 2015 in order to control air pollution from refineries and provide the public with information about refineries’ air pollution. These regulations range from fence line and storage tank monitoring to more complex requirements for key refinery processing units. The rule is expected to be fully implemented in 2018. However additional time has already been proposed by the EPA. The EIA estimates the rule will cost refineries a total of $40 million per year, while the American Petroleum Institute (API) argued that the annual cost would exceed $100 million. This uncertainty has led to a standstill in M&A activity. While M&A Activity in the exploration and production sector has picked up since the beginning of 2016, M&A in refining and marketing has remained sluggish. Over the last nine months, the majority of the transactions in refining and marketing were between chemical and lubricant refineries and renewable fuels refineries. Currently, investors are sticking with what they know – demand for renewable fuels will increase and chemical lubricants are still in high demand. The few transactions that occurred with petroleum transportation product refineries had very little public information. Thus we look to the public market in order to understand valuation multiples. Since the fall of crude prices in 2014, valuation multiples have been through multiple cycles of compression and expansion. For refiners, low oil prices initially signal higher profit margins as refined oil product prices are not perfectly correlated with input prices. This is especially true for non-transportation refined product prices (such as asphalt, butane, coke, sulfur, and propane) whose prices are even less likely to respond to changes in the price of crude oil. Thus, upon the initial fall of prices, earnings increased because the price of refined petroleum products did not fall as quickly as the price of crude. Additionally, the low prices of crude oil and natural gas decrease refiners’ own operating expenses. Refining is itself an energy intensive process and natural gas is used to power refineries. By the fourth quarter of 2015, refiners’ margins began to compress as the price of refined petroleum transportation products started falling. Refiners’ profits continued to fall through the first quarter of 2016, but have since recovered as the price of refined products saw slight increases.1 Buffet’s move gave downstream investors hope that refining profits won’t disappear altogether as the oil and gas market changes. Refining and Marketing valuation multiples are somewhat inflated in the current market due to compressed profit margins. This tells us that the market views refiners’ decline in earnings as temporary. Phillips 66 profitability is in line with the group average, but has a higher EV/ EBITDA multiple of 11.3x whereas the average is 9.1x. This is due to their comparatively large size and depressed first quarter earnings. Additionally Phillips 66 operations are not entirely concentrated in the refining industry. Phillips has well developed midstream operations which they have expanded recently. Midstream operations are not as sensitive to changes in price and thus do not face the same risk of margin compression. Warren Buffet is known for making long term investments. His position in Phillips 66 does not imply smooth sailing ahead for the refining sector. Refiners’ inputs and products are both commodities, which means that the price they pay for inputs and the prices they receive for their products are generally determined by the market and out of their control. However, demand for refined products increases with the strength of the economy, and Chairwoman Janet Yellen’s recent announcement that an interest rate hike is on the table predicts that a strong economy is in our future. The oil and gas industry is still surrounded with uncertainty, but refiners have generally proven to be resilient through the oil market downturn. Despite the uncertainty, we can find some comfort from Warren Buffets recent investment decision. I know that I will find the best food on back streets, in shacks in the Lowes parking lot, and in basements downtown, but reassurance is comforting. When I ask myself what would Warren Buffet do … I think he would eat fried chicken. End NoteThe refiner marker margin (RMM) is a general indicator, calculated quarterly by British Petroleum, which shows the estimated profit refiners earn from refining one barrel of crude.

Twilio and the Rise Of Debt Financing

Despite the inhospitable IPO climate, one tech company managed to brave the market with just the right mix of novelty and disruption to garner attention and reap rewards. Twilio, a cloud communications platform designed to help developers add messaging, voice and video to web and mobile applications, went public on June 23. Priced at $15 per share, Twilio’s share price closed at $28.79, the largest single-day increase of an IPO in over two years, which increased the company’s market cap by 95% to nearly $2.4 billion. The next day, on June 24, the UK voted to leave the European Union. Brexit effectively wiped out over $2 trillion in global equity, ushering in weeks of market volatility and a freefall of the pound. Despite the global volatility, Twilio’s share price as of June 30 was up to $36.50 per share. Optimistic investors lauded the IPO as an indication of a turnaround in the venture-backed IPO market, and for good reason. Over the 2010 to 2015 period, more than half of the 200 tech companies that went public were trading below their initial IPO price by mid-2016.The number of venture capital exits completed in the second quarter of 2016 (153) was the lowest total since the second quarter of 2010, with only 19 venture-backed IPOs in the first half of 2016 (well below the 52 IPOs completed in the first half of 2015). As discussed previously, unfavorable IPO market conditions have led many companies to alternative exits such as M&A. A growing number of venture capital firms have also turned towards another source for cheap cash: debt.Given the current interest rate environment, several unicorns, including Airbnb, Didi Chuxing and Uber, have capitalized on the cheap debt available in the market as an alternative to issuing more equity. The debt markets are proving unusually receptive to venture financing, for example giving Uber, a cash flow negative company with famously opaque financials, over $1.6 billion at 5.0%. Concerns over weaker credit standards in the banking industry have risen as competition for quality loans has driven down loan yields. Prolonged periods of low interest rates have compressed margins and impeded any profitability gained from an increase in loan growth alone. Since the Fed first announced progressive rate hikes in December, banks have positioned themselves as asset sensitive in order to benefit from an increase in rates that has yet to occur. In fact, thanks to Brexit and the wave of capital market uncertainty it created, the central bank has even discussed cutting short-term rates. In order to maintain profitability, banks need lending volume – which is where unicorns come in. Venture capital has taken advantage of the perfect storm that is the banking industry to acquire low-cost debt and build credit for future rate negotiations, should the need ever arise. In addition, private companies use debt financing to avoid breaching the 2,000 accredited investor threshold for remaining private. Crossing the 2,000 limit would require full disclosure of company financials, which could bring to light certain underperforming metrics these companies have been trying to overcome, as evidenced by their refusal to undergo an IPO. Whether more companies choose to go down the debt route is yet to be seen, but it is a financing vehicle that enables companies to avoid having to leave the sympathetic capital still available in private markets.

Three Reasons to Consider a Valuation of Your FinTech Company

“Nowadays people know the price of everything and the value of nothing.”– Oscar Wilde, The Picture of Dorian Gray The above quote seems especially apt in the FinTech industry because the implied values of high-profile, private FinTech companies are often mistakenly reported by the media based on the share price paid by investors in a recently completed funding round. The problem with applying the pricing of the most recent raise to all shares is that the media rarely knows about investor preferences attributable to each funding. As a result, the value of the company is most likely overstated. Capital structures and shareholder preferences matter. Pari passu is not a given although it is often implicitly implied in media reports. Consider the following example. Investors in a late-stage funding invest $100 million in return for 100,000 convertible preferred shares that represent 10% of the company’s post-raise fully diluted shares. The investors also get certain economic, control rights and other preferences with their preferred shares that earlier investors did not obtain. The headline notes that a new FinTech Unicorn has arrived because the implied value is $1 billion based upon the $100 million investment for the 10% interest; however, this simple calculation typically will overstate the Company’s value because the majority of the shares do not have the same rights and preferences as those purchased in the most recent financing round. Valuing companies with limited if any operating history that involves a new technology is inherently difficult. The challenge increases when the subject has a complex capital structure. Nevertheless, valuations—whether reasonable or unreasonable—have very real economic consequences for investors, employees and other stakeholders, especially when new capital is injected into the equation. We are biased, but we believe private FinTech companies will be well served over the long-run to obtain periodic valuations from independent third parties. Reasons to do so include the following.1. To Measure Value Creation Over TimeOne of the best performance scorecard metrics to measure is value creation over extended time periods. For public companies, it is a simple process. Measure a company’s total return (percentage change in share price plus the return from reinvested dividends) and compare it to other benchmark measures such as the broader market, industry, and/or peers. For example, a publicly traded payments company whose shareholders have achieved a one-year total return of 10.0% can note on their scorecard that their performance has outpaced the returns from the S&P 500 and Mercer Capital’s FinTech Payments Index, which rose 4.0% and 4.6%, respectively, in the twelve months ended June 30, 2016.For private companies, annual or more frequent valuations have to be obtained to create a realistic scorecard. Rules-of-thumb exist in every industry, but they are at best approximations and often haphazard guesses that do not take into account the key value drivers of earning power (or cash flow generation), growth, and risk. Some privately held financial services companies like banks may be able to proxy value creation without annual valuations by tracking growth in book value, ROE, and dividend payments, but even for homogenous entities such as banks these metrics say nothing about an institution’s risk profile. FinTech companies with little homogeneity among business models are poorly suited to measure value based upon rules-of-thumbs that are applied to revenues or even EBITDA. Every company is unique, and markets in which companies are valued are not static.Also, there may be a tendency to overlook balance sheets beyond cash because FinTech balance sheets typically do not “drive” earning power as intangible assets, such as customer databases, intellectual property, patents, and the like, are not recorded unless there has been an acquisition. While understandable, ignoring the balance sheet can be a mistake because sometimes there are aspects to it that will impact value.Additionally, dividends (the other element of shareholder return) and dividend paying capacity should be an important value consideration, even though FinTech companies often do not or cannot pay dividends in order to reinvest internally generated capital to fund future growth. Another benefit of the valuation process might be insight that suggests the board should shift to distributions from reinvestment because incremental returns are too low to justify.It is advisable for private FinTech companies to measure value creation by having annual or more frequent valuations performed by an outside third-party. For example, consider Table 1 for Private FinTech Company that tracks returns to shareholders based upon changes in the appraised value of the shares and dividends paid over a three-year period. While the hypothetical 45% total return outwardly appears attractive, there is no context. Comparisons with publicly traded FinTech companies, broad industry indexes and realized returns following an acquisition for public and private companies will provide further relevance to the scorecard (Chart 1).2. For Planning PurposesProjections for an early-stage FinTech company are a given. In theory so too are rising valuations as important milestones, such as targeted market penetration, users, revenues, and EBITDA, are met. Unless the company does not require significant capital and/or internal capital generation is sufficient, the projections should incorporate additional capital raises and expected dilution based upon implicit valuations. On a go forward basis periodic valuations can be overlaid with the initial and any refreshed forecasts to measure how the company is progressing in terms of value creation relative to plan and to alternatives (e.g., a strategy pivot to a collaborative partnership from disruptor). The key is to measure and compare in order to have a contextual perspective to facilitate decision making.3. For Employee Ownership PlansFinTech companies usually attract talent by offering stock ownership so that employees share in the upside should the company’s valuation improve over time. Plus, stock-based compensation lessens a company’s cash needs all else equal. Complex capital structures with private equity investors that have preferences vis-a-vie employees create another potential valuation wrinkle. Returns to the two groups usually will differ. Well documented, periodic valuations are critical. There have been examples where employees have lost money by paying taxes based upon valuations higher than the company realized in a sale. While downside exposure to a company’s faltering performance and/or market conditions is the risk that comes with the potential upside of equity ownership, it is important to have a formalized valuation process to demonstrate compliance with tax and financial reporting regulations. Certainly, scrutiny from auditors, the SEC, and/or the IRS are likely at some point, but very real tax issues also can result from poorly structured or administered equity compensation plans for employees.ConclusionIf you are interested in discussing the valuation needs for your FinTech company, please contact us. Depending upon how it is defined FinTech is a relatively new industry “vertical.” Mercer Capital has been providing valuation and transaction advisory services to a wide swath of financial services companies for over 30 years that runs the gamut from banks to FinTech. Financials are our largest practice vertical. We have a deep bench and would be delighted to assist.This article originally appeared in the Second Quarter 2016 issue of Mercer Capital's Value Focus: FinTech newsletter.Learn More

Royalty Interests: First in Line, Last in Conversation

When the price of oil started its descent during 2014, the majority of media attention was, and still is, focused on exploration, production, and oil field services companies. While bankruptcy courts are busy deciphering reorganization plans and perhaps liquidations of companies, one group of oil and gas participants are getting little attention: royalty owners. While the last two years have been a rough ride, opportunities do exists for forward thinking royalty owners and investors.Although they are first to receive money from production, for the most part, royalty owners have been left to fend for themselves during this commodity price downturn. The lucky ones, holding their breath hoping their operator doesn’t go bankrupt, watched their monthly distributions fall to fractions of their 2014 payments. The unlucky ones haven’t seen a payment in months only to learn through media sources that their operator entered bankruptcy. When this situation occurs, many questions surface:What will happen to my royalty payments?What will happen to the lease contract?What legal action should I take? While Mercer Capital does not provide legal advice we can provide guidance on valuing royalty interests in the current environment. For some guidance on the legal questions, refer to the the first end note. Each of the questions above indicates uncertainty. As uncertainty increases, risk increases as well. As risk increases, the value of a given asset declines. But let us back up. When understanding the value of a royalty interest, it is important to understand its origin and its financial features.OriginRoyalties typically originate from an agreement between a land owner and an exploration and production (E&P) company. E&P companies that approach the owners of the property where they seek to drill wells, have two options: (1) purchase the land from the current owner; or (2) acquire the rights to drill and produce. Option two is typically cheaper, initially. The monetary components of a contract between the land owner and the E&P company is usually comprised of two components: (1) an up-front cash payment (commonly referred to as a lease bonus); and (2) a royalty interest in all future wells on the property.Financial FeaturesThe financial features of a royalty interest are best described in the definition of a royalty as follows: Ownership of a percentage of production or production revenues, produced from leased acreage. The owner of this share of production does not bear any of the cost of exploration, drilling, producing, operating, marketing, or any other expense associated with drilling and producing an oil and gas well.2Generally, royalty payments are made on a monthly basis for the production generated in the prior month. As the definition above indicates, royalty interests are not exposed to the costs of drilling, producing, or operating the well. In simplified terms, there are three main inputs driving the monthly royalty payment: (1) commodity price; (2) monthly production; and (3) royalty interest percentage. Royalty interest percentage typically will stay the same throughout the contract life, unless amendments are made. Therefore, any changes in the paystub come from changes in commodity price and production levels.Valuation of a Royalty InterestAs the financial features suggest, valuation of a royalty interest can be a straight forward exercise for an experienced professional with knowledge of the nuances. Typically there are two methods used to estimate the value of a royalty trust: (1) income approach and (2) market approach.Income ApproachA discounted cash flow analysis is based on the theory that the value of any investment is equal to the present value of its expected future economic benefit stream. In order to calculate the value one must project the future expected cash flows and discounts them back at an appropriate discount rate. Expected cash flows must project both anticipated production of the resource and anticipated prices for the resource. However, a discounted cash flow analysis is only as good as its inputs and as we discussed in our previous blog post, NYMEX future prices are no more than informed speculation. Thus the discount rate must appropriately compensate for the risk.Market ApproachAnother method used to calculate the value of a royalty interest utilizes market transactions of royalty interests in similar oil and gas resource plays. This can be done in two ways: (1) observing direct transactions of royalty interests; and (2) publicly traded royalty trusts.As a primer for O&G royalty trusts, these trusts hold various royalty and net profit interests in wells operated by large exploration & production companies. These trusts have little in the way of operating expenses, have defined termination dates, and can be an investment to provide exposure to oil and gas prices. This Motley Fool article, from 2014, explains the pros and cons of investing in this sort of vehicle.Market indications are available in the form of publicly traded oil & gas (“O&G”) royalty trusts. There are approximately 17 oil and gas focused royalty trusts publicly traded, as of the date of this article.Market ObservationsRoyalty trusts, like the rest of the oil and gas industry, have been hit hard as the price of oil fell. Here is a comparison of the 17 publicly traded royalty trusts’ metrics today versus one year ago.Observations and disclaimers:Price to revenue and price to distributable income indicate, on average, the trusts are cheaper now than a year ago.Yields were higher last year as trailing yields had not caught up to the quickly falling market price (from August 2014 to July 2015, the group was down 40% to 60%).Market prices have leveled off and yields have had a chance to catch up, resulting in lower yields compared to a year ago.Price to PV 10 is higher this year compared to last, primarily the result of timing differences between the releases of reserve reports (end of fiscal year, which for most is calendar year) the mid-year date we captured and the market price.The remaining observations are for commodity prices, both current and futures contract for the 12 month.Disclaimer: no two of the above royalty trusts are alike. Differences abound in asset mix, asset location, term, resource mix, just to name a few. In future blog posts, we will explore each trust individually and discuss their uniqueness. Below is a chart of the market price performance for each royalty trust over the last two years. The above chart looks very similar to the performance of the price of oil and gas over the same time period. Royalty interest owners have seen their monthly payments move in the same manner, and possibly have not experienced the small rebound over the first six months of 2016. Uncertainty is high as operators have been forced to file bankruptcy after commodity prices have remained low for too long for them to survive. Depending on your situation, the current pricing environment may provide excellent planning opportunities as market prices are relatively low. With the Treasury Department attempting to change the way gift and estate planning can be performed, it is even more timely to execute a transfer plan. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed. End Note1 See the article, "Protecting Oil & Gas Royalties in the Event of Bankruptcy" from the Dallas Bar Association on the topic or the article, "Bankruptcy In The Oil Patch" by the Oil and Gas Financial Journal.

What Does the Market Think About RIA Aggregators? Focus Financial is About to Find Out.

My older daughter turns sixteen next month. Most parents dread giving their children vehicular independence, but I managed to repress that instinct by concentrating on the more delightful prospect of adding a new car to the family fleet: a Fiat 500. The original 500 (or Quattrocento) came out in 1957, and Fiat sold almost 4 million of them before they discontinued the model in 1975. Since Fiat announced they were returning to the U.S. market and bringing the Italian equivalent of Britain’s Mini or Germany’s Beetle, I wanted one. While I couldn’t make the Quattrocento work for me, I thought the size (big enough for four adults but easy to park), powertrain (peppy but economical), and unique features (like a folding fabric roof) made it perfect for a new driver who appreciates cars like her dad.Unfortunately, as my daughter’s sixteenth birthday approached, my fantasy of what she should drive had a head-on collision with reality. The Fiat’s small size is handy when you have to wedge your car down Italian city streets (I found one on vacation that was EXACTLY five inches wider than my rented Volvo wagon, with the side mirrors retracted), but not so pragmatic in our town, where every third vehicle is a giant SUV that probably wouldn’t even notice a collision with a 500. I think Fiat may have had the same realization, as their U.S. sales have been far lower than expected, and as a consequence has delayed the reintroduction of Alfa Romeo to the U.S. (a real tragedy). There are at least two lessons to be drawn from this: 1) sometimes bigger is unquestionably better, and 2) some ideas look a lot better on paper than in practice.I was reflecting on both of these themes last week after word got out that Focus Financial Partners had started preparing documents to file an initial public offering. Because Focus has less than $1 billion in revenue, it can keep details of the offering private until three weeks before the offering, so unfortunately we don’t have an S-1 to review. The Company itself hasn’t said anything about filing.Focus is another great idea, at least on paper, but has garnered success in a timeline littered with lots of bumps along the way. If they choose to go through with the public offering this time, their S-1 will be a treasure map of information about RIA consolidation, which is probably going to be as painful as it is inevitable.We have so many questions about the Focus IPO, it’s hard to know where to start. For example:Why Now?Focus is a ten year old company that has been headed for IPO since day one. Part of their pitch to prospective RIA targets is enabling them to ride the rise in Focus’s valuation at the offering. Focus previously started the filing process for an IPO last summer. So, in one regard, this isn’t unexpected.Further, Focus is backed by the VC/PE community, having picked up financing by Summit Partners in 2007 and Centerbridge Partners in 2013. Polaris is also still involved. The timing of those deals is noteworthy, because asset manager multiples were at peak levels in both 2007 and 2013 (so much for booking gains on the buy). We wonder if Centerbridge isn’t looking at the stakes Polaris and Summit have held – for longer than they wanted – and are seeking an exit while they can. We’ll probably never know why Focus didn’t go through with an offering last summer. Compared to a year ago, valuation multiples in the space aren’t any stronger, and the IPO market isn’t any more robust. One would think that Centerbridge, which has been in Focus for three years, would be getting impatient. However, if the stock market coughs and the IPO window closes, it could be some time before Focus is ready to go public again.About the only two compelling reasons we can come up with for a Focus IPO today is 1) the SEC’s proposed rules on transition planning and 2) scale. With regard to the former, the Focus IPO narrative will undoubtedly feature that it appears the SEC is going to require RIAs to document some kind of ownership exit strategy. Focus is all over this issue, and has the capacity and expertise to offer a pre-packaged solution to this aspect of SEC compliance. As for the matter of scale, Focus may be big enough now to garner a better valuation…How Much?Thinking about valuation may be a little premature, since we haven’t yet seen the S-1. Numbers on the order of $1 billion have been bandied about, but not whether that’s pre-money or post. Focus has plenty of debt and preferred stock (possibly north of $750 million), but since debt is cheap, one wonders if the company is in a hurry to pay it down. What we do know is that Focus currently has run rate revenue on the order of $400 million. If Focus is running an EBITDA margin between 25% and 35%, and the IPO prices at 9x to 12x EBITDA, Focus could deleverage and wind up with a balance sheet that looks a little more like a typical RIA, and/or get their VC and PE investors liquidity. The RIA managers who got stock by selling their shops to Focus will probably have to wait.Some have suggested that Focus is pulling a stronger EBITDA margin than my range, and could command a higher multiple. We admittedly don’t know enough to comment at length on margin expectations, but the infrastructure necessary to manage a consortium of small to medium size wealth management firms, some of whom are owned outright and some of whom are partially owned, is expensive. As for the multiple, I think it comes down to whether or not the market is ready to accept this business model.How is This Not a Roll-Up?More than anything, the Focus IPO will cast some light on what the market really thinks of RIA aggregators. Focus management has been, and will likely remain, defiant that their company is not a roll-up firm – probably because they don’t want to be compared to National Financial Partners. But I just did, and so will the market. A more favorable comparison might be to Affiliated Managers Group, but AMG’s valuation has also struggled recently, and is down by almost a quarter over the past year.That said, the notion of a national RIA focused on retail clients makes sense. What Focus and other firms like it are trying to assemble looks a lot like the retail side of the old wirehouse firms, absent all the conflicts of interest. But the RIA landscape may be fragmented for a reason, and re-assembling a diaspora of heterogeneous personalities and corporate cultures will undoubtedly prove challenging. I remember a client of mine in a different industry joining a roll-up in the mid-1990s, and being reassured that change would be “evolutionary, not revolutionary.”That sounds attractive, and Focus has made best efforts to create a platform that allowed acquired RIAs to maintain their individual sense of identity. Trouble is that the RIA industry is highly, and increasingly, regulated. The need for compliance and training and comparable pricing and marketing efficiency will create a gravitational force that will pull the dozens of individual RIAs acquired by Focus toward some regimented similarity.Nothing wrong with that; but it sounds a lot like a roll-up.

The SEC’s Proposed “Transition Plan” Requirement is One More Reason to Think about your Firm’s Ownership

James Bond’s engineering mastermind, Q, makes his living out of planning for the unexpected. Over the years, the star of the franchise has been saved from nearly certain demise by a remarkable variety of devices – but none of them more preposterous than the one that saved Roger Moore’s character in The Spy Who Loved Me, in which Bond escapes a typical car chase in his Lotus Esprit by driving into the Mediterranean, only to have the car immediately transform into a submarine. The whole scene could have been a metaphor for Lotus Motors itself, which was very much underwater – financially – at the time.Lotus’s founder, Colin Chapman, was a genius at designing sports cars, but had a harder time making the business consistently successful. By the late 1970s, Lotus was gasping for air. Desperate for cash, Lotus got involved with John DeLorean to design his eponymous car, the DMC-12, and promptly got embroiled in the DeLorean scandal. The pressure built on Lotus and on Chapman, who died of a heart attack in 1982 at the age of 54. The untimely death of Chapman, coupled with poor sales and the ongoing investigation, almost bankrupted Lotus. Q may have planned ahead for the unexpected for James Bond, but Chapman unfortunately didn’t do a similar amount of planning for Lotus. As a consequence, the Bond franchise has been, all in all, more successful.Picking up on this, the SEC seems concerned about RIAs doing some planning for the unexpected, and hence they’ve unleashed 206(4)-7. By now you’ve probably read the SEC’s proposed rules on Adviser Business Continuity and Transition Plans. While there are two weeks left on the comment period, I’ve been a little surprised at how few comments have been posted, so far at least. Maybe that means the RIA community has decided this is inevitable, and they’re already looking forward to how to comply with the rules once they’re finalized.Most of the proposed rule simply codifies a reasonable standard for practice management at an RIA. Certain of the proposal’s requirements, such as IT management and being able to conduct business and communicate with staff and clients in the event of a natural disaster, are likely to be met with turn-key solutions from vendors. Mercer Capital has had some firsthand experience with these kinds of issues: we had to move to temporary quarters for a year after a fire in our office building fifteen years ago, and we provided an alternative location for a New Orleans-based valuation firm for a short time after Hurricane Katrina. It’s amazing what you can do with remote hosted data, laptops, and cell phones when you have to.Of more interest is how the requirement for a “transition plan” in the event of the death or incapacitation of an advisory firm owner will be implemented. The primary elements the SEC wants to see on business transition planning are:Policies and procedures that would safeguard, transfer and/or distribute client assets during transitionPlans for transitioning the corporate governance of the adviserIdentification of any material financial resources available to the adviserPolicies and procedures that would generate client-specific information needed to transition client accounts to a new adviserAssessing the applicable laws and contractual obligations governing an RIA and its clients that would be relevant given the adviser’s transition Again, much of this is check-the-box kind of stuff that will become fairly routine over time. The one sticky wicket, as we see it, is the requirement to have a plan to transition the corporate governance of the RIA. In other words, if a key owner becomes incapacitated, dies, or for whatever reason cannot fulfill his or her position on the organization chart, who will? Since corporate governance at an RIA is usually accompanied by ownership, what the SEC is really asking is “who is going to own and manage the advisory firm in the event that a key owner/manager cannot?” Most of the commentary on this topic has been directed at small RIAs with one owner, which essentially operate as sole proprietorships. For small firms, the options are many, but follow a similar theme: sell the firm immediately at a pre-arranged valuation to another RIA that is in a position to take over. The narrative included with the SEC’s proposal is careful not to define the parameters of any particular RIA’s transition plan too specifically. Every situation is going to be different, but eventually, the regulation is going to have to get fairly granular with regard to expectations of transition plans. Thinking ahead to that time, we would suggest the following might be a descriptive (as opposed to prescriptive) guide to what issues are going to be prominent for RIAs, depending on size. As has been suggested by several commentators on the proposed regulation, solo practitioners and smaller RIAs probably have no recourse for a transition plan that provides for corporate governance (and, thus, control ownership) than some version of a living will for their practice that sells it, immediately, to either a peer RIA or a consolidator like Focus Financial (who filed for an IPO over the weekend). One thing to keep in mind, at that size, is counterparty risk; will the contracted acquirer/operator of the RIA be in a position – financially and operationally – to purchase and run the selling firm if something happens to its owner, and will the acquirer be able to do it on a moment’s notice such that client service is not interrupted? Will the SEC require some kind of “fire-drill” to check if the transition plan works? And who will be held accountable (estate of the Seller, contracted buyer, or both) if the transition plan fails when it’s triggered? Transitions don’t always go smoothly even in a regular acquisition setting, when everyone has time to plan for them and when the seller is available to assist with the transition process. As the size of the firm increases, so typically does the number of owners. One awkward size might be the next one, a medium sized RIA with up to $1.0 billion under management, a few owners and a dozen or more employees. At that scale, it’s not uncommon for the founding partner to hold a majority stake or at least a substantial minority stake. An RIA of this size usually generates more value, per dollar of AUM, than a smaller firm. More value means, of course, a higher purchase price. So while it may be easier to manage the client service issue internally, not every RIA in this size range will be in a position to finance the purchase of the deceased or disabled partner. The largest RIAs have the internal resources to protect their clients in the event of an untimely death. At these sizes, the most significant issues are whether or not the ownership agreements providing for repurchase of a deceased or disabled partner are thorough and current, and whether or not the ownership group has some agreement as to the value of the business. We are involved in numerous matters each year where one or more of these factors is not present, and as a consequence there is a material disagreement as to the value of a buyout. We are also involved with many clients who substantially mitigate this risk by reviewing their buy-sell agreements regularly and have annual valuations prepared so the owners know what to expect in the event of the unexpected. Obviously, we recommend the latter. Regardless of how much planning you do, your RIA is unlikely to emerge from an unexpected calamity without a scratch, but at least you won’t be all wet.Photo Credit: Sun Motors

The Market is Bearish on AUM Growth, but What if the Market is Wrong?

I just got back from a long vacation in Italy, and while I intended to work on the blog while I was there, Brooks and Madeleine were taking care of things so well I hardly had to look up from my Chianti. About the closest I got to working was spending some time in Modena at the Enzo Ferrari Museum, photographing cars to use in future blogposts.The GT pictured above is a very special Ferrari, the 500 Superfast. It was a limited edition car in 1964 that Ferrari based on a “standard” 330 GT – to which Ferrari then added some Pininfarina bodywork and a larger displacement twelve cylinder motor. A few were made with a five speed manual transmission – a rarity then. A Superfast boasted a top speed of nearly 170 miles per hour. They also cost twice as much as a Rolls Royce (there’s been more than a little multiple expansion since then). Ferrari sold three dozen of them. If you’re interested, I noticed one up for auction in Monterey later this month.Some people can rationalize a car like the Superfast as an alternative asset, but really it’s a 20-standard deviation discretionary expenditure. As in no one needs a collector car. Car collectors don’t need a 50 year old Ferrari. Ferrari collectors don’t need a Superfast. I don’t know how many asset managers will be at Monterey this year, but probably fewer than in the past few years, as it seems like there is a dark cloud hanging over the industry. While conventional wisdom always has value, I’d like to suggest that pessimism is not entirely warranted.Yyuuggeee Walls of WorryWe have written at length about bearish signs in the RIA space, and valuation metrics seem to generally reflect a reduced growth outlook. We wonder, though, if things are really that bad. Market prophets forecasting tough sledding ahead for asset management usually point to three things:Fee schedules are compressing because fees are more visible and clients are more interested in passive products.Demographics suggest the populations of developed countries are moving from the asset accumulation stage of their lives to the asset de-accumulation stage (retirement).The lower outlook for investment returns means RIAs won’t just be able to ride the market to grow revenues. For this post, I’ll set aside the first of these. We suspect there is, over all, some phantom fee compression in the industry as assets are allocated to passive instruments and active managers who charge more don’t get the RFP they once would have. This has been written about extensively here and elsewhere. At present it is a trend, and all trends eventually break. The other two common themes focus on demographics and market outlook which are not, necessarily, bearish for the investment management space.De-Accumulation is OverratedBroadly, there is a public policy assumption that people consume more than they produce, save, or invest in retirement and deplete their assets. This is true of the population as a whole, but the investment management community does not serve the population as a whole.In fact, most wealthy retirees actually accumulate investible assets in retirement, according to a recent article in the Journal of Financial Planning by Chris Browning, Ph.D., Tao Guo, Ph.D., Yuanshan Cheng, and Michael Finke, Ph.D., called “Spending in Retirement: Determining the Consumption Gap”. The paper studies the investment and spending habits of retired Americans in various wealth categories in an attempt to measure the typical “consumption gap” – or the amount that retirees under-consume relative to their potential consumption given certain levels of accumulated assets and investment performance.I won’t recite all of the detail in this study, but the gist of it is this: while most retirees do experience de-accumulation (spending down their investible assets in retirement), those in the top quintile (rank based on financial assets) do not. These relatively more wealthy retirees consume much less than they could in retirement, and in fact the average financial assets of this cohort increases during retirement. This top quintile is the only quintile served by the investment management community, and this habit of elderly clients actually growing investment assets during retirement is more reflective of what RIAs should experience.Even though the baby boomer generation is reaching retirement age and a majority are leaving the workforce, this isn’t likely to drain AUM balances in the investment management community as much as some might anticipate.Low Investment Returns Increase AUM BalancesIn theory, lower interest rates and lower expected investment returns should encourage consumption and discourage investment. This basic supply/demand concept is the theory by which the Federal Reserve attempts to manage growth, inflation, and unemployment. Based on this, lower expected investment returns should be negative for investment managers for at least two reasons: 1) clients have a lower opportunity cost of consumption, so they save less, and, 2) investment managers don’t get the benefit of increased revenue from market appreciation. All else equal, the latter is absolutely the case, but all else is not equal.By definition, saving and investing is deferred consumption. Funding that deferred consumption requires saving enough, with “enough” being a function of expected investment returns. Retirement saving is the biggest category of investment in the United States. If the cost of retiring is held constant – which it pretty much is – and the expected rate of return in a retirement account is reduced, the only way to make up the deficiency is to save more.You know the math: to produce $100 in consumption in twenty years requires an investment of about $21 if the expected investment return is 8%. Reduce that expected return to 5%, and the investment required to produce $100 in twenty years almost doubles to $38. For defined benefit plans and insurance companies, this equation is very real. Even for individuals with 401Ks or 529 plans or other designated savings accounts, lower expected returns implies higher levels of required investment for a given desired level of future consumption.We seem to be living in a time where common laws of economics don’t always hold. Low investment returns may spur more savings, as has been the case in Japan for decades.People are Living Longer, Which Should Delight Pension Fund ManagersTwo years ago, the Society of Actuaries officially recognized that Americans are living longer. The revisions to the life expectancy tables added 2.0 years to the life expectancy of an average 65 year old male and 2.4 years to the life expectancy of an average 65 year old female. The study has not been without controversy, but the likely impact on the asset management industry is very positive:Defined benefit plan contributions will have to increase, by law.Defined contribution plan investments will, similarly, have to increase.Many people will use some of their added life expectancy to work later into life, adding to their years of investment asset accumulationRetirees will be more cautious about spending retirement assets, which could exacerbate the phenomenon that Browning et al. wrote about in the Journal of Financial Planning. Add to this further research which suggests wealthier Americans (again, the clients of the asset management community) live even longer than the life expectancy tables suggest, and the AUM required to fund retirement expands even further.See you in MontereyOnly the financial community could make a crisis out of strong markets and longer life spans. There’s no doubt that the RIA community has plenty to fret over, but there are also plenty of reasons to be optimistic as well. Robo-advisors won’t supplant a relationship business. Indexing won’t outsmart human ingenuity. And clients facing the prospects of longer lives and lower returns will need more help, not less, from their investment managers.

Will Marcellus E&P Companies Make a Comeback?

The Rio Olympics are underway, but the Road to Rio was more than a little rocky. Reports of disease, pollution, and protests left us wondering if they could pull it off. But a dazzling Opening Ceremony made us wonder, are the Rio Olympics the next comeback story?For the last two years we have been asking when will oil prices recover? But natural gas E&P companies have been asking this question for almost seven years. Analysts have worked to predict which companies will make a comeback once prices recover, but the road to recovery has been and will continue to be long and rocky.Natural gas consumption has steadily increased since prices fell in 2009, but consumption of natural gas has been unable to keep up with the increased production that resulted from the shale gas revolution. Over the last ten years, natural gas production increased by a compound annual growth rate of 4% while consumption growth lagged at less than 3% per year.Since 2012, the Marcellus and Utica provided 85% of the U.S.’ shale gas production growth as hydraulic fracturing techniques improved. But this fast growth led to excess supply. The American Oil and Gas Reporter commented, “Production in the Northeast is particularly abundant, with volumes increasing from 2 Bcf/d in 2008 to more than 18 Bcf/d in 2014. That astronomical growth rate is expected to continue, reaching 30 Bcf/d by 2020.” By November of 2015, the northeast was already producing 20.3 Bcf/d.E&P companies have increasingly used debt to finance capital expenditures in order to drive sales volume and maintain revenue in a falling price environment. While heavy debt financing allows companies to maintain revenue, it also threatens their liquidity when prices stay low. A prime example is the case of Rex Energy. Until recently Rex Energy was picked by many analysts as one of the E&P companies expected to make a large rebound. Analysts calculated the implied upside potential as 146% and thirteen analysts gave Rex a buy rating. Rex’s stock price declined at the end of 2008 during the finanical crisis when natural gas prices fell. But, Rex quickly recovered by investing in the Marcellus right before the peak of the shale gas revolution. Rex maintained a debt to equity ratio of less than 80% until mid-2013 when their stock price started to fall again. Since then, Rex’s debt to equity ratio has steadily risen, exceeding 1,320% by the end of the second quarter of 2016. Shares of Rex have been trading at sub $1 levels since early May of this year, placing the stock in danger of being delisted from the NYSE. In an effort to improve short term liquidity, Rex announced two weeks ago that they would exchange debt for common shares. The deal will take some of the immediate pressure off of the company by reducing interest expense by approximately $11.1 million, but the long term solvency of the company is still in doubt barring a significant price rebound. For almost two years analysts have waited for a comeback of Rex Energy, but Shale Experts now predicts that Rex is on the verge of bankruptcy. Rex Energy exemplifies why “cheap, abundant, and profitable” can’t last in the marketplace. As Art Berman explained, shale gas enthusiasts believe that shale is “cheap, abundant, and profitable thus defying all rules of business and economics. That is magical thinking.” Valuation multiples for E&P companies operating in the Marcellus fell over the last six years as natural gas prices declined and production increased.1 There have only been five reported transactions in the Marcellus this year compared with 28 in the Permian. While no one can pinpoint when the price of oil and gas will recover, analyzing supply and demand indicators can be helpful for predicting future price movements. The supply of natural gas is not expected to ease in the near future, but a recent uptick in natural gas consumption may help ease the downward trend in prices by narrowing the gap between demand and supply. The EIA reported that in 2015 natural gas consumption increased more than any other source of power generation and that record consumption in July of 2016 led to an increase in net withdrawals from inventories. The chart below, shared by the EIA on August 8th inToday in Energy, demonstrates that demand is starting to catch up with production. Rex Energy may not be making the comeback that analysts once forecasted, but that does not mean hope is lost for all E&P companies in the Marcellus. The current low price environment may squeeze out some of the highly levered companies, but less aggressively financed companies, such as Antero, have an opportunity to buy inexpensive acreage and expand operations in anticipation of a more favorable pricing environment in the future. A comeback may still be possible for the companies that can last until the price rebounds. Have value questions in the oil and gas space, as an executive, investor, owner, creditor or other interested party? Utilizing an experienced oil and gas reserve appraiser can help in understanding valuation issues in this current environment. Contact Mercer Capital to discuss your needs and learn more about how we can help you succeed. End Note1 EV/ Production multiples are based on the multiples of companies who primarily operate in the Marcellus and Utica Shale. For more information see Mercer Capital’s E&P Index by Mineral Reserve.

Captain Obvious: Location is Key in E&P

I was 14, playing a golf tournament in Austin, Texas. At the time, Hole 11 gave me fits and nightmares. My strength was accuracy and short game, and my weakness was driving distance. Unfortunately, Hole 11 required the participants to carry a rather large hazard, a distance which I could achieve about once every 82 attempts. To add to my frustration, there were no lay-up options, no bail outs, and no safe shots. This situation left me with one option to survive the drive, hit the perfect shot at the perfect time for each round of the tournament. This option had a very low probability of success. As any golfer can imagine, I felt exposed, angry and stuck in a bad situation. Clearly, I did not select a tournament where the course fit my strategy.In today’s energy climate, many exploration and production companies find themselves in a similar situation. Exposed with too much debt, angry with the oil price environment and stuck selling reserve assets at prices they are forced to take because their strategy did not fit their location. For me, I did not pay attention to the layout of the course before entering the tournament. For E&P Companies, the reserves location is playing a significant role on if they can succeed in the current economic environment. For some, their "core plays" continue to produce profitably and new well investment is economic. However, for others, the cost of production is too high and they find themselves stuck in a bad situation with few options, which include selling "non-core" assets before or during bankruptcy reorganization.According to our analysis of the major shale plays in the U.S. (Permian, Eagle Ford, Marcellus, Utica and Bakken), in general the breakeven costs to produce are highest in the Bakken and lowest in the Permian. The remaining plays range between the two. Due to its lower cost structure, the Permian is gaining significantly more attention from opportunistic market participants.Deal activity, while quiet in the first quarter of the year, has picked up significantly in the last four months. In the U.S., there were 103 transactions of oil and gas resource properties with a total disclosed value of $19.7 billion, according to Shale Experts. Approximately 27% of these deals were in the Permian Basin and accounted for 25% of the total dollar volume, or $5 billion dollars. However, activity in the Permian has increased. In the last two months, deals in the Permian accounted for 35% of the transaction volume and 43% of the total dollar volume, or $3.3 Billion for June and July. Therefore, 67% of the Permian’s year to date transaction dollar volume occurred in June and July.Pioneer (PXD) has been one of the more active companies making investments in the play. Although PXD had a large presence in the Permian already, two months ago Pioneer invested $435 million in an additional 28,000 net acres by purchasing the rights from Devon Energy (DVN). According to CEO, Scott Sheffield, PXD’s motivation was protection based:"Why we are acquiring 28,000 net acres in the Midland Basin from Devon…? It's simply because it's totally integrated among our acreage. We did not want somebody to come in… most of the competition couldn't bid on this because they couldn't get longer laterals. We have it, had it totally surrounded allocated $14,000 per acre. And what’s interesting right after we made the announcement on the acquisition, somebody is paying $58,000 per acre right next to this acreage."Clearly PXD has found itself in the right location at the right economic time and is using its recent strong performance and relatively low leverage levels to be aggressive when so many of its competitors are in the weaker position or changing strategies and "core assets", including their transaction counterpart, Devon.Additionally, PXD appears to benefit from successful placement of horizontal wells within their acreage rights, high production rates and operational efficiencies. This translates into favorable cost per BOE information. As CEO Sheffield explained in the 2Q16 earnings call:"What’s amazing to me is that the horizontal well operating costs, excluding taxes, are down to almost $2 per BOE. So definitely we can compete with anything that Saudi Arabia has."While that has the power to drive headlines in the media world (confession, I believe that is how I learned about it), it also appears to be a very selective disclosure. A Forbes article written by Art Berman sheds more light on the specifics of PXD’s cost per BOE. The short of it is, overall PXD has significantly higher cost per BOE company-wide, as in $19 per BOE. However, CEO Sheffield’s comments could be read as an indication that one or more of their wells is experiencing operating costs per BOE of approximately $2.00 (excluding taxes of course and perhaps a few other selective expenses). Regardless, the intimation from the comments is that the Permian is a productive and profitable play at current prices and some wells may produce so well that it can compete with the lowest cost producers in the world. This is also supported by the transaction activity of the stronger E&P companies buying up assets from the weaker entities and the existence of drilling activity in the Permian.However, each location in the Permian is different and the "sweet spots" are just that — spots. They are not everywhere in the Permian. As a result, the valuation implications of reserves and acreage rights can swing dramatically in resource plays. Utilizing an experienced oil and gas reserve appraiser can help to understand how location impacts valuation issues in this current environment. Contact Mercer Capital to discuss your needs and learn more about how we can help you succeed.

Q2 Management Calls Were More "Interesting" than Usual

Management calls are usually, for the most part, fairly mundane. It's usually not a good sign for a call to be "interesting", and this quarter we picked up on several "interesting" themes.In some regards, the second quarter of 2016 seems to be much of a continuation of the first for the asset management space. Most managers are continuing to enjoy handsome margins, but growth appears to be virtually nonexistent and stresses seem to be increasing, generally, across the industry. Although commodity prices have picked up some since the beginning of the year, equities have continued to struggle, favoring ETFs and a flight to other passive instruments, while global strategies have suffered from increased volatility in the aftermath of Brexit among other touchpoints of political unrest. Active managers seem to be struggling to distinguish and substantiate their offerings to retain clients after a period of extended relative underperformance. The DOL's Fiduciary Rule adds a twist to all of this. Although the ruling was intended to primarily impact financial advisors, the ruling expanded regulatory authority over financial advice for IRA holders and the "appropriateness" of fees. Otherwise known as the "Conflict of Interest" rule, the Fiduciary Rule prohibits compensation models that conflict with the client's best interest, and further scrutinizes the risk appropriateness of certain product offerings.As we did last quarter, we take a look at some of the pacemakers in the traditional asset management industry and how they have dealt with the myriad of challenges in the first half of the year.Theme 1: Although uncertainty remains about the timing and impact of the DOL's Fiduciary Rule, managers across the board are focused on the challenges and opportunities implicit in the ruling."As I have discussed in past calls, broadening access to NextShares to include major fund distributors is critical to near term commercial success. Significant progress continues toward that goal. Since the publication in March of the final Department of Labor rule adopting a fiduciary standard for advice to covered retirement accounts, our conversations with broker-dealers are increasingly highlighting the potential role of NextShares in helping advisors address their heightened responsibilities as fiduciaries under the DOL rule." – Eaton Vance's Tom Faust"The Department of Labor's recent fiduciary standard rule has elevated the scrutiny over the appropriateness of fees and product choices. Advisors are demanding solutions for their clients and better technology to support their practice. […] Our investment in Project E (a series of tech, product and brand initiatives) will bring new options to our clients in a more robust technology platform for the financial advisors associated with our broker-dealer, ultimately strengthening the competitiveness of this channel. We believe we will be able to fully address the DOL requirements while preserving our ability to grow advisor productivity and sales with the ongoing inclusion of our products." – Waddell & Reed's Philip James Sanders"We're hearing conversations about all kinds of things, relative to DOL. A couple of things that I think are relevant are – pricing was already decelerating. […] The other piece of DOL I think is that distributors will look intently at their investment offerings and the breadth of them. And in addition to pricing, I think risk, however defined, will be front and center in those discussions. And you've read publicly that one large broker dealer has announced a plan to dramatically prune its product offerings. Whether others follow suit remains less clear. But I think this amalgam of risk and expense will be very much a part of the DOL discussion." – Waddell & Reed's Thomas W. Butch"We're waiting for some more work done on the client side, frankly, to interpret what those new DOL rules will mean for their businesses. And then we'll follow along. We have, obviously, some concerns. We also see opportunities for us in the changing landscape. But it's really too early to have conviction." – Janus's Richard Weil"I think if the large firms move towards more SMA type accounts, we feel pretty well-positioned for that. As you know, in the tax-aware muni space, that's a huge incentive or a huge opportunity for us and has been growing persistently for almost 18 months. So that's an example of us being able to both pivot and take advantage of [the DOL ruling]." – AllianceBerstein's Peter KrausTheme 2: The volatility experienced in the aftermath of Brexit was immediate and acute, but not life-threatening. Many managers believe the impact will be short-term, and have continued to grow their international investments in both Europe and Asia."The Brexit vote in June was yet another episode of volatility and uncertainty. […] The absolute returns of our non-US and global strategies have been impacted in recent periods by poor market performance and overseas developed markets, particularly in Europe." – Artisan Partners's Eric Colson"I think that Brexit over the long-term will be good for the UK. It will result in some short-term pain, probably a brush with recession. But long term, I think it's good that they can control their own destiny apart from being tied to Europe. And in terms of commercial real estate in the UK, we are expecting prices to decline anywhere from 5% to 15% or 20% depending on the property type and the biggest declines are being expected in the office market. However, we think that for some other property type such as industrial where for example the decline in the pound could be good for trade interest and to the property markets in London." – Cohen & Steers's Joe Harvey"We are now investigating how best to service our growing Japanese business and may add additional resources to support that effort. And we have a search underway for a new head of non-US distribution. As our investment capabilities grow more global, it seems natural to focus more attention on serving clients in international markets. While it is unlikely that we'll do something dramatic, the changes afoot in the US market lend greater urgency to our desire to make Eaton Vance a more global company." – Eaton Vance's Tom Faust"We've made significant investments in building our businesses outside the United States. And in that perspective, our non-US businesses have and continued in this past quarter to deliver strong growth." – Janus's Richard Weil"I think the major effect has been a resurgence of sales in the Asia ex-Japan space. I think that is the major difference. Brexit clearly had a chilling effect on risk-taking in Europe and on trading activity, which was reflected in the Bernstein numbers. I don't think we've seen any material move of flow from Europe to the US" – AllianceBernstein's Peter KrausTheme 3: The persistent flight to passive has exposed a number of winners and losers in the active management space. Managers willing and able to adapt and respond to the changing climate by offering a greater mix of both active and passive funds have generally fared better than those trying to wait out the storm."During the quarter, we saw a slowdown in gross inflows which we believe is attributable to a number of factors including market uncertainty and the demand for high-capacity low fee products. In the short term, this is a difficult environment for high value-added active managers." – Artisan Partners's Eric Colson"The pace of change in our industry is accelerating with continued outflows from equity, market share gains by ETFs, investors looking for managers to deliver and distributors responding to the DOL fiduciary rule before it is finalized and while it is being challenged in the courts. […] We are focused on being a specialist manager and delivering more for less. We continue across all fronts to enhance our brand and capabilities and real assets." – Cohen & Steers's Joe Harvey"In this period of disruptive change in our industry, every investment manager is being forced to consider how to respond. […] We are not willing to concede that we can't grow our traditional active business. […] As we said before, we view traditional active management as now a game of winners and losers with Eaton Vance's performance and distribution strengths positioning us to be a winner. We continue to devote significant sales and marketing resources to growing our high performance active strategies." – Eaton Vance's Tom Faust"What we're doing is essentially competing against index funds and index ETFs where we're saying to the client or saying to the financial advisor, we can provide index like or benchmark like returns, but with customization to take into account other holdings that the investor might have, social objectives or social screens that the manager wants to impose, and the ability to achieve better tax treatment because in a separate account you can manage taxes down to the individual lot level and you can pass through losses." – Eaton Vance's Tom Faust"ETFs will absolutely continue to be an important part of the book of business of the financial advisors that we do business with, and looking to see how we can offer either some differentiated actively managed capabilities, either from our current affiliates or through other sub-advisory relationships, as well as are there those smart data types of opportunities, that we also think would be differentiated and work better in ETF than they would work in an open end mutual fund. […] This is an interesting environment for those types of non-correlated, non benchmark type of products because the indices just keep going up and up and up. Our view is that this is a time that people should be investing in those types of strategies, but it's really not as easy to get people to be compelling to buy those types of strategies where right now the indices seem to be doing well." – Virtus Investment Partners's George Aylward"This remains a very challenging environment for active managers. The current global macro-economic and geo-political backdrop has resulted in heightened investor demand for stability, safety, and yield, resulting, in our view, in valuation anomalies across various sectors and markets. We continue to believe that these anomalies will normalize over time, providing a much more favorable backdrop for active management. However, it is also clear that we have not been at our best in navigating the current environment and must do a better job as a whole. The recent performance challenges for active managers combined with an increased focus on fees has resulted in growing demand for passive products. We understand that the landscape has changed, but believe that there is a role for both passive and active strategies in client portfolios. […] We recognize that the industry is evolving and that in order to retain our position of excellence, we must remain open-minded to innovation and change." – Waddell & Reed's Philip Sanders"Given the very challenging global market dynamics and, in particular, how that affected active asset managers, we were particularly pleased to have slightly positive flows for the quarter and very encouraged by the strength of the flows in our U.S. mutual fund business where we gained market share in both fundamental equity and our fixed income business. […] We have a number of strategies which are particularly designed to help clients in period of market stress, in periods of high market volatility. […] Active managers in the first two quarters were experiencing an extremely challenging environment in 2016. Industry outflows for active mutual funds, equity, and fixed income are on pace to post one of the worst years in more than 25 years of history." – Janus's Richard Weil"We are doing as well as we are in such a volatile market because our value proposition has never been clearer. Not only can clients be confident of Bernstein's wealth forecasting, asset allocation, and risk management tools. They can now invest in a series of innovative targeted services that allow them to capitalize on specific market opportunities." – AllianceBernstein's Peter KrausMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

WHITEPAPER | Community Bank Stress Testing

Despite the lack of legal requirements for community banks to perform stress tests, recent regulatory commentary suggests that community banks should develop and implement some form of stress testing on at least an annual basis.While not prescriptive in regards to the particular stress testing methods, the guidance suggests a wide range of effective methods depending on the bank’s complexity and portfolio risk. The guidance also notes that stress testing can be applied at various levels of the organization including transactional level stress testing, portfolio level stress testing, enterprise-wide level stress testing, and reverse stress testing.In order to have a better understanding of the stress testing process, this whitepaper walks through an illustrative example of the primary steps to construct a “top-down” portfolio-level stress test. These steps include determining appropriate the economic scenarios, segmenting the loan portfolio and estimating losses, estimating the impact of stress on earnings, and estimating the stress on capital.

PV-X: WACCs for E&P Companies

In the oil and gas industry, standardized reporting and industry analysts typically use a 10% discount rate on projects’ future cash flows. In this post we explain how such a discount rate is calculated and its effects on valuation; and then discuss a model that provides the discount rates that exploration and production companies face in the current market. Exploration and production companies often use a standardized 10% discount rate in discounted cash flow analysis. The rate appears in oil and gas companies’ reserve reports, where it is used to generate a PV-10 value (an estimate of the pre-tax discounted cash flow value of the company’s cash flows generated from its proved reserves). This standardized discount rate also appears in other calculations where a quick, rough estimate of the present value of a project’s cash flows is needed. Having a sense of a company’s WACC, then, can lead to a more realistic assessment of the value of a company’s reserves. Despite the prevalence of the 10% value, it is unclear how closely this discount rate aligns with reality. Even if the rate is a general benchmark for the industry as a whole, it is unclear how it varies from company to company and region to region. Such information would help determine the oil and gas prices at which companies can justify raising funds for new drilling—at what point US drilling activity might start to recover. The information would give investors a better sense of whether the PV-10 value is a fairly reasonable statement, an overstatement, or an understatement of value. And for companies, it can help them in transactions to understand how they and another company might find very different value in the same reserves. There are several factors in the current market that might push the current discount rate higher or lower than the standard rate of 10%. The first key factor is the low interest rate on government bonds. Interest rates on debt are found by adding a credit spread based on the perceived financial health of the company to the risk-free government bond rate. Thus when interest rates are low, the cost of borrowing is low. Since equity investors compare the returns of the equity market to the debt market, a lower return on debt leads them to require less return on equity. Therefore the low interest rate environment should be a strong force pushing the WACC below 10%. At the same time, the recent volatility in oil prices has increased uncertainty and volatility in the industry, causing investors to require higher returns on investments and creating a higher cost of capital. AnalysisTo better understand the combined effect of these factors, and many others, on the cost of capital for oil and gas companies, we have analyzed WACC for seven groups of publicly traded oil and gas companies.1 We made one important assumption in our analysis—that the funding for the next project would not dramatically differ from a company’s current capital structure. The model does not find optimal company WACCs, but attempts to estimate companies’ WACCs with their current capital structure. With or without this assumption, finding the WACC for each company requires calculating the cost of equity and the cost of debt. The CAPM model (required return on equity=risk-free rate + beta*equity risk premium) was used to calculate cost of equity.2We created two models, using different methodologies to calculate the cost of debt, in order to calculate the WACC. The first method of calculating the cost of debt is fairly standard for a WACC calculation. The model multiplies the current effective interest rate (which is the interest expense divided by simple average of debt at the beginning of last twelve months and end of period) by one minus the company’s marginal corporate tax rate.The second method gives what we think of as a projected future cost of debt for long-term projects (such as oil and gas production). It uses S&P’s company credit ratings, and S&P’s 20 year corporate bond yield curve for bonds of different ratings to assign an interest rate on new loans for a company. The key advantage to this method is that it gives a pre-tax cost of debt based on what the debt market, or at least S&P, assumes it would cost to raise more debt, rather than generating a number based on historical rates. However, these companies have never actually had to pay that amount for debt in the past. Because of this trade-off, the WACCs for companies were calculated using both this method and the standard WACC calculation.The Results The model’s outputs suggest that the standard 10% discount rate is a higher cost of capital than companies are actually facing in the current environment. The unusually low government interest rates have lowered required returns so that even with the recent volatility in the industry, the oil and gas WACC is below what was once considered a reasonable standard. However, how far off the 10% rate is depends on whether one looks at the WACC for these companies based on the standard cost of debt or the projected cost of debt using S&P ratings. A standard WACC cannot always account for the rapid rise in leverage some companies have experienced. For companies producing primarily in North America or North American regions, the minimum standard WACC for each group is based on a company with debt representing over 80% of its capital structure. These companies have low WACCs because the calculation is based on interest rates they obtained in the past when they were less leveraged. Now, due to falling oil prices, their equity values have shrunk and many companies’ remaining capital is mostly composed of old debt. Therefore, that cost of capital appears quite low. However, if the company were to try to raise new funds for a project, their current leverage—and the risk of default associated with it—would force them to pay a very high cost for either debt or equity. Thus, using these numbers overstates the value of reserves, especially for struggling companies. A more contemporary picture of the value of companies’ proved reserves is provided by the S&P ratings based WACC.3 In the case of the Bakken, the most levered company, Halcón Resources, which by the standard measure has the lowest WAAC in the group (6.23%), now has the highest (13.15%). This adjustment now appears particularly relevant as Halcón has filed for bankruptcy. In the Permian, the company with the minimum WACC went from one with over 85% debt to one with only 12% debt. At the same time, not all highly leveraged companies are automatically punished by this model and assigned the highest WACCs. For some, this capital structure may be optimal, and other factors may bolster their S&P credit rating. The S&P rating based WACC model shows that right now a standard discount rate for North American E&P companies should be around 9.4%. Using this rate in the Bloomberg break-even model drops the break-even price 2-3.5% depending on the area. As for the PV-10 calculation: if it were instead a PV-9.4 calculation, those proved reserves included in the PV-10 calculation would be more valuable. Additionally, more reserves would be included in the PV- 10 calculation, as the engineers evaluating the reserves would include some reserves that were once not considered to be economically viable due to the PV-10 value. Therefore a current PV-10 understates the present value of reserves relative to a PV-10 in periods where 10% is the average discount rate. For a more detailed discussion on the valuation process and how Mercer Capital can use its years of oil and gas valuation experience to help you, please contact a Mercer Capital professional. End Notes1 The seven groups include four groups of companies that generate over 50% of production from the Eagle Ford Shale, the Permian Basin, the Bakken, or the Marcellus Shale and Utica Shale; a group of companies having over 90% of production in North America but who are not concentrated in the previously mentioned regions; a global integrated group; and a group of global E&P companies. 2 We used the yield on twenty-year treasuries as our risk free rate. A two year Beta was used, because we feel investors considering an oil and gas company investment would base their decisions largely on what has happened since the fall in prices that began two years ago. Mercer Capital regularly reviews a spectrum of studies on the equity risk premium, as well as conducting its own study. Most of these studies suggest that the appropriate large capitalization equity risk premium lies in the range of 4.0% to 7.0%. The chosen equity risk premium of 5.50% represents a composite assumption which is consistent with this range. The model does not, however, apply a country specific risk premium for global companies, and so global companies’ WACCs are likely understated by the model. 3 Not all of the companies in our sample had S&P credit ratings so some were excluded from our analysis. We ran a control group in order to test whether the exclusion of some companies would bias the model. We estimated the ratings of companies without a rating based on the ratings received by other companies in the group with similar debt to enterprise value ratios. The results suggested the reduction in the number of companies did not significantly affect the model.

Oil and Gas Market Discussion: Part 2

In May 2016, we attended a panel event discussing investment opportunities in the financially distressed oil and gas sector. The panel included a “who’s who” of oil and gas experts located in Texas. Two industry participants, two consultants, one analyst and one economist discussed the economic outlook for energy prices and then corporate strategy and investment opportunities given the economic outlook. This post, the second and last summarizing this panel discussion, will report opinions given on corporate strategy and investment opportunities. (To read more about the economic outlook please read here.)Corporate StrategyAfter discussing the price outlook, the panelists shifted the conversation to practical decision making based on our limited ability to forecast price changes. First, they looked at corporate strategy. Merger and acquisition activity has slowed. Once oil prices started to decline in mid-to-late 2014, the M&A market fell quiet for more than 12 months. This “silent period” is a normal reaction to high volatility periods. For corporations trying to make decisions for the long term, volatility creates an uncertain future, and thus an unfriendly environment for investment. However, the panelists believe the “silent period” is now reaching a breaking point as the amount of debt carried by some companies is beginning to force action. One panelist commented that while there are “no willing sellers in the market,” some transactions have occurred when a “forced seller” tries to avoid or prolong filing for bankruptcy protection.Those bankruptcies are happening more and more frequently, leading one participant to describe four types of energy companies in the market today:The “I need to restructure yesterday” company;The “In denial about restructuring” company;The “Racing to restructure” company (to be healthier when oil prices recover); andThe “Low leverage / healthy” company (looking for opportunities); By categorizing each active company in the oil and gas market into one of these four buckets, it is easier to interpret some companies’ actions, and therefore to interpret the direction of the market. This in turn enables wiser investment strategies.Investing OpportunitiesTwo areas of opportunity discussed were reserves and oil field services. A panelist who actively invests in “low risk, existing producing properties with PUD (proved undeveloped wells) rights” described the potential value of investing in reserves. In recent transactions, this particular panelist was able to pay a purchase price based only on the value of the given property’s PDPs (proved developed producing reserves). The only properties for which he may make an exception and allocate “a little” value for the non-producing areas are those located in the Permian Basin. The time horizon for this investment is definitely long term as the strategy depends on the price of oil recovering so that the PUD opportunities—which the investor pays nothing for in this current market—become valuable again. Thus, this strategy works well for experienced investors with enough cash to pull it off, such as investment funds or other E&P companies.The second investing opportunity is more easily accessible to the average retail investor than purchasing reserves. This simpler opportunity focuses on investing in “higher quality oil field service companies that live in the operating expenses of exploration and production companies.” There are a couple positives to this strategy. Since existing wells must be maintained, this strategy enables one to invest in a high quality company that receives regular business from E&P companies, while also taking advantage of the fact that most companies operating in the oil and gas sector are trading at discounted prices. Furthermore, if prices recover, more wells will be drilled and completed, and these too will need to be maintained. Thus, high quality oilfield service companies may offer low risk returns in the current environment while also offering considerable upside if oil prices increase. A market data point to monitor for this investment strategy is the drilled but uncompleted well count and the well completion count data. As discussed in the previous post, this information is more directly tied to future production than the commonly referred to rig count data, and an increase in completions will mean an increase in business for oil field services companies.SummaryOverall, this panel was a helpful reminder to stay focused on the basics during times of turmoil. Basic supply and demand factors world-wide are still driving the price of oil and gas. The only change has been the behavior of certain suppliers (OPEC) and doubts about future demand (country specific). Because of the way those changes have affected oil prices, overleveraged E&P companies will be forced to restructure their debt or be forced out of the market. After an 18 month “silent period,” more action is either expected in the near term as these debts become due. Lastly, having available, investable cash is critical in order to take advantage of certain investing opportunities in the market today. Certain strategies favor professional and institutional investors, while others can be enjoyed by retail investors. Overall, it is a very volatile time in oil and gas. The perspectives of these six experts in their respective fields provide guidance for strategy and investing in the near and long term. If you want to move forward either as a company interested in M&A activity or as an investor, utilizing an experienced oil and gas reserve appraiser can help to further lift the fog on valuation issues in this current, hazy environment. Contact Mercer Capital to discuss your needs and learn more about how we can help you succeed.

BlackRock Sees Opportunity in Challenging Environment for Asset Managers

A Whole New World

Often branded as an industry bellwether for its size and breadth of services, BlackRock (ticker: BLK) has been as solid as the name would imply given the recent fallout in asset manager valuations. In last week’s earnings call, CEO Larry Fink attributes the company’s recent success to “the differentiating platform we have built at BlackRock over the past 28 years…, the diversity of our product offerings, the risk capabilities of Aladdin, [and] the market insights offered by the BlackRock Investment Institute.” Specifically, BLK benefited from $126 billion in net inflows over the last year as many RIAs have leaked client assets to passive funds and robo-advisors. BlackRock is clearly gaining market share within the industry and currently manages $4.9 trillion in client assets. This scale has allowed it to make the necessary investments in technology and talent to continue the upward growth trajectory in a sideways market. In addition, BlackRock has also recently invested in ETF businesses to take advantage of the rising popularity of indexing strategies. In essence, BlackRock has used its size (and balance sheet) to evolve with the industry and gain market share in the process. Still, the last twelve months have been anything but a magic carpet ride for most industry participants. A low yield environment dominated by ETFs and passive products has not been conducive to many RIAs, especially active managers like Pzena and Legg Mason, which are down 31% and 43%, respectively, over the six months ended June 30, 2016. As we discussed last week, investors are growing increasingly intolerant of the high fee/low performance combination, so both traditional and alternate asset managers are feeling the heat. Mounting regulatory pressures are additional headwinds as the Financial Stability Oversight Council is currently reviewing six areas of the asset management business for potential enhancements to regulatory oversight – liquidity and redemption, leverage, securities lending, data and disclosure, operational risk of service provider concentrations, and resolvability and transition planning. The SEC is also assessing the sector’s systemic risk exposure and should finalize three proposals on mutual fund and ETF regulation at some point this quarter. While the current trend toward passive investing hasn’t shown any signs of strain, we don’t foresee active management ever going away for good. In fact, best-in-class stock and bond pickers should build market share as enterprising investors seek the few diamonds in the rough (last Aladdin reference, I swear) that have actually outperformed their relevant benchmark. Depressed valuations may induce further consolidation, so this trend could ease the number of stand-alone active management firms as competitively priced passive strategies continue to collect AUM. With over 11,000 RIAs and aging owner demographics, such consolidation is probably long overdue.

Asset Managers of All Shapes and Sizes Continue to Underperform the Broader Indices

Nowhere to Hide

Piggybacking off our post from a couple of weeks back, the downward trend in asset manager pricing has persisted for another quarter, no matter how you slice it. Publicly traded trust banks, alt managers, mutual funds, and traditional RIAs are all down over the last year, with hedge funds and PE firms leading the plunge. Rising compliance costs, fee and margin compression, asset outflows on active strategies, and stalling growth prospects are all culprits for the overall decline, but alternative asset managers have definitely been hit the hardest over the last year. As a matter of practicality, it shouldn't be surprising that the most expensive asset class with the worst overall performance would eventually be shunned by investors. This trend is really just a microcosm or more exaggerated example of what's going on across the entire asset manager landscape – individual and institutional investors no longer have to accept high fees and chronic underperformance, so they're turning their attention to passively managed products or indexing strategies to boost their effective return. John Oliver certainly didn't do the industry any favors with his 20 minute rant on advisor fees in his Last Week Tonight episode from a few weeks back. There was also virtually no size effect. Most every asset manager from GROW (U.S. Global) to TROW (T. Rowe Price) has struggled to keep pace with the broader indices. No matter the asset base, a low-fee, passively biased environment is not conducive to most asset managers of any size, shape, or form. Add rising regulatory costs and a market that's not exactly undervalued, and you get multiple contraction and a bear market for RIAs. So what's the market trying to tell us about the future of this business? Probably that fee compression, asset outflows, rising compliance costs, and heightened market volatility will likely have an adverse effect on future earnings for some time to come. For alternative asset managers, the market seems to be pricing in more pronounced cuts to their fee structure and/or continued outflows. It might also signal a buying opportunity for industry participants looking to add scale since most RIAs have finally gotten cheaper after years of steady growth following the last financial crisis. AMG's recent acquisition seems to be at least partially motivated by recent declines in hedge fund valuations. Further consolidation seems inevitable and might be the most viable way to restore a depleted asset base and profit margin. We'll keep you apprised on deal-making trends in future posts.

Bankruptcy: An Overview Part 3

From January through May of this year, 39 E&P companies and 31 oilfield services companies had to file for bankruptcy. This post is the last in a series of three aimed at helping those companies, and any others who may face bankruptcy in the future, to understand the valuation-related aspects of Chapter 11 restructuring. In the first post we highlighted two reorganization requirements tied to valuation. First, the plan should demonstrate that the economic outcomes for the consenting stakeholders are superior under the Chapter 11 proceeding compared to a Chapter 7 proceeding. Second, upon confirmation by the bankruptcy court, the plan must not be likely to result in liquidation or further reorganization. In the second post we explored in depth the consequences of the first requirement. Here we examine the importance of the second requirement.Cash-Flow TestFor a company that has followed the steps explained in the previous post, this second requirement represents the last valuation hurdle to successfully emerging from Chapter 11 restructuring. Even if a company shows that the restructuring plan will benefit stakeholders more than liquidation will, the court will still reject the plan if it is likely to lead to liquidation or further restructuring in the foreseeable future. To satisfy the court, a cash-flow test is used to analyze whether the restructured company would generate enough cash to consistently pay its debts. This cash-flow test can be broken into three parts.The first step in conducting the cash-flow test is to identify the cash-flows that the restructured company will generate. These cash-flows are available to service all the obligations of the emerging entity. Remember the discussion in the second post—a stream of cash-flows is developed using the DCF method in order to determine the reorganization value. Thus, in practice, establishing the appropriate stream of cash-flows for the cash-flow test is often a straightforward matter of using these projected cash-flows in the new model.Once the fundamental cash-flow projections are incorporated, analysts then model the negotiated or litigated terms attributable to the creditors of the emerging entity. This involves projecting interest and principal payments to the creditors, including any amounts due to providers of short term, working capital facilities. These are the payments for each period that the cash-flow generated up to that point must be able to cover in order for the company to avoid another bankruptcy.The cash-flows of the company will not be used only to pay debts, and so the third and final step in the cash-flow test is documenting the impact of the net cash-flows on the entire balance sheet of the emerging entity. This entails modeling changes in the company’s asset base as portions of the expected cash-flows are invested in working capital and capital equipment; and modeling changes in the debt obligations of and equity interests in the company as the remaining cash-flows are disbursed to the capital providers. A reorganization plan is generally considered viable if such a detailed cash-flow model indicates solvent operations for the foreseeable future.ConclusionAlthough the Chapter 11 process can seem like no more than a burden, a rigorous assessment of cash-flows and a company’s capital structure can help the company as it tries to develop a plan for years of future success. We hope that these past three posts explaining the key valuation-related steps of a Chapter 11 restructuring help managers realize this potential.However, we also understand that executives of oil and gas companies going through a Chapter 11 restructuring process need to juggle an extraordinary set of additional responsibilities—evaluating alternate strategies, implementing new and difficult business plans, and negotiating with various stakeholders. Given executives’ multitude of other responsibilities, they often decide that it is best to seek help from outside, third party specialists. Valuation specialists can relieve some of the burden from executives by developing the valuation and financial analysis necessary to satisfy the requirements for a reorganization plan to be confirmed by a bankruptcy court. Specialists can also provide useful advice and perspective during the negotiation of the reorganization plan to help the company emerge with the best chance of success. With years of experience in both oil and gas, and in bankruptcy, at Mercer Capital, we are well positioned to help in both of these roles. For a confidential conversation about bankruptcy proceedings and how we can help, please contact a Mercer Capital professional.

AMG Sees Opportunity in Alt Asset Space

Value Play or Falling Knife?

Last week, Affiliated Managers Group (ticker: AMG) announced the completion of its investment in three alternative asset managers — Capula Investment Management LLP, Mount Lucas Management LP, and Capeview Capital LLP. These transactions are the cornerstone of AMG's 6/6/16 definitive agreement with Petershill Fund I, a group of investment vehicles managed by Goldman Sachs Asset Management, LP, to acquire all of Petershill's minority interests in the aforementioned firms as well as two other alternative investment managers, Partner Fund Management and Winton Capital Group, which haven't yet closed.Under the terms of the agreement, AMG will acquire these interests for approximately $800 million to be paid in cash at closing (roughly half of which was just paid for Capula, Mount Lucas, and Capeview with the balance expected to close by year-end). Given that RIA disclosures only present ownership percentages in range form and three of the entities are headquartered in London, the ADV is of little use to us in ascertaining the exact interest acquired in these businesses (though it's probably safe to assume something close to 50% given their typical investment structure discussed in a previous post).Perhaps more instructive is AMG's admission that management expects the transaction to increase economic earnings per share by $0.50 to $0.80 in 2017, availing some insight on deal pricing (though much of this accretion is likely due to synergies). At first glance an effective multiple of 18-29x next year's earnings seems a bit rich, even in this market, but closer inspection reveals pricing more in line with industry peer measures. The high level of variance in the metrics is largely attributable to the uncertain and variable nature of performance fees and carried interest income. Such ostensibly high valuations are more a function of depressed earnings from fee pressure and fund outflows than overly bullish sentiment on the sector’s prospects. In an investing landscape dominated by indexing strategies and passive products, investors are becoming increasingly weary of the high fees and recent underperformance associated with many hedge funds and private equity firms. Publicly traded alternative asset managers have clearly fared the worst over the last year relative to other classes of RIAs and trust banks. AMG apparently sees this decline as a buying opportunity, since these businesses might be the cheapest they've been in quite some time. And although trying to catch a falling knife is typically ill-advised, AMG has partially hedged this risk by investing in established hedge fund managers with over $1 billion in client assets. At any rate, the market doesn't seem convinced — though only time will tell.

Oil and Gas Market Discussion: Part 1

Like the first few holes on an early morning golf round, the current oil and gas market is very foggy. In golf, hitting a shot into the unknown can be peaceful, enjoyable, and exciting. However, in the oil and gas market, blindly taking investment shots is downright frightening. Uncertainty on the direction of the price of oil, the cause of the historical decline, the future of demand, leverage levels of E&P companies, and the value of oil and gas assets will delay many investment decisions. In May 2016, we attended a panel event discussing investment opportunities in the financially distressed oil and gas sector. The panel included a "who’s who" of oil and gas experts located in Texas. Two industry participants, two consultants, one analyst and one economist discussed the economic outlook for energy prices; and then corporate strategy and investment opportunities given the economic outlook. This post, the first of two summarizing this panel discussion, will report on the economic discussion.Economic Outlook for Energy PricesTo no one’s surprise, the outlook for energy prices depends on forecasts of future supply and demand, and those forecasts in turn depend on predicting the timing and interaction of complex global events. On the demand side, economists do not anticipate significant change in the near term. Many economists are hesitant to project growth as others indicate a global pull back is due. Even looking only at the U.S. we can see how the way we use oil has changed in the last 40 years. Oil was used to power houses, offices, and factories in the 1970's and 1980's, but environmental pressure since then has reduced the use of oil in favor of cleaner energy. Combine the changes to the power grid with efforts to help both the environment and consumers by increasing the energy efficiency of automobiles, and it appears pressure to reduce U.S. demand for oil will continue into the future. Therefore, it is difficult to argue convincingly that an increase in foreign or domestic demand will drive near-term oil price growth.On the supply side, the world is still reacting to OPEC’s increased production, which has enabled those countries to maintain market share by driving down prices. North American production, for instance, is anticipated to continue its decline in the near term — the result of a slow-down in investment over the past year and a half as many resource plays are no longer economically viable. While wells are continuing to produce oil, completion and drilling of new wells has been delayed. As hydrocarbons are a depleting resource, anything produced must be replaced by discoveries elsewhere. Without investment to replenish reserves, depletion becomes a significant hindrance on growth as inventory and reserve levels drop. It is now a waiting game for current wells’ production to decline enough to impact inventory levels. When this happens to companies across an entire region, oil prices may rise. One traditional market indicator frequently monitored by industry participants to determine investment levels is rig count. As rig counts fall, the indication is that new production will go down; as rig counts rise, the opposite is true. However, one panelist suggested, "Rig count is not as important to measure future production as the number of drilled but uncompleted wells." As the price of oil started to decline in 2014, many drillers chose to delay the completion of their wells, hoping for a rebound in price. This price rebound has yet to happen, but the number of uncompleted wells continues to increase. Since it takes less time to complete a well than it does to drill and then complete one, it seems reasonable to assume that companies might be more capable of quickly replenishing their depleted inventories than we would think from looking at the number of rigs. This will help U.S. companies to capitalize if prices start to rise, but also will keep in check any growth in oil prices as supply will increase faster than it normally would. In a shift away from the U.S. market, the panel then emphasized that one should not develop a narrow focus on investment and that production in the U.S. International production decisions, especially those of OPEC, will continue to drive much of the change in oil price going forward. For this international sector, the economist on the panel communicated the theme: "History doesn’t repeat but it does rhyme." He explained his point by highlighting one particular period in the oil industry’s last 50 years that can help us to understand the decisions OPEC is making now. From 1978-2003, the Saudi’s acted as the swing producer in OPEC to influence prices. At the end of this time period, they learned that the swing producer ultimately loses market share. They vowed never again to act in a manner that would shrink their market share. At the time, U.S. production was dropping consistently year over year, and so people paid little attention to the change in attitude. In the mid to late 2000s, however, fracking technology helped unlock significant U.S. inventory. This new technology made the U.S. energy independent, at least as long as oil prices remained above a certain price point needed for the main resource plays to be economical. Jump forward to 2014, and everyone was "shocked" when a significant drop in the price of oil was not met with an OPEC cut in production. From the perspective of Saudi Arabia and the rest of the OPEC nations, however, they simply kept their earlier vow. Deciding to produce at the same or increased levels would better enable them to fend off challenges to their market share from countries such as the U.S. who were starting to fulfill a larger share of the world’s oil needs. Ultimately, however, the economist ended the discussion of future prices by emphasizing that while certain trends can seem clear, especially in hindsight, there are many factors that can influence oil and gas prices. While people have their opinions, no one can consistently and accurately forecast all these complex factors, and thus "no one knows where the prices of oil and gas will go." All we can really say with reasonable certainty is that the "drivers impacting the price will be similar to the past ones." Although this explanation was not "ground breaking"material, we find it helpful to be reminded of the basics during times of turmoil. In the next blog post, we will look at how one can navigate this turmoil to find successful opportunities as either an investor or a business. If you want to discuss further how the current price outlook can shape asset valuations, and how one can project value when the future is so uncertain, please contact a Mercer Capital professional.

Bankruptcy: An Overview Part 2

From January through May of this year, 39 E&P companies and 31 oilfield services companies had to file for bankruptcy. This post is the second of three aimed at helping those companies and any others who may face bankruptcy in the future to understand the valuation-related aspects of Chapter 11 restructuring. In the first post, we highlighted two reorganization requirements tied to valuation. Here we will explore the consequences of the first of those requirements:The plan should demonstrate that the economic outcomes for the consenting stakeholders (creditors or equity holders) are superior under the Chapter 11 proceeding compared to a Chapter 7 proceeding, which provides for a liquidation of the business.A Floor Value: Liquidation ValueIf a company can no longer pay its debts and does not restructure, it will undergo Chapter 7 liquidation. Thus, this law simply mandates that Chapter 11 restructuring only be approved if it is stakeholders’ best option. Given this understanding of the law, the first valuation step in successful Chapter 11 restructuring is assessing the alternative, liquidation value. This value will be a threshold that any reorganization plan must outperform in order to be accepted by the court.The value in liquidating a business is unfortunately not as simple as finding the fair market value, or even a book value for all the assets. The liquidation premise contemplates a sale of the company’s assets within a short period. Any valuation must account for the fact that inadequate time to place the assets in the open market means that the price obtained is usually lower than the fair market value.In general, the discount from fair market value implied by the price obtainable under a liquidation premise is directly related to the liquidity of an asset. Accordingly, valuation analysts often segregate the assets of the petitioner company into several categories based upon the ease of disposal. Liquidation value is estimated for each category by referencing available discount benchmarks. For example, no haircut would apply to cash and equivalents, while reserves, and especially PUD and unproven reserves, would likely incur significant discounts. The size of this discount can be estimated by analyzing the prices commanded by comparable properties under a similarly distressed sale scenario. For instance, as mentioned in "Bridging Valuation Gaps: Part 1," the price Samson recently paid for properties in a distressed sale equaled the reserve report value of PDP and PDNPs. The discount was so steep that the company essentially received the PUD reserves for free.Reorganization ValueOnce an accurate liquidation value is established, the next step is determining whether the company can be reorganized in a way that provides more value to a company’s shareholders than discounted asset sales. ASC 852 defines1 reorganization value as:“The value attributable to the reconstituted entity, as well as the expected net realizable value of those assets that will be disposed of before reconstitution occurs. This value is viewed as the value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after restructuring.”Typically the “value attributable to the reconstituted entity,” the new enterprise value for the restructured business, is the largest element of the total reorganization value. Unlike a liquidation, this enterprise value falls under what valuation professionals call a “going concern” value premise. This means that the business is not valued based on what one would be paid for selling individual assets, but rather the return that would be generated by the future operations of the emerging, restructured entity. To measure enterprise value in this way, reorganization plans primarily use a type of income approach, the discounted cash-flow (DCF) method. The DCF method estimates the net present value of future cash-flows that the emerging entity is expected to generate. Implementing the discounted cash-flow methodology requires three basic elements:Forecast of Expected Future Cash-flows. Guidance from management can be critical in developing a supportable cash-flow forecast. Generally, valuation specialists develop cash-flow forecasts for discrete periods that may range from three to ten years. Conceptually, one would forecast discrete cash-flows for as many periods as necessary until a stabilized cash-flow stream can be anticipated. Due to the opportunity to make broad strategic changes as part of the reorganization process, cash-flows from the emerging entity must be projected for the period when the company expects to execute its restructuring and transition plans. Major drivers of the cash-flow forecast include projected revenue, gross margins, operating costs and capital expenditure requirements. Historical experience of the petitioner company, as well as information from publicly traded companies operating in similar lines of business can provide reference points to evaluate each element of the cash-flow forecast.Terminal Value. The terminal value captures the value of all cash-flows after the discrete forecast period. Terminal value is determined by using assumptions about long-term cash-flow growth rate and the discount rate to capitalize cash-flow at the end of the forecast period. This means that the model takes the cash flow value for the last discrete year, and then grows it at a constant rate for perpetuity. In some cases the terminal value may be estimated by applying current or projected market multiples to the projected results in the last discrete year. An average EV/EBITDA of comparable companies, for instance, might be used to find a likely market value of the business at that date.Discount Rate. The discount rate is used to estimate the present value of the forecasted cash-flows. Valuation analysts develop a suitable discount rate using assumptions about the costs of equity and debt capital, and the capital structure of the emerging entity. Costs of equity capital are usually estimated by utilizing a build-up method that uses the long-term risk-free rate, equity risk premia, and other industry or company-specific factors as inputs. The cost of debt capital and the likely capital structure may be based on benchmark rates on similar issues and the structures of comparable companies. Overall, the discount rate should reasonably reflect the business and financial risks associated with the expected cash-flows of the emerging entity. The sum of the present values of all the forecasted cash-flows, including discrete period cash-flows and the terminal value, provides an indication of the business enterprise value of the emerging entity for a specific set of forecast assumptions. The reorganization value is the sum of that expected business enterprise value of the emerging entity and proceeds from any sale or other disposal of assets during the reorganization. Since the DCF-determined part of this value relies on so many forecast assumptions, different stakeholders may independently develop distinct estimates of the reorganization value to facilitate negotiations or litigations. The eventual confirmed reorganization plan, however, reflects the terms agreed upon by the consenting stakeholders and specifies either a range of reorganization values or a single point estimate. In conjunction with the reorganization plan, the courts also approve the amounts of allowed claims or interests for the stakeholders in the restructuring entity. From the perspective of the stakeholders, the reorganization value represents all of the resources available to meet the post-petition liabilities (liabilities from continued operations during restructuring) and allowed claims and interests called for in the confirmed reorganization plan. If this agreed upon reorganization value exceeds the value to the stakeholders of the liquidation, then there is only one more valuation hurdle to be cleared. This is an examination of whether the restructuring creates a company that will be viable for a long time—that isn’t likely to be back in bankruptcy court in a few years. We will address that process in our third and final blog post of this series. If you want to learn more about the valuation side of the bankruptcy process, and how we at Mercer can use our years of experience in bankruptcy and in the oil and gas industry to help you emerge from Chapter 11 well-prepared for future success, contact one of our valuation analysts for a confidential discussion. Footnote1ASC 852-10-20.

Brexit Just Accelerates Downward Trend in RIA Valuations

Gimme Shelter

Brexit’s full impact on the market is still to be determined, but a quick review of asset manager pricing reveals a valuation gap with the broader equity market that opened over the past twelve months, got much worse in June, and even accelerated over the past week.The headline performance comparison is striking. Over the past twelve months, while the S&P 500 rose modestly, the SNL U.S. Asset Manager index underperformed by over 24%. This trend held for seven of the last twelve months, and accelerated in June with a big blow-out post Brexit. The same asset manager index dropped almost 10% last month, versus a decline of just over 1% for the S&P 500. You can see what last week was like: brutal. Internally, at Mercer Capital, we’ve speculated as to whether or not publicly traded RIAs were essentially a synthetic futures contract on the financial markets. And if asset management firm valuations are falling, does that imply something about sentiment toward the ultimate direction of the capital markets? There is, after all, a lot of other noise to consider. AUM is piling up in passive strategies while only treading water across the industry. Equity markets feel stuck - like a helium balloon on a ceiling – in a narrow trading range at uncomfortably high multiples. The market is awash with liquidity, but actual trading activity seems to be trending downward. So if market valuations in the industry are getting a haircut, what does that mean? If you convert this market activity to some kind of discounted cash flow model, valuations would only drop if a) the cost of capital was rising, b) margins were declining, and/or c) profit growth expectations had dropped. The Cost of Capital for Asset Managers is Probably StableIf you think back to your first or second finance class, you’ll remember that the weighted average cost of capital, or WACC, has two components: the cost of equity and the cost of debt. Most asset managers have very little if any debt in their capital structures, so we really only need to be concerned with the cost of equity. The cost of equity is usually considered to be some premium to the risk free rate, represented by the yield to maturity on government debt. Yields on longer dated Treasuries have collapsed over the past month and the past year, which all else equal would reduce the cost of equity. As for the equity risk premium, in theory this should encompass both systematic risk (volatility of returns relative to the market) and non-systematic risk (issues specific to the individual company). Non-systematic risk isn’t the issue here, and industry beta – which we think of as market neutral or a bit north of 1.0 – is always de-beta-ble. All in all, though, I think it’s safe to say the cost of capital for asset managers has not increased; if anything, it should have gone down a bit. In a yield starved world, the recurring revenue stream of asset management represents a coupon-clipping opportunity that should bid the cost of capital down, and the multiple up, unless something else is also at play.Profit Margins May Have PeakedSeems like we’ve been reading about job cuts and fund consolidations and position realignments every day for weeks now. No one is acknowledging this publicly, but it feels like Q1 board meetings must have been full of internal profit warnings at RIAs. We’ve been watching fee schedules for some time now – particularly at mutual funds – and with the equity markets more or less flat-lining, it’s easy for costs to creep up. Compliance costs are rising – especially at smaller RIAs. Add to this the risk of a market pull back – especially a sustained one – tugging the wrong way on the inherent operating leverage in investment houses, and you see the risk. Hopefully the Q2 management calls will cover this topic; we’ll be there when they do.Growth (or lack thereof) May Be the Big StoryWhere is the growth in the investment management industry? Major indices are not cheap. Indexing is grabbing market share. Clients are more and more fee conscious. Wealth management firms have the built-in relationship advantage, but need a good market tailwind to offset client spending. Client acquisition is always an opportunity, but industry-wide is a zero sum game. So maybe growth challenges (top line or bottom line – your choice) are what we’re seeing in public asset manager pricing. We’ve sounded this alarm before, but the tone of the alarm is getting louder.Moves like JaggerI once saw an interview with Mick Jagger in which he said that, growing up, his most likely career was to be a teacher. His dad taught, and Jagger figured that after he finished with the band-thing he would teach English. By the time he banged up his Aston Martin 50 years ago, Jagger probably knew he didn’t have a future in education. But even then I doubt he foresaw the five decade music career ahead. When ERISA came to be 42 years ago, no one would have expected the asset management industry to grow like it did. As a consequence of that growth, lots of managers got their satisfaction, but after the past eight years many others are probably facing their 19th nervous breakdown.

E&P Third Quarter 2016

Region Focus: Bakken

Region Focus: Bakken Oil prices trended up for the beginning of the third quarter but ended the quarter about where they started.

Brexit and Killen Underscore the Need for Buyer Protection in Asset Manager Transactions

Black swan events and the very nature of the asset management business illustrate the importance of contingent consideration in RIA acquisitions for prospective buyers. The volatility associated with equity managers means AUM and financial performance can swing widely with market conditions, so doubling down on a one-time payment for an RIA can be extremely risky, particularly at high valuations. Of course, the market can just as easily pivot in the buyer’s favor after the deal closes, but gaining Board approval for such gambles is an exercise in futility if insurance is available in the form of contingent consideration.Back in December, we blogged about Tri-State Capital’s recently announced acquisition of $2.6 billion manager, The Killen Group of Berwyn, PA. The deal terms included an initial $15 million payment and contingent consideration of 7x any incremental growth in Killen’s annual run rate EBITDA in excess of $3 million for the pending calendar year (2016). Upon announcement, the estimated total deal value was in the $30-$35 million range, but when the deal closed in April, this estimate dropped to $15-$20 million. The table below illustrates the implied valuation metrics and returns had this deal been structured as a one-time payment under the two value scenarios. Fortunately for Tri-State, the bank elected to structure the deal as an earn-out whereby roughly half of the total potential consideration was guaranteed and the remaining half had to be “earned” by meeting certain earnings objectives following deal closure. The downward revision implies that the business is not likely to generate more than $3 million in EBITDA this year, and an ~11x purchase for a closely held RIA with compliance issues and a declining AUM balance (ADV disclosures indicate that Killen’s AUM fell 27% in 2015) would have been hard to justify had the total deal value been paid up front. Instead, Tri-State is still likely to boast a decent ROI on this deal without paying another dime for it if the business fails to perform in line with initial expectations. The following table shows the implied total deal value under four different scenarios of EBITDA for this year. Under this structure, the seller is incentivized to ensure the business continues to perform after the initial payment. This assurance is critical in many RIAs that are often heavily dependent upon the selling shareholder(s) for client relationships or investing acumen. If key accounts are not transitioned to the prospective acquirer or the market corrects itself following the transaction, the buyer will likely be off the hook for further consideration. Contingent consideration doesn’t always have to be based on future earnings. Perhaps the most acquisitive business in the RIA space is Affiliated Managers Group, whose investment model includes a revenue sharing agreement whereby the target’s fees are split (at a fixed percentage) into two segments: the operating allocation and the owners’ allocation. The operating allocation covers all operating expenses of the affiliate (target) at the discretion of the target’s management, while the owner’s allocation goes to the firm’s partners and AMG according to their respective ownership interest in the business. [caption id="attachment_11668" align="aligncenter" width="500"]Source: AMG[/caption] This structure allows the affiliate to retain operating autonomy while limiting AMG’s exposure to operating leverage because the owners’ allocation is set at a fixed percentage of revenue, not earnings. Since there’s usually some portion of an asset manager’s expense base that is predominantly fixed, earnings are typically more volatile than fee income, so the revenue sharing agreement is a partial hedge against earnings volatility during a Brexit or other black swan event. Still, the best hedge against a market downturn is a solid profit margin, as we’ve discussed in a prior post. With Brexit coinciding with a quarterly billing cycle for many asset managers, earnings are likely to take a huge hit along with the market. Those RIAs with a robust EBITDA margin will likely stay in the black as opposed to their less profitable counterparts that may be under water until market conditions improve.

M&A Activity in the Bakken

Crude prices in North Dakota are even lower than the already depressed price of WTI and Brent. This is largely due to region’s insufficient pipeline network. This creates high transportation costs, and in turn decreases realized wellhead prices. As of June 15th crude oil prices in North Dakota were almost 20% lower than the price of WTI and 21% lower than the price of Brent. On top of lower revenue per barrel, the Bakken faces higher initial drilling costs than many other mineral reserves. Together these factors mean that production is not economically feasible in the current low price environment. As of June 17, even as oil prices rose to above $45 per barrel, Baker Hughes reported that there were only 24 rigs operating in North Dakota. In order to survive, when producing is no longer economically feasible, production companies are selling “non-core” assets to generate the cash.In October of 2015, Occidental Petroleum Corporation sold its Bakken Assets to Lime Rock Resources. This sale marked the first exit of the downturn by a major oil company from the Bakken Shale formation. So far, M&A activity of Bakken assets has slowed in 2016, but most Bakken assets are selling for heavy discounts making them attractive to buyers. Some other recent transactions in the Bakken are highlighted below.The sale of Emerald Oil’s Bakken assets can help us understand the current pricing environment. Emerald Oil, an independent producer in the Williston Basin, filed for Chapter 11 Bankruptcy on March 22 and was delisted from the NYSE on March 24. During this time, Emerald had entered into a deal with Latium Enterprises to sell acreage at $1,740 per acre, but the transaction fell through. Last month, Emerald Oil announced that CL Energy Opportunity fund would buy substantially all of their assets for $73 million which equates to less than $980 per acre. This represents a 44% haircut in just two months. What we see in this case is a continuing fall in the value of acreage as investors learn that assets in the Bakken can be bought at even lower discounts if they wait for the continuation of low oil prices to put more and more pressure on distressed buyers to make a sale. While this is a stalking horse offer, they are not likely to get much higher on the final deal. As Emerald oil became more desperate to reorganize in order to avoid Chapter 7 bankruptcy, they became more willing to sell at a lower price.Oil Prices are expected to remain low into the third quarter of this year and possibly into the second quarter of 2017. As the price of oil remains depressed, many companies avoiding bankruptcy or reorganizing through Chapter 11 will be forced to sell non-core assets in order to generate cash. In a distressed market, it is extremely important to push for the best offer possible. Mercer Capital can help you understand the true value of your assets and can help you through the Chapter 11 Process.

A Watched Pot Never Boils: Still Waiting on Margin Relief

As expected after lackluster job gains in May, the Federal Open Market Committee declined to raise the Fed Funds target at the latest policy meeting on June 15th. While the majority of policymakers still expect the Fed to boost rates twice before the end of this year, the number of officials who forecast just one rate hike increased from one to six from the previous forecasting round in March. In addition, Fed officials lowered their expectations for future years, now expecting the fed funds rate to rise to 1.6% by year-end 2017, down from the 1.9% estimate in March, and 2.4% in 2018, down from the previous estimate of 3.0%. During a press briefing on June 3rd, members of the Economic Advisory Committee of the American Bankers Association said they still expect the Fed to boost rates twice before the end of this year, but after years of speculation regarding timing of rate increases, when that will happen remains anyone’s best guess. The bond market never believed the forecasts.Rate increases are long awaited by community bankers as banks are facing profitability challenges. Net interest margins continue to compress and loan growth remains stymied by intense competition for high quality loans. Margin relief remains out of the grasp of most community banks, absent further rate hikes beyond the December 2015 hike. After rebounding modestly in the third and fourth quarter of 2015, the median net interest margin of community banks (defined as those with assets between $100 million and $5 billion), ticked down modestly in the first quarter of 2016 as intense competition for quality loans drove down loan yields and the decline in long-term rates put downward pressure on securities’ yields (Charts 1 and 2). Overall, median net interest income continued to increase as growth in loans offset margin compression, but intense competition raises concerns over how much credit standards have been relaxed to drive loan growth. Although the majority of banks’ balance sheets are poised to take advantage of rising rates, the lift to net interest margins is dependent on asset yields rising faster than the cost of funds (Chart 3). While deposits costs essentially reached a floor several quarters ago, data suggests the threat of rising deposit rates may limit margin expansion in a rising rate environment. As shown in Chart 4, the percentage of banks reporting quarter-over-quarter increases in the cost of interest bearing deposits has been trending upward over the last eight quarters. In a higher rate environment, customers are more likely to shop around for higher rates. The increase observed in interest bearing accounts could reflect the fact that higher loan growth has compelled some banks to raise rates or perhaps an effort to build goodwill with customers in anticipation of rising rates and increased rate sensitivity. For banks with asset sensitive balance sheets, the benefit of rising interest rates will be greater the stickier low cost deposits are. While net interest margin is a key metric for banks, focusing on other drivers of profitability is one way to combat margin compression in the face of further delays in interest rate hikes or upward pressure on deposit costs. Consider the following: Look for opportunities to grow non-interest income. One strategic option may be to expand bank offerings into non-traditional bank business lines that are less capital intensive and offer prospects for non-interest income growth such as acquisitions or partnerships with insurance, wealth management, specialty finance, and/or financial technology companies. FinTech’s consumer-focused technology and ability to quickly adapt can pair well with community banks who can provide an established customer base and knowledge of the regulatory process and environment. For more information, we recently wrote an article on why current market conditions may be ripe for FinTech partnerships.Leverage technology to curb efficiency ratios. Compliance and regulatory costs continue to rise and represent a bigger burden to community banks who lack the scale to accommodate these expenses in comparison to their larger peers. A recent article from American Banker included data presented by Chris Nichols, chief strategy officer of CenterState Banks, at a recent fintech conference in Atlanta that shows why engaging customers digitally is more efficient. Furthermore, a recent article published on SNL highlights how, in some regards, community banks can be quicker to adopt new technology than larger peers. While size may limit what projects are feasible for community banks, agility has its benefits.Increase scale. Create economies of scale and improve profitability organically or by merging with a larger company. Organic loan growth is an obvious cure to the margin blues, but must be achieved while maintaining credit quality and holding adequate capital. M&A remains a classic solution to revenue headwinds in a mature industry, and bank acquirers can potentially have savings beyond expense synergies with some NIM relief resulting from potential accretion income on the acquired assets, which are marked to fair value at acquisition. Mercer Capital has a long history of working with banks and helping to solve complex problems ranging from valuation issues to considering different strategic options. If you would like to discuss your bank’s unique situation in confidence, feel free to contact us.

Bankruptcy: An Overview

On June 20th, 2014 the price for a barrel of crude oil on the NYMEX reached $107.26. Analysts’ beginning of the year predictions, which priced oil at over $100 for the year, appeared accurate. Few if any expected oil prices to fall, and then keep falling to a dip below $30. Even with hedges in place, this unexpected, sustained price drop has crippled oil E&P revenues. Natural gas E&Ps are suffering from low prices as well. Producers have been operating in a low price environment for five years, but the last time that we saw prices this low was in 2012 during the onset of horizontal drilling. Unlike in 2012, new production and discoveries, particularly in the Marcellus and Utica, mean the oversupply is here to stay. Henry Hub prices are not expected to exceed $4 per MCF for at least 5 years. Many investments in both oil and gas that once projected to generate strong positive cash flows and profits no longer can generate enough cash to support the debts used to fund the project. Thus, as prices remain low, more and more companies are running out of cash to support once manageable debts. 42 oil and gas E&P companies went bankrupt in 2015, and 39 have declared bankruptcy from the beginning of the year to May of 2016. Oilfield services, whose business depends on these E&P companies, have experienced a similar spike in bankruptcies.For these E&P and services companies, the decision to file for bankruptcy does not have to signal the demise of the business. Despite the sense of doom often associated with the word “bankruptcy,” if executed properly Chapter 11 reorganization in fact affords these financially distressed or insolvent companies an opportunity to restructure their liabilities and emerge as sustainable going concerns. Once a petition for Chapter 11 is filed with the bankruptcy court, the company usually undertakes a strategic review of its operations, including opportunities to shed assets or even lines of businesses. During the reorganization proceeding, stakeholders, including creditors and equity holders, negotiate and litigate to establish economic interests in the emerging entity. The Chapter 11 reorganization process concludes when the bankruptcy court confirms a reorganization plan that specifies a reorganization value and that reflects the agreed upon strategic direction and capital structure of the emerging entity.In addition to fulfilling technical requirements of the bankruptcy code and providing adequate disclosure, two characteristics of a reorganization plan are germane from a valuation perspective:1The plan should demonstrate that the economic outcomes for the consenting stakeholders are superior under the Chapter 11 proceeding compared to a Chapter 7 proceeding, which provides for a liquidation of the business.Upon confirmation by the bankruptcy court, the plan will not likely result in liquidation or further reorganization. Within this context, valuation specialists can provide useful financial advice in order to:Establish the value of the business under a Chapter 7 liquidation premise.Measure the reorganization value of a business, which outlines both the haircuts required of pre-bankruptcy stakeholders and the capital structure of the emerging entity. A reorganization plan confirmed by a bankruptcy court establishes a reorganization value that exceeds the value of the company under a liquidation premise.Demonstrate the viability of the emerging entity’s proposed capital structure, including debt amounts and terms given the stream of cash-flows that can be reasonably expected from the business. To learn more about these three steps, and how Mercer Capital’s decades of experience in both oil and gas and bankruptcy valuation can bring value to the company and its stakeholders in each step, read Bridging Valuation Gaps for Undeveloped and Unproven Reserves. Footnote1Accounting Standards Codification Topic 852, Reorganizations (“ASC 852”). ASC 852-05-8.

The Importance of Specialization in Investment Management

A Review of Philip Palaveev’s The Ensemble Practice

In an industry characterized by constant pressure to adapt to market conditions and offer highly specialized client service, many financial advisors still spend a significant portion of their time acquiring new clients rather than collaborating with other professionals. According to Philip Palaveev in his recent book The Ensemble Practice, the majority of financial advisory practices still function as "solos," or one individual against the entire market. This practice is inherently problematic in its lack of sustainability and the problems it poses for an owner who desires to leave a legacy post-retirement.Palaveev argues that, like prehistoric hunters and gathers, solo firms face constrained resources and limited growth due to the amount of time owners must spend on business development. Just as the discovery of agriculture allowed for specialization and the sharing of knowledge and resources, a team-based approach to asset management allows employees to focus on the cultivation of relationships with clients and other professionals. The result, again according to Palaveev, is a lasting organization with more predictable revenue streams.The book defines this organization as an "ensemble," or a team of financial advisory professionals that relies on the team rather than an individual to service and manage client relationships. The advice to shift away from reliance on the owner as a key man is very similar to the recommendations we heard in Success and Succession, but Palaveev offers insight into how and why to develop an ensemble practice even before succession planning becomes a priority.According to the book, an ensemble practice offers a number of tangible advantages. Ensembles are proven to grow faster, attract larger client relationships, achieve higher levels of profitability, and create more substantial long term value for their principals. However, they do require owners to relinquish some control, and not just in terms of influence on the business. A principal in an ensemble practice must ultimately accept a less flexible lifestyle due to his participation in an ambitious team of people. In addition, the process of actually achieving ensemble status is difficult, especially for firms with an ingrained individualistic sales culture. All considered, an ensemble practice offers a number of additional benefits that are promoted throughout the remainder of the book.Leverage and Growth. One of the first steps in the evolution towards ensemble status is the addition of less experienced professionals who can help increase profitability through leverage. According to Palaveev, hiring professionals with less experience and training them is the "most reliable path to building a valuable firm." Though a new hire will require a significant amount of investment, his inexperience will allow the senior advisor to continue to fashion the culture of the firm. This associate increases the income generating capacity of the senior advisor while incurring less expense for the firm per labor hour as compared to a more experienced individual. In addition, the associate can be mentored by the owner and allow for the future growth of the practice. A young, inexperienced professional helps incorporate enthusiasm and energy with the wisdom and relationship of the owner. However, Palaveev warns against a culture in which tenure leads to guaranteed promotion. He argues that 100% "home grown" firms are susceptible to inefficiencies and the possibility of missing out on new ideas and perspectives.Legacy. Eventually, the new associates hired will form the next generation of senior advisors and allow for the possibility of internal succession. In accordance with the advice offered in Success and Succession, Palaveev suggests that internal succession is more reliable and offers the owner more control over the terms of his exit. In contrast, external transactions involve years of hard transition work and the prospect of seeing a stranger take over the practice. Emphasis is again placed on starting the transition process early, because although in a growing firm staying invested will maximize the value to the majority owner, it will leave him with a highly valuable but highly illiquid “chunk of stock.” In conclusion, this book provides valuable insight into how to successfully navigate the transition to an ensemble practice and highlights both the short term and long term benefits of this transition. It shares many themes with Success and Succession and helps solidify the importance of reducing key man risk early in the life of a practice. We would note that, in our experience, it requires a certain scale to implement the ensemble strategy, and it’s a bit of a chicken-and-egg issue as to whether you build a large enough practice first using a more traditional, individualistic sales culture and then try to redirect the culture toward specialization, or invest in specialization up front and hope the clients will come in to justify the overhead. One strategy has certain risks for the top-line, the other clearly affects the margin. In either event, Palaveev seems to capture the importance of specialization – which is significant in any profession – and provides a roadmap to implementation in a traditional investment management firm.

Bridging Valuation Gaps: Part 3

At Mercer Capital we recognize that the low price environment is forcing many E&P companies either to sell reserves to improve their cash balance, or to reorganize through Chapter 11 restructuring. This is the third and final post in a series aimed at helping E&P companies to navigate the sale of non-core assets and bankruptcy by examining how option pricing, a sophisticated valuation technique, can be used to understand the future potential of the assets most affected by low prices, PUDs and unproven reserves. In past posts we discussed the difficulties of valuing PUDs and unproved reserves in low-price markets, and when option pricing can provide a more accurate valuation. In this third and final post we want to delve into the specifics of adapting option pricing from shares of stock to oil and gas, highlighting some of the challenges and key steps of the process.Pitfalls and Fine PrintOption pricing, most often used in valuing stock options, can incorporate factors overlooked by a traditional DCF and enable a company to show to potential buyers or stakeholders the value of PUDs and unproved reserves even in low-price environments. There are, however, key differences in PUD optionality and stock options that create limitations to the model and can make it challenging to implement. Below are some areas where keen, rigorous analysis can be critical:Observable Market. The DCF is typically the best estimate of reserve value, followed by the market approach. This relationship flips when crude prices fall. Market participants understand that prices will eventually recover while it is more difficult to show this expectation using a terminal value for the DCF because the precise date of market recovery is unknown. However, today the prices have fallen so far for so long that the market approach is no longer accurate either. The oil and gas market is operating like a department store having a going out of business sale. In these moments an option pricing method is particularly useful, as it can more fully account for the volatility of oil and gas prices—which have both year to year supply and demand changes and significant seasonal swings.Risk Quantification. We have found that oil and gas price volatility benchmarks (such as long term index volatilities) are not all-encompassing risk proxies when valuing specific oil and gas assets. If not analyzed carefully, the model can struggle to capture some critical production profile and geologic risks that could affect future cash flow streams considerably. Risks include production profile assumptions; acreage spacing; localized pricing versus a benchmark (such as Henry Hub or West Texas Intermediate Crude); and statistical “tail risk” in the assumed distribution of price movements.Sensitivity to Capital Expenditure Assumptions. Analysis of an asset or a project’s cash flows can be particularly sensitive to assumed capital expenditure costs. In assessing capital expenditure’s role as both a cash flow input and an option model input, estimations of future costs can be very challenging, but are an important assumption to measure properly as they drive much of the calculated value.Drilling Resource Availability and Service Costs. When oil and gas prices fall, the availability of drilling resources tends to rise while the costs of drilling and oilfield services often fall precipitousl These factors can create an oscillating delta in both cost and timing uncertainties as the marketplace responds by investing capital into underdeveloped reserves while the fuse burns on existing lease rights.Time to Expiration. This input can require granular analysis of field production life estimates coupled with expiring acreage rights, and then adjusted for the drilling plans of an operator. The resulting time-weighted estimate can present problems with assumption certainty. The time value of an option can increase significantly if the mineral rights are owned; unconventional resource play reserves are included; there are foreign reserves; or the reserves are held by production. In these instances, the PUD and unproved reserve option to drill can be deferred over many years, making the option more valuable by increasing the chance of market fluctuations that will make the reserves profitable.SummaryUtilization of modified option theory is not in the conventional vocabulary of many oil patch dealmakers, but the concept is considered among E&P executives as well during transactions in non-distressed markets. This application of option modeling becomes most relevant near the bottom of historic cycles for a commodity. If the right to drill can be postponed for an extended period of time, (i.e. five to ten years), the time value of the out-of-the-money drilling opportunities can have significant worth in the marketplace.We caution, however, that there are limitations in the model’s effectiveness. Specific and careful applications of assumptions are needed, and even then Black Sholes’ inputs do not always capture some of the inherent risks that must be considered in proper valuation efforts. Nevertheless, option pricing can be a valuable tool if wielded with knowledge, skill, and good information, providing an additional lens to peer into a sometimes murky marketplace. Today’s marketplace is particularly murky, and an accurate appraisal is extremely valuable since establishing reasonable and supportable evidence for PUD, probable, and possible reserve values may assist in a reorganization process that determines the survival of a company. Given these conditions we feel that the benefits of using option pricing far outweigh its challenges.Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Bridging Valuation Gaps: Part 2

The current low price environment is affecting the finances of many E&P companies. At Mercer Capital we recognize that whether companies are looking to sell reserves to improve their cash balance, or are trying to generate reorganization cash flow projections during a Chapter 11 restructuring, understanding how to value PUDs and unproven reserves is crucial to survival in a down market.Option PricingOne of the primary challenges for industry participants when valuing and pricing oil and gas reserves is addressing PUDs and unproven reserves. As discussed in the first post of this installment, if one relied solely on the market approach many of these unproven reserves would be deemed worthless. Why then, and under what circumstances, might the unproven reserves have significant value?The answer lies within the optionality of a property’s future DCF values. In particular, if the acquirer has a long time to drill, one of two forces come into play: either the PUDs potential for development can be altered by fluctuations in the current price outlook for a resource, or, as seen with the rise of hydraulic fracturing, drilling technology can change driving significant increases in the DCF value of the unproven reserves.This optionality premium or valuation increment is typically most pronounced in unconventional resource play reserves, such as coal bed methane gas, heavy oil, or foreign reserves. This is additionally pronounced when the PUDs and unproven reserves are held by production. These types of reserves do not require investment within a fixed short timeframe.Current Pricing Environment: Challenge = OpportunityAs oil prices have dropped—the high WTI price over the past six months was under $50 and the low under $30—PUD values may drop from 75 cents on the dollar to 20 cents on the dollar or less. After the last Recession, some PUDs faced a similar, yet more modest, decline in prices. The price level recovery for PUDs in 2011 was partly attributable to the recovery in the U.S. and global economies, and partly due to increases in the price of oil. Valuation would be made easier if we could determine when oil prices would rise again. Let us look then to see what might change prices going forward. The consensus is that five main factors have significantly increased the world supply of oil and driven down prices: The continued success of shale drillers in the U.S.OPEC’s choice to increase and hold production levels.The U.S.’s elimination of restrictions on crude oil exports.The recent lifting of Iran’s sanctions and the anticipation of additional supply from war-torn countries of Libya and IraOil consumption slowing down in countries like China. While this sounds promising, we must remember the crash in oil prices in 1985 that remained below $20 until 2003. Every analyst has a best guess of what will happen, but there are simply too many variables involved in shifting oil prices to make accurate forecasts. Changes in any of the five drivers of low oil listed above could dramatically impact oil prices; and some of those drivers, such as the relationship between Iran and Saudi Arabia or China’s growth—contain thousands of variables that make them almost impossible to predict. In addition to all these considerations, the potential for technological changes creates another unpredictable component. A common solution in DCF models is to use the NYMEX WTI futures to project price. However, studies show that, even though buyers are estimating the value of this option into the prices they are willing to pay, this too is not a very accurate predictor of the future. When NYMEX forecasts $35 per barrel it could actually be $45 when that future date rolls around. Experienced dealmakers realize that the NYMEX future projections amount to informed speculation by analysts and economists which that many times vary widely from actual results. Note in the chart above how much the future forecasted prices changed in only one year. So what actions do acquirers take when values are out of the money in terms of drilling economic wells? Why do acquirers still pay for the non-producing and seemingly unprofitable acreage? In many cases they are following an options framework. Real Options: Valuation FrameworkPUDs are typically valued using the same DCF model as proven producing reserves after adding in an estimate for the capital costs (capital expenditures) to drill. Then the pricing level is adjusted for the incremental risk and the uncertainty of drilling “success,” i.e., commercial volumes, life and risk of excessive water volumes, etc. This incremental risk could be accounted for with either a higher discount rate in the DCF, a RAF or a haircut. Historically, in a similar oil price environment as we face today, a raw DCF would suggest little or no value for the PUDs or unproven reserves.In practice, undeveloped acreage ownership functions as an option for reserve owners; they can hold the asset and wait until the market improves to start production. Therefore an option pricing model can be a realistic way to guide a prospective acquirer or valuation expert to the appropriate segment of market pricing for undeveloped acreage. This is especially true at the bottom of the historic pricing range occurring for the natural gas commodity currently. This technique is not a new concept as several papers have been written on this premise. Articles on this subject were written as far back as 1988 or perhaps further, and some have been presented at international seminars.The PUD and unproved valuation model is typically seen as an adaptation of the Black Scholes option model. It is most accurate and useful when the owners of the PUDs have the opportunity, but not the requirement, to drill the PUD and unproven wells and the time periods are long, (i.e. five to 10 years). The value of the PUDs thus includes both a DCF value, if applicable, plus the optionality of the upside driven by potentially higher future commodity prices and other factors. The comparative inputs, viewed as a real option, are shown in table below. When these inputs are used in an option pricing model the resulting value of the PUDs reflects the unpredictable nature of the oil and gas market. This application of option modeling becomes most relevant near the bottom of historic cycles for a commodity. In a high oil price environment adding this consideration to a DCF will have little impact as development is scheduled for the near future and the chances for future fluctuations have little impact on the timing of cash flows. At low points, on the other hand, PUDs and unproved reserves may not generate positive returns and thus will not be exploited immediately. If the right to drill can be postponed for an extended period of time, (i.e. five to ten years), those reserves still have value based on the likelihood they will become positive investments when the market shifts at some point in the future. In the language of options, the time value of the out-of-the-money drilling opportunities can have significant worth. This worth is not strictly theoretical either, or only applicable to reorganization negotiations. Market transactions with little or no proven producing reserves have demonstrated significant value attributable to non-producing reserves, demonstrating the recognition by some buyers of this optionality upside. All that said, there are some challenges and dangers in applying the options model to reserves. These issues will be covered in part three of this series. To learn more about option pricing, and whether it could help your company reach optimal results either in sales or bankruptcy negotiations, please contact Mercer Capital. Conversations are in confidence, and our experts combine decades of experience in both oil and gas and bankruptcy to help you succeed.

2016 Q1 Analyst Call Report

Our quarterly summary of analyst calls is as revealing as usual, as pacemakers in the asset management sector review this quarter’s performance and how it may shape the year ahead.Investor sentiment in the first half of last quarter indicated a growing fear of another U.S. recession, as commodity prices continued to drop while initial jobless claims increased and global growth stalled. By late March, however, commodity prices began to stabilize as central banks adopted easing plans to stimulate growth and the dollar eased against foreign currencies, on balance keeping equity prices relatively flat over the quarter despite interim volatility. Overall, the market continues to experience a shift from growth to value stocks that has increased prices, depressed earnings, and further engendered the flight to passive strategies within the RIA industry.Theme 1: A rocky start to the year has led to a modest pullback in the sector, despite a rebound in the second half of the quarter.“Weak and volatile markets for the first half of the quarter curtailed demand for return seeking assets. We felt this in particular in global high yield end equities” – Peter Kraus, AB“Despite a really difficult start to the year across most equity indices, despite a lot of volatility and a V-shaped recovery at the end of the quarter, we’re encouraged by the improvement in total company net flows, driven by ongoing strength across a number of different strategies.” - Richard Maccoy Weil, JNS“The first quarter of 2016 was defined by extreme volatility with large daily swings in asset prices and a sharp reversal in returns. S. equity markets begin the year on an extremely weak note with the S&P 500 posting its worst start in history. […] From this low, equities and commodities moved sharply higher over the remainder of the first quarter, resulting in most industries registering modestly positive returns for the period.” – Brian Casey, WHG“The unusual market volatility during the quarter created an environment that few active managers navigated successfully. Persistently slow growth, unusually accommodative global central banks, negative interest rates, and the uncertainty regarding the upcoming U.S. elections remain at the forefront of investor concerns.” – Philip James Sanders, WDRTheme 2: Much like the U.S., the global market started the quarter on a sour note, only to rebound later in the quarter due to central bank easing across the board (from the ECB to the Bank of Japan), as well as growth within emerging markets.“Exchange rates continue to be a challenge for us in Europe, but have improved recently. In Asia, many of our global trading clients have reduced risks. We’re only just beginning to see them come back into the emerging market asset class.” – Peter Kraus, AB“Turning to international business, we continue to see very strong growth. […] We’re winning business in Japan from both institutional and retail investors.” - Weil, JNS“Central bank policy makers were once again the major catalyst behind the market’s recovery. With the European Central Bank, Bank of Japan, and the People’s Bank of China providing additional stimulus, while the Federal Reserve did its part by once again delaying any additional rate hikes. As we’ve seen with previous central bank driven rallies, low quality, high-data names were the top performers over the second half of the quarter.” – Brian Casey, WHGTheme 3: The battle against active management is likely to continue, with firms trying to find ways to provide a balanced mix to customers while maintaining margins and differentiating from competitors.“I think that passive active battle is going to continue. I think investors have concluded so far that the way they experience active management in the last 20 years has been unproductive for them. […] We don’t think that’s rational, we don’t think it’s right, we understand why you are doing it, [and] we don’t think that’s right, but the answer the industry has to have and that we are promoting is to have managers who, one, are very capacity constrained; and, two, are investing in high conviction ideas and have, as I say, marginally different portfolios” – Peter Kraus, AB“This was a very difficult quarter for all active managers. So it was difficult for us to make the progress we might have hoped for against our performance fees. […] The challenges on the U.S. side are somewhat related to investment performance. I think they’re somewhat related to what’s going on in the marketplace for the main client base; the pressure that is created when many of those clients are looking at barbelling their portfolio and going for a large portion of passive and then very active for the remainder.” – Weil, JNS“In some ways, asset management companies are a little bit like ferryboats. You don’t want everybody running to the same rail at the same time because it causes the boat to rock a lot more than it otherwise would. And having this diversification in terms of products and having this diversification in terms of clients moving in different directions at different times is very helpful for maintaining the overall stability of the franchise.” – Weil, JNS“As we look forward, we see investors at a crossroads from an asset allocation perspective. Many have been disappointed by their allocation with the hedge funds. They are concerned over their fixed income valuations and are looking for where they can source returns to achieve their required rates of return.” - Brian Casey, WHGTheme 4: As a result of the growing demand for passive products, ETFs are gaining ground in popularity and demand, thereby making them even cheaper.“With clients increasingly using ETFs, with the majority of U.S. retail fund flows going to ETFs, it’s imperative that we’re able to develop, launch, and successfully raise ETF assets. […] I think to be successful in the ETF space, I don’t think you can just have one or two offerings. I think you need to offer a few more than that, and we will. It’s hard to predict with great confidence exactly which ETF will be more successful.” – Weil, JNS“I turn to ETFs, which is a very small business for us and it’s still in the early stages. But in terms of new products and in efforts going forward, I think there’s a lot of time and effort being spent there, [and] that’s becoming increasingly a much more important part of the retail investors diversified portfolio, [and] we want to assist with that, so I think there’s a great opportunity there.” – George Aylward, VRTS“Last week, we filed a registration statement with the Securities and Exchange Commission to register three exchange-traded managed funds, or ETMFs. We continue to believe ETMFs are unique and progressive investment product options that in time will be adopted broadly in the marketplace.” – Thomas W. Butch, WDRMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter at @RIA_Mercer.

Are Market Conditions Driving More FinTech Partnerships and M&A?

It has been an interesting few weeks for FinTech.Coming off recent years where both public and private FinTech markets were trending positively, the tail end of 2015 and the start to 2016 have been unique as performance has started to diverge.The performance of public FinTech companies has been relatively flat through the first quarter of 2016 (see Public Market Indicators on page 3 of the First Quarter 2016 FinTech newsletter), and signs of weakness have been observed in alternative/marketplace lending, as well as some of the more high profile FinTech companies that have gone public recently.The median return of the FinTech companies that IPO’d in 2015 was a decline of 16% since IPO (through 3/31/16). For perspective, Square, OnDeck, and Lending Club are each down significantly in 2016 (down 28%, 53%, and 64%, respectively from 1/1/2016 to 5/18/2016).Also, the broader technology IPO slowdown in late 2015 has continued into 2016 and no FinTech IPOs have occurred thus far in 2016.However, optimism for FinTech still abounds, and the private markets continue to reflect that with robust investor interest and funding levels.In 2016, 334 FinTech companies raised a total of $6.7 billion in funding in the first quarter (compared to 171 companies raising $3.2 billion in the first quarter of 2015), and Ant Financial (Alibaba’s finance affiliate) completed an eye-popping $4.5 billion capital raise in April.While the factors driving this divergence in performance between public and private markets are debatable, the divergence is unlikely to continue indefinitely.A less favorable public market and less attractive IPO market creates a more challenging exit environment for those “unicorns” and other private companies.Headwinds for the private markets could develop from more technology companies seeking IPOs and less cash flow from successful exits to fund the next round of private companies.Consequently, other strategic and exit options beyond an IPO should be considered such as partnering with, acquiring, or selling to traditional incumbents (banks, insurers, and money managers).The potential for M&A and partnerships is even more likely in FinTech, particularly here in the US, due to the unique dynamics of the financial services industry including the resiliency of traditional incumbents and the regulatory landscape.For example, consider a few of the inherent advantages that traditional banks have over non-bank FinTech lenders:Better Access to Funding. Prior to 2016, the interest rate/funding environment was very favorable and limited the funding advantage that financial institutions have historicallyhad relative to less regulated non-financial companies.However, the winds appear to be shifting somewhat as rates rose in late 2015, and funding availability for certain FinTech companies has tightened. For example, alternative lenders are dependent, to some extent, on institutional investors to provide funding and/or purchase loans generated on their platform, and a number have cited some decline in institutional investor interest.Banks Still Have Strong Customer Relationships. While certain niches of FinTech are enhanced by demand from consumers and businesses for new and innovative products and technology, presently, the traditional institutions still maintain the majority of customer relationships.As an example, the 2015 Small Business Credit Survey from the Federal Reserve noted that traditional banks are still the primary source for small business loans with only 20% of employer firms applying at an online lender.The satisfaction rate for online lenders was low (15% compared to 75% for small banks and 51% for large banks).The main reasons reported for dissatisfaction with online lenders was high interest rates and unfavorable repayment terms.Regulatory Scrutiny and Uncertainty related to FinTech.Both the Federal Reserve and the OCC have made recent announcements and comments about ways to regulate financial technology.In the online lending area specifically, regulatory scrutiny appears to be on the rise with the Treasury releasing a white paperdiscussing the potential oversight of marketplace lending and the CFPB signaling the potential to increase scrutiny in the area.The lack of a banking charter has also been cited as a potential weakness and has exposed certain alternative lenders to lawsuits in different states.At the same time that FinTech companies are increasingly considering, or being forced to consider, strategic options beyond an IPO, traditional incumbents are starting to realize that they must develop a strategic plan that considers how to evolve, survive, and thrive as technology and financial services increasingly intersect.For example, a number of banks are looking to engage in discussions with FinTech companies.A recent survey from BankDirector noted that boards are focusing more on technology with 75% of respondents wanting to understand how technology can make the bank more efficient and 72% wanting to know how technology can improve the customer experience.FinTech presents traditional financial institutions with a number of strategic options, but the most notable options include focusing on one or some combination of the following: building their own technology solutions, acquiring a FinTech company, or partnering with a FinTech company.One area where we have started to see more FinTech partnerships and M&A already start to play out is wealth management and the industry’s response to robo-advisory.Robo-advisers were noted by the CFA Institute as the FinTech innovation most likely to have the greatest impact on the financial services industry in the short-term (one year) and medium-term (five years).Consider the following announcements in this area over the last few years; on the acquisition front, BlackRock’s acquisition of FutureAdvisor in August 2015, Invesco’s acquisition of Jemstep, and Ally Financial’s acquisition of TradeKing in April 2016.On the partnering front, Motif and J.P. Morgan announced a partnership in October 2015, UBS announced a major partnership with SigFig in May 2016, and Betterment and Fidelity announced a partnership in October 2014. Community banks will also have an opportunity to enter the robo-advisory fray as Personal Capital announced a partnership with Alliance Partners that will allow over 200 community banks offer digital wealth advisory tools.While we do not yet know which strategy will be most successful, discussions of whether to build, partner, or buy will increasingly be on the agenda of boards and executives of both financial institutions and FinTech companies for the next few years.The right combination of technology and financial services through either partnerships or M&A has significant potential to create value for both FinTech companies and traditional financial institutions.Any partnership or merger should be examined thoroughly to ensure that the right metrics are utilized to examine value creation and returns on investment.Transactions and significant partnerships also have significant risks and potential issues will need to be discussed.For example, significant issues with M&A and potential partnerships can include: execution and cultural issues, shareholder dilution, whether the partnership is significant enough to create shareholder value and provide a return on investment, contingent liabilities, and regulatory pressures/issues.These issues must be balanced with the potential rewards, such as customer satisfaction/retention, shareholder value creation, and return on investment.If you are interested in considering strategic options and potential partnerships for your financial institution or FinTech company, contact Mercer Capital. Financial institutions represent our largest industry focus for over thirty years. We have a deep bench with experience with both FinTech companies and traditional financial institutions (banks, asset managers, and insurance companies).This uniquely suits us to assist both as they explore partnerships and potential transactions.

Bridging Valuation Gaps: Part 1

Due to a precipitous drop in oil prices since June 2014, oil exploration and production companies in the U.S. have struggled to pay their debts and in many cases have had to file for bankruptcy. This is the first post in a three part series examining how option pricing, a sophisticated valuation technique, can be used to understand the future potential of the assets most affected by low prices, PUDs and unproven reserves. Whether companies are looking to sell these reserves to improve their cash balance, or are trying to generate reorganization cash flow projections during a Chapter 11 restructuring, understanding how to value PUDs and unproven reserves is crucial to survival in a down market.This first post looks at the traditional DCF valuation method and market approach method and how they underestimate value in down markets. The subsequent two sections will focus on one potential method to use in place of the DCF, the option pricing method, and will explore both its advantages in down markets and the dangers of adopting option pricing models for oil and gas.The Problem: Traditional Valuation in Distressed MarketsThe petroleum industry was one of the first major industries to widely adopt the discounted cash flow (DCF) method to value assets and projects—particularly oil and gas reserves. These techniques are generally accepted and understood in oil and gas circles to provide reasonable and accurate appraisals of hydrocarbon reserves. When market, operational, or geological uncertainties become challenging, such as in today’s low price environment, the DCF can break down in light of marketplace realities and “gaps” in perceived values can appear.While DCF techniques are generally reliable for proven developed reserves (PDPs), they do not always capture the uncertainties and opportunities associated with the proven undeveloped reserves (PUDs) and particularly are not representative of the less certain upside of possible and probable (P2 & P3) categories. The DCF’s use of present value mathematics deters investment at low ends of pricing cycles. The reality of the marketplace, however, is often not so clear; sometimes it can be downright murky.In the past, sophisticated acquirers accounted for PUDs upside and uncertainty by reducing expected returns from an industry weighted average cost of capital (WACC) or applying a judgmental reserve adjustments factor (RAF) to downward adjust reserves for risk. These techniques effectively increased the otherwise negative DCF value for an asset or project’s upside associated with the PUDs and unproven reserves.At times, market conditions can require buyers and sellers to reconsider methods used to evaluate and price an asset differently than in the past. In our opinion, such a time currently exists in the pricing cycle of oil reserves, in particular to PUDs and unproven reserves. In light of oil’s low price environment, coupled with the forecasted future price deck, many, if not most, PUDs appear to have a negative DCF value.Some non-core asset transactions in today’s market seem to concur with this assessed zero value for all categories of unproven reserves and PUDs. An example of this is Samson Oil and Gas’s recent purchase of 41 net producing wells in the Williston Basin in North Dakota and Montana. The properties produce approximately 720 BOEPD, and contain estimated reserves of 9.5 million barrels of oil equivalent. Samson paid $16.5 million for the properties in early January 2016 and estimates that within five years they can fund the drilling of PUDs. Samson’s adjusted reserve report, using market commodity prices at the time of the transaction, indicated PDP reserves worth $15.5 million, PDNPs worth $1 million, and PUDs worth $35 million—a total of $52 million in reserves present valued at 10%. This breakdown indicates dollar for dollar value was given on the PDP and PDNP reserves, but zero cash value given on the PUDs.Significant decline and volatility in oil prices from (1) uncertain future demand and (2) current excess supplyDebt level pressures with (1) loan covenant requirements and (2) cash flow requirementsA low deal volume environment as market participants have been in a “wait and see” stance since oil prices began declining over twelve months ago. Essentially there are few buyers in the current market place and many sellers desperate for cash. Since those sellers need cash quickly to sustain their business, they have to lower their asking prices to levels that will continuously attract bidders. The gap between an asset’s sale value and what it is worth to the new asset holder widens considerably. What does this mean for the E&P companies looking to reorganize under a Chapter 11 Bankruptcy? There are five key concepts for management teams and their advisors to be familiar with to understand how reserve valuation impacts Chapter 11 reorganization.Liquidation vs. Reorganization. The proposed reorganization plan must establish a “reorganization value” that provides superior outcomes for shareholders relative to a Chapter 7 liquidation proceeding.Liquidation Value. This premise of value assumes the sale of all of the company’s assets within a short period of time. Different types of assets might be assigned different levels of discounts (or haircuts) based upon their ease of disposaReorganization Value. As noted in ASC 852, Reorganizations, reorganization value “generally approximates the fair value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after the restructuring.” Reorganization values are typically based on discounted cash flow (DCF) analyses.Cash-Flow Test. A cash-flow test examines the viability of a reorganization plan, and should be performed in order to determine the solvency of future operations. In practice, this test involves projecting future payments to creditors and other cash flow requirements including investments in working capital and capital expenditures.Fresh-Start Accounting. Upon emergence from bankruptcy, fresh-start accounting may be required to allocate a portion of the reorganization value to specific identifiable intangible assets such as tradename, technology, or customer relationships. Fair value measurement of these assets typically requires use of the multi-period excess earnings method or other techniques often used in purchase price allocations following a business combination. If recent market transactions are utilized to establish a liquidation value, then it stands to reason that very little, if any, value will be given to the PUD reserves. For a company trying to avoid liquidation in a distressed market where sale prices do not indicate true value, there may still be a way to show significant value if reserves are retained in reorganization. However, that reorganization value has typically been based on a DCF. It is possible that the DCF may capture significant value in PUD reserves, because in reorganization debt levels are adjusted. When debt levels are adjusted the cash flow PUD reserves need to generate to be viable is much lower. This will provide two significant benefits: more time and possibly more cash. More time may allow the global oil and gas prices to increase while the additional cash flow from lower interest payments may allow investment in future PUD wells. Unfortunately, it is still the case that the present value calculation is strongly tied to current market conditions, and thus even for companies with reasonable leverage, many PUD and unproven reserves show negative cash flow. The presence of some sizable transactions made without significant PDPs shows that there are buyers who disagree with this assessment and see value in these reserves. The issue is demonstrating that value in either a sale or bankruptcy negotiation. An option pricing model is one solution that more accurately accounts for the value of the increased time provided by restructuring the debt. In the next two posts we will look at times when option pricing may be a better model, and examine its potential issues. For a more detailed explanation of bankruptcy, DCF methods, or option pricing, please contact one of our valuation experts.

Resolving Buy-Sell Disputes

On Being a Jointly Retained Appraiser

Detective shows are usually good for automotive product placement, and the 1980s television series, Magnum, P.I., was no exception. It didn't hurt that the show's main character, Thomas Magnum, solved crimes in tropical settings throughout Hawaii, necessitating a requisite number of bikini-clad women sipping Mai Tai's in every episode. But the show's most memorable character was probably Magnum's car, a Ferrari 308. The 308 wasn't the fastest Ferrari of all time; the 3.0 liter eight cylinder motor didn't muster much more than 200 horsepower. It was small enough to have great handling (the seat had to be modified to fit Tom Selleck's 6'4" frame), it had a targa top, and at full throttle it sounded like Barry White eating wasps. With a car like that, a do-gooder role mysteriously funded by an anonymous millionaire, and a very-casual-Friday-everyday dress code, one thing was certain: Tom Selleck had a good job.The closest we get to detective work at Mercer Capital is when we're jointly retained to resolve a shareholder disagreement over a buy-out. Whether we've been court-appointed or mutually chosen by the parties to do the project, we've done enough of these over the years to learn that the process matters as much as the outcome.As a consequence, we've developed some fairly strict procedures for engagements involving buy-sell fights. The backstories for most shareholder disputes in the investment management industry have common themes: long-time partner ends up at odds, usually for economic reasons, with the rest of the ownership and is more or less forced out. There are usually lots of negative emotions on both sides, mistrust, and even impaired careers. The necessity of the buyout is obvious: the ex-partner wants to be paid so he or she can move on, and the remaining partners don't want to share the spoils of ownership (distributions) with their ex any longer than necessary.As the jointly retained appraiser, we're often in the awkward position of serving as judge and jury on the valuation, without the usual protections afforded by a judge or jury (like unlimited indemnification or an armed bailiff). So, like a private detective, we're left on our own to design and conduct an investigation to reach a reasonable outcome. If the process is sufficiently robust and fair, the two parties may not like the result, but they'll have to accept it. Doing so involves focus on a few key issues.Working in a Glass HouseThere is no substitute for transparency. We generally require that all information requested by and shared with us be shared with both parties. We also copy all parties on our communications and request that they do the same. When we conduct interviews with the parties as part of our normal due diligence, we open those meetings to both parties. Typically, the parties agree to not attend each others' interviews so that they'll feel free to speak to us more openly, and inevitably this leads to accusations at some point of our being lied to "in closed door meetings." In reality, no one is blind to the motivations of the parties in a buy-sell dispute, and we usually hear some level of hyperbole from both sides.Separating Fact from OpinionLike any valuation engagement, we start with an information request to get the basic facts of the situation: financial statements, regulatory filings, organization charts, strategic plans, etc. Then we interview the parties, and (frequently) get very different interpretations of those facts. It is not unusual for both sides to have very earnest, if diametrically opposed, opinions of why the facts are the way they are. Squaring those interpretations against what we can discern to be the reality of the situation is part of our job.The Value of Client ReviewIn a normal valuation matter, we prepare a draft report for client review to make sure we understand key elements of the enterprise being valued. In the case of a shareholder dispute, this review process is more structured. We usually have both parties review our work product independently of each other and give a written review that is distributed to us and the opposing party. Then we allow the parties to comment (also in writing) on each other's review. Our expectation is that knowledge of this cross-review process will dissuade the parties from misconstruing issues in their initial comments on our draft. That doesn't always work, but at least we have the benefit of both perspectives before we issue a final report.Economic IndependenceA client in one of these matters told us that he had heard jointly retained appraisers tended to favor the firm over the ex-partner (he was an ex-partner). I haven't heard the same thing, but it's easy to be accused of bias. One of the ways we guard against this is by structuring the engagement such that it is clear our payment is not contingent on the outcome. We start the engagement with a retainer that is applied against the final billing and stipulate that bills be paid current before we release a draft report or a final report. This assures both parties that we're not in anyone's back pocket and that we have the economic freedom to express the opinion of value we think is appropriate.No Man Can Serve Two Masters…Suffice it to say, we've learned a lot of this the hard way. It's no fun to be the punching bag between former partners who no longer want to have anything to do with each other, and business divorces are among the most fractious engagements we find ourselves in. But it doesn't help matters for us to offer to make someone else's problem our problem. Our kind of detective work involves sticking to a disciplined process that is respectful of the facts and allows both parties to openly participate. Unfortunately, it doesn't involve much intrigue, car chases, or hair gel – which probably explains why so few television series are about finance.Tom Selleck on the job as Thomas Magnum | Photo Credit: Magnum Mania!

Ambiguity in Buy-Sell Agreements is Expensive

Usually, I like to start blogposts with the story of some legendary car remembered fondly for its contributions to the automotive community. The car photographed above, a 1990 Chrysler TC by Maserati, is not an example of that. The TC was the mutant offspring of a brief tryst between Lee Iacocca, who headed Chrysler, and Alejandro de Tomaso, who owned the Maserati brand at the time. Iacocca and de Tomaso signed an agreement to jointly produce a sport coupe, and this was the worst they could come up with: a convertible based on Chrysler’s K-car platform, powered mostly by weak Chrysler engines, but tarted up with hand-stitched leather upholstery and inexplicably manufactured in Italy. One might have expected the TC to have had Italian styling and American reliability – instead it was the other way around. None of it made sense any more than the peculiar porthole window in the hardtop. Somehow, over 7,000 were sold. May they rust in peace.Despite talented people, carefully developed business plans, and the best of intentions, not every partnership goes well, and some of those that don’t go well don’t end well either. When a partner leaves an investment management practice, the potential for a major dispute over the buy-out usually looms. Internally, at our firm, we sometimes refer to these situations as “business divorces”, even though the consequent acrimony often exceeds that of a marital dissolution.For the exiting partner who was either pushed out or who left in disgust, it’s usually their last shot at their adversaries. Getting paid in full, and maybe then some, becomes a way to even not only the economic score, but the emotional score as well. For the continuing partners, overpaying risks endangering the business, while a cheap buy-out might be seen as giving the ex-partner what he or she really deserve.Usually, no one sees a business divorce coming until it’s too late to prepare. Once the negative emotions are underway, it’s too late to get the partners to sign a shareholder agreement or modify one that’s inadequately drafted. We started writing about buy-sell agreements at Mercer Capital over ten years ago with the idea that we could help firms avoid costly disputes over ownership. We have succeeded in doing some work in that area, but we are often hired as a jointed retained appraiser to try to help clean up messes after a fight broke out.It is always dangerous to make blanket statements, but I think if we’ve learned one thing from working in the shareholder dispute arena, it’s that a poorly drafted buy-sell agreement may be worse than having none at all. The words on the page look pretty innocuous when everyone is getting along, and unclear verbiage and inadequate guidance can be dismissed (“We know what we mean…”). So, to that end, here are a few mistakes we’ve seen others make, in the hopes that you read this and don’t do the same.Be Clear about the Valuation DateIn one extreme case in which we were involved, there was a $250 thousand hearing just to get the court to determine what the appropriate valuation date was to buy out a joint venture partner. You probably won’t have that big an issue, but the valuation date can be extraordinarily significant. If you have a large RIA with a stable customer base and placid markets, the valuation date may not matter. But what if markets are particularly volatile? What if you’re buying out a partner who left because of FINRA sanctions and now your clients are asking lots of difficult questions? What if a very successful client service partner left for another firm and is now working diligently to move his clients? What if the death of a key partner risks the loss of large mandates? We have seen some buy-sell agreements specify that the entity be valued at the fiscal year end prior to the trigger event for the action, as doing so would value the entity without regard to the issue at hand. That’s one way to handle it, and doing so often benefits the departing shareholder. We have also seen buy-sell agreements specify that the entity be valued at a certain point after the triggering event, to let the dust settle. Obviously, this treatment can be beneficial to the firm if the partner leaving is contemporaneous with some kind of firm trauma. But, more often than not, the valuation date is not clearly specified in the buy-sell agreement. Don’t let that happen to you.Be Clear about How to Choose an AppraiserObviously, you want a valuation expert to handle your business divorce who is both trained and experienced in business valuation and who understands the investment management industry. Your buy-sell agreement should delineate the qualifications of the appraiser or appraisal firm to do the work. But how will he or she be chosen? We have seen agreements in which the appraiser is chosen by the company, and the obvious implication of this is that the departing or departed shareholder is suspicious of conflicts. We have also seen many situations where each party to the agreement chooses an expert who is supposed to agree on a jointly retained appraiser. This works better in theory than in practice, except in instances where the two sides propose the same third appraiser. Whatever you do, be specific about the process. We have been brought in many times after the court had to be asked to intervene on behalf of one side or the other.Be Clear about the Standard of ValueIf your buy-sell agreement doesn’t already specify fair market value as the standard and makes that clear by reference to a definition such as exists in the International Glossary of Business Valuation Terms, then that’s an easy fix. We worked on a lengthy and expensive litigation which was almost entirely related to ambiguity as to the standard of value. Absent clarity, a buy-sell agreement could be settled based on investment value to either the buyer or seller, some notion of intrinsic value, or statutory fair value – particularly since in many shareholder disputes the departing partner could argue for protection under some state fair value statute.Be Clear about Valuation Discounts and PremiumsUsually, the subject interest in a buy-sell dispute is a minority interest in a closely held business. This would suggest that it could be valued, absent guidance to the contrary, at a non-marketable, minority interest level of value (inclusive of discounts for lack of control and lack of marketability). I think it’s safe to say that most partners think of their interest in an RIA as their pro rata participation in the enterprise. If the firm is worth, say, $10 million, and they own 20%, they expect their interest to fetch $2 million per the buy-sell. The acquiring firm has ample economic motivation to argue for discounts, and indeed the continuing partners will benefit if the selling partner is bought out for less than pro rata enterprise value. On the other hand, a well-crafted shareholder agreement will also specify what is meant by enterprise value. Is it going concern on a stand-alone basis (what might be considered a financial control level of value) or is it the value that could be achieved in a synergistic change of control? There is no perfect answer, but think about your firm and how you and your partners would want to buy or be bought out.Best Practice is to PracticeEven with all of the above care given to your buy-sell agreement, it’s difficult to know what will happen once the trigger event has occurred unless you find out in advance. The best practice is to have an annual appraisal done pursuant to your buy-sell agreement. With an annual valuation, you and your partners will know who is doing the work, how the process will occur, and (within a range) what the result will be. It does mean some regular investment of time and money, but the typical dispute we’ve worked on would have paid for a couple of decades of annual appraisals, not to mention the immense frustration and distraction that a shareholder disagreement causes a firm. If you can’t imagine finding yourself or your firm in that situation, now is a good time to start preparing.

How Sweet It Was

In 2015 the United States consumed over 3.6 billion gallons of tea. There’s nothing like a cold glass of sweet tea on a hot day in Memphis, where the average humidity is over 80%. But too many glasses of sweet tea leads to a sugar crash that makes you feel worse than before.Until December, the amount of sweet light crude in the U.S. almost exceeded the amount sweet tea at any Southern picnic. The Shale revolution changed the domestic oil and gas industry. As the stockpiles of sweet light crude increased, and the price of WTI fell, refiners purchased cheap crude in the domestic market. Until December 2015, refiners could buy domestic crude in the U.S. at a price approximately 10% cheaper than the rest of the world, sell refined products in the global petroleum market where prices were dictated by world demand and supply, and realize juicy margins. While the oversupply of sweet crude was at first a blessing for refiners, their sugar crash may be a permanent one.Brent WTI SpreadThe shale revolution, in conjunction with the export ban, created an oversupply of light, sweet crude in the U.S., which put downward pressure on the price of domestic crude oil. This pressure can be seen by examining the WTI – Brent oil price spread. One year ago the European benchmark, Brent crude, sold for $6.33 more than its American counterpart, WTI. The lifting of the export ban has narrowed the Brent WTI spread to less than $1 per barrel today.Refiner Marker MarginThe refiner marker margin (RMM) is a general indicator, calculated quarterly by BP, which shows the estimated profit refiners earn from refining one barrel of crude. Refiners’ margins increased dramatically in the second and third quarters of 2015 as the price of crude fell and the price of refined petroleum products remained high. Refiners in the U.S. were on average making $25 per barrel of oil, while global profit margins barely reached $20 per barrel.Refiners anticipated crude oil exports would increase when the export ban was lifted which reduced excess supply in the U.S. and relieved the downward pressure on market prices. Once the price of crude increased in the U.S., refiners profit margins shrink. As you can see in the graph below, profits shrank as expected. But with falling crude prices worldwide, the compression of downstream margins cannot be explained by the story refiners expected. If the export ban had been lifted in early 2014, before global crude prices started falling, the story would have played out as expected. However, when the export ban was lifted, the U.S. producers were then open to compete in a market which was swimming in crude oil. At year end, there were approximately three billion barrels of excess supply inventory across the globe. No one wanted our excess crude. Exxon Mobil’s downstream earnings were down 67% from this time last year to $187 million for the three months ended March 31, 2016. The reduced downstream margin is driving much of that change, as the company attributes $470 million of their drop in revenue from Q4 2015 to Q1 2016 to this falling margin. On their most recent earnings call VP of Investor relations explained that in order to understand refiner’s current situation, you have to look at the macro level of supply and demand. Thus decline in downstream profits was a result of excess global supply and the decreasing price of petroleum products around the globe. The export ban was lifted and U.S. raw crude oil exports initially declined relative to last year. U.S. Crude exports were down 26% in January and 13% February compared to the previous year. However, as the price of oil rebounded slightly, we have seen a 22% year over year increase in crude oil as of March 2016. When the market readjusts and crude prices rise, E&P profits may increase back to what they were, however refiners may never see the same fat margins they used to as they are now operating in a global market place. Refiners may have to adjust to a new normal. What Does This Mean for Valuation?While E&P companies have been struggling for over twelve months now in the current low price environment, refiners are just starting to feel the pressure. Although the valuation implications are not expected to be as extreme, we expect to see similar valuation issues in upcoming months as we have seen for E&P companies over the last year. As margins compress and cash flows decrease, valuation multiples are expected to fall.Mercer Capital has been valuing oil and gas companies for over 20 years. We understand the volatility of the oil and gas market and can help your company understand the value of your company beyond this year’s cash flows.

Why Should Your Firm’s Buy-Sell Agreement Require an Annual Valuation?

It’s all about Expectations Management

The 1970s weren’t too kind to the auto industry. Between the OPEC oil embargo, new environmental regulations and disco, automotive design mostly devolved into underpowered, uninspired boxes. One noteworthy exception to all this was the Pontiac Trans Am. Neither boxy nor underpowered, the Trans Am was a hot mess with a huge motor that overpowered the car’'s weak brakes and lousy handling. All in all, though, it worked. From the driver's seat, you could forget all about the "malaise" while you stared up at the sky through the T-tops or across the giant decal of a flaming bird on the hood. As GTs go, it was no Aston Martin, but it was good enough to help Burt Reynolds smuggle a semi full of Coors across the southeast in Smokey and the Bandit.What was a perfect statement about America in 1977 is not so applicable today. Almost 40 years later, Burt Reynolds is still around, but Pontiac isn't, and people are more likely to cross state lines to buy craft beer than Coors. It's a point worth remembering when thinking about how to value your RIA for purposes of a shareholder agreement: times change.A recurring problem we see with buy-sell agreements are pricing mechanisms that are out of date. Usually, this shows up in the form of some kind of rule of thumb valuation metric that is no longer market relevant. We've also seen buy-sell agreements that cite standards of value that don't exist in the modern valuation lexicon, and even some that specify appraisers from firms that no longer exist.Keeping the language in your agreement up to date is important, but the most reliable way to avoid some unintended consequence of your buy-sell agreement is to have a pricing mechanism that specifies a regular valuation of your RIA's stock. An annual valuation accomplishes a number of good things for an investment management firm, but the main one is managing expectations.If your ownership sees a set of consistently prepared appraisals over the course of several years, they know what to expect. By this I mean there is some level of agreement over who is to provide the valuation, what information will provide the basis of valuation, and how the valuation itself will be constructed. This doesn't guarantee that everyone will be satisfied with the conclusion of value, and our experience is that partners in investment management firms often have differing opinions of the value of an RIA. Some difference of opinion is to be expected, but the process of having a regular valuation prepared by an independent party can go a long way toward narrowing that difference of opinion. If there is little difference of opinion over the values at which ownership in a firm transacts, there will be little incentive to litigate when a sizable transaction comes along.Recommending an annual valuation may sound a little self-serving and, indeed, doing that sort of work is good business for us. We also handle dispute resolutions for shareholder disagreements, however, and the cost of that work is never less than several times the cost of an annual appraisal – not to mention substantial legal fees and the immeasurable cost of management distractions. All in all, we would rather dispense the ounce of prevention than the pound of cure.P.S.: There is an updated edition of the Trans Am available.

When Buy-Sell Agreements Blow Up

What Would Mom Do?

Nobody's perfect.You're a successful portfolio manager but you forgot Mother's Day this past weekend. What now? May I suggest you buy mom the ultimate grocery-getter: the Ferrari FF. I spotted the one photographed above outside my hotel last week in Grenoble, France, where I was for an all-too-quick business trip. The Ferrari FF has the credentials typical of Maranello: a 6.3 liter V-12 producing 651 horsepower and 504 foot pounds of torque that through the all-wheel drive system propels the FF to 60 miles per hour in less than four seconds on its way to a top speed of 208 mph.Unlike a new Bentley Bentayga – getting one of these for mom won't imply that you just want her to take over carpool for the grandchildren. Your mom may ask whether or not anyone really needs a two door station wagon that goes two hundred miles per hour and costs $300 thousand. Just tell her that the FF is a good example of the answer to a question that no one ever asked.The subtitle of Chris Mercer's original book on buy-sell agreements is "Ticking Time Bombs or Reasonable Resolutions?" Implicit in this title is that parties to buy-sell agreements too often discover the painful implications of the question never asked. I think about this every time we work on a dispute resolution project involving a buy-sell disagreement. In particular, I think about one of the first ones that I worked on, where maybe there was no disagreement, but should have been.Where There are Winners, There are LosersMany years ago we were hired to do valuation work for the estate of the founder of a successful RIA, who died unexpectedly. We were not asked to value the estate’s interest in the asset management firm as this was provided for by a mechanism in the buy-sell agreement. We were merely asked to check the math and make sure the estate wasn’t being short-changed. Long story short, it wasn't.There's no point in going into the particulars of the pricing mechanism in that RIA's shareholder agreement, (as that would be tangential to the story) but the value implied was rich. It might have been achievable in a change-of-control sale to a highly motivated buyer, with capacity, under the very best of circumstances. As it was, the company was required to redeem the interest with the help of some life insurance and, as I recall, some term financing. The decedent was the largest shareholder at the firm, and to the extent that anyone is a "winner" in these circumstances, the estate got the best of the pricing mechanism in the buy-sell agreement.Unfortunately, where pricing creates winners it symmetrically creates losers. The firm was on the hook for the redemption, which means that the remaining, or continuing, shareholders of this RIA were forced to overpay for the estate's interest, effectively diluting the economic value of their ownership for years to come. Compound this with the loss of the founder's contributions to the firm (he was an important client relationship manager), and the continuing partners had to essentially rebuild the value of their ownership. With favorable markets and good stock picking, they succeeded. We've seen other RIAs that, put in a similar circumstance, would not have fared so well.However, going to the other extreme (forcing buy-outs at a heavily discounted value) isn't necessarily better. Economically, to the extent that a minority shareholder is involuntarily redeemed at a discounted value, the amount of that discount (or decrement to pro rata enterprise value) is arithmetically redistributed among the remaining shareholders. Generally speaking, courts and applicable corporate statutes do not permit this approach because it would provide an economic incentive for shareholder oppression.By way of example, assume a business is worth (has an enterprise value of) $100, and there are two shareholders, Sam and Dave. Dave owns 60% of the business, and Sam owns 40% of the business. As such, Dave's pro rata interest is worth $60 and Sam's pro rata interest would be valued at $40. If the 60% shareholder, Dave, is able to force out Sam at a discounted value (of, say, $25 – or a $15 discount to pro rata enterprise value), and finances this action with debt, what remains is an enterprise worth $75 (net of debt). Dave's 60% interest is now 100%, and his interest in the enterprise is now worth $75 ($100 total enterprise value net of debt of $25). The $15 decrement to value suffered by Sam is a benefit to Dave. This example illustrates why fair value statutes and case law attempt to limit or prohibit shareholders and shareholder groups from enriching themselves at the expense of their fellow investors.Answering the Question Nobody AsksSo, when you look at your firm's shareholder agreement, think about the question – "Does my buy-sell create winners and losers?" If so, are you content with whom those winners and losers might be?Does the pricing mechanism create winners and losers? Should value be exchanged based on an enterprise valuation that considers buyer-seller specific synergies, or not? Should the pricing mechanism be based on a value that considers valuation discounts for lack of control or impaired marketability? Exiting shareholders want to be paid more and continuing shareholders want to pay less, obviously. What's not obvious at the time of drafting a buy-sell agreement is who will be exiting and who will be continuing.There may be a legitimate argument to having a pricing mechanism that discounts shares redeemed from exiting shareholders, as this reduces the burden on the firm or remaining partners and thus promotes the continuity of the firm. If exit pricing is depressed to the point of being punitive, the other shareholders have a perverse incentive to artificially retain their ownership longer and force out other shareholders. As for buying out shareholders at a premium value, the only argument for "paying too much" is to provide a windfall for former shareholders, which is even more difficult to defend operationally.What Would Mom Do?Ownership works best when it is structured to support the operations of the firm. Maybe this is easier said than done, but the lesson certainly applies to the mechanics of a buy-sell agreement. Your mom probably told you that "nobody ever said life was fair," but she wasn't giving license to promote unfairness. Balancing the fairness to both exiting and continuing shareholders in your buy-sell agreement will support the operations of your RIA, which will help build enduring value in the firm, ultimately benefiting everyone.

What Matters Most for RIA Buy-Sell Agreements?

In Our Experience…

In 1961, Jaguar stunned the automotive community by adapting its highly successful D-type race car, which had won the 24 hours of Le Mans three consecutive years in the late 1950s, to create the E-type road car. The E-type was instantly acclaimed. It had everything you could ask for in a sports car at the time: an inline six-cylinder motor that powered it to 60 mph in under seven seconds, monocoque construction, disc brakes, rack and pinion steering, independent front and rear suspension, and a top speed of over 150. Most importantly, it was gorgeous. Enzo Ferrari himself said it was "the most beautiful car ever made."No one ever said a particular buy-sell agreement was the "most beautiful" ever written (even in our office), but some are better than others. And, like a good sports car, you can break down the key elements of a buy-sell agreement that must be there for the agreement to be successful. The first hurdle to clear is for the buy-sell agreement to specify that the company is to be valued within reasonable parameters appropriate to the situation. We don't see many shareholders' agreements in the RIA community relying on "rule-of-thumb" like multiples of revenue or AUM – probably because, while simplicity is appealing, it's too easy for that kind of high level analysis to create unintended winners and losers in a buy-sell action.But that begs the question: if an asset manager's buy-sell is going to specify reasonable expectations for the value of the firm, what are they? We think there are at least four.1. A Buy-Sell Agreement Should Clearly Define the "Standard" of ValueThe standard of value is an important element of the context of a given valuation. We think of the standard of value as defining the perspective in which a valuation is taking place. Investment managers might evaluate a security from what they think it's worth (intrinsic value) as opposed to its trading price (market value) and make an investment decision based on that differential.Similarly, valuation professionals such as our squad look at the value of a given company or interest in a company according to standards of value such as fair market value or fair value. In our world, the most common standard of value is fair market value, which applies to virtually all federal and estate tax valuation matters, including charitable gifts, estate tax issues, ad valorem taxes, and other tax-related issues. It is also commonly applied in bankruptcy matters.Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60. It is defined in the International Glossary of Business Valuation Terms as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm's length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.The standard of value is so important, it's worth naming, quoting, and citing specifically which definition is applicable. The downsides of not doing so can be reasonably severe. Take, for example, the standard of "fair value." In dissenting shareholder matters, fair value is a statutory standard that can be very different depending on the legal jurisdiction. By contrast, fair value is also a standard of value under Generally Accepted Accounting Principles, as defined in ASC 820. GAAP fair value is similar to fair market value, but not entirely the same. In any event, it pays to be clear.For most buy-sell agreements, we would recommend one of the more common definitions of fair market value. The advantage of naming fair market value as the standard of value is that doing so invokes a lengthy history of court interpretation and professional writing on the implications of the standard, and thus makes application to a given buy-sell scenario more clear.2. Unless it is Clarified, There will be Costly Disagreement as to "Level of Value"Investment managers in publicly traded securities don't often have reason to think about the "level" of value for a given security. But closely-held securities, like common stock interests in RIAs, don't have active markets trading their stocks, so a given interest might be worth less than a pro rata portion of the overall enterprise. In the appraisal world, we would express that difference as a lack of marketability. Sellers will, of course, want to be bought out pursuant to a buy-sell agreement at their pro rata enterprise value. Buyers might want to purchase at a discount (until they consider the level of value at which they will ultimately be bought out). In any event, the buy-sell agreement should consider the economic implications to the RIA and specify what level of value is appropriate for the buy-sell agreement. Fairness is a consideration here. If a transaction occurs at a premium or a discount to pro rata enterprise value, there will be "winners" and "losers" in the transaction. This may be appropriate in some circumstances, but in most RIAs, the owners joined together at arm's length to create and operate the enterprise and want to be paid based on their pro rata ownership in that enterprise. Whatever the case, the shareholder agreement needs to be very specific as to level of value. We even recommend inserting a level of value chart, like the one you see above, and drawing an arrow as to which is specified in the agreement. 3. Don't Forget to Specify the "As Of" Date for ValuationThis seems obvious, but the particular date appropriate for the valuation matters. We had one client (not an RIA) spend a quarter million dollars on hearings debating this matter alone. The appropriate date might be the triggering event, such as the death of a shareholder, but there are many considerations that go into this.If the buy-sell agreement specifies that value be established on an annual basis (something we highly recommend to avoid confusion), then the date might be the calendar year end. Consider whether you want the event precipitating the transaction to factor into the value? If not, maybe the as-of date should be the day before the event. Or maybe it matters that, say, a given shareholder died or otherwise left the organization, and it's worth considering the impact of the departure. If that's the case, then maybe the appropriate valuation date is the end of the fiscal year following the event giving rise to the transaction.This blogpost doesn't begin to name all of the reasons that specifying an "as-of" date matters to the appraisal, but you get the idea.4. Appraiser Qualifications: Who's Going to be Doing the Valuation?Obviously, you don't want just anybody being brought in to value your company. If you are having an annual appraisal done, then you have plenty of time to vet and think about who you want to do the work. In the appraisal community, we tend to think of "valuation experts" and "industry experts."Valuation experts are known for:Appropriate professional training and designationsUnderstanding of valuation standards and conceptsPerspective on the market as consisting of hypothetical buyers and sellers (fair market value mindset)Experienced in valuing minority interests in closely held businessesAdvising on issues for closely held businesses like buy-sell agreementsExperienced in explaining work in litigated matters Industry experts, by contrast, are known for:Depth of particular industry knowledgeUnderstanding of key industry concepts and terminologyPerspective on the market as typical buyers and sellers of interests in RIAsTransactions experienceRegularly providing specialized advisory services to the industry In all candor, there are pros and cons to each "type" of expert. We worked as the third appraiser on a disputed RIA valuation many years ago in which one party had a valuation expert and the other had an industry expert. The resulting rancor was absurd. The company had hired a reasonably well known valuation expert who wasn't particularly experienced in valuations in the RIA community. That appraiser prepared a valuation standards-compliant report that valued the RIA much like one would value a dental practice, and came up with a very low appraised value – much to the delight of his client. The departing shareholder, by contrast, hired an also well-known investment banker who arranges transactions in the asset management community. The investment banker looked at a lot of transactions data and valued the RIA as if it were a department at Blackrock. Needless to say, that indicated value was many, many times higher than the company's appraiser. We were brought in to make sense of it all. The buy-sell agreement should specify minimum appraisal qualifications for the individual or firm to be preparing the analysis, but also specify that the appraiser should have experience and sufficient industry knowledge to consider the ins and outs of RIAs. Ultimately, you need a reasonable appraisal work product that will withstand potential judicial scrutiny, but you shouldn't have to explain your business model in the process.Final ThoughtsI'll cover in a later blogpost how the appraisal process itself works, and the considerations above are by no means meant to be exhaustive. But when you consider just these four elements, you can see how ambiguity in a buy-sell agreement can be highly disruptive at an investment management firm. While we do occasionally advise clients on setting up shareholder agreements, more often we are called in when an "agreement" is in dispute. We'll cover one such story in next week's blogpost.

Mutual Fund Providers Down Sharply as ETFs Continue to Gain Ground

One streak that remains, albeit less reportedly, is passive funds’ dominance over their active counterparts over the last year. According to Morningstar, active funds endured $268 billion in net outflows over this period while their passive counterparts gained $382 billion in client assets. These dynamics are problematic for many mutual fund companies that rely on active equity products with higher fee schedules and profit margins. As a result, most publicly exchanged mutual fund companies are trading in bear market territory while the market has flat lined over the last year. Active fund outflows are not only attributable to the rise in popularity of low-cost ETF strategies, but also sector-wide underperformance against their applicable benchmarks. Through the first two months of 2016, just 28% of large cap mutual fund managers are beating their benchmarks (27% for all of 2015) and only 1% posted positive returns, according to a Goldman Sachs study. Both individual and institutional investors are now more inclined to shun active managers for cheaper, more readily available products, particularly when performance suffers. Many active managers and mutual funds have responded by cutting fees or offering their own passive products to stem the outflows, but this has adversely affected their revenue yields and profitability. Russel Kinnel of Morningstar elaborates on this trend in his recent article, “It’s Flowmegeddon! Outflows add to the challenges facing active stock fund managers.” “The simple answer to this riddle is competition from exchange-traded funds. ETFs have gained the upper hand in the active/passive debate, even over open-end index funds, which generally offer comparable cost benefits. More advisors are switching to ETF-focused strategies, and, when they get a new client, they quickly sell the weakest performing active funds—possible all the actively managed funds—in the client’s current portfolio. Self-guided investors are moving to ETFs, too.”As Mr. Kinnel notes, these redemptions from active funds wouldn’t be so alarming in a bear market, but we’ve come a long way since the Financial Crisis. This current trend is about investor preferences not investor paranoia.On balance, passive funds appear primed to continue their dominance over active management, but we still question the sustainability of this trend over the long run. While fees are likely to continue their descent over time, it is hard to imagine that passive investing will completely replace active management. Such a scenario could lead to significant mispricing in the securities markets, which would be fertile ground for enterprising investors and mutual funds. While we’re more bullish on the prospects of Golden State and Barca this season, we haven’t completely ruled out active managers in the ongoing quest for investor capital and advisory fees.

Asset Manager Valuations Mixed After a Rocky Q1

From a valuation perspective, it appears that alternative asset managers fared the best in Q1. The group’s median multiple rose 60% in the first three months of the year, besting all other classes of asset managers over the same period. Closer inspection reveals a much bleaker quarter for the publicly traded hedge funds and private equity firms in our alternative asset manager index. Despite significant gains in the back half of the quarter, the group lost roughly 5% of its market cap during the first three months of the year. In other words, the E is falling faster than the P/E is rising for most of these businesses. With many names trading at a 40%+ discount to their 52 week high, the market seems to be questioning the long-term viability of many hedge funds and PE firms whose high fees and subpar performance have come under scrutiny in recent years. On the other end of the spectrum, more traditional, long-only managers appear to have taken some market share from their alternative counterparts over the same period. Investors continue to grow wary of higher fees, especially when performance suffers, so this is no surprise to those who follow the sector. Still, hedge funds are typically better poised to profit from market volatility, which might explain the group’s advancement since its mid-February bottom. Moving forward, this disparity is unlikely to persist if many of these publicly traded alt managers are to remain a going concern. The past few weeks have been promising, but the index as a whole lost roughly half of its market cap from July of last year to February of 2016. An opportunistic investor with a high risk tolerance might see this as a buying opportunity. Others will look skeptically at the sector’s prospects in the era of passive investing.

Business Divorces at RIA Firms

A fellow Mercer Capitalist recently purchased this beauty, a 1976 VEB Trabant or “Trabi,” at a car auction in Chicago. Ironically labeled as “the car that gave communism a bad name,” the Trabi was the most common vehicle in East Germany during the Soviet Bloc era and even made the Los AngelesTime’s prestigious “50 Worst Cars of All Time” list. If these rankings culminated in a March Madness style bracket pool, the Trabi would definitely deserve a #1 seed given its two-stroke pollution generator (that maxed out at 18 hp) and lack of basic amenities like turn signals and brake lights. The body was made of a fiberglass-like Duroplast (reinforced with recycled fibers of cotton and wood) and even had some parts manufactured from papier-mâché when the VEB production plant ran low on steel. As the Berlin Wall fell in 1989, thousands of East Germans drove their Trabis across the border as a sign of automotive liberation from the Communist Bloc.Like the Trabant, business divorces can be liberating, but are mostly just ugly and ill-conceived. This is especially true for RIA firms where the founding principals typically serve as Chief Investment Officers or portfolio managers for the larger accounts. As a result, these shareholders (and the RIA itself) have the most to lose when corporate disputes or partner buy-outs arise. Many times, these conflicts are unavoidable and are the natural bi-product of ownership transition and firm evolution. In these instances, a carefully crafted buy-sell agreement (“BSA”) can resolve these disputes in a fair and equitable manner (from a financial point of view) if the valuation process avoids these common pitfalls:Employing a fixed or formulaic valuation methodology. The most commonly used rule of thumb for valuing asset managers is price (or enterprise value) to AUM, which is fraught with all sorts of issues covered by a previous blog post. Even worse are formulas that call for a departing shareholder to be bought out at a pro rata percentage of book value or his/her capital contribution. Such metrics make little sense for RIAs, which often have minimal capital requirements and balance sheets, meaning one-side is likely to get bought out a price that is in no way indicative of fair market value for his or her equity interest. BSAs that call for fixed multiples of earnings or cash flow are less offensive to us, but don’t account for natural variations in cap rates and can be subject to margin manipulation by the managing partners.Delaying a valuation until a triggering event actually takes place. Business owners often have an inflated (and sometimes deflated) view of what their company is worth. Having the business appraised on a regular basis (annually or bi-annually) precludes the inevitable surprise that takes place when a trigger event occurs and allows both sides to gain familiarity with the appraisal process.Employing multiple appraisers and tie-breaker valuations when both sides’ experts inevitably disagree. Besides being costly and time-consuming, this technique can be especially problematic when there’s an outlier valuation or the parties can’t agree on a third appraiser. In any event, the process can be a huge distraction for an RIA’s management team and shareholder group. The problem that we most often see with shareholder agreement disputes is the potential of a forced transaction creating winners and losers. If a departing shareholder is bought out at a premium to the value of the enterprise, that premium comes at the expense of the remaining shareholders. If the shares are bought at a discount, the remaining shareholders reap a windfall. Some buy-sell agreements are intentionally engineered to favor either the selling shareholder or the continuing shareholders, but if so everyone who is a party to the agreement should be aware of that long before the triggering event. At Mercer Capital, we recommend a regular valuation process for buy-sell agreements at investment management firms for a number of reasons:The structure and process, in addition to being defined in the agreement, will be known by all parties to the agreement in advance.The appraiser’s valuation approaches and methodologies are seen firsthand by the parties before any triggering event occurs.The appraiser’s independence and objectivity will be evident in the consistency of methodology utilized over time.Because the appraisal process is exercised on a recurring basis, it should go smoothly when employed at triggering events and be less time-consuming (and expensive) than other alternatives. Our colleague with the Trabi says that one benefit to ownership is that you never know what’s going to happen when you get into the car. Your buy-sell agreement should, on the other hand, be free of surprises. If it’s been a while since you looked under the hood of your shareholder agreement, we recommend you pull it out of the drawer, read it, and then call your legal counsel if you see the potential for any problems down the road. Then call us.

What is Normal Compensation at an Asset Management Firm?

Part 2

[caption id="attachment_10926" align="aligncenter" width="363"] The Lamborghini Miura was the first mid-engine V-12 road car, and established the company’s reputation for out-of-the-box design.[/caption] [caption id="attachment_10919" align="aligncenter" width="363"] Ferrari’s competitor to the Miura, the Daytona, retained a traditional front engine layout, but its successor, the 365BB, adopted the same mid-engine format as the Miura.[/caption] Legend has it that, sometime in the early 1960s, Italian tractor manufacturer Ferruccio Lamborghini burst into Enzo Ferrari’s office to complain about the Ferrari road car that Lamborghini had recently purchased. He didn’t like the design, thought the manufacture was crude, and was furious that the car was incredibly unreliable. Enzo Ferrari, who had always thought people who bought his overpriced road cars (which Ferrari sold only to fund the company’s racing ambitions) were dupes, told Lamborghini that if he could do better, he should. In 1963, Lamborghini founded a sports car manufacturing company, and Ferrari’s had a competitor ever since. It took a few years for Lambo to gain a footing in the industry, but in 1966 the company introduced the Miura, a two seat sports coupe with a powerful V-12 engine mounted, in a revolutionary fashion for the time, between the passenger compartment and the rear wheels. It competed directly against Ferrari’s more conservative, twelve cylinder GT, the Daytona, and established Lamborghini’s personality as a manufacturer of innovative (and sometimes over the top) sports cars. The Daytona still outsold the Miura two to one, but today at auction a Miura will fetch three times what a similar vintage Daytona will. The more traditional design of the Ferrari appealed to buyers when the cars were new, but in retrospect, Lamborghini’s willingness to experiment is highly regarded. One of the primary differences we observe in investment management firms is not engine placement, of course, but compensation programs. The Miura and Daytona were different approaches to the same product. Our experience is that there are multiple ways to handle staff compensation at investment management firms, and the manner in which compensation is handled often says a lot about the business model and culture of the firm. The “Market” for Investment Management TalentOur experience tells us that the labor market for talent in the investment management community is not terribly efficient – at least not on a position to position, person to person basis. We have seen wide disparities in the compensation program for similar positions, which cannot be explained away by the cost of living in a given market, the size of the asset management firm, or the relative level of profitability.Mercer Capital’s Memphis office is housed in a 34 story high-rise. I’ve often wondered what I would learn by going floor to floor, office to office, in our building and asking what the receptionist in each office is paid. The data would be statistically significant at one level – there are probably 100 people employed as a “receptionist” in our building, all working for services firms and in the same zip code. If I were to do that, how large of a variation in compensation would you expect me to find? Is it possible that the highest paid receptionist in the building would make over twice that of the lowest paid receptionist? And what might account for those differences? Tenure? Size of firm? Profitability of firm? Actual nature of administrative responsibilities? Now imagine that you are, instead, trying to compare senior portfolio manager positions at long/short hedge funds in Kansas City and San Francisco: lining up salary, bonus compensation, performance-based compensation, equity compensation, etc.Our observation is that compensation at RIAs tends to be idiosyncratic, but by this we don’t mean to imply that it is idiotic. Simply put, compensation programs tend to evolve, purposefully, in asset management firms over time and over time take on a life of their own. Inevitably, compensation programs tend to be intertwined with business model and ownership. Internally, they make sense. Externally, they may be hard to compare with the “market.” When we are called in to provide a valuation, we have to make some rational sense of the compensation program to come up with a normalized margin that we can use to value the firm.Compensation Expert AnalysesAt Mercer Capital, we don’t hold ourselves out as compensation experts. But we do encounter a number of compensation experts and their work tends to follow a familiar pattern. Usually, the expert will evaluate the requirements and responsibilities of a given job at an investment management firm, and will use some form of statistical regression analysis to compare a market rate of compensation for that position with published pay data for similar positions at other firms.Not to debate the merits of statistical analysis, but this methodology has some obvious drawbacks. Comparability is hard to establish. No two person’s qualifications are the same, nor are any two positions’ requirements and responsibilities. Does the scale of the firm as measured by AUM matter more to the level of compensation for a CEO, for example, or is it more to be governed by the level of profitability? How are salary, bonus, and equity compensation to be compared – and are each worth the same on a dollar for dollar basis? Is participation in carried interest a factor? If so, finding suitably comparable market data is challenging.Public Company TrendsWhat we can know with some degree of precision is what publicly traded asset management firms spend on staff. This doesn’t answer the question of what a particular position with a particular firm in a particular market would and should pay, but it does give reasonable guidance as to what the compensation/margin tradeoff is for public companies, and in turn gives some idea of what it should be for private companies.Look, for example, at the interaction between compensation and margin at twenty large publicly traded investment management firms. From the trough of the credit crisis through the bull market in 2014, total annual revenues of these twenty firms almost doubled from $25.3 billion to $44.0 billion. If we break down expenses into compensation related costs and non-compensation related costs, we see that operating leverage is more pronounced with non-compensation related expense. Because some compensation related costs get buried in SG&A as distribution expenses or other outsourced services, it’s likely the case that compensation tracks revenue more closely than this high-level analysis suggests. Nevertheless, the big story from this is operating margin. As revenues increase, margin does as well – even at the scale of these public companies. We see this to be the case, regularly, in the private company RIA space, but it’s interesting to see confirmation in the public space, where scale is such that one might expect margin expansion to be more muted. SummaryInvestment management is a talent business, and that talent commands a substantial portion of firm revenue which often exceeds the allocation to equity holders. While there is no perfect answer as to what an individual or group of individuals should be compensated in an RIA, we can look to market data and compensation analysis, measured against the particular characteristics of a given investment management firm’s business model, to make reasonable assumptions about what compensation is appropriate and, by extension, what level of profitability can be expected.

RIA Compensation and Valuation: A Conundrum of Brobdingnagian Proportions

Part 1

Most of the history of race car development focused on creating larger and more complex motors that would generate greater amounts of horsepower. The tradeoff, frequently overlooked, was that a car has to be in scale with the motor, so more horsepower meant a larger and heavier car. A heavier car is more difficult to handle in corners and requires larger brakes. In racing it consumes more fuel (so more pit stops), and a more complex motor is necessarily less reliable.Colin Chapman was one of the first race car designers to recognize the tradeoff between power and weight, and his mantra, "add more lightness," inspired a whole generation of sports cars. Chapman's first road car, the Lotus Elite, had a small and simple, in-line four cylinder motor which only produced about 105 horsepower. What made the Elite competitive was that the car weighed only about 1,000 pounds (the current generation Chevy Tahoe can weigh six times that), so it handled like a dream and could travel at 130 mph. Consequently, the Elite won its class at Le Mans six years in a row.A similar tradeoff in an investment management firm's business model is that of compensation expense versus profit margin. Compensation is almost always the largest expense on an RIA's income statement and has a direct impact on net income.One of my earliest memories of working with clients in the RIA space was standing in the corridor of a $2 billion AUM equity manager one afternoon as the staff was packing up to go home. The managing partner took the opportunity to show me around the empty office and explain the business model to me: "Our assets get on the elevator and go home every night."Yet the most popular rule-of-thumb metric for valuing RIAs isn't price per employee, but price to AUM. The value of an RIA is not an accumulation of talent, but an accumulation of client assets that produce a healthy profit – after paying for things like talent. The contribution of client assets to profitability may be more consistent than the contribution of talent assets. "The meter's always running," my senior analyst at the time told me.The truth, of course, lies somewhere in-between. Managed assets produce a revenue stream which, after paying for rent and research and maybe a nice client dinner or two, must be divided between the staff (who service clients, manage the shop, and manage the portfolios) and the ownership of the firm (who may or may not be actively involved in operations). At Mercer Capital, our internal language to distinguish the two is return to labor and return to capital. Choosing how to allocate returns between labor and capital often says everything about an RIA's business model.A Tale of Two Managers…Take a look at the following pair of asset management firms: ACME and Smith. Both generate $10.0 million in revenue, and both spend $2.0 million on non-personnel related expenses. In both cases, that leaves $8.0 million to pay staff and provide a dividend stream or other return to shareholders. At this point the similarities end, and because of differences in compensation structure and the resulting differential in margins, Smith is five times as profitable as ACME. Since we are a valuation firm, the question we are most likely to be asked at this point is, which firm is worth more: ACME or Smith? That's an interesting question which deserves more than a little thought. I can think of several occasions where we have been confronted with this very question both formally, when we were working out the share exchange on two similar RIAs with different expense and margin structures, and informally, when we coincidentally valued two very similar firms (for different projects) with approximately the same differential in their respective P&Ls as ACME and Smith. On the basis of activity alone, maybe ACME and Smith are worth the same. If they have a similar fee schedule, then similar revenue implies similar AUM. But Smith is five times more profitable than ACME, so doesn't that mean Smith is worth, if not five times as much, at least considerably more? Absent conflicting information, the answer might be yes. Of course, there's usually conflicting information. "Why" Matters More Than "What"Consider the possibility that ACME and Smith are both equity managers serving high net worth and institutional clients. Each employs the same number of staff, and each operates in markets with similar labor availability and costs of living. Now we know a lot of "what" there is to know about ACME and Smith, but we don't know enough of "why" they show the differential in margins.ACME operates in a state with a high corporate income tax rate, but no personal tax rate, so they pay out owner distributions in the form of bonuses that inflate compensation expense and deflate margins. Smith is neutral on the tax issue, but has a minority private equity owner that insists that partners are paid only modest salaries such that performance is rewarded for all owners, both inside and outside, via shareholder distributions.So Which Firm is Worth More?On the basis of the narrative above, ACME and Smith might be worth about the same. The market for talent being what it is, we might normalize the income statements of both companies and get to a similar margin structure (we will cover how to do that next week). Similar profits might yield similar valuations, but there is a business model difference which matters as well. ACME has more flexibility in its compensation structure and could bonus staff based on ownership and/or performance. This might be a recruiting advantage in the never ending war for talent, thus garnering better "assets" for ACME that will make it more successful than Smith. So is ACME worth more? As a shareholder in Smith, you might be concerned about the firm's ability to recruit talent, but you would not be concerned about sharing your distribution stream with that talent. So maybe the Smith shareholder has less upside, but that upside is better defined.The corollary to Collin Chapman's "add more lightness" here might be to give up on expensive talent and focus on margin, because profits are why businesses operate in the first place. Demonstrated profitability beats adjusted profitability any day. Alas, the early Lotus cars were not known for durability (Chapman also thought that a race car that wasn't falling apart at the finish line was overbuilt), and skimping on talent to the point that it impairs the longevity of an RIA does little to improve the value of the firm.Simple, huh?Next week we will finish the thought with Normalizing Compensation Expense.

Success and Succession Offers Targeted and Often Unexpected Insights on Internal Ownership Transition at RIAs

As the Baby Boomer generation continues to age toward retirement, many “founder-centric” asset management firms face the prospect of internal succession. The recent book “Success and Succession,” by David W. Bianchi, Eric Hehman, Jay Hummel, and Tim Kochis, is written from the perspective of three individuals who have experienced successful ownership transitions. The book provides some interesting insights into the logistical, financial, and emotional process that internal succession entails through colorful accounts of past triumphs and train wrecks.Some of the authors’ perspectives and insights are what one might expect. Operational realities cause many asset management firms to revolve around a key man, who may not prioritize a strategic succession or may lack a viable successor. He or she may have flawed beliefs that could doom the transition process, including the insistence that the firm remain the same following succession or the assumption of an unreasonably high valuation of the firm. While ownership transition should celebrate the achievements of the founder, it must also recognize the need for change in order to continue to serve the clients. Clearly, client communication during the transition is crucial, especially for a founder-centric firm in which the majority of client meetings and responsibilities have fallen on the exiting owner.Much of the above, while important, has been said by many others in many forums. The strength of “Success and Succession” is in more than a handful of unique insights into RIA ownership transition which get little if any attention from other industry commentators.Both the founder and the successor need to be aware that firm-wide growth often declines in the first year following the change in management, as the founder-centric firm shifts its brand image and the successor takes on responsibility for creating new business. If a successor is unaware of this trend, he or she could feel additional stress regarding the financial burden he undertook when buying out the former owner. The founder could feel the need to resume fulltime involvement in operations, fearing for his ongoing financial benefits from the firm. The authors advise both founders and successors to take a long term view and not focus on this short term pullback.Regardless of the firm’s performance in the first few years following succession, both the founder and the successor need to set definite (as in finite) expectations regarding the founder’s continued involvement or lack thereof. The founder should remain accessible, as his or her guidance is crucial when the successor faces major issues early on. But it should also be clear to everyone that the successor is now the one charged with minding the store.Though some things do need to change following a succession of management, the successor should avoid creating new positions to retain people who no longer fit into the firm’s long term goals. One benefit of succession is that the new manager may have a fresh perspective on areas of the firm in which cost cutting measures or other efficiencies are possible. Although it may be difficult to assess which employees should remain after the transition, allowing those who are poor fits to remain with the firm does significant damage to the firm’s culture and does not set the proper tone for post-transition success.It is crucial to separate compensation for labor from profit share rewards as the exiting owner becomes less involved in day to day management of the firm. This issue can be resolved through the establishment of a strict reinvestment versus distribution policy going forward. The authors even suggest that the founder employ an independent financial advisor in order to objectively estimate a fair amount of compensation following the sale.Though it is clear that the founder took on a significant amount of financial risk in the creation of the firm, it must be noted that the successor is also taking on risk in the amount of debt he or she must incur to buy out the owner. Both parties have a lot to gain and a lot to lose in the process of succession, and both bear a significant emotional burden. The founder may perceive the transition as a loss of a personal identity that is tied to the firm, and the successor must now bear the responsibility of the ongoing success of the firm.Controversy over what is fair or what is “enough” in terms of a sale price can be resolved through a third party valuation. While it might seem easier to rely on valuation metrics or attractive examples, these tactics are purely short term solutions and can result in overly optimistic estimates. The financial terms of the valuation are already emotionally charged. A third party valuation can provide a much needed “reality dose.” All in all, the book is a practice-management must read for RIA owners contemplating succession – whether they are on the buy side or the sell side. Our experience advising clients on internal succession, in particular, is that successful transition requires a certain level of patience and humility on the part of both founder and successor, but above all long term commitment to a process rather than an expectation of a near term result. The book plugs the necessity of a third party valuation – and we would certainly second that – but we would add that a third party advisor with experience can often provide much needed perspective to keep a succession process realistic and give it the maximum opportunity to work for everyone.

Preferences and FinTech Valuations

2015 was a strong year for FinTech. For those still skeptical, consider the following:All three publicly traded FinTech niches that we track (Payments, Solutions, and Technology) beat the broader market, rising 11 to 14% compared to a 1% return for the S&P 500;FinTech M&A volume and pricing rose sharply over recent historical periods with 195 announced deals and a median deal value of $74 million in 2015 (Figure 1);A number of notable fundings for private FinTech companies occurred with roughly $9.0 billion raised among approximately 130 U.S. FinTech companies in larger funding rounds (only includes raises over $10 million). One of the more notable FinTech events in 2015 was Square's IPO, which occurred in the fourth quarter. Square is a financial services and mobile payments company that is one of the more prominent FinTech companies with its high profile founder (Jack Dorsey, the Twitter co-founder and CEO) and early investors (Kleiner Perkins and Sequoia Capital). Its technology is recognizable with most of us having swiped a card through one of their readers attached to a phone after getting a haircut, sandwich, or cup of coffee. Not surprisingly, Square was among the first FinTech Unicorns, reaching that mark in June 2011. Its valuation based on private funding rounds sat at the top of U.S.-based FinTech companies in mid-2015. So all eyes in the FinTech community were on Square as it went public in late 2015. Market conditions were challenging then (compared to even more challenging in early 2016 for an IPO), but Square had a well-deserved A-list designation among investors. Unfortunately, the results were mixed. Although the IPO was successful in that the shares priced, Square went public at a price of $9 per share, which was below the targeted range of $11 to $13 per share. Also, the IPO valuation of about $3 billion was sharply below the most recent fundraising round that valued the company in excess of $5 billion. In the category its great pay if you can get it, most Series E investors in the last funding round had a ratchet provision that provided for a 20% return on their investment, even if the offering price fell below the $18.56 per share price required to produce that return. The ratchet locked in through the issuance of additional shares to the Series E investors. The resulting dilution was borne by other investors not protected by the ratchet. On the flip side the IPO was not so bad for new investors. Square shares rose more than 45% over the course of the opening day of trading and then traded in the vicinity of $12 to $13 per share through year-end. With the decline in equity markets in early 2016, the shares traded near the $9 IPO price in mid-February. IPO pricing is always tricky—especially in the tech space—given the competing demands between a company floating shares, the underwriter, and prospective shareholders. The challenge for the underwriter is to establish the right price to build a sizable order book that may produce a first day pop, but not one that is so large that existing investors are diluted. According to MarketWatch, less than 2% of 2,236 IPOs that priced below the low end of their filing range since 1980 saw a first day pop of more than 40%. By that measure, Square really is a unique company. One notable takeaway from Square's experience is that the pricing of the IPO as much as any transaction may have marked the end of the era of astronomical private market valuations for Unicorn technology companies. The degree of astronomical depends on what is being measured, however. We have often noted that the headline valuation number in a private, fundraising round is often not the real value for the company. Rather, the price in the most recent private round reflects all of the rights and economic attributes of the share class, which usually are not the same for all shareholders, particularly investors in earlier fundraising rounds. As Travis Harms, my colleague at Mercer Capital noted: "It's like applying the pound price for filet mignon to the entire cow – you can't do that because the cow includes a lot of other stuff that is not in the filet." While a full discussion of investor preferences and ratchets is beyond the scope of this article, they are fairly common in venture-backed companies. Recent studies by Fenwick & West of Unicorn fundraisings noted that the vast majority offered investors some kind of liquidation preference. The combination of investor preferences and a decline in pricing relative to prior funding rounds can result in asymmetrical price declines across the capital structure and result in a misalignment of incentives. John McFarlane, Sonos CEO, noted this when he stated: "If you're all aligned then no matter what happens, you're in the same boat… The really high valuation companies right now are giving out preferences – that's not alignment." A real-world example of this misalignment was reported in a New York Times story in late 2015 regarding Good Technology, a Unicorn that ended up selling to BlackBerry for approximately $425 million in September 2015. While a $425 million exit might be considered a success for a number of founders and investors, the transaction price was less than half of Good's purported $1.1 billion valuation in a private round. The article noted that while a number of investors had preferences associated with their shares that softened the extent of the pricing decline, many employees did not. "For some employees, it meant that their shares were practically worthless. Even worse, they had paid taxes on the stock based on the higher value." As the Good story illustrates, the valuation process can be challenging for venture-backed technology companies, particularly those with several different share classes and preferences across the capital structure, but these valuations can have very real consequence for stakeholders, particularly employees. Thus, it is important to have a valuation process with formalized procedures to demonstrate compliance with tax and financial reporting regulations when having valuations performed. Certainly, the prospects for scrutiny from auditors, SEC, and/or IRS are possible but very real tax issues can also result around equity compensation for employees. Given the complexities in valuing venture-backed technology companies and the ability for market/investor sentiment to shift quickly, it is important to have a valuation professional that can assess the value of the company as well as the market trends prevalent in the industry. At Mercer Capital, we attempt to gain a thorough understanding of the economics of the most recent funding round to provide a market-based "anchor" for valuation at a subsequent date. Once the model is calibrated, we can then assess what changes have occurred (both in the market and at the subject company) since the last funding round to determine what impact if any that may have on valuation. Call us if you have any questions. For those interested in additional FinTech trends, check out our latest FinTech industry newsletter and sign up for future issues here. Related LinksFinTech Newsletter 4Q15 | Venture Capital Case Study: StripeIs a Bubble Forming in FinTechMercer Capital's Financial Reporting BlogMercer Capital monitors the latest financial reporting news relevant to CFOs and financial managers. The Financial Reporting Blog is updated weekly. Follow us on Twitter at @MercerFairValue.

Value Driver Considerations in Appraising Sports Franchises

OverviewThe valuation of sports properties is often perceived as one of the most exciting areas of the appraisal profession. Sports business mandates constitute an amalgam of traditional valuation approaches applied to a specialized industry niche possessing its own distinct value drivers and considerations.Sports property valuations may be required in a variety of situations, including:mergers and acquisitions;fairness opinions;business reorganizations;shareholder disputes;structuring shareholder agreements;income tax;estate planning;insolvency;commercial litigation; andmarital disputes. While the purchase and sale of professional sports franchises and arenas constitute the most visible event necessitating the participation of an experienced valuator, the foregoing situations also can give rise to valuation mandates. For example, in 1994, the Toronto Maple Leafs NHL franchise and the arena in which the team played, Maple Leaf Gardens, were owned by a public company, Maple Leaf Gardens, Limited, which was being taken private. Consequently, the fairness opinions that had been prepared in connection with this going-private transaction were called into question by The Public Guardian and Trustee of Ontario and the Attorney General for Ontario. A vigorous litigation ensued, in which the valuation professionals played a central role. As is the case with many businesses, shareholder agreements can necessitate valuation mandates, as sports teams and arenas are often owned by numerous individuals and/or corporations. For example, at the date this was written, the Calgary Flames NHL franchise was held by over two dozen owners, and the Green Bay Packers NFL team was owned by several thousand individuals, most of whom were members of the local Wisconsin community. Both friendly transactions and acrimonious disputes among shareholders occurring under such shareholder agreements will typically require the involvement of one or more valuation professionals to determine the value of the entity holding the sports-related assets (or interests therein). Income tax and estate planning also constitute frequent sources of valuation work involving sports organizations. Those sports properties that have been owned by families will often, at some point, require valuations to be performed for intergenerational transfers of ownership among family members. Moreover, considering the significant appreciation in value experienced by professional sports franchises around the globe during the past few decades, owners of sports properties eventually may need to contend with capital gains-related issues. Valuation professionals often provide integral assistance in this process. Insolvency or restructuring involving either a professional sports organization or one of the owners thereof is another event that will frequently necessitate the expertise of business valuators. For example, in the 1990s, there were several high-profile bankruptcies of English Premier League football (i.e., soccer) organizations that occurred after several previous rounds of financing had been obtained. At every step of the way, from the initial financing to the restructuring or asset liquidation process, business valuations are typically required to provide an indication of worth of the sports franchise and related properties.Price Versus Fair Market ValueThe valuation of professional sports properties provides an excellent illustration of the difference between price and fair market value in a "real world" setting. As valuation professionals are well aware, there are generally two distinct sets of circumstances where the value of a business is determined:Notional Market Valuation. Fair market value, fair value or some other legislated or defined value is often notionally determined in the absence of an open-market transaction. The value standard most frequently applied in notional market valuations is "fair market value." The generally accepted definition of this valuation term by North American courts is:The (highest)1 price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.Open-Market Transaction. Price is negotiated between a vendor and a purchaser acting at arm’s length. The term "price" is defined as "the consideration paid in a negotiated, open-market transaction involving the purchase and sale of an asset." In a sports market context, sentimental value may occasionally represent a component of price. This concept is evidenced by a sports team owner who is an extremely wealthy individual and does not view the acquisition of a sports team from an economic perspective but rather as a "trophy." An investment involving sentimental value, in other words, may be ego-driven in nature and made by a purchaser who is willing and able to absorb significant losses. Special interest purchasers are often present in the marketplace for professional sports properties. Special interest purchasers are generally defined as: "acquirers who believe they can enjoy post-acquisition economies of scale, synergies, or strategic advantages by combining the acquired business interest with their own." Examples of these types of purchasers are large companies possessing broadcasting, media and entertainment operations that can avail themselves of synergies presented by controlling assets relating to professional sports organizations. In recent years, a number of such companies have successfully acquired professional sports properties in order to benefit from the content provided to the purchaser’s media distribution network. In the sports business world, both of the above sets of circumstances are frequently encountered. As is illustrated below, there may be significant differences between fair market value and price. For example, fair market value typically assumes the following conditions exist:equal knowledge and negotiating skills;no compulsion to transact;generally no special interest purchaser considerations;imprudent actions and emotions are not considered;vendor and purchaser are assumed to deal at arm’s length; andtransaction is assumed to be consummated for cash. In contrast, the price determined in an open-market transaction may be influenced by the following considerations:unequal knowledge and negotiating skills;compulsion to transact may be present (e.g., a sale made in an insolvency setting even if the purchaser intends to continue the sports organization as a going concern);special interest purchasers may force the price upward;price may be struck as a result of imprudent decisions by the vendor, the purchaser or both;sentimental value considerations may force the price upward;outwardly, vendor and purchaser may appear to act at arm’s length, but may have common interests due to the elements of the transaction, such as vendor employment agreements, noncompetition agreements, etc.; and/orthe negotiated price may contain noncash elements, such as contingent "earn-out" or bonus payments, freely trading or restricted shares and/or debt instruments.Valuation ApproachesAs is the case with most businesses, a sports franchise’s value is derived from its future benefits, such as revenues, EBITDA and net cash flow. Among the factors influencing the perceived future benefits for a sports franchise include its management team, trademarks, brands and logos, customer "fan base" relations, customer contracts (e.g., season tickets, corporate boxes, personal seat licenses), player relations and contracts, broadcasting contracts, arena ownership or lease agreements, team-alliance synergies, local demographics (e.g., population size, wealth, popularity of sport), etc.Simply put, the fundamental goal for a sports team owner is to maximize the number of fans in the seats (or viewing the matches via broadcast media), and the goal for an arena/ stadium owner is to minimize the number of "dark nights" in which no event is occurring in the building.Admittedly, while future benefits often cannot be measured with absolute certainty, franchise values will change in a manner commensurate with perceived increases and decreases in such benefits. In the sports business world, while no single approach or formula can be used to determine the value of sports properties in every situation, different approaches and methods have been adopted for estimating future benefits and franchise/asset values.In sports business valuations, the Market Approach is often frequently utilized, considering the active market that exists for many professional sports properties. In the Market Approach, the subject sports property is compared to similar properties by performing a detailed analysis of prior transactions involving similar sports properties and/or in the ownership of the subject sports franchise or asset.Transactional IssuesIn analyzing transactions in sports properties, aside from reviewing the amount and structure of the transaction price, it is frequently necessary for the valuation professional to identify and quantify key organizational elements that generate value for the subject professional sports club, such as (but not limited to) management team and personnel, corporate operations, finance and technology.It is a sports business paradigm that the management team should, in maximizing franchise value, maintain and enhance the quality of the team brand. Such brand value enhancement may be performed in a variety of ways, including winning on-field victories and championships, attracting individual "marquee" players, fostering positive community relations and developing a robust tradition ultimately bestowing "iconic" status on the sports franchise.For example, the valuator should examine the quality of the management team, employees and players, focusing on the club’s ability to retain talent and expertise (on the field, among the coaching staff and in the front office). In order to enhance value, the sports organization should possess the potential to develop future leaders (for both players and management), avoid labor actions (e.g., strikes, lockouts), motivate commitment in its players and employees to the club’s culture and ethics, and strengthen relationships among management, players and employees.In assessing value of sports franchises in a transactional setting, the valuation professional should also examine the ability of the organization to maximize the potential of its corporate operations. For example, the franchise organization should constantly strive to improve capacity utilization wherever possible (e.g., selling out games, maximizing advertising and media revenue). Recent revenue maximization trends by franchise owners in this context have included selling advertising on fixed or rotating panels in close proximity to playing surfaces, inside arena corridors, on building exteriors and on game tickets. Sports team management should also be seeking to optimize other areas of business potential (e.g., creation of team-alliance synergies, increase in the number of official sponsors or partners with the club, etc.).Moreover, the sports organization should periodically assess what investments are required to expand or improve fixed-asset infrastructure (e.g., addition of seats, creation of premium or "club" seat categories, addition or expansion of facility restaurant, bar, concessions and parking facilities). Management should also be cognizant of ways to strengthen the franchise’s market position in the presence of other forms of entertainment competing for the same consumer, media and advertising spending sources.The valuation professional must examine the ability of the sports organization to maximize the value of its intangible assets. Aside from traditional items such as the franchise logo, influencing the popularity of merchandising and licensing revenues, in recent years, savvy sports-marketing experts have derived new sources for professional sports franchises to obtain revenues, notably the leasing of stadium/arena naming rights. Typically, building naming rights are leased for several million dollars annually for terms of 10 to 20 years; these stable revenues often flow directly to the bottom line of the club/building owner.Furthermore, in transactional contexts involving professional sports organizations, the valuation professional should assess the financial strength of the subject business. In particular, the valuator needs to place particular emphasis on the extent to which leverage has been (or may be) utilized to finance capital assets and franchise operations. Other financial issues should be reviewed, including the club’s ability to recognize and maximize all revenues (i.e., deferred revenues) from an accounting standpoint and to depreciate or amortize the franchise itself, player contracts, capital assets, etc. If the franchise is being positioned for sale, it may be desirable for the club to "clean up" the balance sheet, (e.g., eliminate redundant assets such as excess cash, marketable securities, non-operating real estate, inter-company or shareholder loans), adjust overvalued assets and other reserves in order to present the sports business’ true earning power, accelerate the collection of accounts receivable, etc.Finally, sports business valuation experts have increasingly focused on a franchise’s ability to enhance value through the creative use of technology. In recent years, technology has been utilized by sports team owners through innovations such as the use of web-based resources featuring fan club sites and live or archived game broadcasts. Many sports business experts predict a proliferation of fee-based broadcasts of matches and related content through television, Internet audio and video, as well as mobile phone media. Other uses of technology that may create franchise value relate to the extent to which technology can be implemented to improve communications (e.g., within the internal organization, with the fan base and among the league and its members).Value DriversBoth of the concepts of price and fair market value are often influenced by numerous value drivers that relate specifically to professional sports franchises. Among the frequently encountered examples of "external" value drivers (over which a franchise owner exerts little, if any influence) are included, but are by no means restricted to:degree of control of franchise operations by league;finite number of teams permitted in league (i.e., barriers to or ease of entry through expansion);franchise expansion fee (this often constitutes a "floor" to franchise value, as well as a windfall profit to franchise owners when received). For example, in the NHL, the most recent expansion fee paid for a new franchise, occurring 15 years prior to the publication of this paper, was U.S. $85 million. Media reports have stated that the next potential round of NHL expansion could command franchise fees as high as U.S. $400 million;extent and terms of revenue sharing;presence of salary cap;local market barriers to ownership entry/exit;availability of government grants or other forms of financial assistance;market demographics;market radius protection (in the NHL, each franchise is protected by a 50-mile radius, within which another franchise in the league cannot be operated without the existing owner’s permission);ability of the franchise to relocate; andextent to which league approval is required for franchise ownership transactions. Moreover, included among the various salient "internal" value drivers over which a franchise owner typically possesses some ability to influence are:ticket revenue (e.g., season ticket base, ability to increase or vary ticket prices);broadcast revenue (e.g., from television, radio and Internet media);team-alliance synergies (i.e., synergies and benefits derived from common ownership of two or more sports teams);player-transfer fees (i.e., these represent highly lucrative sources of revenue in international soccer);advertising revenue;playoff revenue (revenues from post-season play often contribute significantly to profits);concessions revenue;merchandising and memorabilia revenue (including revenues from licensing team name and logo); andstadium/arena ownership revenues (derived from building sources such as luxury "club" seating, corporate boxes, naming rights and ancillary events such as concerts, unrelated sporting events, conventions, etc.). Interestingly, two factors that do not always constitute significant value drivers for a sports franchise are the win-loss record of the club, as well as the individual players comprising the team. The impact of possessing (or lacking) either championship trophies or superstar players must be assessed by the valuation professional as to the incremental contribution of each to the value of a particular sports organization. Among the important items on the expense side of the income statement that may materially impact the value of a professional sports franchise are included player salaries, which are, in turn, influenced by permitted contractual increases, free agency, union collective bargaining agreements, long-term injuries to or retirements of players, etc. Franchise owners who do not own the stadium/arena facility will also be subject to leases for building rental, as well as possibly leases for concessions, merchandising and/or parking facilities. Moreover, some teams, such as Canadian NHL franchises, must contend with material foreign currency risk, as their revenues will be received in the local currency while some of their expenses (e.g., player salaries) may be denominated in a foreign currency. Finally, the ability of a sports club to claim amortization expense on its franchise cost, player contracts and capital assets will impact its fiscal situation, as well as its operating cash flows.ConclusionWhile the sports business field may be a source of some exciting mandates for the valuation practitioner, as the above narrative indicates, sports properties encompass a highly specialized segment of our profession that is subject to its own distinct challenges.This article originally appeared in Wolters Kluwer's Business Valuation Alert, January 2015.About the AuthorsDrew Dorweiler, MBA, CPA, ABV, CBV, ASA, CBA, CFE, CVA, FRICS, is Managing Partner at IJW Co. Don Erickson, ASA, is Managing Director of Mercer Capital. Endnote1 The word "highest" is added to the Fair Market Value definition in Canada.

2015: A Good Year for Banks

After weak broad market performance in the first quarter of the year and slow advances during the summer, U.S. stocks generally saw amplified returns in the fourth quarter of 2015. The largest banks (those with over $50 billion in assets) generally performed in line with broad market trends, but most banks outperformed the market with total returns on the order of 10% to 15% for the year (Figure 1). Bank stock performance improved markedly in the fourth quarter as speculation following the FOMC’s September meeting suggested rate increases may begin in the fourth quarter. In mid-December, the FOMC met again and, after seven years of its zero interest rate policy, announced an increase in the target fed funds rate. The shift in monetary policy is expected to gradually improve strains on banks’ net interest margins and should be most apparent for banks with more asset-sensitive balance sheets, though community banks that may have made more loans with longer fixed terms or loan floors may experience some tightening in the short term. Bank returns generally averaged around 0% to 30% in 2015, though 17% of the U.S. banks analyzed (traded on the NASDAQ, NYSE, or NYSE Market exchanges for the full year) realized negative total returns. These included banks continuing to deal with high levels of NPAs; banks that are located in oil-dependent areas such as Louisiana and Texas; and some banks that have been active acquirers that missed Street expectations. On the other end, a few high performers in 2015 include merger targets as well as banks that have seen more success from acquisition activity (Figure 2). One of the primary factors contributing to stronger returns in 2015 was loan growth. Banks with loan growth over 10% exhibited above-average returns, while those with slower growth tended to exhibit lower returns, with the exception of banks that shrank their portfolios during the year, though for these banks the higher returns likely reflected prior years’ underperformance that was priced into the stocks (Figure 3). Asset-sensitive banks also outperformed in 2015. While asset sensitivity is difficult to evaluate from publicly available data, we measured asset sensitivity by the proportion of loans maturing or repricing in less than three months from September 30, 2015, relative to total loans (both obtained from FR Y-9C filings). Limiting the analysis to publicly traded banks with assets between $1 billion to $5 billion reveals that the most asset sensitive banks returned about 16% in 2015, or 400 basis points more than less asset sensitive banks (Figure 4). Though the smallest banks generally realized the highest returns in 2015, pricing multiples were strongest for banks with assets between $1 and $10 billion, which generally saw better profitability than the smaller banks. Year-over-year, pricing multiples generally remained flat from 2014 (Figure 5). Mercer Capital is a national business valuation and financial advisory firm. Financial Institutions are the cornerstone of our practice. To discuss a valuation or transaction issue in confidence, feel free to contact us.

The Oil and Gas Shift is Impacting the Industry in a Few Key Areas

Anybody who has been to a gas pump in the last several months can tell you that the energy industry is currently in the throes of change. Prices are falling to lows that they haven’t seen in almost a decade and the industry itself is being impacted in a large number of different ways. The changing face of economics and the marketplace has presented an entirely new set of challenges that businesses will have to adapt to in order to thrive well into the future.The Changing Face of Economics and the MarketplaceAnother significant change that will impact the oil and gas industries in 2015 and beyond has to do with current market fluctuations that will affect profitability. It’s no secret that oil prices started plummeting in 2014 and show no signs of slowing down. Bernstein Research, for example, estimates that a full 1/3 of all shale projects in the United States become unprofitable once prices fall below $80.This is a case-by-case basis, however, and is not blanket fact. The Bakken formation in North Dakota, for example, will still be profitable so long as prices do not fall below $42 per barrel – according to the IEA. ScotiaBank’s own research indicates that prices have to stay between $60 to $80 per barrel for the Bakken formation to remain profitable.Changes in Production and DemandA large part of the reason why oil prices are continuing to fall has to do with two other significant changes that are impacting the industry: namely, changes to the total amount of oil that the United States and Canada are producing, as well as changes to the demand for oil in areas of the world like Europe and Asia.According to the International Energy Agency (also commonly referred to as the IEA), shale production in the United States is expected to shift dramatically in the coming years. In scenarios both where oil prices remain roughly where they are and where they continue to fall even farther, the IEA predicts that shale production will still continue to grow, just at a much slower rate than it has been in the last several years. To put that into perspective, production is still expected to increase an additional 950,000+ barrels per day throughout the entirety of 2015.Another important factor to consider has to do with infrastructure with regards to existing investments. There are a large number of energy companies that have already paid a great deal of money purchasing land, obtaining necessary permits and performing other tasks necessary to drilling. Even if oil prices continue to fall, these companies can’t necessarily curb back on their production or they fear losing an even greater investment than initially feared. In these types of situations, the true “break even” price in production varies depending on the operator and their tolerance versus the amount of debt that they’ve taken on. Even still, it may be too early to tell in many cases how firm those tolerances really are.The boom in increased oil production in the United States and Canada has created something of a tricky situation for the industry as a whole. After sinking a huge amount of money into infrastructure over the last several years, businesses now have to contend with falling prices that show no signs of slowing down. In order to adapt they will have to look for ways to embrace new technology and streamline production in order to stay profitable well into the future and to break through into a bold new era for the industry as a whole.This article was originally published in Valuation Viewpoint, January 2015.

Does the Clippers $2 Billion Deal Make Sense?

In recent court testimony, Bank of America – Merrill Lynch (“BoA”) revealed its bid book (“Project Claret”) prepared for potential buyers of a NBA franchise, the Los Angeles Clippers (“Clippers”). We are going to analyze elements within the Project Claret document with a particular focus on the revenue estimate of the local media contract renewal in 2014.Let’s look at BoA’s estimate of local media revenues primarily related to television content. BoA forecasted television rights payment in June 2014 year-end at $25.8 million from the current contract projecting it to $125 million for a new local media contract. Michael Ozanian of Forbes recently estimated the 2014 new contract amount to most likely be closer to $75 million. I agree with Mr. Ozanian for the following reasons:If the Los Angeles Lakers (“Lakers”), back in 2011, signed a local media television rights contract for $5 billion over 25 years, then the average is approximately $200 million a year. Typically these contracts have annual escalation clauses and if the total payout is $5 billion, then the amount in 2012 is close to $100 million for the Lakers. You need to escalate that to about $110 million in 2014.The television ratings of the Lakers are multiples of the Clippers and cable subscribers ultimately pay for the right’s fees. So if you are a sophisticated buyer of sports content, like Fox Broadcasting Company or Time Warner Cable, are you going to pay the same dollar amount for the Clippers as you did for the Lakers? The Clippers have ½ the television ratings of the Lakers (1.28 vs 2.72) in the current year. To quote a recent Variety article, “This is believed to be the closest the Clippers have come to the Lakers in television ratings since the 1999-2000 season.” Additionally, the Lakers experienced a very poor win/loss record in the 2013-2014 season. If one analyzed their historical results, the Clippers have less than 1/3 of the viewership as the Lakers (121,000 vs 390,000) last year. Therefore, how much will the Clippers realistically get in 2014 with the new contract? $75 million is approximately 68% of our estimated Lakers deal amount and seems generous based on the raw ratings numbers. However, if we utilize the Forbes estimate of $75 million in 2014 and the other BoA revenue estimates for game admissions ($62.3 million) and other team revenue ($136.8 million), the total revenue estimate for the Clippers would be $274.1 million in 2014 versus the $324.1 million utilized in BoA Project Claret. If one assumes a multiple of 5x revenues, which is the high end of multiples paid for an NBA team to date, the indicated enterprise value estimate is $1.370 billion, a far cry from $2 billion. Additionally, many times when dealing with estimates of future results (in this case an estimate of future revenue) the valuation multiple applied should be lower than actual transaction multiples. These multiples are calculated based on historical revenues, which are usually lower than future estimates. It seems clear to us that based on the data available the $2 billion price from Steve Ballmer is a good deal for the Sterling Trust. This article was originally published inValuation Viewpoint, August 2014.

Exploring the Major League Baseball Value Explosion

From 2000 to 2005, Major League Baseball teams were selling for much less than National Football League teams, i.e., typically under $200 million. Most of the MLB teams were showing losses at the time, and there was limited interest in buying the teams that did come up for sale. But the buying and selling environment changed dramatically in 2012, with the Los Angeles Dodgers selling for over $2.15 billion in a spirited auction with sixteen initial bidders.1What has caused this explosion in MLB prices and do these high prices make sense?In this article, I attempt to answer this question as I discuss MLB franchise price/value changes in the last fifteen years and whether these dramatic jumps in prices/values make economic/market sense.First, I illustrate actual transaction prices for MLB teams in the early 2000s. I then show the significant increases—starting in 2008—leading to the blockbuster $2.15 billion Dodgers deal in 2012.I then demonstrate the value changes published by Forbes Magazine and discuss key economic changes in the industry (i.e. MLB) that have contributed to these price jumps of twice—and sometimes three times—the 2005 prices for MLB franchises.Finally, I explore the actual financials for the Texas Rangers and a history of the prices paid for the Rangers over the years.For definition purposes, when we discuss values, we are always discussing enterprise (equity + debt), not equity values, and when we discuss revenue multiples, we are discussing total revenues from team/franchise and stadium interests, but excluding regional sports network (RSN) interests.Deal Prices and MLB Values Estimated by Forbes MagazineAs Chart 1 shows, enterprise prices for MLB teams from 2000 to 2005 were less than $200 million, except for the 2004 Dodgers deal, which came in at $430 million. In 2006, two transactions increased to the low $400 million range. In 2008, a San Francisco Giants deal indicated $700 million, and the Chicago Cubs in 2009 were sold for over $800 million. In 2009 during the “Great Recession,” a smaller market team, the San Diego Padres, transacted at $500 million. Also in 2009, the Texas Rangers sold at $595 million during a bankruptcy bidding war. Finally, the chart shows the big jump with the bankruptcy auction prices of the L.A. Dodgers and their stadium and land at $2.15 billion in 2012.Changes in Revenue MultiplesUnlike entities in other industries, major league sports teams are usually valued using a market approach rather than an income approach. Most of their enterprise values are referenced as a multiple of team and stadium revenues.The multiples in revenues paid for actual transactions in the early 2000s were in the 2.0 times to 2.5 times range, but recent deals have been over 4.0 times revenues. The recent 4.0 times multiple reflects anticipated growth in revenues since sophisticated and well-heeled buyers are anticipating significant future revenue growth.In Table 1, Forbes estimates are developed by Forbes editors utilizing public sources, their proprietary methods of estimating team revenues and expenses, and their judgment as to the valuation multiple to be applied to their revenue estimates.3 By 2014 (see Table 2), Forbes average MLB value estimate had jumped to $811 million and had a 3.3 times multiple. The values ranged from $2.5 billion for the Yankees to $485 million for the Tampa Bay Rays. The average revenue estimates for the league have only increased from $183 million to $237 million or thirty percent. Yet the average valuation multiple increased from 2.6 times to 3.3 times causing the average team value to increase sixty-four percent. What caused this significant increase? The answer: potential for increased local revenues due to an explosion in media rights fees. Meteoric Media Rights Fee IncreasesAs mentioned earlier, recent media rights fees for local broadcasts of MLB teams have increased three to five times that of older contracts. These older contracts may have been ten years in length, but the new ones can be in force as long as twenty-five years.Unlike the total revenues for NFL teams and, to a lesser extent, those of the NBA, local media rights fees make up the majority of revenues for MLB teams. In many markets, the content providers (cable and satellite companies) are vying for a unique live product that can differentiate them in the marketplace. This competition has caused bidding wars for TV and other media rights to MLB teams.The largest current local MLB media contract was negotiated by the L.A. Dodgers and was recently approved by MLB. In this contract, the L.A. Dodgers will reportedly receive $6 billion after a revenue-sharing split with MLB. This equates to an average of $240 million a year over twenty-five years. The old Dodgers contract was approximately $50 million dollars in its last year.The next highest are the Texas Rangers and the Houston Astros at $80 million a year on average. In addition, the national TV MLB has jumped also—see Table 3. It should be noted that part of the massive increase in payments to the L.A. Dodgers by Time Warner Cable is covered by Time Warner’s plan to pass the costs on to other pay TV providers, including Direct TV, Dish Network, Charter Communications, and Cox Communications. Currently, Time Warner Cable and their providers are deadlocked on the price increases they will pay for airing the L.A. Dodger games. The providers contend that Time Warner’s cable price for their L.A. Dodger sports channel is too high. How this negotiation is settled will affect prices other providers pay nationwide. For example, the Houston Astros RSN has not been picked up by many of the local providers and the RSN has been forced to file for bankruptcy. Table 4 shows the changes in the MLB National media contracts with the various networks. We note that the ESPN contracts increased from $296 million a year to $700 million a year. The Fox contract increased from $257 million a year to $525 million a year, etc. In short, the new national contracts increased by 120 percent from the other contract. At the height of the recession, the San Diego Padres sold for $500 million in 2009. It resold in 2012 for $800 million due primarily to a major jump in a local media contract. Are the teams making so much money that they warranted such a much higher price based on profits? The answer, surprisingly, is “no, not really.” Case Study: Texas RangersThe Texas Rangers sale in 2009 to the highest bidder out of bankruptcy court7 is a good example (Table 5). Note that these numbers were prior to any regional media contract increases now scheduled to begin with the 2015 season. Also note that annual amounts shown in the both the local and national contracts are averages and the initial year of the contract is usually much less than the average price shown. All teams are subject to a player salary cap, which come with significant penalties if violated. So conceptually, if your revenues go up $50 million in a particular year, that amount could fall to the bottom line. How much is $50 million of profit worth to buyers whose primary value driver is not cash flow? It could be $500 million. It could be $1 billion. Which then causes people to wonder how much profit do these teams actually make? The answer is that many lose money—some significant amounts. Many people ask why anyone would pay these amounts to buy teams if they do not make a reasonable profit. There are two main answers to that: Every buyer has a different motivation.Few of us can look at “investments” through the lens of a multi-billionaire to whom a $10 to $50 million annual loss is not significant to their financial well-being.Texas Rangers Price HistoryThe Texas Rangers also provide a good example of transaction price changes in the MLB. Table 6 shows the transactions in the team since 1974. Please note that in the $595 million 2010 transaction, the team was making very little money and with signing bonuses deducted, was not cash flow positive. What is the value of this team, considering such facts? ConclusionThe intensity of local revenues for MLB has created a perfect storm for MLB teams as the media engages in a buying frenzy for live local sports entertainment.Multiples of 4.0 times revenues are now becoming the new normal versus 2.0 times prior to 2006 driven by local revenue growth with media leading the way. Media contracts are increasing three to five times the annual amounts negotiated in the early to mid-2000s. The outlook for increased local media contracts will create new and higher MLB club transactions for years to come.But what about value creation? In the case of the Dodgers, if their media revenue increases up hypothetically $200 million a year from the previous contract, how much increase in value will that create? Could it be an extra billion dollars or more? At the end of the day, these local media contract increases, coupled with the new increased national media contracts, generally tend to support the new much higher level of MLB prices.Obviously, the smaller markets do not enjoy the same increases as the major markets like Los Angeles and New York, etc., but their new contracts will increase in multiples of older contracts i.e., from $15 to $20 million a year to $50 million plus as media providers compete for the exclusive content that live sports provides.This article was originally published inThe Value Examiner, September/October 2014.EndnotesBrian Solomon, “$2 Billion Dodgers Sale Tops List of Most Expensive Sports Team Purchases Ever,” Forbes Magazine, March 29, 2012, http://www.forbes. com/sites/briansolomon/2012/03/29/2-billion-dodgers-sale-tops-list-ofmost-expensive-sports-team-purchases-ever/.Michael K. Ozanian and Kurt Badenhausen, “The Business of Baseball,” Forbes Magazine, April 16, 2008, http: http://www.forbes.com/2008/04/16/baseballteam-values-biz-sports-baseball08-cx_mo_kb_0416baseballintro.html. Note the remaining nineteen teams are shown on the NACVA website at http://www.nacva.com/examiner/14-SO-Charts.asp.Until recently, Forbes was the only public source of estimates for major league sports teams. They have been developing revenue, profit, and value estimates for over seventeen years. Numbers are as of Dec. 31, 2013.Mike Ozanian, “Baseball Team Values 2014 Led by New York Yankees at $2.5 Billion,” Forbes Magazine, March 26, 2014, http://www.forbes.com/sites/mikeozanian/2014/03/26/baseball-team-values-2014-led-by-newyork-yankees-at-2-5-billion/.Sources: Proprietary team sources.6 Christina Settimi, “Baseball Scores 12 Billion in Baseball Deals,” Forbes Magazine, October 2, 2012, www.forbes.com.Bankruptcy Court For The Northern District Of Texas Fort Worth Division, Texas Rangers Baseball Partners, Chapter 11, Case No. 10-43400-DML.Source: ProprietarySource: Proprietary

Are There Really 2 NHLs?

When it comes to the four major league sports (NFL, MLB, NBA, NHL), the NBA and MLB have had less success in Canada vs. the USA, primarily due to demographics. With the exception of Toronto, most of the cities tend to be smaller and have fewer corporate headquarters relative to U.S. cities. Currently there is only one NBA and one MLB team in Canada, both in Toronto.There is one major league sport, however, that is thriving in Canada, the National Hockey League (“NHL”). The NHL teams in Vancouver, Calgary, Edmonton, Winnipeg, Ottawa, Toronto and Montreal are doing very well. In fact, they’re doing much better on average than their U.S. counterpart cities that have much larger populations (i.e. Dallas and Atlanta which is now a former NHL city). So much so that one may say there are really two NHLs, the Canadian NHL and the U.S. NHL.How can that be?Let’s look at the estimated 2013 franchise values of the teams as published by Forbes magazine. Three of the seven Canadien teams are in the top four of league franchise values. The Toronto Maple Leafs are first at $1.2 billion, the Montreal Canadiens third at $775 million and the Vancouver Canucks fourth at $700 million. The NHL league average is $413 million. The remaining Canadian teams are valued as follows:(#11) Calgary Flames $420 million(#14) Edmonton Oilers $400 million(#15) Ottawa Senators $380 million(#16) Winnipeg Jets $340 million Our home team, the Dallas Stars, comes in at $333 million and the Columbus Blue Jackets rank last at $175 million. Now some interesting numbers: the seven Canadian teams feature values averaging $595 million, while the 23 American NHL teams average $358 million. That’s a little over half of the Canadian teams. How can the New York Islanders, with a metropolitan statistical area (“MSA”) population of 19.9 million, be worth $195 million, while the Winnipeg Jets, with an MSA population of 0.7 million, are valued at $340 million? Additionally how can Vancouver, with a MSA population of 2.3 million, be valued at $700 million? The franchise value relationship with MSA population does not directly correlate. How can this be? The answer is the popularity of hockey in Canada has no comparison to most U.S. cities. Hockey is the national sport of Canada. Kids grow up playing it, watching it and living it. That culture creates much greater revenue and profits for their teams. This can be demonstrated by analyzing the national television revenues and the local revenues of NHL teams.NHL: National Television RevenuesThe U.S. has a population of 319 million people vs. 35 million for Canada, yet the national TV rights for the NHL in Canada was recently won by Rogers Communications for $5.2 billion over 12 years, or an average of $433 million a year. This compares to the $2 billion, 10-year NBC U.S. deal which averages $200 million per year. In addition, 65% of the Canadian national TV rights will be shared with the 23 U.S. teams. It is interesting that a country with one-tenth the population gets about 2.2 times the national TV revenues compared to the U.S. and then has to share with the U.S. teams.NHL: Local RevenuesLocal TV rights are retained by the teams, as are other local revenues from suites, sponsorship and ticket revenues. Here again, the Canadian teams far outshine the U.S. teams. Forbes estimates the average NHL ticket prices in Canada for six out of the seven teams was $70 for non-premium tickets. Forbes estimated that small markets, Edmonton and Calgary, each had $1.6 million in annual ticket revenues. Compare that figure with the New York Rangers ticket revenue of $1.8 million, and that comparison is shocking (if that is not shocking to you, please compare populations of the three cities). Additionally, local television viewing shows the same type of comparisons as national TV viewing. Therefore, smaller Canadian markets like Vancouver will have multiples of local TV revenue when compared to a larger U.S. market, like Dallas.ConclusionIn conclusion, after considering the numbers, it is hard to make a case for franchise value comparison between Canadian and U.S. NHL teams. Clearly, the economics indicate there are two different NHLs.This article was originally published inValuation Viewpoint, October 2014.

NBA Team Values: Three Ways Cuban and his Owner Bretheren are Cashing In

In a recent article Mark Cuban commented how media revenues will push National Basketball Association (“NBA”) valuations far higher than they are currently. “If we do this right, it’s not inconceivable that every NBA franchise will be worth more than $1 billion within ten years,” he was quoted as saying. While that observation could be on the money, it’s not the only engine that drives NBA team values. NBA franchises are unique properties that are often among the most attractive and reported upon assets in the US (and globally for that matter thanks to Mr. Prokhorov). The undergirding economics of these teams are complex and nuanced. When value drivers align, good things happen and value is unlocked. Like a flywheel with momentum, certain dynamics can push values upward quickly. However, the same dynamics can push the flywheel off its hinges, bringing values crashing down. It’s an exciting property that doesn’t always follow the path of conventional valuation theory, which might be a reason why a Maverick like Mark Cuban loves it so much.NBA franchise values have recently gone in an upward direction as evidenced by the Sacramento Kings’ $534 million sale in January 2013. That’s quite a figure for the 27th ranked metropolitan statistical area (“MSA”) in the country. This transaction is especially fascinating in light of the Philadelphia 76ers (5th largest MSA) selling for only $280 million just 18 months earlier. What fuels such a vast difference? We explore three issues that contribute considerably to these variances – media rights, arena lease structure, and the NBA’s collective bargaining agreement (“CBA”). Some of these factors are more within an owner’s control than others, but all of them contribute to situational changes that valuations hinge upon. We’ll also explore the tale of two transactions: the 76ers and Kings, to see why and how these factors influence the purchase price.Media Rights: The Quest for Live ContentIt is important to note the majority of NBA team revenues come from local sources, (i.e. game day revenues and local media contracts). The most dynamic (and thus value changing) of these sources in the past few years has been local media rights. National media revenues in NBA are significant but are a much lower percentage of total revenues than the biggest league in North America, the NFL. According to Forbes, the 30 NBA teams collectively generated $628 million from local media last season (about $21 million average per team). In addition, national revenues from ESPN, ABC & TNT total $930 million per year and these deals expire in 2015-2016. It’s a relatively balanced mix compared to the other major leagues. NHL & MLB’s media revenues are more locally focused, while the NFL is nationally dominated.Basketball’s popularity has grown in recent years. This, coupled with intense media competition for quality live content, has fueled increased media contracts in many markets at unprecedented levels (300% to 500%) over prior contracts.Live sports programming has a relatively fixed supply and is experiencing increased demand from networks looking for content those viewers will watch live. This commands higher advertising dollars compared to content that is consumed over DVRs and online forms (Netflix, Hulu Plus, Amazon Prime, etc.). Content providers also covet the low production costs and favorable demographics of younger fans. These factors, among other variables, have helped fuel the rapid price increases for sports media rights.Recently, new media rights contracts across all sports programming have soared to record high annual payout levels. The NHL signed two new TV deals in April 2011 which more than doubled the league’s previous annual payouts with an upfront payment of $142 million. Even the media rights for Wimbledon have seen an increase in the amount of suitors. The NBA’s current national deal expires in a couple of years (2016). Many people expect that the next deal’s value will at least double the current agreement. [Side note: In negotiations that date back to the 70’s ABA/NBA merger, two brothers – Ozzie and Daniel Silna, received a direct portion of the NBA’s national TV revenues – in perpetuity. That’s right…perpetuity. In January 2014 they agreed to a $500 million upfront payment from the NBA and a pathway to eventually buy them out completely. The old transaction has withstood litigation and it has been termed as ‘the greatest sports business deal of all time’] At the local level, in 2011 the Los Angeles Lakers signed the richest television deal in the NBA which dwarfs other teams. The contract reportedly averages $200 million per year for 20 years. The upper tier NBA franchises historically have received $25 to $35 million annually. Some big market teams have expiring contracts in the next few years, such as the Mavericks. While bidding has not yet begun, it’s reasonable to expect Mr. Cuban and his Mavericks to anticipate a healthy bump in rights fees in the future assuming good counsel and creative structuring.How did these factors translate to the Kings and 76ers? Even with substantial MSA differences, they were at opposite ends of the media spectrum. The Kings’ deal with CSN California expires after this season, which put ownership in strong position to negotiate a new deal at the time of the transaction. The 76ers signed a 20 year contract in 2009 with Comcast Sports Net, which was reported by Forbes to be “undervalued” from the 76ers perspective, reportedly paying the team less than $12 million the season prior to purchase. That’s quite a difference and it almost surely played a pertinent role the Kings’ and 76ers’ valuations.Arena Lease and Structure: Slicing Up the Game Day PieIn the NBA, game day and arena revenue typically make up the lion’s share of a franchise’s income. These revenue streams filter up from a multitude of sources. Aside from regular ticket sales there are club seats, suites, naming rights, parking, concessions, merchandise, and sponsorship revenue. In addition there are non-game revenues such as concerts, events and meetings. On the expense side there’s rent (fixed or variable), revenue sharing (or a hybrid arrangement), capital expenditures, maintenance, overhead allocation and more. All of these aspects are negotiable among the business, municipal, and legal teams involved.Arena deal structures vary across the board. For example, the Detroit Pistons own The Palace at Auburn Hills while the Golden State Warriors are tenants at Oracle Arena (probably until 2017/2018 anyway). Most arena structures involve some form of public/private partnership. One common theme is public ownership, usually financed via local bonds, with the sports franchise as a tenant paying rent of some form. The chief aspect to consider for legal teams is how to structure agreements for the various revenue streams, expense and capital items.Historically, some of the most negotiated aspects to the arena lease are how proceeds from certain items as defined by the CBA are allocated. For example, while players as a group receive a flat percentage of basketball related income (“BRI”), they receive reduced percentages of others, such as luxury suites and arena naming rights. This nuance represents an opportunity for team ownership to retain a larger portion of these revenues and legal teams to employ shrewd negotiating tactics. In addition, as the arenas age and significant maintenance costs are required, cost sharing between the public/private partnerships can become an issue. Lease structure also can make outright ownership of a stadium appear less attractive without a partner to share or bear costs.Again as we examine the Kings and 76ers a contrasting picture emerges. Prior Kings’ ownership (the Maloofs) and the city could not reach an agreement on a new stadium lease after nearly a decade of negotiations. Initially there was a buying group that planned to move the team to Seattle, but then, new local ownership purchased the team (with substantial input from the NBA). This agreement included an agreement for a new $447 million stadium (the majority funded publicly) and a guarantee to keep the team in Sacramento. This new deal was reported to be more favorable to ownership and gives the franchise an opportunity to attract more fans and create refreshed revenue channels. The 76ers on the other hand had already been locked into a long term lease at less favorable terms that were more geared towards revenue sharing with Comcast. Again, the Kings’ new opportunity appears more attractive than the 76ers existing arrangement.Collective Bargaining Agreement: Leveling the Playing FieldOn December 8, 2011, after a 161 day lockout, the NBA and its player union reached a new collective bargaining agreement. This agreement brought about meaningful changes to the salary structures, luxury tax, BRI, and free agency (among other things). Although the CBA is not under direct control of a franchise owner, its impact on competiveness, team operational strategy and expense management is significant.The changes were important for owners, who had reportedly lost over $300 million annually as a group in the three prior years to the negotiations. From a valuation perspective three items deserve focus: (i) length, (ii) BRI, and (iii) luxury tax provisions. Prior to the agreement, there was a great deal of uncertainty as to how negotiations would play out. Uncertainty infers risk and where there’s more risk, values usually fall. The 10 year agreement (with a 2017 opt-out) brings stability to both players and owners as to what operating structure they can plan for the near to intermediate term future. In addition, BRI revenue splits to the players were lowered from 57% of BRI to around 50% for most of the contract. This split brings cash flow relief (but not competitive relief) to owners across the league. Lastly, the luxury tax structure became much more punitive for big-spending owners, like Cuban. In fact, it economically functions similarly to a hard salary cap that the NFL and NHL employ. In light of this change, NBA franchises have committed an enormous amount of time and resources to understand and execute an appropriate competitive strategy. The luxury tax provisions even the competitive playing field for smaller market teams such as Sacramento and the Memphis Grizzlies (who sold for a reported $377 million in October 2012) and constrains the spending of larger market teams such as the Mavericks, Lakers or Knicks.How did this facet play out with the Kings and 76ers? All one needs to know is that the 76ers were sold before the new CBA was agreed (Summer 2011) to and the Kings were sold after the CBA was in effect (January 2013). Timing, coupled with the Kings small market status, has an increasingly positive effect on them compared to the 76ers. Advantage: Kings.Takeaway: NBA Boats Don’t Necessarily Need the Tide to Rise (or Fall)NBA franchise values are on the rise. There is a buzz around the league that if there were teams on the market the price would be robust right now. The values are driven by a number of different factors (TV, arena rights, CBA), some that cannot be controlled by owners and their advisory teams, but others that can be. Don’t be fooled by market size. A value creation scenario can occur in almost any market. In one of the smallest markets in the country, Tom Benson paid more for the Hornets than Josh Harris’ group did for the 76ers. However, owner involvement, savvy counsel and careful negotiations are a must; because as some transactions have shown, there are no guarantees.This article was originally published in The Texas Lawbook in March 2014.

2015 Bank M&A Recap

Statistics can be deceptive. The bank M&A market in 2015 could be described as steady, bereft of any blockbuster deals. According to SNL Financial 287 depositories (253 commercial banks and 34 thrifts) agreed to be acquired in 2015 compared to 304 in 2014 and 246 in 2013. Since 1990, the peak in M&A transactions occurred in 1994 (566) followed by 1998 (504). For those who do not remember, 1998 was the blockbuster year when NationsBank/Bank of America, Norwest/Wells Fargo, Bank One/First Chicago NBD and SunTrust Banks/Crestar Financial among others agreed to merge (Figure 1). There has been a cumulative impact of M&A activity over the years. As of September 30, 2015, there were 6,270 insured depositories compared to about 18,000 institutions in 1985 when interstate banking laws were liberalized. M&A activity when measured by the number of transactions obviously has declined; however, that is not true on a relative basis. Since 1990, the number of institutions that agreed to be acquired in non-assisted deals ranged between 1.4% (1990) and 4.6% (1998) with an overall median of 3.2%. Last year was an active year by this measure, with 4.4% of the industry absorbed, as was 2013 (4.5%). What accounts for the activity? The most important factors we see are (a) good asset quality; (b) currency strength for many publicly traded buyers; (c) very low borrowing costs; (d) excess capital among buyers; and (e) ongoing earnings pressure due to heightened regulatory costs and very low interest rates. Two of these factors were important during the 1990s. Asset quality dramatically improved following the 1990 recession while valuations of publicly traded banks trended higher through mid-1998 as M&A fever came to dominate investor psychology. Today the majority of M&A activity involves sellers with $100 million to $1 billion of assets. According to the FDIC non-current loans and ORE for this group declined to 1.20% of assets as of September 30 from 1.58% in 2014. The most active subset of publicly traded banks that constitute acquirers is “small cap” banks. The SNL Small Cap U.S. Bank Index rose 9.2% during 2015 and finished the year trading for 17x trailing 12 month earnings. By way of comparison, SNL’s Large Cap U.S. Bank Index declined 1.3% and traded for 12x earnings. Strong acquisition currencies and few(er) problem assets of would-be sellers are a potent combination for deal making. Earnings pressure due to both the low level of rates (vs. the shape of the yield curve) and post-crisis regulatory burdens are industry-wide issues. Small banks do not have any viable means to offset the pressure absent becoming an acquirer to gain efficiencies or elect to sell. Many chose the latter. The Fed may have nudged a few more boards to make the decision to sell by delaying the decision to raise short rates until December rather than June or September when the market expected it to do so. “Lift-off” and the attendant lift in NIMs may prove to be a non-starter if the Fed is on a path to a one-done rate hike cycle. As shown in Figure 2, pricing in terms of the average price/tangible book multiple increased nominally to 142% in 2015 from 139% in 2014. The more notable improvement occurred in 2014 when compared to 2013 and 2012, which is not surprising given the sharp drop in NPAs during 2011-2013. The median P/E multiple was 24x, down from 28x in 2014 and comparable to 23x in 2013. The lower P/E multiple reflected the somewhat better earnings of sellers in which pricing was reported with a median ROA of 0.65% compared to 0.55% in 2014. Although the data is somewhat murky, we believe acquirers typically pay on the order of 10-13x core earnings plus fully-phased-in, after-tax expense savings. Figure 3 provides perspective on pricing based upon size and profitability as measured by LTM ROE. Not surprisingly, larger and more profitable companies obtained better pricing in terms of the P/TBV ratio; however, as profitability increases the P/E multiple tends to decline. That is not surprising because a higher earning bank should have fewer issues that depress current earnings.The other notable development in 2015 was the return of non-SIFI large banks to the M&A market after largely being absent since the financial crisis as management and regulators sorted through the changes that the Dodd-Frank Act mandated. BB&T Corporation, which is among the very best acquirers, followed-up its 2014 acquisitions for Bank of Kentucky Financial Corp. and Susquehanna Bancshares with an agreement to acquire Pennsylvania-based National Penn Bancshares. The three transactions added about $30 billion of assets to an existing base of about $180 billion. Other notable deals included KeyCorp agreeing to acquire First Niagara ($39 billion) and Royal Bank of Canada agreeing to acquire City National Corporation ($32 billion). Also, M&T Bancorp was granted approval by the Federal Reserve to acquire Hudson City Bancorp ($44 billion) three years after announcing the transaction.To get a sense as to how the world has changed, consider that the ten largest transactions in 2015 accounted for $17 billion of the $26 billion of transaction value compared to $9 billion of $19 billion in 2014. The amounts are miniscule compared to 1998 when the ten largest transactions accounted for $254 billion of $289 billion of announced deals that year.Law firm Wachtell, Lipton, Rosen & Katz (“Wachtell”) noted that with the approval of several large deals this year there is more certainty to the regulatory approval process and there is no policy to impede bank mergers x-the SIFI banks. A key threshold for would-be sellers and would-be buyers from a decision process has been $10 billion of assets (and $50 billion) given enhanced regulatory oversight and debit card interchange fee limitation that applies for institutions over $10 billion. Wachtell cited the threshold as an important consideration for National Penn’s board in its decision to sell to BB&T.There were a couple of other nuances to note. While not always true, publicly-traded buyers did not receive the same degree of “pop” in their share prices when a transaction was announced as was the case in 2012 and 2013. The pops were unusual because buyers’ share prices typically are flat to lower on the news of an announcement. Several years ago the market view was that buyers were acquiring “growth” in a no-growth environment and were likely acquiring banks whose asset quality problems would soon fade.Also, the rebound in real estate values and resumption of pronounced migration in the U.S. to warmer climates facilitated a pick-up in M&A activity in states such as Georgia (11 deals) and the perennial land of opportunity and periodic busts—Florida (21). The recovery in the banking sector in once troubled Illinois was reflected in 25 transactions followed by 20 in California.As 2016 gets underway, pronounced weakness in equity and corporate bond markets if sustained will cause deal activity to slow. Exchange ratios are hard to set when share prices are volatile, and boards of sellers have a hard time accepting a lower nominal price when the buyer’s shares have fallen. Debt financing that has been readily available may be tougher to obtain this year if the market remains unsettled.Whether selling or merging, we note for the surviving entity a key goal should be something akin to Figure 4 in which there is shared upside for both the acquirer’s and seller’s shareholders (assuming a merger structured as a share exchange). A well-structured and well-executed transaction can improve the pro forma bank’s profitability and growth prospects. If so, all shareholders may benefit not only from EPS accretion, but also multiple expansion. We at Mercer Capital have over 30 years of experience of working with banks to assess transactions, ranging from valuation to issuing fairness opinions in addition to helping assess the strategic position (e.g., sell now vs. sell later). Please call if we can help your institution evaluate a significant corporate transaction.

August Market Performance & Augustus Caesar

In contemplating August’s market activity, our thoughts drifted to Roman times. In 45 B.C., the Roman Senate honored Julius Caesar by placing his name on the month then known, somewhat drably, as Quintilis. Later, the Senate determined that Augustus Caesar deserved similar recognition, placing his name on the month after July. But this created an immediate issue in the pecking order of Roman rulers – up until then, months alternated between having 30 and 31 days. With July having 31 days, poor Augustus’ stature was diminished by placing his name on a month having only 30 days. To rectify this injustice, the Senate decreed that August also have 31 days, accomplished by borrowing a day from February and shifting other months such that September only had 30 days (to avoid having three consecutive 31-day months).We provide this historical interlude to illustrate that, while July and August now are equivalent in terms of the number of days, the market environment in these two months during 2015 bore few similarities. In August, volatility returned, commodity prices sank, and expectations of Federal Reserve interest rate action in September diminished.Most broad stock market indices declined between 6% and 7% in August, taking the indices generally to negative territory year-to-date in 2015. As indicated in Figure 1, except for the largest banks, publicly-traded banks generally outperformed the broader market, both year-to-date in 2015 and in August specifically. For the year, banks benefited from several factors. First, investors appear to expect that rising interest rates will, if not enhance banks’ earnings, at least prove to be a neutral factor. Other sectors of the market, though, may be less fortunate, as companies face higher interest payments or other adverse effects of higher interest rates. Second, banks generally reported steady growth in earnings per share, as assisted by a benign credit environment. Within any index, though, the performance of individual companies may vary greatly. Seeking to isolate factors influencing the August market performance, we focused on publicly-traded banks with assets between $500 million and $5 billion. Given the market backdrop, these 212 banks performed relatively well in August, with a median share price depreciation of only 1.1% (see Figure 2). For the year, the median bank reported a 2.9% increase in its stock price. While linking company-specific factors to market performance during a volatile period is difficult, we identified three groups of banks that underperformed in August: After losing investor favor in the second half of 2014, banks in the oil patch states of Louisiana, Oklahoma, and Texas performed well in 2015, advancing by 9% between December 31, 2014 and July 31, 2015. However, oil prices falling below $40/barrel dealt these banks a setback in August, as the median share prices of banks in these states fell by 5%.All the banks that completed IPOs during 2015 fell during August, with a median depreciation of 6%. Nevertheless, post-IPO performance remains favorable, as all the banks reported share prices at August 31, 2015 that exceeded their IPO prices by 10% to 20%. Investors in these banks may have wished to realize profits during a volatile period.Banks identified with Asian American communities also suffered, owing to their perceived greater exposure to slowing economies in China and throughout the Asian region. Even after the August decline, though, these banks have reported solid performance in 2015. Several risks that influenced August’s volatility have not dissipated, including uncertainty surrounding China’s opaque (and potentially over-leveraged) economy and the effect of any Fed policy tightening. Analyst estimates for 2016 EPS often suggest favorable growth over 2015, and such estimates bear watching to the extent that the recent market volatility spills over into the real economy.

What’s Stopping Banks from Getting into Wealth Management and How to Overcome It

Final Thoughts on AOBA

In the mid-1960s, the Department of Transportation was considering banning the sale of convertibles in the U.S. because of safety concerns for occupants in the event of roll-overs. What we now know as the “sun-roof” became a popular response to this regulatory threat, but Porsche went one step further and developed a version of its popular 911 series that had a removable roof and a removable (plastic) rear window known as the “Targa”. Essentially, the Targa was a convertible with a cosmetically-integrated roll-bar, or a cross between a coupe and a convertible that provided the open-air experience of one with the (relative) safety of the other.The DOT never actually banned the sale of convertibles in America, but Porsche pressed on and the potential for regulation spawned a response that, over time, became recognized as an iconic design. Other automakers quickly followed suit, and a trend was born. Porsche still offers the 911 in a Targa configuration, although the mechanism for removing the roof has become considerably more elaborate.Do Regulations Suggest a New Model for Banking?As discussed in last week’s blog, economic circumstances and technological change, to say nothing of Dodd-Frank, are forcing banks to reconsider their business models. For many, the opportunity in this lies in another piece of legislation: the repeal of Glass-Steagall. Much like Porsche discovered fifty years ago, many banks are responding to regulatory changes by opting for a hybrid model that pairs trust and wealth management operations with traditional banking. The advantages of banks developing their investment management operations are pretty easy to see: it produces a more stable and diverse revenue stream, it provides more touch points for customer relationships, and it can substantially improve a bank’s return on equity.Some see this opportunity very clearly. Last year, I attended a reception at a successful trust bank and overheard a conversation between the CFO’s mother and a new employee at the bank, whom she told “we just used the lending function to pay bills until we could ramp up the wealth management practice.” I decided that evening that when a corporate executive’s relatives can express the strategic plan perfectly in twenty five words or less, it’s a good plan.Of course, opportunity is a two way street, and banks looking to venture into investment management, especially by acquisition, typically encounter a couple of major obstacles: balance sheet dilution and culture clash. Both of these challenges arise from the main difference between traditional banking and asset management. Whereas banking is asset heavy and personnel light, asset management requires not much of a balance sheet, but plenty of expensive staffing. It’s a significant difference that can only be managed head on.ROE > TBVFrom the perspective of a typical money manager, banker obsession with tangible book value can seem without merit, particularly in an era where net interest margins are evaporating and pursuing return on assets can seem Quixotic. But at some level, banking is what it is, and without TBV to leverage, there’s no bank. For a bank with excess equity, even today it can look much more attractive to buy another bank instead of an RIA.Despite our current era of low and declining NIMs, TBV dilution for an acquiring bank paying 50% more than tangible book can be earned back in three or four years, thanks to the opportunities for expense saves in the right merger. RIAs often transact for lower pre-tax multiples than banks, but the price to book multiples can be nearly incalculable. A wealth manager might sell for eight or nine times pre-tax net income (the real range is larger), but 90% of that transaction is ultimately allocable to intangible assets. There is little in the way of expense saves in combining, say, an existing wealth management firm with a bank’s trust operations. The earn-back period on tangible book dilution for an investment management acquisition can stretch to a decade, absent favorable markets or other growth catalysts, which is more than a lot of banks are willing to bear.There’s plenty of reason to absorb the TBV dilution, though, and for banks to do RIA acquisitions anyway. Most banks are starved for ROE these days, and there’s no quicker path to improving ROE than trading some book value for the recurring earnings that only an asset management shop can provide. Bank mergers may be easier to digest financially on the front end, but after the dust settles, it’s just more bank, which doesn’t solve the problem of how to make money when the environment for banks is as negative as it is currently.While the dilution to TBV can’t be avoided, some of the dilution can be mitigated (or at least justified), by paying for a substantial portion of the acquisition with a performance-based earn-out. It isn’t uncommon to pay one-third or more of the purchase price of an asset management firm acquisition using contingent considerations. While there’s still a down payment, or initial consideration, to be paid in an investment management firm acquisition, an earn-out consideration can at least allow the bank to experience part of the TBV diminution at the same time that earnings are being produced to justify the balance sheet impact.This model works even better when the contingent consideration is paid as compensation (bonuses), so book value dilution is avoided altogether, and the acquirer gets the real time tax benefit of salary expense. Few selling investment managers are willing to agree to this because of the tax impact to them, but it’s a negotiating point worth remembering.Managing (Accepting) Culture ClashIt’s not an exaggeration to say that investment management firms brag about how much they pay their people, and banks brag about how little they pay their people. The regulatory item that requires banks to disclose their average compensation – where lower is considered better – has never existed in the investment management community (where the material trappings of success were the ultimate performance ratio).Banks acquiring asset management firms have to accept the fact that they can’t put a bunch of investment managers on a bank’s compensation plan without enduring value-killing turnover and customer attrition. An RIA’s business model is inescapably different than a bank, and the rigid work environment and salary structure that is endemic to banking simply won’t work in the investment management community.This can make integrating an RIA acquisition into an existing trust operation especially challenging, and at some level there has to be acceptance on the front end that the wealth managers will probably make more than the lenders, but that their impact on the bank’s P&L will justify it. It isn’t unusual to see personnel costs in a well-run, mature RIA sum to half of revenue. The revenue and profit per employee of an RIA is simply much greater than the same metrics applied to a bank, and compensation is higher.So while the mixture of Mazdas and Maseratis in the employee parking lot may be awkward at first, in the long run, a bank with a successful trust or wealth management franchise will provide growth opportunities and earnings stability that benefit all of a bank’s stakeholders.Eyes Wide OpenIt remains to be seen whether the either/or business model of banks with wealth management practices (or wealth management practices with banking operations – depending on your perspective) will endure like the Targa design of the 1960s. But the banking environment today demands something of a response, and developing a revenue stream from investment management offers banks a path to remain relevant and independent in spite of a lousy lending and regulatory environment. We just recommend bankers accept the challenges that come with RIA acquisitions and face them head on. In some regards, the issues of tangible book value dilution and culture clash stem from the very reason banks should be getting into investment management – a high margin, capital light financial service that is difficult to commoditize. In the end, the challenges of acquisition/integration are actually the sources of upside – so long as you’re willing to accept a little wind in your hair.

Strategic Planning for Community Banks on the Mend

Despite much commentary about the significant economic and regulatory headwinds impacting community banks, profitability is on the mend. Community bank earnings improved in the trailing twelve months ended June 30, 2015 with net income up 14% to $17.6 billion compared to $15.5 billion in the twelve months ended June 30, 2014.1 Nearly 60% of community banks reported higher profitability based upon annualized first half 2015 net income compared to 2014 levels. The number of unprofitable banks also declined to 41 in the second quarter of 2015, compared to 109 in 2014 and 167 in 2013. The median return on assets (ROA) for community banks was up to 0.96% (annualized based upon the first half of 2015), which was the highest level since 2008.As detailed in Figure 1, key contributors to improving earnings were higher net interest income and lower loan loss provisions. Loan growth drove the improvement in net interest income as 84% of community banks reported loan growth in the trailing twelve month period, with the median community bank’s loan growth rate reported at 7.2%. Loan growth offset net interest margin (“NIM”) compression as NIMs were at their lowest level over the 10-year historical period. As the Federal Reserve’s zero-interest rate policy (“ZIRP”) grinds on, asset yields continue to compress while funding costs have essentially reached a floor. One interesting item to gauge in future quarters is how much interest rate and credit risk is being taken by community banks to grow loans and earnings. Another sign of improving community bank health is that deal activity is up from recent prior periods as shown in Figure 2. Price/earnings multiples have also improved in recent periods (Figure 3) and appear to be relatively in line with long-term trends at approximately 20x. Price/tangible book multiples are still below longer-term trends, largely reflecting that although improved from the Great Recession returns on assets and equity remain below pre-financial crisis levels. While it is difficult to tell whether community bank earnings have peaked and how long this cycle may last, improving profitability expands the strategic options available to community banks. A recent article by SNL Financial noted that a number of community banks are looking to sell as earnings may have plateaued. While selling is one option available to community banks in this environment, the range of strategic options available is much broader than that. A well-rounded strategic planning session should include an assessment of the bank’s unique strengths, weaknesses, and opportunities as well as a review of the bank’s performance and outlook relative to both its history and peers. Then, a broader discussion of a range of options that can deliver growth and enhance shareholder value should be discussed. Those other options could include organic and/or acquisitive growth and other ways to provide liquidity and enhance returns to shareholders such as special dividends, share repurchases, management buy-outs, and employee stock ownership plans. Founded in 1982, in the midst of and in response to a previous crisis affecting the financial services industry, Mercer Capital has witnessed the industry’s cycles. Despite industry cycles, Mercer Capital’s approach has remained the same – understanding key factors driving the industry, identifying the impact of industry trends on our clients, and delivering a reasoned and supported analysis in light of industry and client specific trends. Mercer Capital has experience facilitating strategic planning sessions for community banks and providing a broad range of specialized advisory services to the sector. Contact us to discuss scheduling a strategic planning session or your institution’s specific needs in confidence.

Small Bank Holding Companies: Regulatory Update & Key Considerations

During 1980 the Federal Reserve issued the Small Bank Holding Company Policy Statement (“Policy Statement”), which recognized from a regulatory perspective that small bank holding companies have less access to the capital markets and equity financing than large bank holding companies. Although the Fed has sought to limit holding company debt so that the parent can serve as a “source of strength” to its subsidiaries, especially the deposit-taking bank subsidiaries, the Policy Statement allowed small bank holding companies to utilize more debt to finance acquisitions and other ownership transfer-related transactions than would be permitted by large bank holding companies. The Policy Statement initially applied to bank holding companies with assets less than $150 million; it was amended in 2006 to include bank holding companies with assets up to $500 million. Effective May 15, 2015, the threshold increased to consolidated assets of less than $1 billion for both bank holding companies and savings and loan holding companies, provided that the company complies with the Qualitative Requirements and does not:engage in significant nonbanking activities either directly or through a nonbank subsidiaryconduct significant off-balance sheet activities (including securitization and asset management or administration) either directly or indirectly through a nonbank subsidiaryhave a material amount of debt or equity securities outstanding (other than trust preferred securities) that are registered with the SEC Holding companies that meet the above requirements may use debt to finance up to 75% of the purchase price of an acquisition, but are subject to the following ongoing requirements:parent company debt must be retired within 25 years of being incurredparent company debt-to-equity must be reduced to 0.30:1 or less within 12 years of the debt being incurredthe holding company must ensure that each of its subsidiary insured depository institutions is well capitalizedthe company is expected to refrain from paying dividends until it reduces its debt-to-equity ratio to 1:1 or less The primary benefit of small bank holding company status is that it creates a larger universe of bank and now savings and loan holding companies that are not subject to the Federal Reserve’s risk-based capital and leverage rules, including the Basel III rules. As of year-end 2014, 454 bank holding companies with assets between $500 million and $1 billion filed a Y-9C according to SNL Financial LC. From a functional standpoint, small bank (and S&L) holding companies do not file a quarterly Y-9C or Y-9LP; instead these companies only file a Y-9SP semi-annually. Regulatory capital rules for these companies continue to apply to their bank subsidiaries, which represents no change from past practice.ImplicationsExpansion of Policy Statement eligibility is likely to affect strategic and capital planning for small BHCs.Companies that now fall under the Policy Statement oversight can use traditional debt at the holding company level and potentially generate higher returns on equity with a lower cost of capital. Senior debt may be used to replace existing capital such as SBLF preferred stock or fund stock repurchases or dividend distributions.Higher capital requirements for larger bank holding companies, coupled with relaxed capital regulations for small bank holding companies, may provide smaller companies an advantage when bidding on acquisition targets inasmuch as the ability to fund acquisitions with a greater proportion of debt results in a lower cost of capital.S corporation bank holding companies should remain particularly cognizant of the 1:1 debt/equity ratio constraint that should be maintained in order to declare dividends. For S corporations, the inability to declare dividends may result in shareholders being responsible for their pro rata share of the BHC’s taxable earnings with no offsetting distributions from the BHC. Since the debt/ equity ratio is calculated using equity determined under Generally Accepted Accounting Principles, significant volatility in securities carried as available-for- sale may impair the BHC’s ability to declare dividends.If the subsidiary bank holds assets with more onerous risk weightings under the Basel III regime (such as mortgage servicing rights), the holding company may wish to evaluate whether holding such assets at the holding company, rather than the bank, may be more capital efficient. For more information or to discuss a valuation or transaction advisory issue in confidence, please do not hesitate to contact us.

Can Getting into Wealth Management Save Community Banking?

An AOBA Conference Followup

Last week, Brooks Hamner and I spoke at Bank Director’s Acquire or Be Acquired Conference in Scottsdale about how banks can build value through their trust and wealth management businesses. Our session got a great response, probably because we were some of the only speakers offering the banking community some hope. Most of the sessions at AOBA this year were, on balance, fairly gloomy. Between a yield curve that is entirely inhospitable to net interest margins and technology that threatens to denude the value of expensive branch networks, session after session seemed targeted at one message to bankers: sell.Just before AOBA began, RM Sotheby’s held one of its annual collector car auctions at the same resort, and conference attendees could wander outside between sessions and watch the Sotheby’s auction “winners” load their precious iron onto car carriers to ship them home. I was reflecting on one of the more pessimistic conference sessions while watching a late 60s Aston Martin being loaded onto a truck, and it reminded me of a project I worked on early in my career.James Bond and the Future History of BankingAbout fifteen years ago, I was sitting in the boardroom at David Brown Group in Huddersfield, England, while the management team eulogized what was once one of the greatest industrial companies in the U.K. The boardroom still felt like the British seat of power it had once been, with a massive Scottish oak conference table and oil paintings of successive generations of David Browns (some of them knighted) looming from the walls. Next door was a vast factory that had, at its peak around World War II, employed 40,000 workers building tractors and heavy industrial equipment. The company was so successful that Sir David Brown was able to indulge one of his hobbies, buying Aston Martin in 1947 and investing in it heavily to return England to competitiveness in auto racing. It’s because of David Brown that many Aston Martins still carry the “DB” series badges (one current model is a DB9) even though David Brown sold Aston Martin in 1972. The automaker was never profitable, but Brown had accomplished his goal anyway: Aston Martin was a prominent name in racing in the 1950s and 60s, and even James Bond favored the marque (much to the chagrin of Bentley and Jaguar).The David Brown Group I consulted with wasn’t even a shadow of its former self: technological change and a global recession got the best of the company in the 1960s, and after a series of damaging restructurings and neglectful owners, all that was left was a niche manufacturer with about 200 employees, operating as a mostly-forgotten unit of an American conglomerate.Fifty years from now, we may look back on the threat to banking today as being as severe as what David Brown faced in the 1960s. Banks won’t fix this by getting into sports car racing, but one opportunity is wealth management. It’s no secret that many banks treat their trust departments like an afterthought. We estimate that maybe a third of bank trust franchises are profitable, and the excuses for hanging onto an underperforming trust department are pretty similar bank to bank:Trust complements other lines of business by maintaining major relationships.There’s no easy solution as to whom to sell trust to or how to unwind it.Trust is staffed by loyal and long term employees of the bank whom management wants to support. But trust, if ignored, can become an earnings-dilutive cauldron of liability. Legacy relationships maintained by trust can become abusive of the time and attention of trust staff. And long term employees, while loyal in one sense, can become more focused on self-preservation than supporting their institution. Those are just the problems trust departments can face in good times.Are Trust Franchises an Asset or a Liability?If net interest margins were headed up and returns on equity were solid, unprofitable and possibly risky trust operations would be easier to ignore. The reality today, of course, is very different. Banking is in a race to rationalize operations, and from talking with community bankers from across the country at the AOBA conference, it sounds like a lot of bankers are looking for ways to either get out of trust or to refocus on the business to make it a viable (if not vital) part of their business. It won’t surprise you to hear that we suggest the latter approach.A seemingly obvious solution is to acquire existing wealth management companies to bulk-up and supplement trust. Greater scale brings better expertise to customers, and margins to the bank. For over-capitalized banks trying to boost ROE, acquiring a wealth management firm is an opportunity to invest some equity for a high returning asset (swapping some “E” for more “R”). AUM-based fees are largely uncorrelated from the credit cycle, and wealth management customers have different decision cycles than, say, commercial loan clients. Trust and wealth management (we look at these interchangeably because both are revenue streams supported by client assets) don’t require large ongoing capital commitments, and the costs of these operations are largely embedded in staffing. On the surface, it seems like a perfect way for many community banks to diversify their financials and grow despite a tough environment for banking.As for the seller’s perspective, the RIA industry is facing a physical cliff, with more practicing series-7 registered reps over the age of 70 than under the age of 30. Many, if not most, of the 11,000 RIAs in the U.S. have inadequate ownership/leadership transition plans and will ultimately have to sell to a more established institution with experience in growing talent for senior roles. Many RIAs are not suitable acquisition candidates for banks, but many are.So why aren’t banks rushing to buy RIAs? It’s risky to make sweeping generalizations, but based on our experience there are two obstacles banks must overcome to acquire an RIA: culture clash and balance sheet dilution. Both are inevitable, but both are also manageable. More on that next week.

Bridging Valuation Gaps for Undeveloped and Unproven Reserves

The petroleum industry was one of the first major industries to widely adopt the discounted cash flow (DCF) method to value assets and projects—particularly oil and gas reserves. These techniques are generally accepted and understood in oil and gas circles to provide reasonable and accurate appraisals of hydrocarbon reserves. When market, operational, or geological uncertainties become challenging, however, such as in today's low price environment, the DCF can break down in light of marketplace realities and "gaps" in perceived values can appear.While DCF techniques are generally reliable for proven developed reserves (PDPs), they do not always capture the uncertainties and opportunities associated with the proven undeveloped reserves (PUDs) and particularly are not representative of the less certain upside of possible and probable (P2 &P3) categories. The DCF's use of present value mathematics deters investment at low ends of pricing cycles. The reality of the marketplace, however, is often not so clear; sometimes it can be downright murky.In the past, sophisticated acquirers accounted for PUDs upside and uncertainty by reducing expected returns from an industry weighted average cost of capital (WACC) or applying a judgmental reserve adjustments factor (RAF) to downward adjust reserves for risk. These techniques effectively increased the otherwise negative DCF value for an asset or project's upside associated with the PUDs and unproven reserves.At times, market conditions can require buyers and sellers to reconsider methods used to evaluate and price an asset differently than in the past. In our opinion, such a time currently exists in the pricing cycle of oil reserves, in particular to PUDs and unproven reserves. In light of oil’s low price environment, coupled with the forecasted future price deck, many—if not most—PUDs appear to have a negative DCF value.Distressed MarketsIn the past, we have analyzed actual market transactions to show that buyers still pay for PUDs and unproven reserves despite a DCF that results in little or no value. In today’s market, however, asset transactions of “non-core assets” indicate zero value for all categories of unproven reserves. A highlighted example of this is Samson Oil and Gas’s recent purchase of 41 net producing wells in the Williston Basin in North Dakota and Montana. The properties produce approximately 720 BOEPD and contain estimated reserves of 9.5 million barrels of oil equivalent. Samson paid $16.5 million for the properties in early January 2016 and estimates that within five years they can fund the drilling of PUDs. Samson’s adjusted reserve report, using the most current market commodity prices, indicated PDP reserves worth $15.5 million, PDNPs worth $1 million and PUDs worth $35 million—a total of $52 million in reserves present valued at 10%. This breakdown indicates dollar for dollar value was given on the PDP and PDNP reserves, but zero cash value given on the PUDs.Is this transaction the best indication of fair market value or fair value?We believe there is a convincing argument to be made that the Samson transaction and a handful of other asset deals in the previous six months are not the best indication of asset value. In short, these sales could be categorized as distressed or “fire sale” transactions for the following reasons:Significant decline and volatility in oil prices from (1) uncertain future demand and (2) current excess supply.Debt level pressures with (1) loan covenant requirements and (2) cash flow requirements.The low deal volume environment as market participants have been in a “wait and see” stance since oil prices began declining over twelve months ago. In this low price environment, buyers don’t have to blink first. These factors indicate that some companies may feel pressure to lower their asking prices to levels that continuously attract bidders. The market looks distressed. What does this mean for the fair market value/fair value of oil and gas assets? The definitions of fair market value and fair value require buyers and sellers to operate in a “distress-free” environment. When the marketplace is not distress-free, perhaps non-market methods should be utilized to estimate the real value of PUDs and unproven reserves. In these scenarios, one useful method to price these assets is the use of option theory.Option PricingIf one solely relied on the market approach, it appears much of these unproven reserves would be deemed worthless. Why then, and under what circumstances, might the unproven reserves have significant value?The answer lies within the optionality of a property's future DCF values. In particular, if the acquirer has a long time to drill, one of two forces come into play: either (1) the current price outlook can change radically for a resource, and subsequently alter the PUDs or (2) drilling technology can change, such as the onslaught of hydraulic fracturing, and the unproven reserves accrue significant DCF value.This optionality premium or valuation increment is typically most pronounced in unconventional resource play reserves, such as coal bed methane gas, heavy oil, or foreign reserves. This is additionally pronounced when the PUDs and unproven reserves are held by production. These types of reserves do not require investment within a fixed short timeframe.Current pricing environment: challenge = opportunityOne of the primary challenges for industry participants when valuing and pricing oil and gas reserves is addressing PUDs and unproven reserves. As oil prices have dropped over 50% in the last six months, reaching 12 year lows, it should be anticipated that PUD values may drop from 75 cents on the dollar to 20 cents on the dollar or less. After the Great Recession, some PUDs faced a similar, yet more modest, decline in price. The price level recovery for PUDs in 2011 was partly attributable to the recovery in the U.S. and global economies, and partly due to increases in the price of oil. Five main factors have significantly increased the world supply of oil and driven down prices: The continued success of shale drillers in the U.S.OPEC’s choice to continue to increase production.The U.S.’s elimination of restrictions on crude oil exports.The recent lifting of Iran’s sanctions.Oil consumption slowing down in countries like China. In August of 2015, it was estimated that Iran’s return to the global oil market would add approximately one million barrels of oil a day to the market and decrease the price of oil by $10 per barrel. Iran is currently ready to increase exports by half a million barrels of oil per day, and the fear of further over-supply pushed the price of oil below $30 on Friday, January 15. Now, the question is when will oil prices recover? The Chief of the IEA estimated that oil prices will recover in 2017. Prices are predicted to remain low in 2016 as expected demand for oil is growing at lower rates than in the past thanks to economic slowdowns in China, India, and Europe. However, the growth in oil supply is predicted to slow in 2017 as the current cuts in research and development catch up with many exploration and production companies. We must also remind ourselves of the crash in oil prices in 1985 that remained below $20 until 2003. As previously mentioned, PUDs are typically valued using the same DCF model as proven producing reserves after adding in an estimate for the capital costs (capital expenditures) to drill. Then the pricing level is adjusted for the incremental risk and the uncertainty of drilling “success,” i.e., commercial volumes, life and risk of excessive water volumes, etc. This incremental risk could be accounted for with either a higher discount rate in the DCF, a RAF or a haircut. Historically, in a similar oil price environment as we face today, a raw DCF would suggest little or no value for the PUDs or unproven reserves. Interestingly, market transactions with similar reserves (i.e., with little or no proven producing reserves) have demonstrated significant amounts attributable to non-producing reserves, thus demonstrating the marketplace's recognition of this optionality upside. Studies have shown that NYMEX futures are not a very accurate predictor of the future, and yet buyers are estimating the value of this option into the prices they are willing to pay. When NYMEX forecasts $35 per barrel, it could actually be $45 when that future date rolls around. So what actions do acquirers take when values are out of the money in terms of drilling economic wells? Why do acquirers still pay for the non-producing and seemingly unprofitable acreage? Experienced dealmakers realize that the NYMEX future projections amount to informed speculation by analysts and economists which many times vary widely from actual results. Note in the chart above how much the future forecasted prices changed in only one year. Real Options: Valuation FrameworkIn practice, undeveloped acreage ownership functions as an option for reserve owners; therefore, an option pricing model can be a realistic way to guide a prospective acquirer or valuation expert to the appropriate segment of market pricing for undeveloped acreage. This is especially true at the bottom of the historic pricing range occurring for the NG commodity currently.This technique is not a new concept as several papers have been written on this premise. Articles on this subject were written as far back as 1988 or perhaps further, and some have been presented at international seminars.The PUD and unproved valuation model is typically seen as an adaptation of the Black Scholes option model. An applicability signal for this method is when the owners of the PUDs have the opportunity, but not the requirement, to drill the PUD and unproven wells and the time periods are long, i.e. five to 10 years. The value of the PUDs thus includes both a DCF value, if applicable, plus the optionality of the upside driven by potentially higher future commodity prices and other factors. The comparative inputs, viewed as a real option, are shown in table below.Pitfalls and fine printThere are, of course, key differences in PUD optionality and stock options as well as limitations to the model. Amid its usefulness, the model can be challenging to implement. Below are some areas in particular where keen rigorous analysis can be critical:Observable market – Unlike a common stock, there is no direct observable market price for PUDs. The inherent value of a PUD is the present value of a series of cash flows or market pricing for proven reserves, if available. All commodity prices are volatile, but oil and gas prices are more volatile than most since they have both year-to-year supply and demand changes in addition to significant seasonal swings.Risk quantification – We have found that oil and gas price volatility benchmarks (such as long term index volatilities) are not all-encompassing risk proxies when valuing specific oil and gas assets. If not analyzed carefully, the model can sometimes have trouble capturing some critical production profile and geologic risks that could affect future cash flow streams considerably. Risks can include items such as (1) production profile assumptions; (2) acreage spacing; (3) localized pricing versus a benchmark (such as Henry Hub or West Texas Intermediate Crude); and (4) statistical “tail risk” in the assumed distribution of price movements.Sensitivity to capital expenditure assumptions – Underlying analysis of an asset or a project’s economics can present particular sensitivity to assumed capital expenditure costs. In assessing capital expenditure’s role as both (1) a cash flow input and (2) an option model input, estimations of future costs can be very acute, yet challenging, assumptions to properly measure.Time to expiration – This input can require granular analysis of field production life estimates coupled with expiring acreage, then filtered within the drilling plans of an operator. The resulting weighted time estimate can present problems with assumption certainty. The availability of drilling resources tends to decline while the costs of drilling and oilfield services tend to rise, often precipitously, when oil and gas prices rise. These factors can present an oscillating delta in both cost and timing uncertainties as the marketplace responds by investing capital into underdeveloped reserves while the fuse burns on existing lease rights. The time value of an option can increase significantly if (1) the mineral rights are owned; (2) unconventional resource play reserves are included; (3) there are foreign reserves; or (4) the reserves are held by production. In these instances, the PUD and unproved reserve option to drill can be deferred over many years, thereby extending the option.SummaryUtilization of modified option theory is not in the conventional vocabulary among many oil patch dealmakers, but the concept is clearly implicitly considered (as evidenced in many market transactions). This application of option modeling becomes most relevant near the bottom of historic cycles for a commodity. Here, the DCF will often yield little or no value even though transactions are being made for substantial values, thereby validating our belief that option theory is being utilized in the marketplace either directly or indirectly. If the right to drill can be postponed an extended period of time, i.e. five to ten years, the time value of those out of money drilling opportunities can have significant worth in the marketplace.We caution, however, that there are limitations in the model’s effectiveness. Black Sholes’ inputs do not always capture some of the inherent risks that must be considered in proper valuation efforts. Specific and careful applications of assumptions are musts. Nevertheless, option pricing can be a valuable tool if wielded with knowledge, skill, and good information, providing an additional lens to peer into a sometimes murky marketplace.Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

How to Combat the Margin Blues?

Following the Great Recession, significant attention has been focused on bank earnings and earning power. While community bank returns on equity (ROE) have improved since the depths of the recession, they are still below pre-recession levels. One factor squeezing revenue is falling net interest margins (i.e., the difference between rates earned on loans and securities, and rates paid to depositors). Community banks are more margin dependent than their larger brethren and have been impacted to a greater extent from this declining NIM trend. As detailed in Figure 1 below, NIMs for community banks (defined to be those with assets between $100 million and $5 billion) have steadily declined and were at their lowest point in the last ten years in early 2015. While there are a number of factors that impact NIMs, the primary culprit for the declining trend is the interest rate environment. As the Federal Reserve's zero-interest rate policy ("ZIRP") grinds on, earning asset yields continue to reprice lower while deposit costs reached a floor several quarters ago. Loan growth has also been challenging for many banks for a variety of reasons, which has stoked competitive pressures and negatively impacted lending margins. While competitive pressures can come in many forms, several data-points indicate intense loan competition giving way to easing terms. For example, the April 2015 Senior Loan Officer Opinion Survey on Bank Lending Practices noted continued easing on terms in a number of loan segments. This appears to be supported further by reported community bank loan yields, which have slid close to 200 basis points (in all loan segments analyzed) since 2008 as shown in Figure 2. Aside from paying tribute to the late B.B. King and playing "Everyday, everyday I have the blues," what can community bankers do in order to combat the margin blues? While not all-encompassing, below we have listed a few strategic options to consider: Increase Leverage. One strategic consideration to maintain ROE in light of declining NIMs may be to increase leverage subject to regulatory limits. Some potential ways to deploy available capital include growing loans organically, M&A, stock buybacks, and/or shareholder dividends. For those below $1 billion in assets, recent legislation has relaxed holding company capital requirements by exempting them from the consolidated regulatory capital ratios. For those that are capable, small bank holding companies may choose to upstream excess capital to the holding company from bank dividends or lever the holding company to fund special dividends and/or buybacks. This higher leverage strategy may be viewed as too aggressive by some shareholders and investors though.Consider M&A. An investor at a recent community bank conference noted that he would rather see banks sell than head down lending's slippery slope. This is not surprising to hear because competitive lending pressures usually seed tomorrow's problem assets. M&A represents a classic solution to revenue headwinds in a mature industry whereby less profitable smaller companies sell to the larger ones creating economies of scale and enhanced profitability. Some signs of this can be seen in recent periods as deal activity has picked up. Beyond expense synergies, acquirers may see temporary NIM relief resulting from accretion income on the acquired assets, which are marked to fair value at acquisition. For those community banks below $1 billion in assets, the combination of the relaxed capital requirements for their holding companies and more options for holding company debt may attract some to consider M&A as a strategic option.Acquire/Partner with Non-Financials. Another strategic option may be to expand into non-traditional bank business lines that are less capital intensive and offer prospects for non-interest income growth such as acquisitions or partnerships with insurance, wealth management, specialty finance, and/or financial technology companies. We have spoken on acquiring non-financials in different venues and there is some evidence of increased activity in the sector. For example, a recent article noted a growing trend in acquisitions of insurance brokers or agencies by banks and thrifts, with deal volume on pace to significantly exceed 2014. Another interesting example of this strategy being deployed includes the recent partnership announced between Lending Club and BancAlliance that allows over 200 community banks to access the peer-to-peer lending space.Improve Efficiency by Leveraging Financial Technology. While compliance and regulatory costs continue to rise as NIMs decline, the industry faces intense pressure to improve efficiency. Technology is an opportunity to do so as both commercial and consumer customers become more comfortable with mobile and online banking. Thus, many banks may view the margin blues as a catalyst to consolidate and/or modernize their branch network and/or invest in improved technology offerings to reduce longer-term operating costs and still meet or exceed customer expectations.Maintain Status Quo. Experience may lead bankers to wait on the Fed to act and usher a return to "normal" yields and "normal" NIMs. Banks with a healthy amount of variable rate loans and non-interest bearing deposits will see an immediate bump in revenue if short-term rates rise, while most traditional banks eventually will see a reversal in NIM trends. But as has been enumerated in past Bank Watch articles, rates have been expected to rise for a "considerable time," and yet continue to remain at historic lows.Further, the potential negative impact of rising rates on credit quality is difficult to foretell. Yet, even this status quo strategy may present some opportunities for those bankers to employ certain of the other strategies mentioned previously in small doses. Mercer Capital has a long history of working with banks and helping to solve complex problems ranging from valuation issues to considering different strategic options. If you would like to discuss your bank's unique situation in confidence and ways that your bank may consider addressing the margin blues, feel free to give us a call or email.

Using Employee Stock Ownership Plans: Helping Community Banks with Strategic Issues

In our view, Employee Stock Ownership Plans (ESOPs) are an important omission in the current financial environment as a number of companies and banks lack a broader, strategic understanding of the possible roles of ESOPs as a tool to manage a variety of strategic issues facing community banks. Given the strategic challenges facing community banks, we strive to help our clients, as well as the broader industry, fill this gap, and discuss some common questions related to ESOPs in the following article.We will be glad to discuss your bank’s current situation as well as the role an ESOP can play in detail. If you are interested in learning more about ESOPs, read our book,The ESOP Handbook for Banks: Exploring an Alternative for Liquidity and Capital While Maintaining Independence (you can find it in the Products section of our website). In addition, if you would like to speak to a Mercer Capital professional, contact Jay Wilson at 901.685.2120 or wilsonj@mercercapital.com.For those less familiar with ESOPs, we answer a few basic questions related to ESOPs. For those more familiar with ESOPs, skip to the question entitled “How can an ESOP help the bank deal with strategic issues?”.What Is an ESOP and How Does It Work?ESOPs are a written, defined contribution retirement plan, designed to qualify for some tax-favored treatments under IRC Section 401(a). While similar to a more typical profit-sharing plan, the fundamental difference is that the ESOP must be primarily invested in the stock of the sponsoring company (only S or C corporations). ESOPs can acquire shares through employer contributions (either in cash or existing/newly issued shares) or by borrowing money to purchase stock (existing or newly issued) of the sponsoring company. Once holding shares, the ESOP obtains cash via sponsor contributions, borrowing money, or dividends/distributions on shares held by the ESOP. When an employee exits the plan, the sponsoring company must facilitate the repurchase of the shares, and the ESOP may use cash to purchase shares from the participant. Following repurchase, those shares are then reallocated among the remaining participants.What Are Some Tax Benefits Related to ESOPs?Similar to other profit-sharing plans, contributions (subject to certain limitations) to the ESOP are tax-deductible to the sponsoring company. The ESOP is treated as a single tax-exempt shareholder. This can be of particular benefit to S corporations, as the earnings attributable to the ESOP’s interest in the sponsoring company are untaxed. The tax liability related to ESOP planholder’s accounts is at the participant level and generally deferred similar to a 401(k) until employees take distributions from the plan.Who Can Sponsor an ESOP?Both publicly traded and private banks/holding companies (C or S-Corps.) can sponsor ESOPs, but the benefits are often more profound for private institutions that are not as actively traded, as the ESOP can promote a more active market and enhance liquidity more for the privately-held shares.How Can an ESOP Help The Bank Deal With Strategic Issues?While not suitable in all circumstances, an Employee Stock Ownership Plan may provide assistance in resolving a number of strategic issues facing community banks and can offer benefits to plan participants, existing shareholders, and the sponsor company, including:Augmenting capital, particularly for profitable institutions facing limited access to external capital. Though an ESOP strategy generally builds capital more slowly than a private placement alternative or a public offering, it provides certain tax advantages and may result in less dilution to existing shareholders. For additional perspective, consider the following example. Let us assume that the holding company has $5 million of debt or preferred stock (this example could also include TARP or SBLF funding) with a five year term and an interest rate of 5%. Assuming that the subsidiary bank is the holding company’s primary source of cash (which is often the case for most community banks), the typical option to service this holding company obligation would be dividends from the bank to the holding company. However, an ESOP is another option that might be worth considering as ESOP contributions are tax-deductible expenses and this allows the bank’s capital position to benefit. In the ESOP strategy, cash contributions received by the ESOP are used to purchase newly issued shares of the sponsor’s common stock (in this case, the holding company), providing liquidity that the bank holding company then uses to service holding company’s debt. As detailed in the table below, the ESOP strategy provides the necessary cash flow to the holding company for its obligations but results in approximately $2 million of added bank capital (approximately 35% of the cash needed to service the holding company obligation) at the end of the five-year period. This higher capital could be used in a variety of ways by the underlying bank, either to fund future earning asset growth organically or through acquisitions, pay additional distributions to the holding company for shareholder dividends, or as a cushion against adverse events such as credit losses. However, there is a trade-off to augmenting the bank’s capital using the ESOP strategy, as the holding company’s shares outstanding will increase thereby causing dilution to existing shareholders.Facilitating stock purchases and providing liquidity absent a sale of the bank to outsiders by creating an "internal" stock market whose transaction activity can promote confidence in stock pricing. The ESOP offers the further advantage of providing a vehicle to own shares that is “friendly” to the existing board of directors. For example, the ESOP can offer an alternative exit strategy beyond selling the bank to outside investors through an IPO or acquisition by providing a liquidity avenue that allows for ownership transition while maintaining independence. For C-corporations, the shareholder may even have the ability to sell his or her shares in a tax-free manner subject to certain limitations related to a Section 1042 rollover, including the ESOP owning 30% or more of each class of outstanding stock after the transaction and the seller reinvesting the proceeds into qualified replacement property from 3 to 12 months after the sale; and,Providing employee benefits and increasing long-term shareholder value. ESOPs provide a beneficial tool in rewarding employees at no direct cost to themselves by providing common stock and tying their reward to the long-term stock performance of the bank/company, which can serve to increase employee morale and shareholder value over time. For example, a recent study by Ernst & Young1 found that the total return for S Corporation ESOPs from 2002 to 2012 was a compound annual growth rate of 11.5% compared to the total return of the S&P 500 over the same period of 7.1%. The measure of S ESOP returns considers cumulative distributions as well as growth in value of net assets, net of those distributions (i.e., growth in underlying value per share).What Is the First Step for Those Considering an ESOP?For those considering implementing ESOPs, the first step is generally a feasibility study of what the ESOP would actually look like once implemented at your bank. Parts of the study would include determining the value of the company’s shares, the pro-forma implications from the potential transaction/installation, as well as what after-tax proceeds the seller might expect. This will help determine whether the bank should proceed, wait a few years to implement, or move to another strategic option. There are typically a number of parties involved in implementations including among others an appraiser/valuation provider, trustee, attorney or plan designer, and administrative committee.What Are Some Potential Drawbacks to ESOPs?ESOPs are subject to both tax and benefit law provisions (such as the ERISA act of 1974). Certain negatives associated with them can include:The costs of setting up and maintaining the plansThe repurchase obligation for the sponsoring company as employees retire or exit the planRegulatory issues with the Deportment of Labor serving as primary regulator and the IRS being able to review plan activitiesFiduciary roles associated with ESOP trusteesPotential complexities related to shareholder dilution from issuing new sharesAre There Any New Developments for ESOP Trustees to Consider?For existing ESOPs, two recent legal and regulatory developments have brought up important issues for trustees to consider as well.DudenhoefferIn 2014, the Supreme Court ruled on the case of Fifth Third Bancorp v. Dudenhoeffer, which involved a public company that matched employee contributions to a 401(k) plan by contributing employer stock to an ESOP that was part of the plan. The ruling states that the standard of prudence applicable to all ERISA fiduciaries also applies to ESOPs, though ESOP fiduciaries are not required to diversify the ESOP’s holdings. The Court ruling was focused on public company ESOPs, but its implications for private company ESOPs are unclear. However, trustees should consider ensuring an investment policy statement is in place for the ESOP, stating that the policy is to invest primarily in employer stock in accordance with the purpose of the Plan; and, if applicable, the policy statement could potentially clarify that employees have diversification options through other benefit plans such as a 401(k) plan.GreatBanc TrustScrutiny related to ESOPs, particularly as it relates to certain valuation issues, has increased in recent years, with the DOL bringing a number of cases against trustees and other parties. In the case of Perez, Secretary of the DOL v. GreatBanc Trust Company, there is a process agreement that we encourage ESOP companies and their trustees to review. While the process requirements are only specific to GreatBanc, the case has received a lot of attention in the ESOP community.In October 2012, The U.S. Department of Labor filed a lawsuit against GreatBanc Trust Co. and Sierra Aluminum Co. in the U.S. District Court for the Central District of California. Among other issues identified in the suit, the DOL alleged that GreatBanc violated the Employee Retirement Income Security Act by breaching its fiduciary duties to the Sierra Aluminum Employee Stock Ownership Plan when it allowed the plan to pay more than fair market value for employer stock in June 2006. The suit also named the ESOP’s sponsor, Sierra Aluminum, as a defendant. The sponsor’s indemnification agreement with GreatBanc allegedly violated ERISA regulations. The suit focuses on the quality of the appraisal on which the trustee relied, particularly on the supportability of the assumptions used in the cash flow projection.As part of the settlement negotiations, the DOL and GreatBanc have agreed upon a specific set of policies and procedures as trustee of an ESOP. While specific to GreatBanc, the transaction procedures are presumed to be applicable to all Trustees and related appraiser relationships. The process requirements cover the following areas:Selection and Use of Valuation AdvisorOversight of Valuation AdvisorFinancial StatementsFiduciary Review ProcessPreservation of DocumentsFair Market ValueConsideration of Claw-BackOther ProfessionalsIn general, the process agreement makes clear that trustees must ensure that ESOP valuations are well documented with thoroughly supported assumptions.How Can Mercer Capital Help?Mercer Capital has been providing ESOP appraisal services for over 25 years and has extensive ESOP experience through providing annual valuations, installation advisory, feasibility studies, financial expert services related to legal disputes, and fairness opinions. Our appraisals are prepared in accordance with the Employee Retirement Income Security Act (“ERISA”), the Department of Labor, and the Internal Revenue Service guidelines, as well as Uniform Standards of Professional Appraisal Practice (“USPAP”). We are active members of The ESOP Association and the National Center for Employee Ownership (NCEO). Our professionals have been frequent speakers on topics related to ESOP valuation throughout our 32-year history. Mercer Capital professionals also co-authored the publication, The ESOP Handbook for Banks (2011), which provides insight into key ESOP-related issues affecting banking organizations.For additional ESOP resources, view our whitepapers Insights on ESOPs and Choosing a New ESOP Appraiser.Endnote1 Contribution of S ESOPs to participants’ retirement security: Prepared for Employee-Owned S Corporations of America March 2015) Report can be accessed at: http://www.efesonline.org/LIBRARY/2015/EY_ESCA_S_ESOP_retirement_ security_analysis_2015.pdf.

How Banks Build Value via Trust and Wealth Management Franchises

In the late 1960s, Enzo Ferrari committed to building an "entry-level" sports car that would appeal to a more mass-affluent buyer than his eponymous marque. His design team engineered a mid-engine two seater with a 2.4 liter, six cylinder motor called the Dino, named after his late son who was to be heir to the Ferrari dynasty. Although Ferrari manufactured the car and eventually badged a later version of it, the original design was never a “Ferrari Dino,” just a Dino. Buyers of the car did well on their entry-level investment – well preserved Dinos now routinely sell at auction for close to half a million dollars.There are a few Dinos for sale right now in Scottsdale, where Brooks Hamner and I are attending Bank Director’s Acquire or Be Acquired conference. We spoke today on how banks can build value through trust and wealth management franchises. It just so happens that there are a number of annual collector car auctions going on here at the same time, and I could draw more than a few parallels between the events.Much like Enzo Ferrari’s strategy fifty years ago, banks are looking to reach a mass-affluent investor community by offering sophisticated asset management services and personal attention once reserved for high net worth and institutional clients. Time will tell if this acquisition binge is as transformational for the banking community as the Dino was for Ferrari (today more than half the cars they sell follow the same mid-engine format). I’m sure acquiring bankers hope that investing in their trust and wealth management businesses will pay off as well as the purchase of a Dino did in the late 1960s – even if ownership may not be quite as much fun.Here’s the slide-deck from our presentation. Even with the present market instability, banks have an interesting opportunity to expand their financial services while diversifying their revenue streams with asset management. We sense some growing demand for sophisticated trust services, and a lot of RIAs in the wealth management space see banks with existing trust departments as a complementary environment to sell into. Give us a call if you’d like to know more. I’ll be back with some conference hearsay next week.

Five Things to Improve the Value of Your Investment Management Practice

Which Have Nothing to Do with the Stock Market

Cold enough for ya?Back in early December when the temperature was unusually high and the VIX was unusually low, many of our clients were calmly contemplating 2016 while they developed their budgets for the year ahead. Six weeks later, the debate over whether or not weakness in high yield would spread has been settled — and most of the eastern U.S. is covered in snow.Boxer Mike Tyson once said, “Everybody has a plan – ‘til they get hit in the face.” With equity markets and most debt markets draining AUM from client portfolios lately, many asset managers and wealth managers are reeling. Between watching firm revenues tail off with all the red on the screen, plus fielding phone calls from anxious and sometimes angry clients, it’s easy to feel out of control, if not helpless. But out of control and helplessness are two different things.I once read an interview with a veteran airline pilot who said that, when confronted with a crisis, the first thing to do was order coffee. In other words, step away from the crisis, get control of your own thinking, and consider your options from there. In that spirit, take a moment to step away from Bloomberg, grab some coffee, and think about the business of your investment management firm.Here are some brief thoughts about five topics, posed as questions, that can make or break the value of RIAs. These topics have longer term and more strategic implications than the day-to-day fluctuations in capital markets, and while equity research may be more fun, these are more reliably lucrative.1. Do the Right People Own the Right Amount of Your Firm?Ownership is a sticky wicket, and indeed can be the most distracting issue for an otherwise successful shop — all the more reason to focus on ownership now, rather than kicking the can down the road another quarter. Any ownership program has benefits and tradeoffs. Usually that tradeoff involves rewards to the builders and producers of the firm versus the sustainers and future leadership.We have some clients with dynamic ownership programs that get tweaked every year. This willingness to be flexible can allow RIAs to ensure that the ownership is supporting the long term strategy of the firm. But doing that means giving up some of the “permanence” that is usually associated with ownership, and can make equity participation walk and talk a lot more like a compensation plan.Others have a hard time getting shares moved from generation to generation, usually because the spread between the bid and the ask is just too wide. A frequent internal quip at Mercer Capital is that RIAs are worth so much that no one can afford to own them. Some try to solve this with interesting terms or creative financing, but we usually discourage clients from trying to cure price with terms.2. Are Your Corporate Documents Updated and in Order?Specifically, think about your buy-sell agreement and whether or not it supports the long term continuity of leadership at your firm. What is the pricing mechanism in your ownership agreement? What happens if someone dies? What if the partner group has a member who is no longer productive to work with – can you fire them and buy them out?It won’t surprise anyone to learn that we recommend calling for an independent appraisal to establish pricing at the time of a transaction. Not that we know more about what your firm is worth than you do, but our experience is that, when a valuation dispute arises (often when an owner is kicked out), the bid/ask spread can be huge. With an independent valuation opinion resulting from a structured process, the matter can be resolved by someone with no skin in the game other than their professional reputation.Of course, the best way to avoid confrontations over valuation is to get a regular valuation analysis prepared by an outsider. It sets the stage for ownership transitions, and while there is still usually some spread between expectations and reality, at least the spread is much more narrow.3. Do Your Client Demographics Support your Business Model?Just like ownership, the client base of every RIA evolves. The question is: are you managing that evolution for the long term strategic benefit of your firm?We did expert testimony work a few years ago for a partner in a firm managing $6 billion for 14 institutional clients. Needless to say, that’s an efficient and highly profitable way to run an RIA – until you post too many periods of negative alpha.Most client concentrations aren’t that extreme, but it’s always worth thinking about whether you have the optimal client composition. If you run an independent trust company or wealth management firm, you probably have mostly high net worth clients. What do they have in common? Did they make their money from the same industry? Are they geographically concentrated? How old are they? How are their kids involved in the family wealth? Is that money being managed for this generation or the next?We sat down recently with an asset manager who has, over time, managed their client base very deliberately. They are a straightforward long-only manager, but they have investors via mutual funds, wrap programs with wire-house firms, direct relationships with high net worth clients, direct institutional relationships, and institutional relationships they handle through consultants. They explained that, because their investment style goes in and out of favor with trends in the market, they wanted clients with a diversity of pressure points and decision timelines. If their performance dips because of market conditions, not everyone heads for the exit at once. If they outperform, they don’t immediately slam up against their capacity with a lot of hot money that will leave just as quickly.4. Is Your Firm Growing Because of Markets, or Because of Marketing?As a follow-on to the commentary about customer demographics, it’s important to think about what you’re selling. Investment performance waxes and wanes, so just selling alpha in good times can really burn a shop when the market turns. Having a message that resonates about what you do that is unique can attract clients when you are outperforming and when you are underperforming, and it is a more reliable way to accumulate AUM than the steady upward drift of the capital markets.Also, don’t forget to market to (educate) your existing clients. If they are educated about why you do what you do, they’re less likely to leave when the market doesn’t favor your style. A dollar of AUM retained is worth just as much as a dollar of AUM gained – maybe more.5. Do You Have a Series of Products Available to Grow Beyond the Capacity of Your Current Offerings?In scarcely a generation, the investment management profession has gone from offering relatively straightforward buy-low-sell-high services to ETFs to ESG. Clients still want their investment managers to buy low and sell high (or least buy high and sell higher), but the “buckets” have changed some and will continue to change.It’s an obvious statement that you have to be offering products that clients want to buy. But if you were starting your RIA fresh today, what would your product offering be? From where you are today, is there a logical progression of product offerings to capitalize on your firm’s strengths and grow your client base and AUM base for decades to come?It’s difficult to know what kinds of products clients will want in the future, but it’s certain that clients will want investment management products in the future, and will probably be willing to pay about 100 basis points for products that are sufficiently differentiated such that clients can see the value.Improving the Value of Your Practice Regardless of Market DynamicsHappiness is expectations netted against reality. Unless you came into this year massively overweight cash, or with a big short position on energy, you’re not too happy and neither are your clients. However, it’s a good time to keep your eye on the practice management ball, because it will give you a competitive advantage in a year where most RIA managers can’t get their minds off the ticker.If you can improve the fundamentals of your practice in 2016, the markets will eventually take care of themselves, and you’ll be in a better position to profit when the bears go back into hibernation. It has been our consistent experience that good practice management builds value in an RIA, and in turn building value in an investment management practice reinforces the better aspects of the business model.In that vein, Brooks Hamner and I will be at the Arizona Biltmore in Scottsdale next week to speak to Bank Director’s Acquire or Be Acquired conference about how banks can build the value of their trust and wealth management franchises. This happens to coincide with several important collector car auctions, not to mention 75 degrees and sunshine. Yes, I can hardly contain my excitement. We’ll post the slide deck, and hopefully photos of some premium iron, next week.

Are You GIPS-Compliant?

The Global Investment Performance Standards (GIPS®) were adopted by the CFA Institute in 1999 and are widely accepted among the international investment management industry. GIPS are a set of ethical principles based on a standardized, industry-wide approach that apply to investment management firms and are intended to serve prospective and existing clients of investment firms. While compliance by investment firms is voluntary, many investors consider GIPS compliance to be a requirement for doing business with an investment manager. Alternative managers have lagged behind the industry in claiming compliance with GIPS, but changes in the industry suggest GIPS compliance is becomingly increasingly important.On the CFA Institute Market Integrity Insights blog, Beth Kaiser identifies two reasons GIPS compliance is becoming increasingly important, specifically for alternative investment managers. One driver is that alternative strategies are becoming increasingly mainstream and investors and consultants are engaging in more comprehensive due diligence. Compliance with GIPS can help managers to stand out amongst their peers. Furthermore, the issuance of the GIPS Guidance Statement on Alternative Investment Strategies in 2012 makes it easier for alternative investment managers to comply.The GIPS Guidance Statement on Alternative Strategies and Structures specifically addresses compliance for hedge funds and other alternative investment strategies. GIPS standards state that portfolios must be valued in accordance with the definition of fair value and that all investments, regardless of liquidity, must have valuations that adhere to the definition of fair value. In addition, firms are to disclose if pricing has been performed internally and not by an external third party.At the 2015 GIPS Annual Conference, it was revealed that the California Public Employees’ Retirement System (CalPERS) inquires of all investment managers, including alternative investment managers, seeking to do business with them whether they are GIPS-compliant. The position of CalPERS in the industry suggests that managers will take the steps necessary to win its business and that GIPS-compliance is quickly becoming the norm for investment managers.Related LinksPortfolio Valuation - Private Equity Marks & TrendsUpdated: Valuation Best Practices for Venture Capital and Private Equity FundsRules for the Modern Investment ManagerMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.

Asset Manager and Mutual Fund Valuations Continue their Decline through Year-end

A quick look at year-end pricing of publicly traded asset managers reveals a continued skid in multiples for traditional RIAs and mutual funds with modest advancement for the alternative managers and trust banks. Earnings multiples are essentially a function of risk and growth, so a decline in cap factors for the traditional managers and mutual funds means one of two things must be happening: either the cost of capital is increasing or the growth outlook for asset managers is stalling. Despite the Fed’s recent actions, WACC’s are generally declining in most industries. There is no reason to assume the cost of capital is now higher in asset management than a year or two ago, so the trend in multiples suggests that the growth outlook for RIA earnings continues to be revised downward. Given that traditional asset managers and mutual funds are so highly levered to market conditions, some consider RIA valuations as a de facto futures contract on the broader indices. If that’s the case, a continued contraction in multiples could portend a pullback or lack of upside for the stock market in general. The market activity on the first trading day of this year tends to confirm this suspicion. Since most of the group is currently trading at a 30% discount to their 52 week high, the market is clearly bearish on the prospects for many of these businesses moving into the new year. Meanwhile, more optimistic investors will view this as a buying opportunity for companies that have gotten a lot cheaper in recent months. Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.

E&P First Quarter 2016

Region Focus: Eagle Ford

Region Focus: Eagle Ford The collapse of oil prices in late 2014 had immediate effects on the exploration and production industry.

E&P Second Quarter 2016

Region Focus: Permian Basin

Region Focus: Permian Basin After collapsing in late 2014, oil prices reached historic lows in the first quarter of 2016 but have since started to show signs of recovery.

Refining Second Quarter 2016

Refining Overview: The refining industry is surrounded by uncertainty. Refiners’ inputs and products are both commodities, which means that the price they pay for inputs and the prices they receive for their products are generally determined by the market.

Refining Overview: Permian Basin After collapsing in late 2014, oil prices reached historic lows in the first quarter of 2016 but have since started to show signs of recovery.

TSC buys $2.5B manager for Six Times (!)?

As usual, it’s not that easy

Over the Christmas holiday weekend I had the coveted experience of riding in a friend’s recently restored 1970 DeTomaso Mangusta. I didn’t take him up on the offer to drive the car as the roads were a little damp and Mangustas are notorious for being a little tail-happy, especially in the wet. The last thing I wanted was to be responsible for putting so much as a scratch on a specimen car that is as rare as hen’s teeth. DeTomaso built 401 of them before switching production to the much more common Pantera in 1972. There are maybe 200 Mangustas surviving today. This particular car was bought by my friend’s dad at an auction in Florida over twenty years ago. It had been owned by a member of Pablo Escobar’s drug cartel and still had a bullet hole in the fender. After restoration, it’s probably better today than new – so despite the sordid provenance I wasn’t too keen on sliding it into a bridge abutment.What’s even more rare than the Mangusta was the announcement earlier this month that Tri-State Capital Holdings, Inc. (traded on the Nasdaq as TSC) bought The Killen Group, a $2.5 billion manager of the Berwyn mutual funds, for about six times EBITDA. More specifically, TSC paid Killen $15 million cash up front (based on trailing EBITDA of $3.0 million), plus an earn-out paying 7x incremental EBITDA (which could add another $20 million to the transaction price). So, best case scenario for Killen is for them to deliver about $6 million in EBITDA and get paid $35 million (!).On the surface, the deal looks awfully cheap. Reading between the lines, Killen has a (very sustainable) effective average fee of 56 basis points, a normalized EBITDA margin of 35%, and a five-star rating form Morningstar on its largest mutual fund product, the Berwyn Income Fund (BERIX). All good. So why didn’t Killen make a killing (extract a double-digit EBITDA multiple from TSC)? No one expects that kind of an asset manager to sell low. At first glance, it’s the bookend to the Edelman transaction back in October, which appeared to be priced astronomically high. In the end, though, the two deals have more in common than not. In both cases the headline price gives one impression of the deal, while the underlying narrative says something very different.Much of the valuation work we do in the RIA space is, for one reason or other, performed pursuant to a standard of value known as fair market value. The standard of value is essentially a framework for the perspective of a given appraisal. Fair market value is defined by the American Society of Appraisers as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.When we look at transactions data in preparing fair market value appraisals, one thing we keep in mind is that transactions do not occur at fair market value – or if so only by coincidence. Transactions involve real buyers and sellers, not hypothetical ones. They might act at arm’s length in an open and unrestricted market, but usually they have a compelling reason to transact. It seems like that was the case in the TSC/Killen transaction.The press release and slide deck that went with the announcement didn’t go into detail, but TSC management alluded to Killen reporting $3.0 million in trailing twelve month EBITDA, which was really about $5.0 million net of a trading error. A $2.0 million trading error is substantial, but we don’t know much else about it. What we do know from looking at Killen’s ADV is that they also reported some FINRA compliance issues which appear to be connected with their president and chief compliance officer.Admittedly, the disclosure is thin and what is disclosed doesn’t sound terribly ominous. But some consider any “yes” answer to regulatory issues to be a big red flag, especially in connection with a $2.0 million trading error. Charlie Munger once said that, in the securities industry “integrity is like oxygen, no one thinks about it until it’s gone – then it’s the only thing they think about.” If the regulatory issue threatened Berwyn’s five-star rating, it could have a huge impact on client behavior. Put all of this in the context of a small firm (13 employees) with an aging founder who still holds a control position in the stock, and you’ve got what appears to be a motivated seller.We won’t speculate on what the multiple “could have been” in absence of the factors mentioned above, or what specific role they played in generating the terms of the Killen sale to TSC. But it appears to be an outlier transaction for outlier reasons, and like the Edelman deal shouldn’t be misinterpreted as signaling anything unusual about valuations in the asset management industry.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.

Updated: Valuation Best Practices for Venture Capital and Private Equity Funds

The International Private Equity and Venture Capital Valuation (IPEV) Guidelines were developed in 2005 to set out recommendations on best practices in the valuation of private equity investments. The IPEV Board is made up of leading industry associations from around the world, including the National Venture Capital Association (NVCA) and the Private Equity Growth Capital Council (PEGCC) in the United States. In October 2015, the IPEV Board published draft amendments to the existing guidelines that, if approved, will go into effect at the beginning of 2016.The IPEV Valuation Guidelines are intended to be applicable across a range of private equity funds, defined in a broad fashion to encompass seed and start-up venture capital, buyouts, growth/development capital, mezzanine debt, and other types of private investment vehicles. While US GAAP and IFRS financial reporting guidelines do not require that the IPEV Guidelines be followed, the IPEV Guidelines were created with the compliance requirements and implications of these standards in mind.The stated objective of the IPEV Valuation Guidelines is to set out best practices where private equity investments are reported at “Fair Value” to help investors make better economic decisions. The guidelines are concerned with valuation from a conceptual, practical, and investor reporting standpoint and do not seek to address best practice as it relates to internal processes, controls/procedures, governance, committee oversight, or the experience/capabilities required of the valuation professional.The proposed amendments to the IPEV Guidelines include edits to improve readability and clarity of understanding, as well as technical edits. The technical edits include the following:Update on IASB Unit of Account Progress to conform with international standards.Additional guidance emphasizing that fair value estimates (1) should be developed independently for each reporting entity (or fund) and (2) should be estimated using consistent valuation techniques.Modification of guidelines for the valuation of debt for purposes of determining the value of equity, including the treatment of prepayment penalties in the calculation of the fair value of debt.New guidelines to describe back-testing, including assessing what information was known as of the Measurement Date and whether known information was included in the Fair Value assessment.New guidelines aimed at clarifying certain valuation techniques, including the use of Market Approaches (Price of Recent Investment, Multiples, Industry Valuation Benchmarks, or Available Market Prices), Income Approaches (Discounted Cash Flows), and Replacement Cost Approach (Net Asset Value).Discussion of certain special considerations, including non-control minority positions, guidance on mathematical models, and guidance on the sum-of-the-parts method. With increasing activity and interest from investors, valuation guidance for private equity and venture capital investments continues to become more clearly defined. Mercer Capital will continue to present periodic updates on the evolving fair value landscape here at the Financial Reporting Blog and other forums. For more information on the guidelines, please refer to the International Private Equity and Venture Capital Valuation Guidelines, Edition December 2015 DRAFT. If you have questions regarding fair value or fair value measurements, please contact a Mercer Capital professional to discuss your situation in confidence.

A Few Thoughts on Valuing Investments in Startups

Concurrent with Madeleine Harrigan’s post last week about IPOs being the new private equity downround, the financial reporting group at Mercer Capital published an interview with the head of the group, Travis Harms, on the difficulties mutual funds face in valuing level 3 assets (think Square). The following is an excerpt from that interview.With respect to portfolio valuation, who are your clients and what services do you provide? In our portfolio valuation practice, clients cover the spectrum from debt-focused funds, to hedge funds, traditional private equity funds, venture funds, and sector-focused credit and equity funds. Despite the diversity of strategies, what they all have in common is the need to develop reliable, defensible fair value marks for hard-to-value assets in a real-time reporting cycle. That reporting cycle varies by client – we mark some assets on a monthly basis, while we look at others annually. The frequency with which we mark assets is generally a function of the fund manager’s ability to develop interim marks on their own – do they have the requisite expertise and staffing to develop and document reasonable interim marks? Now, of course, the fund manager has the expertise to value assets. However, the fund manager’s valuation objective is to determine “intrinsic” or “investment” value, which may well differ from the prevailing market consensus. That is not the objective of fair value reporting, though. Fair value is not the fund manager’s price target based on his investment thesis. It is a particularly defined standard: fair value is the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. Developing and documenting the corresponding market participant inputs can be time-consuming and requires a different perspective than the fund manager is accustomed to using. Sometimes we are developing our own independent estimates of fair value from scratch; other times we are examining the fund manager’s own estimates for the purpose of providing positive assurance that the marks are reasonable. Regardless of the scope of our work, documenting, presenting, and defending our conclusions to auditors and, potentially, regulators is always part of our job. Looking to the VC markets a bit, you have commented on the Unicorn phenomenon and suggested that from a valuation perspective, “What’s obvious isn’t real, what’s real isn’t obvious.” What do you mean? What we mean by that is that – while the headline valuation ascribed to a company following a fundraising round is obvious (price x fully-diluted shares outstanding), that is not the real value of the company. What is less obvious, but considerably more real, is that the price per share in the most recent round reflects all of the rights and economic attributes of that share class. Those rights and attributes are not the same for all of the other shares included in the fully diluted share count. It’s like applying the per-pound price for filet mignon to the entire cow – you can’t do that because the cow includes a lot of other stuff that is not filet. In the same way, the “obvious” pxq calculation overstates the value of an early-stage company. Now, no doubt the values of many “unicorns” are substantial, even when calculated correctly – but the real values are not nearly as obvious as the often breathless headlines would suggest. Last week, a Wall Street Journal article elaborated on some of the difficulties that mutual funds face in valuing their investments in startups. Based on your experience with providing periodic fair value marks for VC funds, what are some of the elements that go into valuing such investments? What are some of the pain points? Valuing startup investments, including “unicorns” such as those mentioned in the Wall Street Journal article, requires developing a thorough understanding of the economics of the most recent funding round, which provides a market-based “anchor” for valuation at subsequent measurement dates. What we find most effective is to build our valuation model so that it corroborates the “anchor” value as of the date of the most recent external funding round. Once our model is appropriately calibrated, we can then develop appropriate market participant model inputs for the measurement date that take into account changes in markets, company performance, and prospects for future exit with regard to timing, amount, and form. Valuing these investments is particularly challenging given the illiquidity of the securities. When observable transactions occur only sporadically or at long intervals, it can be difficult to assess how changes in the market and company prospects will influence value. The longer the holding period – in other words, as you move from days to months to years – the greater the uncertainty regarding reasonable inputs and the wider the range of potential outcomes. Things become even more difficult when you layer in the unique features of many of these securities, such as liquidation preference, conversion, participation, and other rights and features. Finally, the WSJ article discusses the fact that there is variation, sometimes substantial, in the valuation marks provided by different investors in the same company. Is that troublesome? Is it troubling that different reasonably informed investment professionals come to different good faith estimates of the fair value of the securities we’ve been discussing? No. As we mentioned previously, illiquidity necessarily increases uncertainty. This is a phenomenon that you can observe even in securities that trade in markets – the less liquid and shallower the market, the wider the bid-ask spread will be. Even if you follow a rigorous calibration process like we outlined earlier, there is uncertainty about inputs. For example, you may know – on the basis of an observed market transaction – that a company’s value was $40 at a particular date, but what you still cannot directly observe is whether that was 8 times 5 or 10 times 4. Those unobservable inputs will necessarily breed good faith differences of opinion as the $40 value becomes stale with the passage of time. That is not to say that anything goes – there is a range of reasonable conclusions. But no, different estimates of fair value for these securities are not in themselves troubling. A different question, whether it is troubling – given this valuation uncertainty – that an open-end mutual fund owns such securities is for the regulators to decide. It may be that the fair value estimates are reasonable, and reasonably different, but those differences are simply not tolerable from a regulatory standpoint. That, however, is ultimately not a valuation question.Related LinksUnicorn Valuations: What’s Obvious Isn’t Real, and What’s Real Isn’t ObviousHow to Value Venture Capital Portfolio InvestmentsValuation Best Practices for Venture Capital FundsMutual Funds Flail at Valuing Hot Startups Like Uber (subscription required)Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.

Are IPOs the New Down Round?

There's something about nature that abhors a vacuum. Right now that vacuum seems to be the imbalance between the public and private markets, with the latter attracting maybe too much interest since the credit crisis, at the expense of the former. Blame fair value accounting or Sarbanes-Oxley or the plaintiff's bar, but it has been some time since being public was actually considered a good thing. With interest running high in the "alternative asset space" and cheap debt for LBOs, the costs of being public have not been particularly worthwhile. This situation is not sustainable, and was never meant to be. Family businesses can stay private forever, but institutional investors eventually need the kind of liquidity that can only come from the breadth of ownership afforded by established public markets. Valuations are never really proven until exposed to bids and asks. So the circumstance in which private capital markets are considered more desirable than public markets is to express an illiquidity preference which is at odds with basic investment logic and the requirements of portfolio management. This cannot last, and the end – which appears to now be unfolding - will ripple throughout the asset management industry. Continuing a trend set into motion in the first half of 2015, third quarter IPO activity fell 34% year over year in 2015, while the median capital raised in private fundraising rounds hit a staggering $92 million. The tech industry in particular has suffered from a glut of capital in late-stage funding rounds, leading to a general hesitation to leave the safe (because it is comfortably theoretical) harbor of the private market. Only 11% of IPOs completed in 2015 so far involved tech companies, with a majority of them generating returns of less than 3% from their IPO prices, and producing a negative 15% from their debut closing prices. Within the tech industry, the sheer amount of capital inflow from the private market has distorted the usual hubbub around the IPO. Private valuations have quietly (and in some cases, publicly) reached levels unsustainable in the public market, and companies now face a reality in which going public may in fact devalue the company – at least from late financing rounds. It seems only fitting that a company whose entire platform is built on the concept of impermanence should fall prey to the largest tech devaluation in the private market in 2015. Snapchat, a photo, text and video messaging app in which messages "self-destruct" in ten seconds or less, took a hit this past week when it was revealed that Fidelity Investments cut the value of its stake in the company by a whopping 25%. Earlier this year, BlackRock reduced its valuation of the cloud-storage software DropBox by 24%. However, as mutual funds, both Fidelity and BlackRock are obligated to mark their portfolios to market on a regular basis and disclose their valuations. In the third quarter, plummeting gas prices, unstable Asian markets, and whatever new catastrophe was going on with the Eurozone were in full effect. As a result, Twitter saw its stock price fall by 29%, while Facebook also had less than stellar returns. In all likelihood, Snapchat and DropBox were victims of market pressure rather than fundamental performance. It's a buyer's market in the IPO world, as 16% of IPOs downsized their debuts during the third quarter. Investors burned by lower than expected returns in the public market are putting pressure on startups to offer protections or lower their share price. Square, Inc., a mobile payment company founded in the heart of Silicon Valley, recently announced plans to sell 27 million shares in an IPO offering ranging from $11 to $13 per share, a significant discount from the company's October 2014 funding round that valued shares at $15.46. Granted, late stage Square investors are operating under a "ratchet" agreement (not the adjective kind). Square agreed to provide extra shares to certain investors if the company went public at a share price lower than the funding valuation the investor bought in at. If Square goes public at a share price below $15, the IPO will trigger the ratchet and diminish the outstanding shares. But terms don't fix price, as the "protection" afforded some Square investors will come from other Square investors. Ultimately, price is a zero sum game. Although startups do not often publicize whether investor protections are in place, it is an additional factor that has led several startups to postpone a planned IPO. LoanDepot is the latest company to get cold feet before their big day, as the company's prospective share price plummeted from a high of $18 per share to below $12. Instead of floating the lower valuation, LoanDepot walked, citing "market conditions" as the primary culprit behind the lower valuation. The IPO market has become a waiting game, as more and more startups have punted going public in favor of private capital. Whether the current market squeeze filters its way down to affect private valuations is only a matter of time. It's hard to imagine that a buildup of companies waiting to go public will somehow improve IPO pricing. And it is hard to imagine this ending well. ZIRP and arguably over-regulated public markets have created a robust private market, but it is a market of "Level 3" assets without validation. If private markets seize, will they also become more regulated? If rates ever rise significantly, can financing get rolled over to sustain leveraged ownership? Can pension plans and endowments satisfy their funding liabilities without liquidity for alternative assets? At some point, liquidity preference is going to have to restore some reason for public ownership. Ultimately, though, the question is whether that comes from improvement in the public markets or deterioration in the private market.

Asset Manager Valuation and Rules of Thumb

One of the most glorious places on earth to eat is La Colombe d’Or in Saint-Paul de Vence, France – just above Nice. Known as much for its art collection as for its food, just inside the garden entrance at the restaurant is a giant marble thumb, carved by the artist Cesar, to greet you as you enter. The placement appears inspired to give guests the "thumbs-up" on their arrival or departure from the restaurant, setting up the right mood for a tremendous calorie fest (and corresponding tab). It’s impressive, at least until you notice the collection of Legers, Picassos, Calders, and Miros that "Cesar’s Thumb" has to compete with.The shorthand method of valuation in many industries has long been some kind of "rule of thumb", usually a multiple of some measure of gross scale or activity.Twenty years ago, money managers were often thought of as being worth something on the order of 2% of assets under management. Even today, transactions in RIAs often disclose only the transaction value, which when compared to the latest AUM measure in the firm's ADV filling, yields something of a transaction value as a percentage of AUM. Because this is often the only valuation metric available from an RIA transaction, it still receives a lot of press – more than it deserves.A not very close look at the transactions data belies the use of price-to-AUM as a standalone indication of value. While some recent RIAs have transacted at a value that was at or near 2% of AUM, others are very different. And publicly traded asset managers might command 4% of AUM or more.So, obviously, there's more to the story than a measure of central tendency with regard to AUM. The 11,000 plus RIAs in the U.S. come in all shapes and sizes, and the value of any business is typically some conversion from a measure of expected future cash flow, not simply activity.Imagine an RIA with $1.0 billion under management. The old 2% of AUM rule would value it at $20.0 million. Why might that be? In the (good old) days when RIAs typically garnered on the order of 100 basis points to manage equities, that $1.0 billion would generate $20 million in revenue. After staff costs, office space, research charges and other expenses of doing business, such a manager might generate a 25% EBITDA margin (close to distributable cash flow in a manager organized as an S-corporation), or $2.5 million per year. If firms were transacting at a multiple of 8 times EBITDA, the value of the firm would be $20.0 million, or 2% of AUM.The reality, today, can vary widely. If that same RIA is a fixed income manager, the fee schedule on managing debt instruments might only yield 30 basis points, or $3.0 million on $1.0 billion in AUM. Running a fixed income shop of that size might require fewer people than an equity manager, and the cost per employee might be lower. Still, if the EBITDA margin were lower, say 20%, then distributable cash flow might be more on the order of $600 thousand for the fixed income manager, or less than a quarter of that in the first example. Again, if the prevailing multiple of EBITDA is 8x, then the implied valuation, or $4.8 million, is less than half of one percent of AUM, and a quarter of the value implied by the rule of thumb.So what do rules of thumb tell us? To the extent that businesses transact with certain measures of value in mind, they become self-fulfilling prophecy and are instructive as to value. Asset managers are usually pretty savvy with regard to ROI, though, so profitability matters. Fee schedules (realized, not just published) influence the return off a given dollar amount of AUM, as do cost structures. And this is before we talk about concentration risks, growth trends, and overall sustainability of the business model. And it's before we talk about how sought after asset management is today as a sustainable source of profitable returns. Fee schedules may be down. Margins may be all over the place. Risks vary wildly. And multiples may be higher.So the next time someone suggests a rule of thumb to value your RIA, don't hesitate to ask: whose thumb?

Asset Manager M&A Continues Ascent Despite Sell-Off

Despite the recent setback in the markets, RIA transaction activity posted solid gains for Q3 and into the month of October. We caution against reading too much into this since transaction value is often not reported, though it is promising that the number of deals has increased fairly consistently over the last year. The fourth quarter looks to continue this trend with Hellman & Friedman’s recent purchase of Edelman Financial (covered in a previous post). The quarter-end multiples for the public RIAs reveals that pricing remains firm but not egregious, a conducive environment for continued transaction activity in the sector. Prospective buyers will also be intrigued by many of these businesses now trading at a 30% discount to their 52 week high. [caption id="attachment_9618" align="aligncenter" width="650"] Source: SNL Financial[/caption] Placing the recent uptick in its larger historical context reveals a lull in deal making after the active 2006 to 2009 period that culminated in BlackRock’s purchase of Barclay’s asset manager business. The sector’s ability to shrug off the most recent correction is a testament to its resiliency in the face of declining management fees and impending regulatory changes. Despite the recent uptick, we believe the backlog for deal making remains fairly robust given the four year pause in transactions from 2009 to 2013 and the aging demographics of many investment management firms. The real threat to deal making would be a longer, more pronounced downturn in the equity markets that would crater AUM levels and investor confidence. We note the decline in transaction activity following the financial crisis of 2008 and 2009 as indicative of what another bear market could do to M&A trends. The outlook for deal making is therefore more nuanced and dependent on market conditions. The market’s stabilization since the last correction has clearly boded well for sector M&A, and the future appears bright – as long as security pricing holds up. Another significant setback would likely curtail the recent momentum and valuation levels.

What are you afraid of this Halloween? FinCEN

If you haven’t already figured out your costume, let this serve as a reminder that Halloween is coming this Saturday night. If you’re an investment manager, you already have a lot to be scared of this season, but at least that opens up some possibilities for Halloween attire. You could come dressed as earnings season (Eeyore). You could come dressed as the end of capital gains treatment for carried interests (Robin Hood). You could come as the Headless Horseman (robo-advisors). You could come dressed as Frankenstein (multi-strategy ETFs). You could come dressed as Donald Trump (Donald Trump). You could come dressed as the Fed (any hockey mask will do). Or you could always dress up like the living dead, and tell your friends that the zombie that haunts your dreams has a name, FinCEN, the US Treasury Department’s Financial Crimes Enforcement Network.In the midst of a bumpy third quarter, the FinCEN released a proposal to establish anti-money laundering requirements for advisers registered with the Securities and Exchange Commission (SEC). If you think you’ve seen this horror movie before, you have. FinCEN made the same proposal back in 2003 – but then withdrew it as the financial world came crashing down in 2008, citing the “passage of time” as the primary reason. Apparently the passage of more time led regulators back to the same place in the corn maze. On August 25, FinCEN dusted off the proposal and is trying once more to bring investment advisors under the anti-money laundering (AML) obligations.On the second go-around, FinCEN’s proposed rules have more (and sharper) teeth than the 2002 and 2003 proposals. Not only will registered investment advisors (RIAs) have to establish and maintain AML program requirements, advisors will be subject to additional suspicious activity reporting, information sharing, and record keeping. Investment advisers would be defined as “financial institutions” and would be required to file Currency Transaction Reports (CTRs), keep records on the transmittal of funds, and allow FinCEN to require advisers to search their records and voluntarily share information between financial institutions. Advisers would be responsible for filing suspicious activity reports (SARs) to FinCEN on any investor suspected of nefarious behavior. SARs reports are generally filed for transactions in excess of $5,000, though the adviser has discretion on reporting activity below the minimum threshold. Thankfully, all SARs reports are protected under a safe harbor provision to protect advisers from potential litigation for disclosing investor activity.The greatest challenge under the proposal, however, will be in implementing the AML program itself. The AML program requirements are built on four main pillars, with varying degrees of difficulty in application. The pillars include 1) implementing and overseeing policies, procedures, and controls; 2) hiring or appointing an AML Compliance Officer; 3) ongoing employee training; and, 4) independent testing or auditing of the program. Although the proposal only applies to the larger, non-exempt investment advisers (advisers with less than $100 million in AUM are not required to register with the SEC), the burden of implementation will fall heavily on smaller RIAs without risk management processes already in place. The proposed rules will require additional staff, in-depth training, ongoing monitoring and oversight, and external expertise. RIAs are able to adapt existing rules and contractually delegate some parts of the compliance process, with the caveat that the RIA will remain fully responsible for the efficacy of the program. With the SEC capable of enforcing the AML requirements, all advisers will be spending a lot more time – and money – ensuring compliance.Those in favor of the AML compliance believe the RIA industry got off easy, as it is still undecided on whether or not small and mid-sized RIAs, exempt reporting advisers, and foreign private investment advisers will be subject to the proposed rules. Misery loves company. FinCEN also expects to further address the controversial topics of customer identification procedures and information sharing requirements through future regulations. Although the proposal does not include a customer identification program requirement as stringent as those found within banks and broker-dealers, RIAs may have a hard time checking accounts and transaction records against names provided by FinCEN without stronger due diligence into customer identities.Comments on the Proposed Rules are open until November 2, although it is expected that the AML proposal will be passed mostly intact.Sometimes the fear of a thing is worse than the thing itself, and being haunted by proposed regulations may indeed turn out to be worse than compliance. But this horror show may turn into a series with multiple episodes, so clutch your popcorn and stay tuned.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.

Monday Morning Quarterback: Edelman sells for $800 million (!)

Last week brought the news that PE firm Hellman & Friedman had acquired Lee Equity Partners's controlling interest in mega wealth manager Edelman Financial. Edelman is headed by radio-show personality Ric Edelman, and manages about $15 billion for over 28,000 clients. While terms of the deal were not officially disclosed, the Wall Street Journalreported the transaction valued Edelman at a number north of $800 million, a nice pickup from Edelman's going private deal in 2012, which transacted the company at $263 million. The financial press was practically hyperventilating over the price last week, but a little analysis on the number reveals pricing that is more normal than most would imagine.Breathe normallyThe headline optics of the deal are eye-popping. An $800+ million price is more than triple the transaction value only three years ago, and further implies a price to AUM multiple of over 5% (!). The financial press that immediately followed the announcement ballyhooed the deal as proof that RIAs were hot properties fetching premium pricing and that we could expect more of the same. Count us as being a little more measured in our perception of the deal. While we're not going to describe the Edelman deal as a "meh" transaction, the firm's underlying fundamentals are likely far more responsible for the price than an overheated market. Indeed, our analysis suggests Edelman's pricing was fairly normal. Here are a few reasons to be happy, but not ecstatic, about the Edelman sale:Edelman is a growth machineWhen Edelman went private three years ago, the company reported assets under management of about $8 billion. It's almost twice that today. While a 30% CAGR in AUM has no doubt been assisted by bull market tailwinds, most of Edelman's growth has been from growing its investment advisor base and, correspondingly, the number of clients.Past growth explains the change in valuation from the 2012 going private transaction to the current deal, but Edelman is showing signs of continued growth as well, increasing the number of investment advisors by about 20% this year. RIAs can't always count on the market to grow the top line, but if a marketing platform is there to add clients, value will accrue.Edelman fetches premium feesThe real reason Edelman commanded such a high multiple of AUM is the firm's superior ability to extract fees per dollar of AUM.Investment management fee schedules are all over the map, with robo-advisors clocking in at around 25-40 basis points, and wealth managers often sticking between 100 and 125 basis points. Historical disclosures suggest that Edelman commands big fees for what they do. In their last public filing (Q2 2012), Edelman boasted investment management fees of over $32 million. Using that quarter as a proxy for an annual run rate of almost $130 million, Edelman was earning realized fees of 160 basis points on AUM of $8 billion. Even assuming that has been dialed back some by market forces puts Edelman's investment management fee base today at something on the order of $225 million.Add this to the Company's other revenue streams (which probably haven't scaled up to the same extent in the past three years), and we would estimate Edelman's revenue today to be on the order of $300 million. That's no threat to Schwab, but in the independent RIA space it suggests that Edelman has defied certain laws of gravity for wealth managers that have plagued other shops at much lower levels of performance. No doubt the scale of Edelman, the pricing power of their services in the market place, and the potential to grow further attracted a strong multiple.As a caveat to this, higher than market fee schedules are at risk of being "normalized" and doubtless this influenced the valuation of Edelman. That said, it is likely they have been successful at maintaining their value to customers in the marketplace so far.Edelman has revenue sustainabilityRic Edelman built his firm as a radio personality dispensing advice and gathering assets. His advisor network was excellent at client conversion and retention, and that formula has held up. The cult of personality firm, which we have written about in other posts, has drawbacks. Some still suggest that the firm's dependence on Edelman at the helm is a risk. We do not entirely disagree, but note that with 28,000 clients investing on average $536 thousand with Edelman, the firm has a solid lock on the mass-affluent investor market.Client demographics are a big factor in the value of investment managers, and while it's easier to service a few huge clients, if they leave they take firm value with them. The great thing about larger wealth managers like Edelman is that there is client diversification and product diversification, such that revenue is highly sustainable going forward.For a PE manager looking for investment return opportunities in what seems to increasingly be a low return environment, Edelman offers a higher quality coupon than most. We know that better coupons pay lower yields, which in Edelman's case suggests a multiple at the high end of the range.Edelman probably has a solid marginSince Edelman has been private for three years, we don't have a lot of margin visibility, but we can look back to 2012 and see what we can normalize to get there, especially if it's consistent with industry norms. Our analysis of Edelman's run rate at the time of the going private transaction suggests an EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) margin on the order of 30% to 35%. That's strong, but not out of range with similar firms in the wealth management space. Edelman may have achieved some margin leverage with the growth it has experienced over the past three years, but probably not much. Thus Edelman's margin provided an optimal circumstance for the valuation multiple, with solid profit performance that does not need "repair" from a new owner, but also not so high as to risk being unsustainable.Edelman likely got a good, but not extraordinary, multiplePut it all together and the Edelman transaction looks fairly normal. Assuming an EBITDA margin at or just about 30%, consistent with the level of profitability the company reported before the 2012 going private transaction, HF paid a high single digit multiple of EBITDA. The deal multiple was likely upward biased by the growth pattern and trajectory of the company, and the risk mitigation afforded by a diverse client base and large scale. Weighing down the multiple was likely some lingering concern over the dependence on Ric Edelman as the spiritual guru of the organization, concern over the sustainability of the firm's fee schedule, and some angst in general over the direction of capital markets. As solid as this pricing was, we wonder if Edelman couldn't have fetched closer to $1 billion a year ago when folks believed the market had more room to run. But that's neither here nor there. Kudos to Edelman and Lee Equity Partners for a solid return on their three year investment in the company, and to Hellman & Freidman for acquiring a great franchise at a reasonable price such that their investors can also profit. All in all, an increasingly rare event in the PE universe.

Many Alternative Asset Managers in Bear Market Territory

A particularly rocky quarter for the equity markets precipitated huge market cap losses for most of the publicly traded hedge funds and PE firms. The lone bright spot and only sector component to generate a positive return over the last year is Blackstone, which benefited from strong performance fees on its portfolio company investments earlier this year. Still, the stock is down over 20% since its peak in May, which shows just how volatile the industry can be, particularly during times of market distress (our recent post discusses the impact of the recent downturn on asset manager shares). With over $300 billion in AUM, Blackstone’s size is both a blessing and a curse. On the one hand, a large AUM base affords it the opportunity to invest in a multitude of asset classes and industries to enhance its risk/return profile with a diverse product offering. But, size can be a drag on performance and cut into carried interest fees if the underlying fund’s stature trumps viable investment opportunities. Still, some of this risk is mitigated by the added stability of higher management fees from a larger asset base. And the market doesn’t seem to mind this trade-off as AUM fees represent a relatively stable source of income to complement unpredictable and often inconsistent returns from carried interest. Stocks of publicly traded PE firms have typically displayed more volatility than traditional money managers, and building larger funds with longer investment horizons may be one way to temper this disparity. Diversifying fund offerings beyond LBOs and into other asset classes such as hedge funds and real estate also helps. Sector analyst Marc Irizarry at Goldman Sachs notes, "All of these firms…have done a lot to diversify their businesses or to position themselves to grow assets on a more sustainable basis." Indeed alt manager shares have outperformed the RIA index as a whole over the last year, albeit by a fairly small margin. Much of the divergence in financial and investment performance within the alternative asset manager sector can be explained by timing. A Bloomberg News piece in Financial Advisor expounds, "buyout firms' earnings rarely follow a linear path because they are driven by the lumpy timing of exits as well as the "mark-to-market" valuations of fund holdings, which are vulnerable to market swings and required each quarter under accounting rules." The economic cycles and gyrations in the stock market since the financial crisis have compounded this volatility as many of the deals that were struck at the last buyout peak of 2005 to 2007 have taken longer to exit at profitable levels, so their shareholders have yet to witness a full fund cycle while these businesses have been publicly traded. Irizarry elaborates, "[alternative asset managers] are still 'show-me' stories in the eyes of the market. There's some reluctance on the part of investors to ascribe higher valuations on these managers until they see how sustainable these businesses really are." Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.

Rough Quarter for the RIA Industry

Q3 was an especially bad quarter for asset managers, with the group losing over $40 billion in market capitalization during a six week skid. Given the sector’s run since the last financial crisis, many suggest this was overdue and only pulls RIA valuation levels closer to their historic norms. The multiple contraction reflects lower AUM balances and the anticipation of reduced fees on a more modest asset base. The most recent sell-off brings the industry to the brink of a bear market despite the S&P being down only 10% or so over the last few months. Such underperformance is not surprising for a business tethered to market conditions and investor sentiment. The market is acknowledging that revenue for equity managers is directly tied to index movements and earnings often vary more than management fees due to the presence of fixed costs (as demonstrated in the example below). Combining these dynamics with some multiple contraction reveals the market’s rationale for discounting these businesses in recent weeks. The impact on sector M&A is more nuanced. On the one hand, the lower price tag might entice prospective buyers fearful of overpaying. Yet for others the market’s recent variability could spook potential investors, and sellers may be less inclined to part with their businesses at a lower valuation. Though the third quarter figures aren’t out yet, the recent slide could curtail the deal making momentum we’ve witnessed over the last year-and-a-half. The outlook also remains uncertain and will ultimately be determined by market movements and asset flows. We’re neither smart enough nor dumb enough to predict future market movements and will defer that to the experts. As for asset flows, fee-richer active funds are losing ground to indexes and alternative products despite typically outperforming more passive strategies during market downturns. Overall, asset flows to riskier products (active or passive) are unlikely to improve until the recent volatility declines to more normal levels. [caption id="attachment_9360" align="aligncenter" width="500"] Source: Morningstar[/caption]

Look out below! As capital market valuations apex, so too will RIA margins

Investment returns and the steady upward drift of equity markets are usually kind to investment management firm profits and valuations.This does not seem to be a “usual” period, however, and it serves as a reminder that profit margins are not simply an allocation of returns to equity holders; they also serve as a margin of safety in bear markets.Few industries are as susceptible to market conditions as the typical RIA.With revenues directly tied to stock indexes (in the case of equity managers) and a relatively high percentage of fixed costs, industry margins tend to sway with market variations.While the concept of operating leverage is not new to anyone in the asset management industry, it is easy to forget how easy it is for margins to collapse in a market downturn.It is, of course, striking to notice how RIA margins have recovered to the previous peak of 2007, a potentially ominous warning for equity markets now.Even more striking is how deep profits can fall in a market meltdown.The Qs reflecting the P&L impact from the most recent correction aren’t out yet, but we suspect that profits will be adversely affected for at least the next couple of quarters, depending on the extent of the downturn.Indeed, the market appears to be already anticipating this for most publicly traded asset managers, as they have lost several billion dollars in aggregate market cap over the last six weeks.On the private end of the spectrum, smaller, closely held RIAs tend to be more susceptible to market conditions than their publicly traded counterparts.Private RIAs don’t typically have the AUM and corresponding profit margins to serve as a cushion against a bear market.Anecdotally, we saw many asset managers with under $1 billion in AUM report negative earnings in 2008 and 2009 (at least for a few quarters) while most of the public RIAs stayed in the black.A healthy, larger RIA with 30% to 40% margins in good times can absorb a bear market event without reporting a loss, but many closely held asset managers with half that margin aren’t so resilient.The upward drift in the market from 2009 to 2014 buoyed AUM levels to new highs without the corresponding increase in expenses for many asset managers whose only variable costs tend to be compensation related.As a result, our group of publicly traded asset managers was able to recoup their entire 11% drop in average profit margins in just one year after the financial crisis. Only a few years after 2009, asset manager margins swelled to unprecedented levels; but operating leverage works both ways, and many public RIAs are trading in bear market territory following last month’s correction.The recent downturn should serve as a wake-up call to an industry that hasn’t had much interference in its upward trajectory over the last several years.As valuations drop and revenues contract, more attention must be devoted to expense controls if margins are to be maintained in the short run.Moving forward, this may be a challenge for many industry participants facing higher regulatory costs, a growing complexity of financial products, and personnel expenses that have moved almost in lockstep with revenue since the credit crisis.All of these costs tend to be fairly sticky on the downside. Against a backdrop of increasing fee pressure and robo-advisory competition, this correction may have been long overdue for an industry that’s nearly doubled in size since the Great Recession. Though future market performance remains uncertain, it’s hard to imagine that RIA margin expansion will continue its ascent from the prior six years without another bull market tailwind. Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.

Valuation concerns mark Southern Capital Forum

Are VC trends the canary in the RIA coal mine?

Mercer Capital had a great time sponsoring the Southern Capital Forum on Lake Oconee last week. The annual gathering of the venture community is a favorite to check in with many of our clients and get a read on capital markets from some intentional listening. Beautiful weather and the bucolic surroundings of Reynolds Plantation helped, and on the second day of the conference, Janet Yellen kept her foot on the cost of capital. So what’s not to like? Despite the generally upbeat attitude of the sponsor community, and plenty of planned fund raisings, we heard one theme repeated over and over again that threatens the broader asset management world: stretched valuations.It was hard to miss that what used to be a Georgia-centric and then a southeastern conference has gained a national following. The Southern Capital Forum now attracts participants from New York, Chicago, and San Francisco. Why? Because the venture communities in New York, Boston, and Silicon Valley have pushed up valuations in those markets to the point that opportunities to invest profitably are few and far between. Funds are going to Phoenix, Ft. Lauderdale, and St. Louis to find opportunities that are not available in nearby incubators, which seem to be popping up everywhere. But the entrepreneur communities aren’t as established in secondary markets, so while the competition for deals is smaller, so is the number of deals. We heard several comments from the podium that gave us pause for the immediate future of alternative investing (and prospectively the investment community as a whole):"Angel investors are back, and no smarter than they were pre-2008." Tourists to growth equity investing, and special purpose vehicles have re-emerged. Investing by these groups is no more intelligent than it used to be, but it pushes up the competition for deals – which pushes down the cap rate, which depresses returns, which could end up depressing LPs.Mega-funds have gone down-market into traditional VC opportunities to try to generate alpha. "90% of VC returns are generated by 10% of the funds" and that seems to be going to the biggest players these days.LPs are "desperate" to get into growth capital funds."You make money when you buy – which is a lot harder these days.""Valuations are stretched and terms are loose." Participating preferreds are becoming less common in Silicon Valley and the other strongholds of VC investing.Capital raises have become a technology company's "defensive moat" to ensure a high enough spending pace to develop expensive products (or to develop products expensively) and buy market share. "We're pushing on the outer level of sustainable valuation and burn rates." In other words, we're past sustainable.The concept of "valuation agnostic" has emerged, with some sponsors suggesting they can use terms to protect against downside risk while creating a coupon."It's become difficult to impossible to build a firm on proprietary deals. Sellers are more sophisticated." There was lots of talk at the conference about "Unicorns" – a term for mega-cap venture companies which didn't even exist two years ago. Some suggest that Unicorns exist because some very successful high growth private companies don't want to deal with activist shareholders. Still, LPs need an exit, and the IPO market has been providing that (though at a more modest pace than 2014). However, venture investment rarely gets a full exit until a secondary or tertiary offering, if they don't have to dribble stock out over time. The upshot of this is a growing concern that there is an emerging venture capital overhang in the public equity markets, as funds seek exits for larger investments.

Valuing RIAs

Understanding the value of an investment management business requires some appreciation for what is simple and what is complex. On one level, a business with almost no balance sheet, a recurring revenue stream, and an expense base that mainly consists of personnel costs could not be more straightforward. At the same time, investment management firms exist in a narrow space between client allocations and the capital markets, and depend on revenue streams that rarely carry contractual obligations and valuable staff members who often are not subject to employment agreements. In essence, RIAs may be both highly profitable and prospectively ephemeral. Balancing the particular risks and opportunities of a given investment management firm is fundamental to developing a valuation.

Valuing RIAs

Unicorn Valuations

What’s Obvious Isn’t Real, and What’s Real Isn’t Obvious

In the two short years since Aileen Lee introduced the term "unicorn" into the VC parlance, the number of such companies has steadily increased from the 39 identified by Lee’s team at Cowboy Ventures to nearly 150 (and growing weekly) by most current estimates. Pundits and analysts have offered a variety of explanations for the phenomenon, with some identifying unicorns as the sign that the tech bubble of the late 1990s has returned under a different guise, others attributing the existence of such companies to structural changes in how innovation is funded in the economy, and the most intrepid of the group suggesting that the previously undreamt valuations are fully supported by the underlying fundamentals given the maturity and ubiquity of the internet, smart phones, tablets, and related technologies.We suspect there is merit to each of these perspectives. As valuation analysts, however, what sets our hearts atwitter is the very definition of "unicorn", which is predicated on valuation. Since companies are christened unicorns upon closing a financing round, one would assume valuation to be self-evident. Alas, that is generally far from the case. Because of the common features of VC investments, the "headline" valuation numbers are not reliable measures of the market value of the underlying enterprises. As a result, the frequent breathless comparisons of the value of startup X to publicly traded stalwart Y are often overblown and potentially misleading.Consider the following example. The capitalization of a hypothetical freshly-minted unicorn, BlueCo, is summarized in the following table: With 200 million fully-diluted shares post issuance, the $5.00 per share Series E offering results in a headline valuation of $1.0 billion (on a pre-money basis, BlueCo’s headline valuation is $825 million). But is BlueCo really worth $1 billion? In other words, what does the Series E investment imply about the value of the stakes in BlueCo held by other investors? The value of the whole is equal to the sum of the individual parts. So, for BlueCo to truly be worth $1 billion, all 200 million fully-diluted shares must be worth $5.00 each. But the various share classes are not created equal. At each subsequent funding stage, investors in startup companies negotiate terms to provide downside protection to their investment while preserving the upside potential if the subject company turns out to be a home run. Such provisions commonly include some or all of the following: Liquidation preferences that put the latest investors at the front of the line for exit proceeds. This is especially advantageous in the event the Company fails to meet expectations (basically LIFO treatment: the last one in is the first one out).Cumulative dividend rights that cause the liquidation preference to increase over time. When such rights are present, the preferred investors not only stand at the front of the line, but are entitled to a return on their investment if there are sufficient proceeds.Anti-dilution or ratchet provisions that allow preferred investors to hit the reset button on many of their economic rights in the event the company is forced to raise money in the future at a lower price.Participation rights that allow the preferred investors to simultaneously benefit from the payoff to common shares while also recovering their initial investment via liquidation preference.A recent New York Times article highlighted additional, more exotic rights and privileges being attached to recent financings. For the sake of illustration, we will assume that the terms of BlueCo’s Series E preferred shares are generally favorable to the other investors: pro rata liquidation preference to other preferred investors, non-cumulative dividends, and no participation rights. Despite these relatively benign terms, owning Class E shares is clearly preferable to owning more junior classes. Consider the waterfall of proceeds under various strategic sale exit scenarios: Even under the relatively disappointing $400 million exit scenario, the Scenario E shareholders are entitled to return of their investment, or $5.00 per share, while the proceeds to more subordinate classes range from $1.14 per share to $3.00 per share. The following chart depicts the superiority of the proceeds for Series E preferred shares to Series A shares over enterprise exit values less than $1.0 billion: The area between the payoff lines for Class E and Class A preferred shares represents the incremental value available to the more senior Class E shares. Borrowing from the fair value measurement lexicon, if the recent Series E issuance price of $5.00 per share is consonant with market participant expectations, then that same group of market participants would rationally assign a lower value to the Class A shares. Valuation analysts use two primary techniques for estimating the magnitude of the difference in share value across the various classes. Examining the relative merits of the two techniques (the probability-weighted expected return method, or PWERM, and the option pricing method, or OPM) is beyond the scope of this blog post. Both models are reasonably intuitive but require numerous assumptions for which irrefutable support can prove elusive. We use the OPM to illustrate the impact of the rights and preferences of the most senior preferred shareholders on the economic value of a nominal unicorn. The two most subjective assumptions in the OPM are the time remaining until exit and the return volatility of the underlying business. The sensitivity table below depicts the implied total enterprise value of BlueCo (that would reconcile to the $5.00 per Series E preferred share transaction price) using the OPM under a range of assumptions for exit timing, given assumed volatility of 100%: Over the range of exit timing assumptions noted above, the implied total enterprise value ranges from less than $600 million to just over $800 million, meaningful discounts to the $1 billion headline number. The reliability of the OPM and the assumed inputs can be debated; however the point remains that, since the subordinate classes are necessarily worth less than Series E, the total enterprise value is less than $1 billion. So what? Is the preceding analysis just so much valuation pedantry? Perhaps, but we suggest that these observations reflect one practical peril of high valuations for late stage investors and management teams. The implied enterprise value based on rights and preferences of senior investors is relevant precisely because buyers in the exit markets for start-up companies – strategic sales and IPOs – assess the value of the entire enterprise, not individual interests. The exit markets assign a value for the entire company, exhibiting a serene indifference to how that value is allocated to various investors. This can result in unflattering headlines and unpleasant outcomes for late stage investors. Let’s return to the BlueCo example to illustrate. Assume that the appropriate assumptions for BlueCo from the sensitivity table above are three years to exit, implying an enterprise value of $748 million. In the year following the Series E investment, BlueCo management executes its strategy successfully, causing the enterprise value to increase 30% to $975 million. If BlueCo exits via a strategic sale at that point, none of the incremental enterprise value will accrue to the Series E investors; despite identifying an attractive company, and the strong execution of management, the Series E investors will receive their capital back with no return. If the exit occurs instead by IPO, things get even more awkward. In contrast to a strategic sale, an IPO is a pro rata exit, meaning that the realized return for the Series E preferred investors will actually be negative, despite the 30% increase in enterprise value. Further, the Company and its management team will likely be subject to some unfavorable press for executing a "downround" IPO, although in reality, it generated a handsome return for the investor group as a whole. So when is a unicorn really a unicorn? We hesitate to draw a bright line; circumstances and assumptions vary. Regardless of size, the lesson for investors and management teams at early-stage companies is to beware the headline valuation number. Appearances can be deceiving.

Rules for the Modern Investment Manager

This guest post first appeared on Mercer Capital's Financial Reporting Blog on July 17, 2015. On May 20, 2015, the Securities and Exchange Commission proposed new rules and amendments to modernize and enhance information reported by investment companies and investment advisers. The proposed rules would be applicable to most investment companies registered under the Investment Company Act of 1940 and all investment advisers registered under the Investment Advisers Act of 1940. The SEC is the primary regulator of the asset management industry, and over the years, assets under management have grown, new product structures have been developed, and technology has evolved. The SEC staff estimated that there were approximately 16,619 funds registered with the SEC as of December 2014 as well as 11,500 investment advisers and 2,845 exempt reporting advisers as of January 2015. Assets of registered investment companies exceeded $18 trillion at year-end 2014, having grown from $4.7 trillion at year-end 1997. Per SEC 33-9776, the proposed rules aim to:Increase the transparency of fund portfolios and investment practices both to the Commission and to investors,Take advantage of technological advances both in terms of the manner in which information is reported to the Commission and how it is provided to investors and other potential users, andWhere appropriate, reduce duplicative and otherwise unnecessary reporting burdens in the industry. The proposed rules include two new forms (N-PORT and N-CEN), new rule 30e-3, and amendments to Regulation S-X that would rescind current Forms N-Q and N-SAR. Management investment companies currently are required to report their complete portfolio holdings to the SEC on a quarterly basis (on Form N-Q for 1Q and 3Q and Form N-CSR for 2Q and 4Q). The proposed Form N-PORT would replace Form N-Q, would require registered funds other than money market funds to provide portfolio-wide and position-level holdings data to be filed monthly with the SEC, and would be available to the public every third month, sixty days after the end of the month. Form N-PORT requires a structured format that will make it easier to analyze and requires additional data not currently provided on Forms N-Q or N-CSR such as information relating to derivative investments and certain risk metric calculations that measure a fund's exposure and sensitivity to market conditions. Rule 30e-3 provides funds the option to meet shareholder report transmission requirements by posting reports online, if certain conditions are met. The proposed amendments to the existing Regulation S-X require standardized enhanced derivatives disclosures in fund financial statements. Currently, Regulation S-X does not include standardized requirements as to the terms of derivatives that must be reported for most types of derivatives including swaps, futures, and forwards. The proposed amendments should allow for greater comparability between funds and help all investors better assess a fund's use of derivatives. Form N-CEN would replace the existing Form N-SAR, which was adopted thirty years ago, and continue to report census-type information similar to Form N-SAR. The new form will replace some of the outdated elements of Form N-SAR with ones that are more relevant today. In addition, Form N-CEN will be filed in XML format, which will reduce filing burdens and make it more user friendly for the SEC and other users. Finally, Form N-CEN would be filed annually, rather than semi-annually as is currently required by Form N-SAR The investment adviser proposals include amendments to the investment adviser registration and reporting form (Form ADV) and amendments to Investment Advisers Act Rule 204-2. The proposed amendments to Form ADV would require aggregate information about separately managed accounts, incorporate certain "umbrella registration" filing arrangements that are currently outlined in staff guidance, and provide additional business information about the adviser's offices, the number of employees, and the use of social media. The amendments to the Investment Advisers Act Rule 204-2 would require advisers to maintain records of the calculation of performance information distributed to any person, which is more stringent than the existing rule that applies to information distributed to ten or more persons. Furthermore, the amendments would require advisers to maintain communications related to performance or rate of return of accounts as well as securities recommendations. Mercer Capital provides investment managers, RIAs, trust companies, private equity firms, and other financial sponsors with corporate valuation, financial reporting valuation, transaction advisory, portfolio valuation, and related services. Contact a Mercer Capital professional to discuss your needs in confidence.Related LinksPortfolio Valuation: Private Equity Marks & Trends | Second Quarter 2015Portfolio Marks: 2Q15 OutlookAsset Management Industry NewsletterMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.

The Valuation of Asset Management Firms

To many people, asset management is the business model dreams are made of. A few skilled people in one office can make millions providing a sophisticated and straightforward service. Billing simply requires deducting fees from client accounts, and the upward drift of the markets propels revenue growth. Looked at from the inside-out, however, it is a fiercely competitive industry in which one is judged unforgivingly by the numbers, and depending entirely on relationships between owners, employees, and clients. Profit margins can be huge, but can evaporate in two quarters of a bear market.On one level, all RIAs (registered investment advisors) are alike, as there are significant similarities between development of fee income and the composition of the expense base to support the revenue that generates and sustains profitability. Nonetheless, recognizing the distinct characteristics of a given investment management firm is necessary to understanding its value in the marketplace.All Businesses SellLike all private companies, ownership interests in RIAs eventually transact. Whether voluntary or involuntary, these transactions tend to be among the most important of the owner’s business life.The table below depicts events ranging from voluntary transfers such as gifts to family members or an outright sale to a third party to involuntary transfers such as those precipitated by death or divorce. An understanding of the context of valuing your business is an important component in preparing for any of these eventualities.Industry Conditions & IssuesThe idea of independent investment advisors gathered steam as high net worth clients migrated from the transactional sales mentality of brokerage firms. The financial advisory business model transformed from large wire house shops, and cold calling staffs paid by transaction-based commissions, to credentialed professionals paid on the basis of assets under management, or AUM. The popularity of RIAs centered on the fiduciary responsibility associated with such practices, as well as the greater degree of accessibility and high touch nature of their business operations. Additionally, the smaller size of independent advisors allowed for greater innovation and more specialized services. The number of total investment advisors registered with the SEC has increased four-fold from approximately 6,000 in 1999 to over 30,000 today (excluding all investment advisors only required to register with their respective states). Parallel to the proliferation of RIAs is the rise of state-regulated independent trust banks in the wake of mega-bank mergers and bailouts following the financial crisis of 2008. While there has been some consolidation of firms, the rate of acquisition in the industry has been far outpaced by startup formation.In spite of all the changes taking place in recent years, there remains some debate regarding whether the asset management industry is mature or evolving. If anything, it is continuing to niche into more discrete asset classes, investment styles, and client focus.Rules of ThumbThere are both formal and informal approaches to value, and while we at Mercer Capital are obviously more attuned to the former, we don’t ignore the latter. Industry participants often consider the value of asset managers using broad-brush metrics referred to as “rules-of-thumb.” Such measures admittedly exist for a reason, but cannot begin to address the issues specific to a given enterprise.Understanding why such rules-of-thumb exist is a good way to avoid being blindly dependent on them. During periods of consolidation, buyers often believe that the customer base (or AUM in the case of an asset manager) of an acquisition candidate can be integrated with the acquiring firm’s existing client assets to generate additional profits. So if most asset managers are priced at, say, 10x earnings and profit margins are 40%, the resulting valuation multiple of revenue is 4.0x. If revenue is generated by average fees of 50 basis points of assets under management, then the implied valuation is about 2% of AUM. Note, however, all the “ifs” required to make the 2% of AUM rule of thumb work.As with other businesses, the revenue of asset management firms is a function of price and quantity. In this case, price represents the rate charged for assets under management, and quantity reflects the asset base or AUM for RIAs. Value, however, is related to profits, which can only be derived after realizing the costs associated with delivering asset management services. High priced services are typically more costly to deliver, so margins may fall within an expected range regardless of the nature of the particular firm. Still, larger asset managers generally realize better margins, so size tends to have a compounding effect on value.Activity ratios (valuation multiples of AUM, AUA, revenue, etc.) are ultimately the result of some conversion of that activity into profitability at some level of risk. If a particular asset manager doesn’t enjoy industry margins (whether because of pricing issues or costs of operations), value may be lower than the typical multiple of revenue or AUM. On a change of control basis, a buyer might expect to improve the acquired company’s margins to industry norms, and may or may not be willing to pay the seller for that opportunity.In the alternative case, some companies achieve sustainably higher than normal margins, which justify correspondingly higher valuations. However, the higher levels of profitability must be evaluated relative to the risk that these margins may not be sustainable. Whatever the particulars, our experience indicates that valuation is primarily a function of expected profitability and is only indirectly related to level of business activity. Rules- of-thumb, if used at all, should be employed with an appropriate level of discretion.As an example of this, industry participants might consider RIAs as being worth some percentage of assets under management. At one time, asset manager valuations were thought to gravitate toward about 2% of AUM. The example below demonstrates the problematic nature of this particular rule of thumb for two RIAs of similar size, but widely divergent fee structures and profit margins. Firm A charges a higher average fee and is significantly more profitable than Firm B despite having identical AUM balances. Because of these discrepancies, Firm A is able to generate over six times the profitability of its counterpart. Application of the 2% rule yields a $20 million valuation for both businesses, an effective EBITDA multiple of 8x for Firm A and 50x for Firm B. While 2% of AUM, or 8x EBITDA, may be a reasonable valuation for Firm A, it is in no way representative of a rational (or non-synergistic) market participant’s realistic appraisal of its counterpart; it would imply an effective EBITDA multiple of 50x. It is our experience that money managers with higher asset balances, fee structures, and profit margins typically attract higher AUM multiples in the marketplace. In the case of RIAs with performance fee components to their revenue stream, the math gets a bit more interesting. Background Concepts of "Value"The industry issues discussed above can and should impact the valuation of asset managers, but a professional valuation practitioner considers other issues as well.Many business owners are surprised to learn that there is not a single value for their business or a portion of their business. Numerous legal factors play important roles in defining value based upon the circumstances related to the transfer of equity ownership. While there are significant nuances to each of the following topics, our main goal is to help you combine the economics of valuation with the legal framework of a transfer (whether voluntary or involuntary).Valuation DateEvery valuation has an "as of date" which, simply put, is the date at which the analysis is focused. The date may be set by legal requirements related to a certain event, such as death or divorce, or may be implicit, such as the closing date of a transaction.PurposeThe purpose of the valuation is significant to how the valuation is performed. A valuation prepared for one purpose is not necessarily transferable to another. The purpose of the valuation is likely to determine the “standard of value.”Standard of ValueThe standard of value is a legal concept that influences the selection of valuation methods and the level of value. There are many standards of value, the most common being fair market value, which is typically used in tax matters. Other typical standards include investment value (purchase and sale transactions), statutory fair value (corporate reorganizations), and intrinsic value (public securities analysis). Using the proper standard of value is part of obtaining an accurate determination of value.Level of ValueWhen business owners think about the value of their business, the value considered commonly relates to the business in its entirety. From this perspective, the value of a single share is the value of the whole divided by the number of outstanding shares. In the world of valuation, however, this approach may not be appropriate if the aggregate block of stock does not have control of the enterprise; in some cases, the value of a single share will be less than the whole divided by the number of shares. The determination of whether the valuation should be on a controlling interest or minority interest basis can be a complex process, and it is also essential. A minority interest value often includes discounts for a lack of control and marketability; therefore, it is quite possible for a share of stock valued as a minority interest to be worth far less than a share valued as part of a control block. Grasping the basic knowledge related to these issues can help you understand the context from which the value of a business interest is developed. Typical Approaches to ValuationWithin the common valuation lexicon, there are three approaches to valuing a business: the asset approach, the income approach, and the market approach.The Asset ApproachThe various methodologies that fall under the umbrella of the asset approach involve some market valuation of a subject company’s assets net of its liabilities. In the case of an RIA, the primary “assets” of the business get on the elevator and go home every night. In some contexts, it may be useful to evaluate the worth of a company’s trade name, assembled workforce, customer list, or other intangible assets. The balance sheet can be significant regarding the presence of non-operating assets and liabilities or excessive levels of working capital, but the value of any professional services firm, including asset managers, is usually better expressed via the income and market approaches.The Income ApproachThe income approach usually follows one of two methodologies, a discounted cash flow method or a single period capitalization method. The discounted cash flow methodology (or DCF) requires projecting the expected profitability of a company over some term and then “pricing” that profitability using an expected rate of return, or discount rate. Single period capitalization models generally involve estimating an ongoing level of profitability which is then capitalized using an appropriate multiple based on the subject company’s risk profile and growth prospects. In either case, the income approach requires a thorough analysis of the risks and opportunities attendant. In the case of valuing asset managers, the income approach can be a useful arena to delineate issues unique to the industry and the particular company.Within the spectrum of asset managers, entities styled as family office operations may exhibit lower growth (which, all else equal, would suggest lower valuations), but also more stable client bases (with higher probability of recurring revenue, which tends to raise valuations). On the other end of the spectrum, valuing a hedge fund manager might require balancing the potential for supernormal earnings growth with supernormal earnings volatility.A wealth manager or independent trust company might fall somewhere in between these two extremes. These RIAs tend to enjoy a loyal (sticky) customer base, but often at the price of lower margins expected in a multi-discipline, high-touch business where client expectations for technical expertise and customer service compound staffing costs. There are similar opportunities for earnings leverage as with any asset manager, but these can be tempered by the nature of services that these asset managers provide.The Market ApproachOf the three approaches to value, the market approach may be the most compelling due to the high availability of pricing data. The market approach can be accomplished in a number of ways: by looking at the valuation multiples implied by outright sales of similar businesses, or by observing the trading activity in shares of publicly held companies.While the market approach may be the most useful way to value assets managers, it is often the most misused. It is possible to find transactions involving investment management companies or publicly traded trust banks and RIAs that are similar to a given RIA, but it is also important to understand and isolate what is different about the subject company that can affect value.Market data also has its drawbacks. Transactions data may offer limited information about multiples paid for various measures of profitability, and there may be no real way to isolate potential synergies reflected in the transaction pricing that might have been unique to the buyer and seller. Publicly traded investment management firms offer more thorough and consistent data, but they tend to be much larger and more diversified than closely-held RIAs.The potential differences in margin and product line have already been discussed in this article, but smaller asset management firms may have other limitations that are a product of scale. These issues include greater dependence on certain managers or clients, the loss of which could be difficult to replace without a detrimental impact on the financial returns of the business. Narrow product offerings or problems in the economic area served by the RIA could also constrain growth opportunities. Of course, it’s also possible that a subject enterprise might have a better than market opportunity because of a particular customer base served or a particular product offering.In any event, the valuation multiples implied by transaction activity or public asset managers may and often do require some adjustment for various factors before application to the subject RIA.Putting It All TogetherValuation analysis is not complete if it is left untested. In the valuation of RIAs, whatever methodologies are employed should ultimately reconcile to a conclusion of value that is reasonable given expectations for the company relative to industry pricing. This might ultimately fit within some kind of rule of thumb, but only by coincidence. Experience has taught us that in the asset management industry, as elsewhere, maximizing opportunity and minimizing risk usually enhances value.

Put In An Order for More AAPL – But First, Let Me Take a Selfie!

Recently, Russia took on the awesome task of trying to deter rampant narcissism by opening a 24/7 helpline to support anyone thinking they might be addicted to photographing themselves – a selfie hotline – if you will. Russia’s Interior Ministry went to social media to educate its citizens on the dangers of taking selfies, which include falling down stairs, being attacked by wild animals, and being hit by trains. Selfie addiction, according to the Politburo, is very real and very dangerous. Asset managers should take heed, and consider dialing in. Of all the concentration risks that an RIA faces, dependence on key staff ranks at or near the top. Unless you’ve taken the CFA Institute’s indoctrination (advice) and you just run an index fund (in which case, why are you competing with Vanguard?), your business is tied, sometimes to an extreme degree, to the persons who work with you, and maybe you yourself. Talent is everywhere, yes, but clients who choose to invest with a given firm frequently do so, directly or indirectly, based on their confidence in the individual(s) who will be servicing their account and making their investments. The primary assets of an RIA “get on the elevator and go home at night,” and in our country (not sure about Russia), a firm can’t have title to individuals. Even with a non-compete. That said, sometimes good people can be too good. A sector asset manager investing in small cap equities for large institutional clients might be able to run $5 billion with twelve or fifteen people, of whom maybe five are actually involved in the investment research and portfolio management process. A comparable wealth management firm would require 100 employees or more to manage as much wealth. The fee schedules of the two shops might be similar, generating similar revenue streams. But margins are likely to be very different. A sector asset manager as we’ve described could generate twice the EBITDA margin off of the same revenue as the wealth management firm. High margins aren’t everything, though; which one would you rather own? One paradox of value in an RIA is that the driver of growth in a firm, usually an individual, can also be its undoing (e.g. everyone’s favorite selfie-manager, Bill Gross). The small cap manager described above is at risk every time one of its portfolio managers crosses the street in traffic. High margins don’t always portend high valuations, because high margins can be hard to sustain. And, although it takes a strong personality to build an investment firm, that doesn’t mean it has to become an all-expenses-paid ego trip. Consider the asset outflows around the time of Bill Gross’s departure from PIMCO. [caption id="attachment_9013" align="aligncenter" width="500"] Source: Business Insider[/caption] Looking at the chart above, you would think PIMCO was insane to let Gross leave. Janus was clearly trying to reverse asset flow trends when it agreed to take in Gross despite his controversial personality. [caption id="attachment_9014" align="aligncenter" width="500"] Monthly Asset Flows at Janus Capital Since 2009[/caption] And, of course, asset flows do have impact on value. PIMCO’s parent, Allianz, has pretty well underperformed Janus since Gross left. [caption id="attachment_9015" align="aligncenter" width="500"] Source: SNL Financial[/caption] It isn’t so much that Allianz has performed poorly, as that Gross woke things up a bit at Janus. That trend has shown remarkable endurance so far, but the message is clear that key staff and value are interactive in RIAs. This simple fact has so many implications for asset managers that they’re hard to list, but here are a few. Compensation per capita at RIAs can be astronomical. The cure to this is typically to grow AUM faster than staff compensation. Indeed, the more successful a team is, the more assets they attract. This should (and often does) lead to operating leverage, but successful team members can command more compensation. Margins don’t grow forever.RIA transactions are frequently structured with as much as 25% to 50% of total consideration being paid in the form of an earn-out. This may cover some of the risk of client and product transition, but mostly it means that buyers and sellers share in that risk.Many capital providers who invest in RIAs don’t even try to cash out key employees, taking partial positions in the firms so that managers remain invested and economically tied to the firm.The profession is facing something of a physical cliff, as RIAs that began within a decade or so of the start of ERISA (1974) struggle to transition ownership from aging founders to the next generation. This is complicated by many things, most notably high valuations. It’s easy to quip that RIAs are worth so much no one can afford to buy them, but that’s a topic for another day. Ideally, an RIA grows beyond the reputation and attributes of an individual or group of individuals and becomes a brand, such that clients come as much or more for the institution than the people. Easier said than done. But sustainability of the revenue stream over time has a big influence on value. Of course, maybe the investing world will be taken over by index funds and robo-advisors. Until then, though, FINRA should consider installing a selfie hotline.

Death Week (for Active Management?)

Mercer Capital's asset management valuation practice is run from our main office in Memphis, Tennessee, and this time of year here means one thing: Death Week. Every year since his death on August 16, 1977, the city of Memphis spends a week memorializing Elvis Presley, the King of Rock and Roll. If you have never been, Death Week is basically seven to ten days of activities in which the Presley faithful arrive from every continent to pay their respects and enjoy what has to be some of the hottest, most humid weather anywhere on the globe.From all the press lately, you would expect that a similar wake was being held for active management, and with it, much of the RIA community. Elvis is dead, and so too must be active management. We live in the age of auto-tune and robo-advisors, a time when big vocal chords and beating the market have become anachronisms – or are they?Academics have been testifying as to the shortcomings of active management for decades, and by the time I was studying for the CFA exams (back in the '90s, as a colleague is quick to remind me), what was then known as AIMR (a midlife identity crisis between its founding as ICFA and what is now known as CFAI) had joined in to "educate" us on the relative virtue of passive investing. Today, ETFs and indexing are common, and in the wealth management community, have done much to streamline asset allocation. For asset management, though, the rise of indexing is the number one threat to the lifeblood of the RIA community: fees.The RIA business model is, after all, pretty simple; AUM times fee schedule equals revenue, revenue minus labor costs and other more mundane expenses equals margin, and sustainability of margin drives value. If active management fees are threatened, it will ultimately threaten to disinflate valuations in the asset management community.There is cause for concern. A study performed by the Investment Company Institute (or "ICI") and Lipper showed average mutual fund expenses and fees declining 30% (!) over the past fifteen years, from about 99bps to 70bps in equity funds (read the study at www.icifactbook.org). Bond funds fared only slightly better, dropping 25% from an average 76bps to 57bps over the same period. The trend-line is basically unbroken with not inconsequential declines over the past three to five years. The decline in fees has been stealthy, as active managers haven't been cutting fees so much as missing out on new assets to manage. During this same timeframe, AUM in equity index funds has increased almost six fold, from $384 billion in 2000 to $2.1 trillion last year. Actively managed funds have reduced fees somewhat: with expense ratios dropping from 106 basis points in 2000 to 86 last year. Some of this can be attributed to the growth in size (and the corresponding efficiencies) created by larger actively managed equity funds, but the competitive threat from equity index funds (with average fees of 11 basis points), has to have kept more than one young manager contemplating a buy-in to his or her RIA up at night. Anecdotally, our valuation practice at Mercer Capital seems to serve an RIA community that is unaffected by all of this. We routinely ask clients if they are facing fee pressure and/or are contemplating revising fee schedules downward, and we are routinely told "no." Institutional clients are reasonably savvy about negotiating fees, but they always have been. High net worth clients just "want to win", and are willing to pay for the opportunity to do so. Who's to say they're wrong? Many commentators have written that active management is more challenging today than ever precisely because of the professionalization of the investment management industry (when everyone is skilled and educated, no one has an advantage). But passive investing could ultimately generate its own demise, as the rise of robo-group-think in the market constrains liquidity in many securities, and creates the kinds of price inefficiencies that favor active management. Passive investing may eventually just be a "style" that falls out of favor. As the old saying goes in economics, in the long run we'll all be dead (or at least retired), so this is no time to be sanguine about fee schedules. Investors of all stripes have more options to put their money to work, investment costs are becoming more transparent than ever, and switching is becoming easier. As clients become more sophisticated, the RIA community will become more so as well, defending fees with unique strategies and service offerings, and defending margins with better use of technology and managed staffing costs. But that's a topic or two for another post.

Does Size Matter for RIAs?

Smaller asset managers outperformed their larger brethren over the last year. Still, it’s important to remember that our smallest sector of asset managers (AUM under $10 billion) is the least diversified and therefore most susceptible to company-specific events. Its strength is more attributable to DHIL’s (~80% of the market-weighted index) outsized gain in market value rather than any indication of investor preference towards smaller RIAs. For closely held RIAs, size appears to be more prevalent at least at a certain asset level. Managers with less than $100 million in AUM typically lack the profitability of a billion dollar plus RIA though exact breakeven points tend to vary with location and fee structure. The inherent operating leverage of the asset management business allows margins to expand with AUM as the incremental expenses associated with rising fees can be relatively minimal. Higher AUM balances can also serve as a cushion against future losses from client attrition and may lead to higher valuations though pricing also comes down to growth prospects, which can be more of a challenge for the larger managers. Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry

Simmons First National Acquisition of Ozark Trust and Investment

On April 29th, 2015, Simmons First National Corporation (NASDAQ ticker: SFNC), announced it has entered into an asset-purchase agreement to acquire Ozark Trust and Investment Corporation (OTIC) and its wholly owned subsidiary, the Trust Company of the Ozarks (TCO), a Registered Investment Advisor (RIA) headquartered in Springfield, Missouri. The Trust Company of the Ozarks administers over $1 billion in client assets for over 1,300 clients with a 16% AUM compound annual growth rate. Simmons First National Corporation has agreed to a purchase price of $20.7 million, with a consideration of 75% stock and 25% cash. The deal is to close in quarter 3 of 2015. Unlike most acquisitions of closely held RIAs, the terms of the deal were disclosed via a conference call and investor presentation; the details of which are outlined below. Similar to the Boston Private/Banyan Partners deal late last year, management delineated how the Trust Company of the Ozarks’ attributes met Simmons First’s strategic rationale: Cultural Fit. Simmons understands the importance of cultural fit with any acquisition. Through the due diligence process, Simmons found TCO’s culture to be very compatible to that of its own. TCO is conservatively managed, yet has achieved impressive AUM growth since 2007.Strong Relationship Between TCO and Liberty Bank. Gary Metzger, Chairman & CEO of the former Liberty Bank, served on the TCO board of directors since its inception in 1998. Moreover, Jay Burchfield, TCO Chairman, served as an Advisory Director of Liberty Bancshares, Inc. The respective staffs of TCO and the former Liberty Bank have a strong, long-standing relationship.Market Expansion. Simmons has identified TCO as a high priority acquisition opportunity following the acquisition of Liberty Bank. Simmons believes the acquisition of TCO will provide the needed trust and investment management scale for its increased footprint in Southwest Missouri. TCO is the only independent trust company in Missouri outside of St. Louis or Kansas City. With total AUM of approximately $1 billion, TCO will increase total AUM of Simmons First Trust Company by almost 25%."Sticky" Clients and Assets. TCO has made customer service a focus of its business, which has created a loyal client base. Generally speaking, trust services and AUM do not transfer easily. Moreover, it is hard to replicate TCO’s client service trust and investment management model. TCO’s team has established long-term relationships with all of TCO’s key customers.Strong Experienced Team. TCO’s team has over 200 years of combined experience. TCO’s Senior Management has excellent community relationships. The team has consistently matched or outperformed industry benchmarks. TCO’s team has expressed optimism in being able to grow the business further and take advantage of Simmons’ platform.Reputable Branch Name. TCO is among the region’s most reputable trust companies and is well-known throughout Southwest Missouri. These recent deals are particularly instructive to other industry participants since, of the nearly 11,000 RIAs nationwide, approximately 80 (<1%) transact in a given year, and the terms of these deals are rarely disclosed to the public. Part of this phenomenon is attributable to sheer economics – a new white paper from third-party money manager, CLS Investments, argues that many advisors lose out financially in an outright sale of the business. Another recent publication titled “Advisors: Don’t Sell Your Practice!” in research magazine ThinkAdvisor notes that many principals earn more in salary and bonuses than they would from the consideration they would otherwise receive in an earn-out payment over a period of time, as many of these deals are structured. In other words, returns on labor exceed potential returns on capital for many advisors, particularly for smaller asset managers that typically transact at lower multiples of earnings or cash flow. In these instances, an internal transaction with junior partners might make more sense for purposes of business continuity and maximizing proceeds. For larger RIAs, recent deals suggest that buyers are willing to pay a little more for the size and stability of an advisor with several billion under management.

Portfolio Valuation: How to Value Venture Capital Portfolio Investments

The following outlines our process when providing periodic fair value marks for venture capital fund investments in pre-public companies.Examine the most recent financing round economicsThe transaction underlying the initiation of an investment position can provide three critical pieces of information from a valuation perspective:Size of the aggregate investment and per share price.Rights and protections accorded to the newest round of securities.Usually, but not always, an indication of the underlying enterprise value from the investor’s perspective. Deal terms commonly reported in the press (example) focus on the size of the aggregate investment and per share price. The term "valuation" is usually a headline-shorthand for implied post-money value that assumes all equity securities in the company’s capital structure have identical rights and protections. While elegant, this approach glosses over the fact that for pre-public companies, securities with differing rights and protections should and do command different prices. The option pricing method (OPM) is an alternative that explicitly models the rights of each equity class and makes generalized assumptions about the future trajectory of the company to deduce values for the various securities. Valuation specialists can also use the probability-weighted expected return method (PWERM) to evaluate potential proceeds from, and the likelihood of, several exit scenarios for a company. Total proceeds from each scenario would then be allocated to the various classes of equity based on their relative rights. The use of PWERM is particularly viable if there is sufficient visibility into the future exit prospects for the company. The economics of the most recent financing round helps calibrate inputs used in both the OPM and PWERM.Under the OPM, a backsolve procedure provides indications of total equity and enterprise value based on the pricing and terms the most recent financing round. The indicated enterprise value and a set of future cash flow projections, taken together, imply a rate of return (discount rate) that may be reasonable for the company. Multiples implied by the indicated enterprise value, juxtaposed with information from publicly traded companies or related transactions, can yield valuation-useful inferences.Under the PWERM, in addition to informing discount rates and providing comparisons with market multiples, the most recent financing round can inform the relative likelihood of the various exit scenarios. When available, indications of enterprise value from the investor’s perspectives can further inform the inputs used in the various valuation methods. In addition to the quantitative inputs enumerated above, discussions and documentation around the recent financing round can provide critical qualitative information, as well.Adjust valuation inputs to measurement dateBetween a funding round and subsequent measurement dates, the performance of the company and changes in market conditions can provide context for any adjustments that may be warranted for the valuation inputs. Deterioration in actual financial projections may warrant revisiting the set of projected cash flows, while improvements in market multiples for similar companies may suggest better pricing may be available for the company at exit. Interest from potential acquirers (or withdrawal of prior interest) and general IPO trends can inform inputs related to the relative likelihood of the various exit scenarios.Measure fair valueMeasuring fair value of the subject security entails using the OPM and PWERM, as appropriate and viable, in conjunction with valuation inputs that are relevant at the measurement date. ASC 820 defines fair value as, "The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date."Reconciliation and tests of reasonablenessA sanity check to scrutinize fair value outputs is an important element of the measurement process. Specifically as it relates to venture capital investments in pre-public companies, such a check would reconcile a fair value indication at the current measurement date with a mark from the prior period in light of both changes in the subject company, and changes in market conditions.Mercer Capital assists a range of alternative investment funds, including venture capital firms, in periodically measuring the fair value of portfolio assets for financial reporting purposes to the satisfaction of the general partners and fund auditors. Call us – we would like to work with you to define appropriate fund valuation policies and procedures, and provide independent opinions of value.

Why Banks Are Interested in RIAs

As noted in Mercer Capital’s presentation to the 2014 Acquire or Be Acquired conference sponsored by Bank Director entitled Acquisitions of Non-Depositories by Banks, the relatively high margins associated with asset management is one of the many reasons that banks and other finance companies have been so interested in RIAs over the last few years.[caption id="attachment_8888" align="aligncenter" width="500"] Source: SNL Financial[/caption] Other often-cited rationales for bank acquisitions of asset managers include: Exposure to fee income that is uncorrelated to interest ratesMinimal capital requirements to grow AUMHigher margins and ROEs relative to traditional banking activitiesGreater degree of operating leverage – gains in profitability with management feesLargely recurring revenue with monthly or quarterly billing cyclesPotential for cross-selling opportunities with bank’s existing trust customers Although deal terms are rarely disclosed, the table below depicts some recent examples of this trend with pricing metrics where available. While multiples for activity metrics (AUM and revenue) can be erratic and tend to vary with profitability, EBITDA multiples are often observed in the 10x-15x range for public RIAs with their private counterparts typically priced at a modest discount depending on risk considerations, such as customer concentrations and personnel dependencies. Powered by a fairly steady market tailwind over the last few years, many asset managers and trust companies have more than doubled in value since the financial crisis and may finally be posturing towards some kind of exit opportunity to take advantage of this growth. Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry

Third Quarter 2015

Value Focus: Energy

As the 4th quarter begins, uncertainty is rife within the Exploration and Production (E&P) industry.

Recent Trends in the Fair Value of Community Bank Loan Portfolios

Although successful bank acquisitions largely hinge on deal execution and realizing expense synergies, properly assessing and pricing credit represents a primary deal risk. Additionally, the acquirer’s pro forma capital ratios are always important, but even more so in a heightened regulatory environment and merger approval process. Against this backdrop, merger-related accounting issues for bank acquirers have become increasingly important in recent years and the most significant fair value mark typically relates to the determination of the fair value of the loan portfolio.Fair value is guided by ASC 820 and defines value as the price received/paid by market participants in orderly transactions. It is a process that involves a number of assumptions about market conditions, loan portfolio segment cash flows inclusive of assumptions related to expected credit losses, appropriate discount rates, and the like. To properly evaluate a target’s loan portfolio, the portfolio should be evaluated on its own merits, but markets do provide perspective on where the cycle is and how this compares to historical levels.We reviewed fair values of recently announced community bank deals to determine if any trends emerged. As detailed in Figure 1, the fair value mark (i.e., the discount based on the estimated fair value compared to the reported gross loan balance) in recent deals appears to increase as the level of problem assets increases. However, the range remains quite wide and rarely hits the trendline, which could partially reflect the unique nature of isolated community bank loan portfolios. Overall, the median fair value mark observed was 3.30% while the median level of adjusted non-performing loans (as a percentage of loans) was 2.22%.Sources: Mercer Capital research, company SEC filings, company investor presentations The recent fair value marks were generally below those reported in deals during (2008-2010) and immediately after the financial crisis (2010-2012). This trend reflects a number of factors including:Stable to improving macro-economic trends. While contracting during the financial crisis, real GDP growth was relatively stable in 2013 and 2014 at approximately 2.20%. Real disposable income also increased 1.70% in 2014 after remaining relatively flat in 2013. Additionally, employment considerations have continued to improve in recent periods with the unemployment rate down to 5.7% in January of 2015 compared to 7.9% and 6.6% in January of 2013 and 2014, respectively.Higher real estate collateral values. While the 20-city S&P/Case-Shiller Home Price Index remains about 15% below its peak in mid-2006, it has increased about 25% since year-end 2011. Additionally, economic data from the Federal Reserve of St. Louis indicated that commercial real estate prices have been increasing year-over-year since year-end 2010 and were up 7.3% over the 12 months ended September 30, 2014.Reduced levels of noncurrent loans. As detailed in Figure 2, credit migration continued to be positive and levels have declined to almost pre-financial crisis levels (third quarter 2014 levels approximated early 2008 levels). Source: FDIC Reduced Credit Spreads. Credit spreads provide perspective on a number of factors, including where the credit cycle has been and where it is headed, as well as potential portfolio issues at a target when there are no apparent issues. While credit spreads did increase in mid-2014, they have generally declined since the financial crisis as economic conditions as well as investor sentiment have improved. For example, BB credit spreads have declined from 5.0% in January of 2012 to 3.5% in January of 2015. All else equal, reduced credit spreads serve to lower the discount rate applied to the expected cash flows for a target’s loan portfolio, thereby increasing the fair value of the loan portfolio. Mercer Capital has provided a number of valuations for potential acquirers to assist with ascertaining the fair value of acquired loan portfolio. In addition to loan portfolio valuation services, we also provide acquirers with valuations of other financial assets and liabilities acquired in a bank transaction, including depositor intangible assets, time deposits, and trust preferred securities. Feel free to give us a call or email to discuss any valuation issues in confidence as you plan for a potential acquisition. Reprinted from Bank Watch February 2015.

First Quarter 2015 Energy Industry

Sector Focus: Exploration & Production

Sector Focus: Exploration & Production: In 2015, oil and gas exploration & production activities in the US are expected to generate $320.0 billion in revenue.

Fourth Quarter 2014 Energy Industry

Sector Focus: Oilfield Services & Equipment

Sector Focus: Oilfield Services & Equipment: In 2014, the oilfield services & equipment industry is expected to generate $133.6 billion in revenues in the United States.

Waiting on Margin Relief

Although it is difficult to discern with the ten-year U.S. Treasury presently yielding about 2.4% compared to 3.0% at the beginning of the year, many market participants believe the Federal Reserve will begin to raise the Fed Funds target rate next year. The thought process is not illogical. How high short-term rates may rise is unknown. (A corollary question for others is what, if anything, will the Fed do with its enlarged balance sheet as shown in Table 1.) Pimco’s Bill Gross has opined that the “new neutral” target rate will be around 2% rather than a historical policy bias of 4%. For lenders, money market funds and trust/processing companies, a hike in short rates cannot occur soon enough.

WHITEPAPER | Valuing Urgent Care Centers

This whitepaper is structured to provide further details outlining the factors contributing to the proliferation of the urgent care services industry, the key players and their activities, and considerations for current and prospective owners of these facilities related to the valuation of urgent care centers. This whitepaper is part of Mercer Capital’s expertise in providing valuation and transaction advisory services to a diversity of businesses and for a wide range of purposes, including those operating in the healthcare service sector, such as urgent care centers and similar businesses.

Third Quarter 2014 Energy Industry

Sector Focus: Alternative Energy

In 2013, energy from renewable sources represented just under 10% of U.S. energy consumption.

First Quarter 2014 Energy Industry

Sector Focus: Exploration & Production

In 2013, the oilfield services & equipment industry generated an estimated $131.7 billion in revenues in the United States.

Community Bank Stress Testing: A Hypothetical Example

The following provides an illustrative example of the primary steps to construct a “top-down” portfolio-level stress test.

Fourth Quarter 2013 Energy Industry

Sector Focus: Oilfield Services & Equipment

In 2013, the oilfield services & equipment industry generated an estimated $131.7 billion in revenues in the United States.

Community Bank Stress Testing

For a hypothetical example to accompany this article, please see "Community Bank Stress Testing: A Hypothetical Example."While community banks may be insulated from certain more onerous stress testing and capital expectations placed upon larger financial institutions, recent regulatory guidance suggests that community banks should be developing and implementing some form of stress testing and/or scenario analyses. The OCC’s supervisory guidance in October 2012 stated “community banks, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial conditions.”1 Further, the OCC’s guidance considers “some form of stress testing or sensitivity analysis of loan portfolios on at least an annual basis to be a key part of sound risk management for community banks.”2 A stress test can be defined as “the evaluation of a bank’s financial position under a severe but plausible scenario to assist in decision making with the bank.”3The hallmark of community banking has historically been the diversity across institutions and the guidance from the OCC suggests that community banks should keep this in mind when adopting appropriate stress testing methods by taking into account each bank’s attributes, including the unique business strategy, size, products, sophistication, and overall risk profile. While not prescriptive in regards to the particular stress testing methods, the guidance suggests a wide range of effective methods depending on the Bank’s complexity and portfolio risk. However, the guidance does note that stress testing can be applied at various levels of the organization including:Transaction Level Stress Testing: This method is a “bottom up” analysis that looks at key loan relationships individually, assesses the potential impact of adverse economic conditions on those borrowers, and estimates loan losses for each loan.Portfolio Level Stress Testing: This method involves the determination of the potential financial impact on earnings and capital following the identification of key portfolio concentration issues and assessment of the impact of adverse events or economic conditions on credit quality. This method can be applied either “bottom up,” by assessing the results of individual transaction level stress tests and then aggregating the results, or “top down,” by estimating stress loss rates under different adverse scenarios on pools of loans with common characteristics.Enterprise-Wide Level Stress Testing: This method attempts to take risk management out of the silo and consider the enterprise-wide impact of a stress scenario by analyzing “multiple types of risk and their interrelated effects on the overall financial impact.”4 The risks might include credit risk, counter-party credit risk, interest rate risk, and liquidity risk. In its simplest form, enterprise-wide stress testing can entail aggregating the transaction and/or portfolio level stress testing results to consider related impacts across the firm from the stressed scenario previously considered.Further, stress tests can be applied in “reverse” whereby a specific adverse outcome is assumed that is sufficient to breach the bank’s capital ratios (often referred to as a “break the bank” scenario). Management then considers what types of events could lead to such outcomes. Once identified, management can then consider how likely those conditions are and what contingency plans or additional steps should be made to mitigate this risk.Regardless of the stress testing method, determining the appropriate stress event to consider is an important element of the process. Little guidance was provided although the OCC’s guidance did note that the scenarios should include a base case and a more adverse scenario based on macro and local economic data. Examples of adverse economic scenarios that might be considered include a severe recession, downturn in the local economy, loss of a major client, or economic weakness across a particular industry for which the bank has a concentration issue.The simplest method described in the OCC guidance as a starting point for stress testing was the “top-down” portfolio level stress test. The “Hypothetical Stress Testing Example” that follows provides an illustrative example of a portfolio level stress test based largely on the guidance and the example provided from the OCC.What Should We Do with the Stress Test Results?The answer to this question will likely depend on the bank’s specific situation. For example, let’s assume that your bank is relatively strong in terms of capital, asset quality, and recent earnings performance and has taken a proactive approach to stress testing. A well-reasoned and documented stress test could serve to provide regulators, directors, and management with the knowledge to consider the bank’s capital levels more than adequate and develop and approve the deployment of that excess capital through a shareholder buyback plan, elevated dividend, capital raise, merger, or strategic acquisition. Alternatively, let’s consider the situation of a distressed bank, which is in a relatively weaker position and facing heightened regulatory scrutiny in the form of elevated capital requirements. In this case, the stress test may be more reactive as regulators and directors are requesting a more robust stress test be performed. In this case, the results may provide key insight that leads to developing an action plan around filling the capital shortfall (if one is determined) or demonstrating to regulators and directors that the distressed bank’s existing capital is adequate. The results of the stress test should enhance the bank’s decision-making process and be incorporated into other areas of the bank’s management of risk, asset/liability strategies, capital and strategic planning.How Mercer Capital Can HelpHaving successfully completed thousands of community bank engagements over the last 30 years, Mercer Capital has the experience to solve complex financial issues impacting community banks. Mercer Capital can help scale and improve your bank’s stress testing by assisting your bank in a variety of ways, ranging from providing advice and support for assumptions within your Bank’s pre-existing stress test to developing a unique, custom stress test that incorporates your bank’s desired level of complexity and adequately captures the unique risks facing your bank. Regardless of the approach, the desired outcome is a stress test that can be utilized by managers, directors, and regulators to monitor capital adequacy, manage risk, enhance the bank’s performance, and improve strategic decisions. Feel free to call Mercer Capital to discuss your bank’s unique situation in confidence.Endnotes1OCC 2012-33 “Supervisory Guidance” on Community Bank Stress Testing dated October 18, 2012 and accessed at www.occ.gov/news-issuances/bulletins/2012/bulletin-2012-33.html. 2Ibid. 3“Stress Testing for Community Banks” presentation by Robert C. Aaron, Arnold & Porter LLP, November 11, 2011. 4OCC 2012-33 “Supervisory Guidance” on Community Bank Stress Testing dated October 18, 2012 and accessed at www.occ.gov/news-issuances/bulletins/2012/bulletin-2012-33.html.

WHITEPAPER | Understand the Value of Your Trucking Company

There are many reasons why a trucking company can be worth more or less than a standard rule of thumb might imply, and many reasons why a particular interest in a trucking company can be worth more or less than the pro rata value implied by that rule of thumb.This whitepaper provides useful information as to how trucking companies are valued and what impact that might have on their owners.The whitepaper breaks down basic concepts that must be defined in every valuation and goes into depth about three commonly accepted approaches to value. Financial and market considerations are discussed as are the differences between public and private companies as well as public and private trucking companies.

The Ins and Outs of Business Development Companies

With more than 35 public registrants reporting nearly $40 billion of assets under management, business development companies, or BDCs, are increasingly important financial intermediaries, matching a wide variety of businesses needing capital with yield-hungry investors eager to provide it.Compared to private equity funds, BDCs have historically garnered less media and investor awareness, although the persistent low yield environment has helped to raise the profile of BDCs. Like private equity funds, BDCs invest in a portfolio of generally illiquid securities of privately held companies. Unlike private equity funds, which are structured as finite-lived investment partnerships, BDCs are publicly traded vehicles accessible to retail investors, providing permanent capital for investment. As long as certain distribution requirements are met, BDCs are not subject to income tax. Like any other publicly traded company, a BDC must file quarterly and annual reports with the SEC. These reports provide a window into the trends and economic factors influencing the broader universe of investors providing debt and equity capital to middle market companies.The purpose of this whitepaper is to review the principal financial statement components of BDCs with a view to clarifying the factors that are most likely to influence financial performance.

WHITEPAPER | Community Bank Mergers: Creating the Potential for Shared Upside

In this 2013 whitepaper we review financial issues arising when community banks merge or sell to a larger, public institution. It is not intended to answer every question and, in some instances, our intention is to raise questions for directors and managers to evaluate. In a series of follow-up papers and webinars we will address specific topics that merit further scrutiny.

WHITEPAPER | Understand the Value of Your Agricultural Equipment and Machinery Dealership

The purpose of this whitepaper is to provide an informative overview regarding the valuation of agricultural equipment and machinery dealerships. A lack of knowledge regarding the value of your business could be very costly. Opportunities for successful liquidity events may be missed or estate planning could be incorrectly implemented based on misunderstandings about value. In addition, understanding how equipment and machinery dealerships are valued may help you understand how to grow the value of your business and maximize your return when it comes time to sell.

WHITEPAPER | Understand the Value of Your Insurance Brokerage

Many business owners tend to rely on industry rules of thumb when estimating what their company is worth. Aren’t insurance agencies worth 2.0x revenue? Or is it 7x EBITDA? A platform agency must be at least 10x EBITDA, right? A lack of knowledge regarding the value of your business could be costly, leading to missed opportunities or inadequate wealth planning.On a practical level, understanding how insurance agencies and brokerages are actually valued may help you understand how to increase the value of your business and maximize your return when it comes time to sell or perpetuate your agency.The purpose of this whitepaper is to provide an informative overview regarding the valuation of insurance brokerages and agencies.

Fairness Opinions

A fairness opinion provides an independent objective analysis of the financial aspects of a proposed transaction from the point of view of one or more of the parties to the transaction.They are often used to protect the interests of company directors, stockholders, investors and involved parties with any kind of fiduciary responsibility. While fairness opinions can not only help avoid disagreements among the individual stakeholders or between stakeholders and the Board, a fairness opinion is often necessary for a Board to have fulfilled their fiduciary duties.Mercer Capital leverages its historical valuation and investment banking experience to help clients navigate a critical transaction, providing timely, accurate and reliable results. We have significant experience advising boards of directors, management, trustees, and other fiduciaries of middle-market public and private companies in a wide range of industries. Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction, and we are well-versed in the new industry standards regarding fairness opinions issued by FINRA in late 2007.A variety of factors in transactions involving both public and private companies can trigger the necessity for a fairness opinion, including:Merger or sale of the companySale of subsidiary businesses, or distinct lines of businessRecapitalizationsStock repurchase programsSqueeze-out transactionsSpinoffs, spinouts, or split-upsCertain ESOP-related transactionsOther significant corporate events When performing a fairness opinion, it is also important to take into account any number of alternatives that may exist to the proposed transaction. As a valuation services firm, Mercer Capital is particularly well-equipped to provide the analysis for a deal in which a consideration other than cash if offered – namely, when the consideration is an interest in a closely held company. Mercer Capital's comprehensive valuation and transaction experience with public and private capital companies empowers us to efficiently provide unbiased fairness opinions that can rely on to assure stakeholders that the decisions being made are fair and reasonable. Contact a Mercer Capital professional to discuss your needs in confidence.

Out of the File Cabinet: The Ideal Time to Review Your Buy-Sell Agreement

Almost every privately owned company with multiple shareholders has a buy-sell agreement (or other agreement that acts as a buy-sell agreement).If your business is like most companies, then you have one too. You likely had an attorney draft the document for you several years ago. You and your fellow shareholders might have had some discussions about the specifics of the buy-sell language at the time, but these discussions were likely minimal. You then signed the document, put it in a file cabinet in the office and have not looked at it or thought much about it since.True? Well, this might be an extreme example, but it highlights an important issue – most business owners do not have a current understanding of the details and potential pitfalls that lurk within their own buy-sell agreements. Most view these agreements as obligatory legal documents that can be forgotten about until needed. Unfortunately, when a buy-sell agreement is needed it is too late to fix any problems within the agreement.For the past several years, Chris Mercer, the CEO of Mercer Capital, has used the image of a ticking time-bomb as a metaphor of what might be awaiting some business owners within their buy-sell agreements. Would you ignore an actual bomb that was ticking away in your file cabinet? Of course not, and you should not ignore your buy-sell agreement either.The Ideal Time to Review Your Buy-Sell AgreementThe time for a comprehensive review of your buy-sell agreement is not this year or this month – it is right now. You have finished the first quarter of the year. Make it a priority now to get your buy-sell agreement out of that file cabinet and review it with your partners and appropriate professional advisors.Things to Look for When Reviewing Your Buy-Sell AgreementAs you review your buy-sell agreement, it is important to understand what the document is and what it is intended to accomplish.Buy-sell agreements are legal documents, but they are also business and valuation documents. These agreements govern how ownership will change hands if and when something significant, often called a trigger event, happens to one or more of the shareholders. Buy-sell agreements are intended to ensure the remaining owners control the outcome during critical transitions. They do this by specifying what happens to the ownership interest of a fellow owner who dies or otherwise departs the business, and mandating that a departing owner be paid, hopefully reasonably, for his or her interest in the business.Some buy-sell agreements call for fixed pricing or value the shares based on a set formula, while others lay out a specific appraisal process to develop the value of the subject interest.Fixed Price Agreements Are Typically Never UpdatedFixed price agreements are simple to start. The actual dollar price of the stock is set out in the buy-sell agreement and is intended to be updated on some regular basis based on agreement amongst the shareholders.The problem with these agreements is that they are almost never updated. When it comes time that an update must be done, such as at a trigger event, the interests of the parties may have diverged and agreement could be difficult, if not impossible.Formula Agreements Often Outgrow Their FormulaFormula agreements attempt to remove uncertainty by establishing a set calculation through which value will be determined at the appropriate date. The primary disadvantage of formula agreements is that no single formula can capture all of the complexities of change and provide reasonable and realistic conclusions over time. If your buy-sell agreement has a formula mechanism, when was the last time the formula was calculated?Valuation Process Agreements Are Often the Most WorkableBuy-sell agreements that lay out a specific valuation process as the means of valuing the shares at the appropriate date (“process agreements”) are typically preferable and tend to provide the most efficient means of achieving a fair resolution for all parties.There are different varieties of process agreements. Multiple appraiser agreements outline processes by which two or more appraisers are employed to determine value. Generally, each party will hire their own appraiser and, if needed, will jointly hire a third appraiser to either select the appropriate value from the first two appraisers or deliver their own binding conclusion of value. Single appraiser buy-sell agreements outline processes by which a single appraiser is employed to determine the price.We suggest a Single Appraiser - Select Now, Value Now process. For more information on this valuation process, see this article.Six Things That Should Be Clear in Any Valuation Process AgreementRegardless of whether a valuation process involves multiple appraisers or a single appraiser, there are six defining elements that must be in a buy-sell agreement in order for the valuation process to work smoothly and reasonably. If you have a valuation process as part of your buy-sell agreement, make certain that each of these six elements are present.While the six defining elements of a valuation process may seem obvious, they are prominent in their absence or unclear treatment in many buy-sell agreements.Standard of value. The standard of value is the identification of the type of value to be used in a specific valuation engagement. The proper identification of the standard of value is the cornerstone of every valuation. Will value be based on “fair market value” or “fair value” or some other standard? The parties to the agreement should select that standard of value. If they do not, the appraisers will have to select it and the parties may not like their choices.Level of value. Will the value be based on a pro rata share of the value of the business or will it be based on the value of a particular interest in the business? This distinction is critical to any appraisal process and to the shareholders of any business who are parties to its buy-sell agreement. If knowledgeable choices are not made by the parties to the agreement, someone else, i.e., the appraiser(s), will make it for them. The problem is that many agreements are written such that they are subject to differing interpretations regarding the appropriate level of value.The “as of” date. Every appraisal is grounded at a point in time. That time, referred to as the “as of date” or “valuation date”, provides the perspective, whether current or historical, from which appraisals are prepared. Unfortunately, some buy-sell agreements are not clear about the valuation date which should be used by appraisers. Because value changes over time, it is essential that the “as of” date be specified.Qualifications of the appraiser(s). If the parties do not decide on the kind of appraiser(s) they want to help for their buy-sell agreements, then, unfortunately, almost anyone can be named by either party to the agreement. Do you want a college professor who has never done an appraisal as the appraiser? How about an accountant who has no business valuation training? How about a broker who has no business valuation experience unrelated to transactions? How about a shareholder’s brother who has an MBA but has never valued a business before? The picture is clear. Buy-sell agreements must specify the qualifications of appraisers who may be called when trigger events happen.Appraisal standards to be followed. It is in the interest of all parties to ensure that selected appraiser(s) follow accepted business valuation standards. Some buy-sell agreements do this by naming the specific business appraisal standards that must be followed by the selected appraiser(s). Business appraisal standards provide minimum standards (criteria) to be followed by business appraisers in conducting and reporting their appraisals.Funding mechanisms. The funding mechanism is thought of separately from valuation yet is an important aspect of any buy-sell agreement. Why? Because life insurance is often purchased on the lives of one or more owners of companies having buy-sell agreements. Does the agreement tell the appraisers how the parties want the proceeds to be treated in their valuations? Appraisers will develop potentially widely divergent valuation conclusions depending on whether the life insurance is a funding vehicle (and not considered in reaching a value conclusion) or a corporate asset (and added to value prior to determining price for the agreement).A Tool to Help in Reviewing Your Buy-Sell AgreementBuy-sell agreements are important legal documents. They are also important business and valuation documents. How they operate when triggered can have huge consequences for business owners, their family, and the business. Unresolved problems within a buy-sell agreement truly are like ticking time-bombs.Do not wait for the countdown to run out, review your buy-sell agreement now with your partners and professional advisor(s). It will be far easier to get agreement on revisions made today than it will be after a trigger event.

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Senior Professionals

Timothy K. Bronza

Karolina Calhoun

Matthew R. Crow

Jeff K. Davis

Lisa L. Doble

Bryce Erickson

Donald Erickson

Andrew K. Gibbs

Brooks K. Hamner

Travis W. Harms

Nicholas J. Heinz

Thomas C. Insalaco

Owen T. Johnson

Timothy R. Lee

Z. Christopher Mercer

Lucas M. Parris

Barbara Walters Price

Sujan Rajbhandary

J. David Smith

Jay D. Wilson, Jr.

Insights

What a Cold Snap Teaches Us About Cycles in RIA M&A

Bank Watch: January 2026

RIA M&A Update: Q4 2025

The Role of the Third Appraiser

Defying the Cycle: Haynesville Production Strength in a Shifting Gas Market

The State of Wealth Management Entering 2026

December 2025 SAAR

Haynesville Shale M&A Update: 2025 in Review

RIA Market Update: Q4 2025

Bank Watch: December 2025

Medtech and Device Industry Newsletter - Q4 2025

PODCAST | Beyond the Lot: Understanding Dealership Valuations